11/3/20: Market Update by Jack Ablin, Chief Investment Officer at Cresset
Say what you will about the policy implications of the election, the most vital financial risk facing the markets is higher interest rates. Since the early 1980s, monetary policy has been the primary mechanism for achieving the Federal Reserve’s “dual mandate” – full employment without inflation. Employing its one-dimensional lever, the Fed lowered interest rates to spur borrowing and increase economic activity or raised interest rates to inhibit growth by increasing the cost of borrowing. Against a backdrop of secular slowing of labor force growth and sagging productivity gains, the general trend in interest rates over the years has been to the downside. During the course of the last 40 years, the Federal Funds Rate went from 20 per cent in 1982 to zero in 2020. The policy, which was predicated on bringing future spending forward with debt, had been largely successful until 2007 when Chairman Greenspan’s “too much of a good thing” spurred a mortgage-fueled housing bubble and subsequent financial crisis. By the middle of 2009, US home mortgages peaked at 73 per cent of GDP.
At the height of the financial crisis in December 2008, the 10-year Treasury yield dipped to 2.2 per cent. Big bank bailouts and the socialization of debt enabled monetary policy’s borrowing-led strategy to continue. As of this year, the benchmark 10-year yield plunged to an all-time low of 0.6 per cent, helping spur unprecedented corporate debt expansion. Non-financial corporate debt levels exceeded 36 per cent of pre-pandemic GDP.
At the same time, a multi-year boom in stocks and bonds was the fortuitous byproduct of lower interest rates. Over the last 10 years, the Barclay’s US Corporate High-Yield Bond Index rose more than 80 per cent while the S&P 500 surged more than 230 per cent. Now, equity market valuations are approaching an all-time high, thanks to rates that are lower than a limbo stick. The cyclically adjusted price-earnings ratio (CAPE) is currently situated at 26x, representing the 92nd percentile of its 45-year range. History has shown that equity market valuations are a function of nominal interest rates and interest rates relative to inflation.
The prospect of higher “real” interest rates – the difference between the Federal Funds Rate and inflation – is the biggest financial risk facing today’s credit and equity markets. Reversing 40 years of monetary policy will inflict pain, something central bankers are loath to do. In fact, Federal Reserve Chairman Jay Powell has pledged to maintain his zero-interest rate policy indefinitely. The central bank’s stance reflects its predicament. The market got a bitter taste of higher real rates in 2018 when the Fed attempted to normalize monetary policy by ratcheting the Fed Funds Rate higher by 1 per cent, to 2.5 per cent. Financial markets weren’t happy about this: the S&P 500 retreated 13.5 per cent in Q4/18, while high- yield bonds fell 4.5 per cent in response. Unfortunately, monetary policy has gone too far, but, without inflation, policymakers can’t reverse course. Meanwhile, central banks worldwide have perpetuated an environment of insolvency as chronically unprofitable companies keep their doors open thanks to ever-cheaper financing rates. At last tally, bonds worth $16.5 trillion carry a negative interest rate while one-third of Russell 2000 small cap constituents have not posted a profit for at least five years.
The next chapter in economic policymaking will be fascinating. A fiscal policy-led shift could be central bankers’ salvation, allowing them to let inflation run before responding with higher rates. Allowing prices to rise without raising rates would push the real Federal Funds Rate further negative, a bullish ingredient for financial markets. Eventually, central banks may be forced to decide between preserving the financial markets or maintaining a stable pricing environment. Fed Chairman Paul Volcker, in 1982, opted to control inflation – the decision that set today’s monetary policy in motion.
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