Stable funding cost equals multiple expansion
One of the factors that does not get credit as a true driver of the extraordinary rally in risk assets that we have witnessed in the past 12 months is the collapse in volatility in long term USD funding costs.
The acquisition of any asset effectively has two legs: a) the expected return on the asset, and b) the funding cost of acquiring that asset. The two sides of the ledger: The asset side and the liability side. It is just like buying a house with a three-year interest only loan. If you expect the rate you are going to pay to rise dramatically in the next three years, then your expected return on the property is going to be lower than if you think rates are going to continue to stay low. Putting it another way, the lower your perceived roll over risk on your funding, the higher the expected return of that asset.
Currency traders often think this way. They look at the volatility to carry ratio. The lower the volatility versus the yield of the currencies, the higher the expected return. This can be extrapolated out to all assets. So, when the US 10-year bond is experiencing its tightest trading range in living memory, is it any wonder that investors have extrapolated that returns on equities, credit, and effectively all risky assets will be elevated. The market is implying a small chance of dramatically higher funding costs. This is reflected in equity multiple expansion and tighter spreads across all credit oriented products.
Think of this scenario. If I could predict with a strong degree of confidence that the 2018 range in the US 5-year bond is going to roughly trade within a 50bp range like it has throughout the course of 2017, what multiple would you be prepared to pay for developed and emerging market assets? More, or less than this year? For me the answer is obviously more.
Founder, View from the Peak
IND-X Advisors Limited
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