Where Did my Rate Cuts Go
Alkimia? - CAT
Alkimia Capital ESP
Alkimia Capital FRA
The behaviour of interest rates in 2024 is a paradigmatic example of how financial markets can pivot their outlook 180o in a short period of time. In a few weeks, we have gone from expecting interest rate cuts to practically ruling them out for this year. This scenario does not come as a surprise to us: for some time, we have warned how the dynamics of fiscal irresponsibility by states and ease in financial conditions make it very challenging to keep inflation under control. In principle, nothing has changed: the restrictive monetary policy of central banks is being neutralized by states that have become accustomed to operating with large fiscal deficits. Or perhaps it has? The sharp rise in gold and bond interest rates could, in our opinion, signal a loss of confidence in fiat currencies and the system's ability to function via indefinite borrowing. Is this the beginning of a market asset adjustment, or simply volatility? Only time will tell, but we believe that current dynamics are leading us towards the former scenario.
Real Assets vs Financial Assets (1960-2024)
In this context, April has been a challenging month for both fixed income and equities. The aggregate bond index has fallen by -1.75%, with cumulative losses reaching -2.11%. It has also not been a positive month for stocks, with the MSCI World declining by -2.7%, despite the ongoing positive corporate earnings season due to strong figures reported by companies. However, inflationary and geopolitical pressures have weighed more heavily, contributing to the strong performance of commodities, notably oil and gold. This latter factor has generally benefited Alkimia's portfolios, with a significant exposure to this asset class.
Returns of Major Markets: 31/03/24-30/04/24
Gradually, markets are beginning to accept that interest rates could be structurally higher in the coming years. This leads us to reflect on the resilience of certain economic agents in this new environment. The past two decades have transformed the financial system, especially since the great crisis of 2008. In recent years, regulators have been vigilant in preventing excessive leveraging of the balance sheets of systemic banks, those too big to fail without threatening the stability of the financial system. Consequently, today the discipline in the credit standards of these banking entities is much higher than in the past. However, it would be misleading to assert that systemic risk has been reduced thanks to the good condition of the major banks. Thus, debt has been transformed and relocated within other circuits of the financial system, generating a less visible leveraging than two decades ago.
Today, leverage is primarily located in non-bank financial entities, often referred to as the "shadow banking" sector. The following chart illustrates how over the past two decades, non-bank financial agents have taken on a predominant role in the expansion of credit markets, nearly quadrupling their volume to nearly $40 trillion.
Credit Volume in Non-Bank Financial Institutions ($Tn)
The growing importance of asset management companies in the debt of the system escapes the usual control mechanisms of financial regulators. The strong growth of private debt is a direct consequence of the increased capital requirements on major banks. Today, asset managers are gradually gaining ground that was previously occupied by banks. However, these new entities are exposed to the same credit cycle dynamics as banks, and over time it will be inevitable for them to repeat the same mistakes. For the first time, central banks will have multiple doors to knock on when facing the next debt crisis, uncharted territory that makes us very cautious when taking risks within our portfolios.
Cost of Private Debt vs Alternatives
Another entity that will miss interest rate cuts are governments. They increasingly need to issue higher volumes of bonds to meet their refinancing needs. Here, we emphasize an idea presented in previous letters: the growing competition between public and private entities to capture available resources can generate tensions in the financial system, gradually creating a force that drives bond yields higher. This is known as the crowding-out effect, where states directly compete with companies and other economic agents. At a time when central banks are reducing their balance sheets and withdrawing liquidity from the system (Quantitative Tightening), governments continue to absorb resources. What will central banks do if they need to curb inflation? Will they halt QT and lose monetary discipline, or will they remain firm despite the rising interest rates? The resolution of this conflict will have significant consequences for assets, especially if, as we suspect, monetary discipline is eventually lost. In that case, only real assets will effectively protect portfolios. From this perspective, a significant portion of our investments at Alkimia is directed towards these types of assets.
Evolution of United States Debt Issuance (2000-2023)
As a final reflection, we believe it's more necessary than ever to be discerning about the prices we pay for assets in our portfolios. The force of higher interest rates works to eliminate the complacency in valuations of the past decade. We acknowledge that we don't know if this process will be gradual or abrupt. Nevertheless, we believe that the accumulation of imbalances in the financial system compels us to consider portfolios built to withstand future challenging market scenarios. So far, investors have experienced a sweet market period, but it's precisely in these moments that we must remember that before thinking about winning, we must first avoid losing.