Churchouse Letter
October 2014          by Peter Churchouse

Questioning Conventional Wisdom

I learned one thing in university, amid all the chat and trips to the pub. It’s that you should always question “conventional wisdom.”

We have thousands of little home truths and clichés that guide us through life.

“Numbers never lie.”

“If it ain't broke don't fix it.”

“We all learn from our mistakes.”

If I had followed all those little truisms, I would be broke. In fact my sailboat and I would probably both be at the bottom of the ocean.

There’s a bit of conventional wisdom floating around the financial world. And we shouldn’t take it on board, either.

It’s this: higher interest rates are going to hurt stocks, bonds and property prices. That’s the way it’s always been. And that’s the way it’s going to be again.

Interest rates are most certainly going to rise, and prices might fall down the line. But I will explain to you why, in the next one to two years, you should not expect rising interest rates to precipitate a collapse in asset prices.

Also, despite being perhaps the worst month we've seen in a while, especially in the emerging markets space, a few of our recommendations have held up admirably. We take a short review of our positions.

Enjoy the issue,

Peter


Why rising interest rates will not cause a collapse in equity markets or real estate prices

As an eager undergraduate of the University of Waikato in Hamilton, New Zealand back in the “good old days,” I particularly enjoyed my sociology classes. A young British lecturer was new in town and he, like all young people new in town, wanted to shake things up.

He was a bright young chap. He graduated from Cambridge University in England and had migrated to New Zealand to take up a post at our brand new little university. I happened to be among the second-ever intake of students. When I started, the total student roll was about 500.

We studied many of the big names of the sociology world: Emile Durkheim, Margaret Mead, Talcott Parsons, and Karl Marx. Our Cambridge man was bright, provocative, sardonic, and had a compelling way with words. He wasn’t just there to teach – he wanted to teach us how to think. We sometimes adjourned late-afternoon lectures to the pub, where the issues of the day would be debated over a jug of beer.

I particularly liked that last bit.

Now, a few things still stay with me after those hazy days of study and chat. I really took to Max Weber and his book “The Protestant Ethic and the Spirit of Capitalism.” It has turned out to be a long-standing favourite of mine. And I also remember a particularly important phrase that I picked up around the same time:

"All generalisations are dangerous, even this one..."

  - Alexandre Dumas

My abiding memory of that young enthusiastic lecturer, still fresh with the idealism of Cambridge, was a very simple exhortation – you’ve got to question everything, particularly conventional wisdom. This is a simple observation, but to a fresh undergraduate fresh out of high school, this was a new thought. We were students, and we were young at the time.

One of the things we’d been told was that “travel broadens the mind”.

“Not necessarily,” was his response. He pointed out that travel often just confirms the prejudices that the traveler had in the first place. And, you know, how true is that? How many times have you seen someone come back from their overseas trips repeating what they said about their destination before they left? I know I’ve heard it happen many times over the years.

That little lesson and that particular example have stayed with me ever since.

Don't fall in love with the way things have always been.

We all tend to accept “conventional wisdom” in its many forms. We figure that’s the way it’s always been done in politics, health care, relationships, economics, finance, investment and business.

I’m not saying we throw away everything we’ve ever learned. But there are hundreds of truisms that litter our thinking, well-worn clichés that we no longer question. In researching this piece I came across one list of 1,000 of these little so-called self-evident truths in life. I recognized all of them.

Here are some examples of those clichés, ones we will all recognize.

“He who hesitates is lost.” Well, hesitation when it comes to investments can often save you from making costly mistakes.

“If it ain’t broke don’t fix it.” That mantra was adopted by the world’s central banks before the GFC, and look where that got us. If I had adopted that attitude in running my sailing boat, it would have sunk by now, taking crew and guests with it.

“Never put off until tomorrow what you can do today.” Fine, but it might be cheaper tomorrow.

“Numbers don’t lie.” This is total rubbish! They can lie like a cheap watch. Numbers can be selective, manipulated and made to show just about anything a good number-cruncher wants.

“The early bird catches the worm.” Often the first mover withers, and it is the Johnny-come-lately that flourishes.

“We all learn from our mistakes.” Yeah, right! (Apparently this doesn’t apply to central banks).

“You can’t make a silk purse out of a sow’s ear.” Well, we have a very successful business doing just that in real-estate investment.

“Neither a borrower nor a lender be.” Try to imagine where the world would be if that maxim were adopted. Try to buy a house or start a business in a world where this was adhered to.

“Time is the great healer.” If businesses relied only on time to fix their problems, bankruptcy would be the inevitable result.

The list goes on and on.

Conventional Thinking In The World of Finance

Why is this important, you may be thinking?

Because there’s a particular piece of conventional wisdom from the world of finance that is causing great fear for investors right now.

But there is not as much cause for worry as conventional wisdom suggests.

I’m talking about interest rates. This subject has been on investors’ minds more than any other over the past five years.

The babble in the financial media is never-ending. My friends and associates ask for my thoughts on this topic more than anything else. That’s all the more true since our Hong Kong monetary system moves in lock-step with the United States.

And it’s a fair question! Look at Figure 1 below. This is the effective federal funds rate going back over 60 years. It’s a well-worn chart. But it reminds us just how extraordinary and extreme the last six years have been in the grander scheme of normal interest rates.

The conventional wisdom says that the inevitable rise in interest rates we are soon going to face will send asset markets into a deep spiral. Stocks, bonds, real estate, commodities.

Soon after the U.S. central bank, the Federal Reserve, began its massive money printing in 2009, markets started to anguish about the hyperinflation that strategy was about to unleash on the world. And of course that would mean massive hikes in interest rates.

Markets took fright, and it took them about a year or so to realise that hyperinflation was not a realistic prospect in the short term, or even in the medium term. A repeat of the hyperinflation of Germany's Weimar Republic was not remotely on the cards. So a massive surge in interest rates wasn’t going to happen after all. The hysteria quietly disappeared.

Then we had the “taper tantrum” of mid-2013. Inter-est rates suddenly topped the worry list again after the Fed proclaimed that it would begin “tapering,” or scaling down, its monthly asset purchases at some point. That triggered a sharp sell-off in equity and bond markets. We saw the 10-year Treasury yield spike from around 2 percent to 3 percent. The S&P 500 saw a short, sharp five percent correction. But markets quickly regained their composure.

Figure 1. Federal Funds Effective Rate 1954-2014

The Fed has gone ahead with its tapering plans – and U.S. equity and bond markets have surged to new highs.

Interest rate increases are inevitable and getting closer but that has not stopped equities and bonds from setting records. Many major real estate markets around the world are also hitting new highs. The point here is that rising interest rates are not new news. We all know higher rates are coming.

But the conventional wisdom still says that rising interest rates spell dire declines for a wide range of assets. That concern peppers just about every analysis of the financial markets.

The Logic Makes Intuitive Sense …



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