If I say the word “vigilante”, what image springs to mind? For many years it would have been Sylvester Stallone as Rambo. He’s the muscled-up army veteran using his skills to fight corruption and oppressive outcomes.
However, it’s fair to say the action hero industry is evolving, and these days we’re increasingly seeing female characters such as Charlize Theron taking a leading role in the latest action blockbusters.
Financial market vigilantism is also evolving. From the “bond market vigilantes” of the early 1990s, we are increasingly seeing the rise of equity market vigilantism, particularly in the Initial Public Offering (IPO) market. This will challenge a range of assumptions that market participants are currently making about how markets play out through time.
The rise of bond vigilantes
The term “bond market vigilantes” arose in the early 90s to describe the power that the US bond market exerted on wayward governments and companies. Financial vigilantism is rooted in the role that investors play in setting differentiated costs of capital for individual countries and companies. Where bond investors perceived that inflation risk (for governments) or credit risk (for governments and companies) were not being managed adequately, issuers would be “punished” with low bond pricing, ie, high bond yields.
Bond investors withheld their buying, thus driving up costs to access capital markets. At extremes, this acted as a constraint on the ability of governments to underwrite big spending by issuing lots of debt. It was a very powerful weapon.
Do bond vigilantes still have the same influence today? I’d argue no. Far from holding governments and management teams to account, bond investors seem more willing to support issuers, even those offering negative interest rates, blowing out their debt levels or having a rap sheet of previous defaults, bond markets these days are behaving more like the sleepy cat than the powerful mastermind.
Why did the bond market have so much power in the 1990s and what has changed to today? As with most things in financial markets, the most fundamental drivers are supply and demand. By the mid-80s, bonds had been in a multi-decade bear market. The average interest rate paid on government and corporate debt peaked at 10% – which in today’s low-return looks highly attractive but at the time reflected years and years of painful losses on the face value of bonds. Consequently, investors shunned bonds and the overall US bond market was valued at less than 75% of US GDP. There were a lot of issuers seeking support for new bonds but very few bond funds able to invest. Bond funds could be very picky and invest in only the highest quality issuances and earn very rich coupons. Issuers needed bond investors much more than the bond funds needed issuers.
Fast forward to today and a lot has changed. Thanks to the Michael Milken-led junk bond revolution, and central bank-led QE, the overall US bond market relative to GDP has doubled, swelling to almost 150% of US GDP. Bond investors lost the upper hand in their search for any bonds that might offer a skerrick of yield. The balance of supply and demand has been turned on its head.
The next generation
So, given the bond market vigilantes of the 80s and 90s aren’t out there enforcing discipline, who are the vigilantes in today’s markets?
Power comes from scarcity, so we just need to look to today’s scarce pools of capital to find the answer. But thanks to an underlying excess of savings which began to be evident in the 2000s, and the layering of QE on top of that, most asset classes in the world are awash with capital. Investors have been crowded out of lower-risk asset classes and shifted out into riskier assets to promote real-world investment and economic growth. Waves of liquidity have sloshed from sovereign bonds, into corporate bonds, then high yield bonds / equities / property / venture capital / fine art. Venture capital has especially seen a massive influx of capital.
There are a range of drivers. We’ve seen asset allocators seeking higher returns than those on offer in mainstream asset classes, and also seeking returns which are less correlated with bond and equity markets. And there’s been an expansion of availability of debt in amounts which can turbocharge VC strategies, shifting the supply / demand balance. In 2000, US early stage venture capital investments equalled 0.8% of US GDP but over less than two decades this almost doubled to now stand at 1.4% of GDP. Whilst there hasn’t been much of a loosening of terms, valuations are continuing to drift up – and there are signs that perhaps the overall quality of companies getting funded has degraded through time.
What about equities? Overall, stock markets have also seen a major expansion, albeit with significant volatility along the way. In the 1980s the US stock market was valued at 40% of US GDP. It peaked at approximately 185% in 1999 with the dotcom bubble and then by 2009 it had fallen all the way back to 85% of GDP. The bull market of the past 10 years has seen US stock markets climb back up to approximately 180%. So despite significant levels of corporate buybacks which “de-equitise” the market, the US stock market also seems to enjoy abundant liquidity.
