Rational Exuberance - The Equitile Blog

18th March 2021

Posted by: George Cooper

Making a Virtue Out of a Necessity


Yesterday’s FOMC statement is important (March 17th 2021).

There are three points worthy of note:

1: “the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time”

This is a commitment to the ‘make up strategy’ whereby the Fed seeks to achieve higher future inflation to make up for previously having failed to achieve its desired 2% inflation target. From the FOMC’s perspective, this narrative provides the flexibility keep interest rates extremely low even if it becomes manifestly clear it is failing to maintain inflation at or below its 2% target. This is, as explained by the following passage, now the FOMC’s goal:  

2: The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.

The FOMC’s goal is first to achieve a negative real interest rate of at least 2% and then to maintain that negative interest rate for ‘some time’. In other words, the FOMC would like to see the spending power of money, saved in the government bond markets, falling by at least 2% per year for the foreseeable future. In order to achieve this the committee is making an open-ended and asymmetric commitment to balance sheet expansion, arguably a euphemism for debt monetization:

3: Federal Reserve will continue to increase its holdings of Treasury securities by at least $80 billion per month and of agency mortgage backed securities by at least $40 billion per month until substantial further progress has been made toward the Committee's maximum employment and price stability goals.

In our view, FOMC is being both honest and pragmatic, effectively admitting the cost of the economic lockdown policies of 2020 and 2021 can only be funded through the printing press. As a result, we believe we are already in the early stages of an uptrend in inflation which will likely last several decades.

We expect the inflation trend to be maintained and accelerated through monetary and fiscal policy coordination; governments will continue spending far beyond their means and central banks will continue ‘footing the bill’ with monetization and negative real interest rates. If so, the global government bond markets will cease to be a viable long-term savings vehicle for the private sector.    


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18th February 2021

Posted by: Andrew McNally

US Retail sales in lockdown - who'd have thought?

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8th February 2021

Posted by: George Cooper

Must we really talk about negative interest rates?

Silvana Tenreyro, one of the external members of the Bank of England’s Monetary Policy Committee gave an important speech on January 11th titled Let’s talk about negative rates.

The content of the speech itself it not especially ground-breaking. As the title suggests it is a discussion of the pros and cons of the Bank of England pushing short term interest rates into negative territory. Nevertheless a few passages are noteworthy.

First there is a reminder that the Bank of England is already doing the work to ensure negative interest rates can be implemented in the British banking system:   

“the Bank of England began structured engagement with firms on operational considerations regarding the feasibility of negative interest rates…Once the Bank is satisfied that negative rates are feasible, then the MPC would face a separate decision over whether they are the optimal tool to use to meet the inflation target given circumstances at the time.”

Then there is a longer section explaining how successful negative interest rates have been in other countries:  

“the ‘financial-market channels’ of monetary policy transmission have worked effectively under negative rates in other countries …the evidence from experiences of negative rates in other countries suggests that ‘bank-lending channels’ of monetary policy transmission have also been effective at boosting lending and activity”

· Financial-market channels appear to be unimpeded under negative rates, and some may even be stronger than usual.

  • · While pass-through to household deposit rates can be constrained near zero, pass-through appears to be less constrained for corporate deposit rates, which may stimulate spending by firms.
  • · There is strong evidence of transmission into looser bank lending conditions, even if this is somewhat constrained relative to ‘normal’.
  • · There is no clear evidence that negative rates have reduced bank profits overall, and a number of studies find positive impacts, once you take into account the boost to the economy.
  • · Taking these points together, the evidence suggests that negative rates can provide significant stimulus.”

We are not persuaded of the benefits of negative interest rates.

We remain concerned over the negative impact negative rates have on the banking sector. As Silvana Tenreyro notes negative interest rates were implemented in the Eurozone in 2014, since then the index of European bank stocks has fallen by approximately 45% in value. Over the same period a similar index of US bank stocks has risen by approximately 50%.

We are also unpersuaded negative rates help stimulate the real economy. Economists argue lower rates drive asset prices higher, boosting borrowing and thereby economic activity. We find this argument persuasive but only up to a point. In our view it is important to recognise much savings are effectively non-discretionary. The savings people put aside for the purpose of house purchases and to fund their retirement are driven by necessity rather than choice. To the extent lower interest rates boost the price of assets and lower the income from those assets the policy means people must divert more of their income toward savings and away from consumption, causing a drag on economic activity.  

