ANDREW LAPTHORNE: Fearful of saying this, but this time is different. I know it's deadly to say that, but if you look at bull markets over time, they're driven by economic prosperity.
Even in the 1990s, which had a big tech boom, globally, it was driven by profits. Yes, the NASDAQ was through the roof and the YASDAQ was through the roof but primarily, it was a profit driven story. What we've seen globally over the last five or six years is a market solely driven by valuation change.
If you look at the average return on assets of a US company, it is no different to the average return on assets of a Japanese company, or a European company. The only difference is leverage. You have created this mirage and that has helped because most companies in the US trade are on a multiple of what they do in Europe and Japan.
ROGER HIRST: Andrew Lapthorne is head of quant strategies at SocGen who are a bank who have been doing quant strategies within derivatives and macro for a very long time. His career goes back pretty much quarter of a century. He's had the benefits of working very closely with Albert Edwards for much of that time so he's got a very great and unique perspective from the macro side to add into the quant side. He has a very, very rounded view of global markets, was also looking at them from very much the detail and the quantitative side.
What's going to be interesting here is he's been looking at this big move in the bond markets, looking at the reasons behind it, which we're going to discuss. He's also been looking at how these moves have created distortions within the equity space between things like value stocks, and so-called defensives and why defensives may not be as defensive as the market currently thinks. He's also been looking at the high yield universe, particularly in the US, and the risks that are inherent there and how volatility is a very important element in studying the risks of that sector.
I'm very interested to hear what Andrew has to say. I think he's going to have a lot of interesting perspectives on this whole connectivity between the central banks, the drive that they've created in yield, the expectations for growth, and how this world of investing, this everything bubbled has created these pockets of extreme value and extreme access, and what the risks are to those areas.
Andrew Lapthorne, welcome to Real Vision. I think this is the second time you've been on our channel but it's been quite a long time since we last saw you. Could you just give us a little bit about yourself-- because you've been running the quantitative strategies and research at SocGen but you've had a near 25-year career in the city, maybe could you just give us a little bit of background so our viewers can understand where you come from and what you've been doing. Then we'll have our discussion about what's going on in bond markets and related equities.
ANDREW LAPTHORNE: Yeah, good to be back. I started I guess in the mid-1990s. I actually started my job photocopying, some probably the least qualified quant in the market, spent 13 years at Dresdner, joined SocGen two days before the quant crash in 2007. My own example of market timing, I guess. I've been there ever since, running a very talented quant team, which covers equities, cross-asset, the whole gamut of things which we could analyze really.
ROGER HIRST: Certainly, with an extensive background, you've been obviously in this business for a while, what do you make of this move in the bond markets where we've seen bunds hit minus 75%, we?ve seen this collapse in yields, collapse in and flattening of yield curves. What is your take on the driving forces behind this move that we've seen, I guess, really over the last six months, but it's been something that's been ongoing in a way for the last 10 years?
ANDREW LAPTHORNE: Well, I've been sitting next to a guy called Albert Edwards for last, well, 25 years, who has this view on the ice age but eventually, yields would go to zero. Even in 2002, 2003, we had something called Plan B, which was this notion that central banks would run out of interest rates. As ever, we were a bit early with the course.
The direction of yields in itself is not unusual. I'm going to ever low yields every single cycle. I think the recent moves, the one, particularly in July, which were radical changes in yields over quite short period, I think was largely down to properly technical factors. I think one of the things that I think it's really changed over the last 20 years is a move from asset returns seeking to really just finding a place to store your cash. As yields when lower or negative, there was a desperate rush to find anything with a positive yield in the fixed income market where you could store your cash.
In part, that could be just simply natural, you're fearful of a recession, and therefore you're fearful of losses. There's also a lot of regulation which is in place now where that solvency to whether that's a big build up in asset matching type strategies, which is forever seeking fixed income. I think there's obviously the recessionary part of it, but there's also been quite a lot of structural changes over the last 20 years.
ROGER HIRST: Have you seen that, within that, there's been fear that cash in banks is not safe anymore. Therefore, sovereign bond markets have become an alternative to keeping money, a so-called safe in banks, but that's not the case in this new paradigm and particularly Europe.
ANDREW LAPTHORNE: Again, regulation and what we've seen in regulation has made a lot of cash not safe in banks. You have bail-ins, you saw that in Cyprus. If you're going to lose money by having your cash in the bank, then you're going to take your cash out the bank and find a safe instrument. You might stick it in bonds instead. Also, large cash deposits, very large cash deposits are not considered the same as small cash deposits in the bank. If you own 10 pounds, you could put it in a bank, but if you own 100 billion pounds, you can't. You are forced to buy safe government assets at the time when other people non-say market agents are also trying to buy those bonds.
