Asset markets have experienced unprecedented growth since the financial crisis as central banks globally attempted to offset deflationary trends through massive injections of liquidity. In effect, their actions have prevented or delayed a default cycle. While unsuccessful in inflating away excessive levels of debt, their efforts have been extremely successful at creating inflation in financial assets. Artificially low levels of interest rates have forced savers to become investors and investors to become speculators.
To some extent, the current bull markets in bonds and stocks owe their origins to an early period in June of 1981 when the Federal Reserve under Paul Volcker raised the Fed Funds Rate to 20%. By allowing real rates to rise to a level that discouraged wage and price inflation in favor of investment, Volcker created the potential for the inflation in financial assets that we are currently experiencing. Both stocks and bonds have experienced historic levels of performance as discount rates have fallen. Despite similar performance over a 20-year period, there are major differences in the last 10 years that have favored stocks. The divergence of stock and bond returns currently portend rising risks.
Lower interest rates have produced rising bond prices allowing investors to enjoy capital gains on bonds. However, as interest rates approach zero, these gains will be limited. Investors are reluctant to buy bonds for capital gains, while coupon rates are so low. Equities, on the other hand, do not have a psychological cap on returns. Lower rates lead theoretically to higher valuations as evidenced by the recent expansion in price to earnings ratios. Last year the S&P 500 Index gained over 30% despite no growth in earnings and the P/E ratio rose from 19 to 21.
The outperformance of stocks has generated very few signs of speculation despite outsized returns. Pensions have been net sellers. The public has also been reluctantly participating. Public companies, through stock buybacks, have substantially reduced the supply of stock available for investment. The shortage of equities has been further aggravated by M&A activity, which has reduced the number of publicly traded companies.
Bonds, meanwhile, have enjoyed very little enthusiasm. For the most part, the retail investor participates in the bond market at the recommendation of their wealth manager as a hedge for their equity investments. Often, they are further encouraged to invest in bond substitutes for their “yield,” which undermines the potential of the “hedge.”
Absent from the equity blow off are signs of euphoria and speculation. Last year’s gains, in combination with the rapid gains in technology and software, are certainly an indication that we are getting closer to the euphoric phase. Gains in Apple, Microsoft, Google and Amazon are certainly concerning. Parabolic moves in stocks like Tesla, however, are truly indicative.
Bonds conversely exhibit the momentum of an aging bull market but are far from loved. The concept of negative-yielding bonds defies logic. Bond prices reflect the notion that central banks have been unable to generate inflation. Japan has promoted these policies for over 20 years, the ECB has tried for over a decade, and now the Federal Reserve has joined the party. Central banks are now “all in” in their willingness to tolerate higher inflation.
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