A simple thought experiment on the topic of negative interest rates is worth pondering:

Case A: You wake up one morning to find the bank has made a terrible error, paying you 100% interest. The money in your bank account has doubled overnight.

Case B: You wake up one morning to find the bank has made a terrible error, charging you 100% interest. The money in your bank account has vanished overnight.

In which of these two scenarios do you increase your spending? To economists focussing on capital market effects negative interest rates look like a stimulus. To savers, worried about banks withdrawing money from their accounts, negative interest rates look like the opposite of a stimulus.  

The discussion of negative interest rates in the speech is entirely concerned with the effect on the private sector economy. In our view this misses the true purpose of negative interest rates which is largely to augment government finances.

The main beneficiary of negative interest rates are governments which can issue bonds with negative yields and get paid, by their central bank, with newly printed money, for doing so. In other words, negative interest rates could be viewed as a thinly veiled mechanism of enabling monetised deficit spending. Given the extraordinary level of government spending, caused by the economic lockdown, the pressure on the Bank of England to facilitate monetised deficit spending has grown dramatically in the last year.  

In summary, we view recent comments by Bank of England officials as preparing the groundwork for negative interest rates. Investors and savers should take note and consider their own response. Although we disagree with the Bank’s sanguine assessment of the impact of negative interest rates on the real economy and banking sector, we agree such a policy is likely to cause further asset price inflation.  

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2nd July 2020

Posted by: Andrew McNally

All Pent-Up

It doesn’t look like the permitted re-opening of retail stores in the UK has marked a rush back to the shops. One might have expected people to be cautious in the first week or so but even in week two the footfall in England and Northern Ireland was still down 53.1% on the same week the year before (Springboard). It’s hard to say how quickly confidence builds from here, especially in light of an impending sharp rise in unemployment once the government’s furlough scheme comes to an end. One thing is clear though - there’s no shortage of cash right now.

The Bank of England published data last week showing the sharp increase in retail bank deposits.  There’s a startling build up of saving as those with an income spent more than 100 days, with the exception of Amazon and grocery stores, with no where to spend.

Wherever you look, there’s been a significant improvement in consumers’ balance sheet in aggregate. In fact, taking both consumer and companies together, saving has been significantly higher than borrowing for some weeks.

It can’t go on forever of course, Keynes’ so-called Paradox of Thrift can soon take hold. For now though, those left with an income have plenty of financial capacity to fulfil their pent-up demand.

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2nd December 2019

Posted by: Carsten Wilhelmsen

Breakfast at Tiffany's

A visit to Tiffany’s would, to most of us, prove an expensive affair but the breakfast Antonio Belloni, Group Managing Director at LVMH, had with Tiffany’s CEO early in October will be the most lucrative one he’ll have this year. The European luxury conglomerate will overtake Switzerland’s Richemont as the leading player in high-end jewellery after it completes a EUR 14.6 billion takeover of Tiffany in 2020 – building on its position as global leader when it comes to fashion & leather goods, fine spirits and luxury boutique hotels.

The deal becomes most interesting, however, when one looks at the funding of it.

LVMH will acquire Tiffany by issuing corporate bonds at ultra-low rates. With their current 2024 bond yielding minus 12bps, the opportunity for the company to lock in long-term funding costs of close to zero is clear. Even bonds issued by LVMH with a 10 or 15 year maturities will yield next to nothing. Despite the low yield, they won’t struggle to find demand however - the company issued a EUR 300 million tranche with a negative yield in March this year and the deal was six times oversubscribed.

Even if longer-term funding costs were, say, 50bps - realistic in a world where USD 10 trillion of debt has negative yields and the combined entity will still only have net debt/EBITDA of 1.6x – LVMH will pay EUR 73 million annually to bondholders in return for Tiffany’s annual estimated operational cash flow of EUR 500-600 million.

In effect, the bondholders who are paying for Tiffany are bound to lose money, in real terms, while the shareholders of LVMH will extract a net annual cashflow EUR 430-530 million. And that’s before the growth - there are already material plans to expand in China and Japan, markets where LVMH has proven success (Tiffany has remained largely an American brand).

LVMH’s customers, of course, are the sort of people who own shares in LVMH. As central banks keep interest rates close to zero, assets like Tiffany can be bought at virtually no cost to the acquirer’s shareholders who, in turn, have more to spend on expensive handbags and jewellery. 

It’s a textbook case of how wealth polarization works in practice in the current monetary environment. As an investor, in this case at least, it’s a chance to be on the right side of it.


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