ROGER HIRST: Does that mean that for instance, the absolute level of yields and potentially the flattening of the yield curve are maybe in excess of the underlying macroeconomic factors, i.e. these point to an extreme recessionary scenario. Are you potentially saying that actually, yes, the recession is involved and that we fear of recession, but also that there's a snowballing momentum behind these other factors that really drove things much further than the actual underlying economic growth numbers should dictate?
ANDREW LAPTHORNE: On the quant, I tend to read some fairly boring stuff about regulation. If you read any article in the press about yields collapsing, every single one of those articles talk about people seeking alternative fixed income instruments, whether that's Argentinean bonds or it's high yield debt. None of them talk about buying equity, because in many ways, they're constrained. I find it slightly bizarre that you could pay almost anything for a long duration bond, but that same money is completely unwilling to buy, say, a cheap value stock.
Again, part of I suppose the Ice Age view was that when people experience losses over long periods of time, they become so fearful of those losses. That what drives there, I suppose, investment outlook is not losing money rather than seeking returns. If you look at asset values, they're now pretty much aligned. Cheap assets are things like emerging market, equity, financial stocks, and the most expensive thing is cash.
In part, that's because we've had certainly a couple of vicious cycles, which we didn't have before and in part, it's because if you've only got a very low interest rate, if you could make nothing from owning cash in the bank, and you lose 10% of your money, how do you make it back? 20 years ago, if you lost 10% of your money, you could just stick it in the bank and earn 5% interest. In collapsing yields, you're collapsing the ability to make money and at the same time, you're collapsing risk appetite.
There's also some technical factors there. The rolldown of the bond yield curve was the way to make money. You buy your 10-Year, you hold it till it becomes a 9-Year, because you've got a curve, the steep curve, you'd make some money just by then selling it and buying the 10-Year. That roll down was an important feature of fixed income markets. That's now almost commoditized. You could argue there's lots of systematic strategies out there, which are doing that automatically.
That makes it difficult for traditional bond investors like say, Bill Gross, and he stated that one of his problems was actually you've got lots of quant participants doing that. It also affects, it flattens the curve. Maybe the curve is exaggerated in some way because of these technical forces and these regulatory forces, which we didn't see maybe 20 or 30 years ago.
ROGER HIRST: Do you think that maybe some of this has come about because in 2008, the system was well and truly broken and in some ways, it's remarkable how quickly financial assets recovered from that, because obviously, there's this ongoing regime of QE and central bank intervention. Do you think that the central banks and their intervention have led to this ever dwindling yield, or do you think that the system is broken, we have no growth and therefore central banks had to do this, or do you think it's a combination of both, i.e. is it declining future growth expectations overall forcing central banks to do more QE, or central banks doing more QE, which is actually destroying future growth?
ANDREW LAPTHORNE: It's a big question, I think we'd probably need several recessions. We both know that we have to save more for our retirement, because we're not making any return from just leaving it in the bank. You could argue that we spend less because we have to save more. There's a big discussion around that.
Most of what central banks have done over the last few years is just get people to take on more debt. That naturally makes the market more fragile, because for every percentage point on bond yields that you add back, people lose more money. Again, a point we make is that if we were to add 100 basis points to global bond yields, people would lose a lot of money. They made a lot of money recently, and they're all applauding that but backing yourself out of that is very difficult as well.
I think when you do see a need for central bank intervention is when the volatility of the market is so high, that it's very difficult to price assets. If it's very difficult to price assets, credit markets just close. You could argue that the reversal that you saw earlier this year have, the shot reversal by the Fed was a reaction to disorderly, higher credit markets.
ROGER HIRST: In some ways, I guess what you're saying is that the put in some ways, the central bank put which was in equities, maybe in the bond market, but actually, it's probably more a case that it's a cap on volatility. Central banks, the world over, are trying to just suppress volatility because of the reaction function that that might have across global risk assets?
ANDREW LAPTHORNE: Yeah, and I think that's the outrageous mistake. You hear central bank bankers complaining that the high yield universe or the investment grade universe is full of BBB stocks. Now, credit markets are priced on leverage and volatility. We use volatility as some measure of cyclical risk. You're more likely to lend money to a utility company than you are a semiconductor company and do you measure that because of their relative volatility.
If you spend a long period of time as we have been suppressing volatility overall, makes it very difficult to differentiate between a utility asset and a semiconductor asset. What then happens is you go into a recession and you thought you were lending to a utility company. It turns out, it's a semiconductor business, and therefore, volatility spikes up, you're then going to get a catastrophic collapse in its credit rating, and all things and follow on.
Actually, I think you need to initially suppress volatility or to allow credit markets open again, but then to continue trying to suppress volatility means that people take risks and are not aware of the downside potential of the risk. What you've seen is a lot of cyclical businesses borrow an awful lot of debt when they shouldn't, because it makes them more fragile in a recession.