Today, issuers – whether profligate sovereign states, drill-at-all-costs shale-frackers, or vapourware software start-ups – can all obtain funding – and mostly at rates which are unbelievably attractive in the context of history.
Power from scarcity
However, there is still a pocket of the financial economy that is not awash with liquidity. Allocations to active equity managers have been shrinking for a decade. In the midst of an overall equity bull market, it’s been a bear market for active allocations. The vast majority of the expansion in US equity holdings has been via passive and other algorithmic strategies.
There are some unintended consequences to this shift – and a potential silver lining. The first impact is to market price efficiency. The shift away from active management has in part meant a shift towards strategies where valuation does not play a role in stock selection.
This is a seismic shift. Previously, the majority of stock market actors, whether institutional or retail, were employing some form of buying stocks perceived to be undervalued and selling stocks thought to be expensive. This meant every trade mobilised the wisdom of crowds to arbitrage stocks towards an underlying “fair value”. This is the mechanism of market efficiency. It was never perfect, and there have clearly been periods of excess exuberance or pessimism in the past, but it generally worked to obtain a level of price discovery. But with a large and increasing cohort of investors not looking at the underlying fair value, we may have to change the expectation that markets will be efficient over any time horizon.
The second impact is the societal aspect of this deterioration of market price efficiency. The inverse of price is cost of capital. Simplistically, “good” companies should trade at high valuations and enjoy a low cost of capital, while “bad” companies should trade at low valuations and face a much higher cost to access capital markets. When stocks aren’t priced efficiently their cost of capital is also not at an economically efficient level. When prices are out of whack, companies face either a much higher or a much lower cost of capital than they should. Clearly in some sectors of the market, the earnings yield – which approximates the cost of capital – is extremely low and in many cases even negative. This creates distortions in the real economy, since these companies are given an incentive to over-expand. The likely outcome is that returns on that expansion capital will ultimately disappoint. Uber, anyone?
The third impact is the risk of a reduction of discipline on management and boards. When equity holders are no longer as likely to “vote with their feet” if the board adopts poor governance practices, one brake on corporate excesses is absent. Arguably one driver of the increase in ESG engagement is a need for “captive” investors (who are unable to sell down) to have a mechanism with which to push back on corporate boards.
The potential silver lining of the shift away from active to passive and algorithmic strategies is that scarcity creates power. While active managers may have to wait for longer for a return to price discipline in the broader equity markets, there is a place where only active managers play providing the power to enforce the price discipline we need to see in a well-functioning market.
That place is in the IPO market. Historically, only active managers have participated in IPOs, thereby determining which companies make it onto bourses and at what price. The rejection of WeWork’s IPO, even at cut-down valuations, and the local rejection of Latitude and PropertyGuru, demonstrate that where scarcity remains, there is probity within financial markets.
What are the implications of this? Funding into private equity is swollen and there will be a time when companies held in these funds need to be monetised. Historically this has mostly occurred via IPOs. But if active managers, deploying their scarce capital, create a skinny little bottleneck of sensible pricing between private markets and public markets, how will the highly-valued holdings emerge from their enormous private funds?
Investors within PE funds can expect to face lower returns as monetisation rates slow and holding periods extend. And as asset allocations inevitably then shift from stock markets to PE, investors will end up paying higher fee levels for access to the same range of businesses they would previously have owned on the stock market.
So if active managers are the vigilantes using their scarcity to enforce sensible pricing in the IPO markets, where does this story end? Vigilante storylines follow a familiar arc: a downtrodden minority rises up from their difficulties to take a stand against injustice. In financial markets, the story plays out with an abundance of liquidity morphing Rambo into the fluffy white cat.
But in Hollywood movies the vigilantes prevail, Jedi-style! Let’s hope active investors keep wielding the lightsaber and can prevail over undisciplined pricing and shareholder-unfriendly governance – at least in the IPO space – and that that the bond market vigilantes of the 90s are surpassed in their effectiveness by the equity market vigilantes of the 2020s.
Published by Kate Howitt, Portfolio Manager Fidelity Australian Opportunities Fund