Jim Keohane sees troubling signs in today’s markets
‘These things have always ended badly’
Jim Keohane has seen his share of market crises. Now a senior pension advisor in his role as a director of the Alberta Investment Management Corp. (AIMCO), Keohane was early in his investment career when the 1987 market crash hit. Two decades later, he steered the Healthcare of Ontario Pension Plan (HOOPP) through the Great Financial Crisis, emerging with narrower losses than many other pension funds in Canada and around the world.
He’s also a student of market history, and when he looks out at today’s markets, sees many of the characteristics associated with the worst bubbles of the past century — and a landscape that could leave policy-makers with limited options if things go south.
“The common elements seem to be that it was excessive speculation in housing, stocks and commodities, driven by cheap interest rates. It’s exactly the situation we’re in today,” Keohane told the Financial Post. “These things have always ended badly. You never know what the trigger is that will cause that to happen, but … something takes that off the rails (and) the downside can usually be very significant.”
Keohane, who retired as chief executive of HOOPP in March of 2020, said government and central bank supports to promote liquidity that were put in place in the wake of the 2008 financial crisis — through measures such as quantitative easing — and low interest rates and government supports that have continued to be the order of the day through the COVID-19 pandemic are propping up markets including residential real estate.
There are signs some of those supports may be coming to an end. The U.S. Federal Reserve, for example, signalled in September that it may soon slow asset purchases used to juice the economy and could raise interest rates in 2022. And, as pointed out by the Financial Times last week, the cost of borrowing is being hiked in advanced and emerging economies including Norway, Pakistan, Hungary and Brazil — signalling that central banks are no longer driven by the sole goal of making sure companies, households, and governments can borrow money at “exceptionally” favourable rates.
The pullback on stimulus may be a positive sign for the global economic recovery but could point to choppy times ahead for markets, which have been “fuelled by the extreme liquidity provide by the Fed and other central banks,” Keohane said. That could create a difficult environment in which to make investment decisions.
He recalled the sell-off during a so-called stock market “taper tantrum” in 2018 when the U.S. Fed made a similar announcement about planning to reduce bond purchases.
“The market reacted very negatively and only recovered once the Fed reversed that stance,” he said. “I don’t necessarily think that this will lead to a market crash but it is a warning sign.”
The challenge for the Fed and other authorities is to find the balance of reducing monetary stimulus and maintaining market confidence and Keohane believes “the odds of that are low.”
There are already signs of volatility on financial markets. U.S. equities had their worst week since June last week, with inflation fears in the mix along with other factors such as continuing supply chain disruptions.
The Dow Jones, S&P500, and the Nasdaq Composite indexes all dipped lower Wednesday morning, extending the losses, before rebounding in the afternoon.
Keohane sees other concerning links to past “manias and bubbles” created by easy access to cheap credit. Price distortions from fundamentals are high on the list.
For example, he doesn’t feel the bond market is reflecting economic conditions because governments have been buying up bonds as part of the stimulus, and other investors are reacting to their participation in the market.
“It’s a completely artificial market and it’s priced as if it’s priced for deflation not for inflation,” he said.
“The bond market is pricing as if inflation is going to be transitory, and maybe it will be, but if it’s not, I mean I think there’s a lot of downside risk.”
He is particularly perplexed by the European government bond market, where negative yields have become common due to weak economies and years of monetary intervention, and says he’d short that market if he could figure out how.
“To me it’s just a complete head scratcher ... It’s completely irrational,” he said. “Your best-case scenario is you lose a small amount of money and your worst-case scenarios you lose a lot of money. So, any one of those scenarios is not particularly attractive ... (This) is one of the craziest things I have seen in my investment career.”
Nevertheless, regulatory requirements are keeping banks in the bond market despite the distortions, Keohane said, and factors such as muted consumer lending are driving some even further into low-paying government bonds.
“That’s one of the great shorts that’s out there, I mean it’s hard to short (but if it could be done) I think that’s one place you’re gonna make a lot of money,” he said.
The stock market isn’t particularly appealing for long-term investors like pension funds either right now, Keohane says, adding that doesn’t see an easy path forward even if there is a broad move to higher interest rates.
“Stocks have actually provided a very good return last couple of years, so it’s been a good place to be. But you know valuations are starting to get pretty high,” he said.
In a rising rate environment, these stocks that are fairly priced or slightly overvalued will look even more expensive, he said.
“Stock market valuations are very sensitive to changes in interest rates so if interest rates go up, I think, stock market valuations will start to look very high,” he said. “Interest rates (are a) key element that you got to keep an eye on here.”
Some long-term investors, like the Ontario Teachers’ Pension Plan, are beginning to hedge against current market conditions by stepping up investments in gold and other commodities.
But Keohane isn’t convinced he’d go that route.
“People talk about gold as a hedge against inflation (but) … it just hasn’t been,” he said. “It actually over the long term has had a very poor return, and has not kept up with inflation.”
His greatest skepticism, though, is reserved for the proliferation of cryptocurrencies.
“It’s rampant speculation … because it has no intrinsic value,” he said, comparing it to the mania over tulip bulbs in the Netherlands in the 1600s.
“It’s essentially a greater fool theory ... Was a greater fool out there (that will pay a) higher price than I paid for this thing?”
The emergence of cryptocurrencies has been part of a phenomenon that has seen retail investors dive into markets of all kinds — a liberating sign for some, but a deep concern for Keohane.
He sees it as troubling ingredient of past manias going back to the 1929 stock market crash and linked to the recent run-ups of stocks such as Gamestop and Blockbuster, driven, at least in part, by chatter on message boards and amateur videos uploaded to Youtube.
“That’s just an observation that you can see over time ... I don’t think all retail investors are stupid, but generally speaking, they tend to be in the wrong place (at) the wrong time,” he said.
“So they’re all selling in 2008 when of course the market was cheap (and then they’re) all buying (this) year when the market’s gone five times (or) six times since 2008.”
If this is the top, Keohane is as worried for Main Street as he is for Bay Street and Wall Street, particularly if it means higher interest rates.
Even a one percentage point increase would be more concerning to those paying a mortgage than earlier more extreme rate increases on a higher base, he said, because it would represent a doubling of the money required to service the debt.
“You’re going to create a lot of distress-selling because of that,” he said. “You don’t need to raise (rates) very much higher to actually start creating distress in the economy. So, you know, you kind of get … stuck in this box.”
ONE OF THE CRAZIEST THINGS I HAVE SEEN IN MY ... CAREER.