ROGER HIRST: I think this is comes on to a lot of your particularly recent work has been looking at this distortion of the bond market has created a distortion in the equity market where certain equities that are doing quite well in terms of earnings are pricing recession in the way that maybe the bond market appears to be pricing recession versus the S&P, which is pricing quite an optimistic outlook. What are these distortions? Because there's a lot of risk now built into the system where these bond proxy equities that look like safe havens may not be safe havens if and when things start to unravel.
ANDREW LAPTHORNE: Fearful of saying this, but this time is different. I know it's deadly to say that, but if you look at bull markets over time, they're driven by economic prosperity. If you decompose your returns from equities, bull markets are driven by earnings growth. You get an economic acceleration, you get earnings growth going up, and that then pushes equity prices along. Normal things happen, interest rates go up, the yield curve steepens, bond yields are rising, value stocks are outperforming defensive stocks. That's the normal flow of data stretching back multiple decades.
ROGER HIRST: This business cycle basically is--
ANDREW LAPTHORNE: Yeah, classic business cycle. Even in the 1990s, which had a big tech boom, globally, it was driven by profits. Yes, the NASDAQ was through the roof and the YASDAQ was through the roof, but primarily, it was a profit driven story. What we've seen globally over the last five or six years is a market solely driven by valuation change, solely driven by a feeling that you could rewrite certain stocks, because they assumed to be less risky than cyclical stocks, which you know are risky.
Now, we've done a lot of work looking at portfolios based on simple bond correlations. You take for global universe, you cut it into your quintiles. Your top quintile is the most correlated to bonds, benefits when bond yields go down. The other one is the inverse of that.
Now, they both started off five or six years ago, with a similar PE of around 14 times. The bond proxy portfolio has gone to 25 times. The anti-bond portfolio has gone to eight or nine times. You're left now with a market which is absolutely polarized. You left with one market, the cyclical part of the equity market, which is already forecasting recession, and then you've left with another market, which is entirely dependent on bond yields going lower and lower.
We've seen the reaction over the last week where it's not the case, necessarily, that value has to suddenly rebound strongly because we get economic prosperity. All you need is a reversal in bonds. It's very interesting that when we saw bond yields going much lower in July, most people didn't-- there's a lot of commentary on it but most people are making money, most people are long bonds, long duration, and also long high quality stocks in the equity market.
The outcry of last week was basically everyone short cyclical risk. When bond yields backed up, most strategies lost money. One of the problems I have is actually a lot of investor-- it's strange coming from a team which is typically quite cynical, is that a lot of people are on the way upsized surprises. Everyone seems to be overweight bad news. If something happens, whether it's trade wars or anything positive on an economy, a lot of strategies will lose money.
Just add, the drawdown on these defensive assets will be different. The way people measure defensiveness is often simply a historical price return. The reason why your bonds rather well at the moment is because they had a very good financial crisis relative to equity. What happened then is that although the spreads were going up, interest rates were going down quite quickly. That actually helped high yield debt perform in absolute basis reasonably well.
What happens to high yield debt now when volatility goes up and spreads go up when you don't have the support being able to take 400 basis points of interest rates? It could be that people are investing in high yield fixed income thinking that it's safe, based on what happened last time. The opposite is true to value stocks. No one wants to buy value stocks because they had a horrible recession last time around.
If you're around in the 1990s, late '90s to 2003, you know that value stocks spent two years derating after the Asian crisis so we're already pricing in a recession. When the recession turned up, they did okay. In fact, relatively, they're fantastic. I think that's the scenario we've got now. We've got a recession in bond markets to a certain extent priced in, you've got a recession in value stocks to a certain extent priced in, but you have the S&P near all-time highs and volatility well behaved. Actually, I think the mispricing is in the S&P and vol.
ROGER HIRST: Do you think there's a case to be made or in some of this, because this massive alligator jaws between active money and passive money-- and when I say passive, I mean rules-based rather than ETF money, but the combination whereby the active money is still seeing this constant selling, which is driving underperformance, which is often the stocks should be doing well in cyclical markets aren't doing as well as they should. The passive money or the rules-based money is always saying I want dividend, it might be at 30 PE, 4% dividend is more exciting than 10 PE in a 1% dividend.
That just continues to drive this, strains disruptive forces whereby these bond proxy continue to be driven because of min vol risk party rules-based and the active guys are consistently underperforming this momentum because they've got negative momentum. Is that part of this and is that because-- taking all the way back, it actually goes back to central banks driving down volatility and yields and returns on assets. That makes logical sense and this will carry on until that break somewhere.
ANDREW LAPTHORNE: I designed systematic strategies. Again, when we started building systematic strategies 20 years ago, it's exciting, you do a back test and now, dropped 10% to 15%. Most-- particularly in the equity factor space, most of the strategies that you designed were delivering you almost double digit returns. You could take the risk, you could take the drawdown, you could take the risk.
Post-financial crisis, most of those same factors delivered almost nothing. If your return forecast is lower, obviously, the risks you could take have to be lower as well. Your Sharpe ratio is one over the other. You're absolutely right that if your return forecast is lower, then everything is