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Holly Cook: At the recent Morningstar Investment Conference I had a chance to sit down with Francis Scotland, he is Director of Global Macro Research at Brandywine. And I asked him to explain his concept of the ‘risk of success’—not that some sort of global failure is actually the main risk for investors but rather that actually success, that maybe things don't turn out too badly, is the main thing that investors need to be aware of. Let see what he had to say.
Francis Scotland: As you said, Holly, everybody has been focused on the risk of failure for the last few years. Ever since the great financial crisis, people have been sort of looking left at all the things that could go wrong, the things that could pull us back over the deep end of another catastrophic failure. So it’s things like the break-up of the Monetary Union in Europe, crash landing in China, going over the fiscal cliff in the United States, deflation, deleveraging, all these things that we've been obsessed about. But, in fact, the surprise over the last four or five years has been things have gotten better, not worse; actually the information surprise has been positive, which has encouraged us to think about the tail risk of success.
Risk of success to us is the possibility that all these unorthodox measures of stimulus might actually work, so investors have actually been worrying about the wrong thing. Why is it a risk? Because in the extreme, if success truly does play out, then it means an end to quantitative easing, means the Fed raises interest rates, and it means nominal bond yields [which] are currently trading well-below growth rates in most countries would have to rise. So the risk is that if success plays out, we get a fundamental realignment of asset prices around the world, and among other things, it means that the asset group that’s considered to be the safest might actually turn out to be the riskiest.
Cook: So on that point, so if asset prices are distorted, you talked about the distortion actually being the safe haven assets, not the risk assets, which is a sort of slightly different view from what most people seem to be thinking and have been thinking for the last few years.
Scotland: Right. Most people are pre-occupied with the impact of all this unorthodox monetary policy on the stock market. But when you go and actually look at asset prices, the earnings yield is at a level which is sort of low end of the range it's been at for the last four or five years, which is well-above the average of the previous five to 10 years. The real valuation anomaly – the biggest valuation anomaly in the macro space that we see is real interest rates. If you look at the yield on a 10 or five-year TIPS, it's negative.
So basically anybody who contracts to invest in that security is basically saying I am willing to accept a loss of purchasing power of my money over the course of the lifetime of this investment. Why would anybody do that? They would do that because they are completely worried about the uncertainty of the future, so I am willing to take guaranteed loss in the purchasing power of my money, because if I invest in anything else, I might lose even more. So that's where the distortion is, it’s a real anxiety with these left tail risks, and if the world turns out to be better as it seems to be, these things are – these kinds of investments are negative real yields in the safe haven investment are very risky.
Cook: So what does this actually mean for investors? Does it mean that because we've got this pessimistic outlook a lot of people might be positioned for a pessimistic outcome that actually was going to be more optimistic than we expect?
Scotland: That's right. If at some point what it means is that people who have invested out of fear into some of these supposedly safe haven markets may experience capital loss, are likely to experience capital loss over the course of the next three years as expectations adjust to the reality that success is actually playing out. We've had a reduction in systemic risk and there is grounds for cautious optimism on the economic outlook, all of which is moving us into the direction – more in the direction of optimism, and ultimately the tail risk of success, in which case the reach for yield is going to continue. Risk assets are going to continue to appreciate in value. It's the perceived safe haven assets which stand to lose the most amount of money over the next few years.
Cook: Francis Scotland, thank you very much for your time today.
Scotland: My pleasure.
