- The expected real return on most “safe haven” assets is currently negative.
- Risk seeking behavior could result in a bubble encompassing all risky assets.
- While current indicators support a pro risk stance, we are prepared to change our positioning as market conditions dictate.
There is a great deal of discussion currently about the likely emergence of asset bubbles in capital markets driven by hyper-stimulative central bank policy. However, we are in the sixth year of the recent ultra-low interest rate regime and it is not at all obvious that any bubble has formed (Exhibit 1).
Exhibit 1: Fed Funds Rate – low for six years
Source: Federal Reserve
Yes, some hyper growth stocks got significantly overbought, but they represented a fairly small percentage of total stock market capitalization so their recent sharp correction has not resulted in broad market action distinguishable from typical volatility (Exhibit 2).
Exhibit 2: One year cumulative returns to the S&P Biotech ETF versus the S&P500
Sources: Standard and Poor’s and Columbia Management Investment Advisors, LLC
So has all this bubble discussion been much ado about nothing?
The potential for bubbles to form in the current environment is a valid concern. We are six years into a bull market, admittedly off a very depressed post-crisis base, so we have to be cognizant of the risks for asset prices to become unduly inflated. Bubbles (or at least their breaking point) are hard to foresee, otherwise they wouldn’t form to begin with. It’s quite possible though that identifying bubbles in the current environment is going to be a particularly confounding exercise. The reason is that we tend to view things in a relative context: a 6’8″ basketball player might look short out on the court when everyone else is approaching 7 feet, yet in a more typical crowd they will look like a giant.
A similarly misleading context could easily occur in asset markets. Instead of a particular asset class reaching exorbitant heights (like technology in the late 1990s), it’s conceivable that all risky assets could be pushed to these heights. That’s because the fundamental building block of all asset pricing, the risk free rate, has been kept artificially low — which forces investors out on the risk spectrum and pushes the prices of those asset classes higher. In fact, expected returns on typical safe haven bonds have been pushed so far down through central bank policy that they are actually negative once inflation is considered (Exhibit 3).
Even though this graph was first published in February, 2013, the message is unchanged: there is nowhere to go but up the curve. An essentially guaranteed loss of purchasing power each year for the next five years is a powerful incentive for investors to hunt for returns that will at least not be certain to lose money in real terms, even if that means dabbling in asset classes such as emerging market debt that until recently were considered too racy for a standard portfolio, or indeed buying stocks after six years of sharp gains.
This risk taking behavior is an intentional and essential part of central bank policy. Post credit crisis, all sectors of the economy wanted to de-lever their balance sheets at the same time. If no one is willing to invest or spend, economic activity halts. So central bank policy is geared toward rewarding borrowing (presumably to spend/invest) and penalizing saving. If pushing investors farther out on the risk curve increases the potential for speculative extremes by pushing the prices of those assets progressively higher, why isn’t the next bubble obvious? Well, if everyone on the court is 7 feet tall, 7 feet looks normal. If all prices are pushed up, nothing stands out as overvalued. Sure, credit spreads on riskier debt such as U.S. high yield and peripheral European sovereigns is extremely low, and sure, equity market multiples in the U.S. are high; but you have to consider the alternatives. If the expected return on most safe haven assets is negative, then it makes sense that the price on risky assets is going to be bid up to the point where expected future returns are also extremely low. The insidious feature of this process (and what distinguishes it from prior cycles) is that it doesn’t exist in a bubble! It is driven by distortions in the risk free rate which is used as the fundamental building block for valuation analysis of every other asset. Moreover, this process is likely to unfold only gradually. If we do reach a bubble phase, it will be hard to see because it will be everywhere, and because its formation will be so gradual.
Are we doomed? Not necessarily, and not immediately, in our view. If prices are being inflated by low risk-free rates, then it makes sense they will be deflated by higher risk free rates, and that is not a realistic concern this year. Central banks are committed to keeping rates low long enough to make sure the economic recovery is on a solid footing. Further, there are no signs of inflation, which is the typical trigger for higher rates. Eventually, however, economic growth will resume and so will inflationary pressures. Interest rates will rise, with or without central bank approval, and that is when the system will be at risk.
At a minimum, expectations for returns on a diversified portfolio of assets need to be lowered given the price inflation that has already occurred, but this is far from catastrophic. In fact, our longer term return forecasts for global stocks still suggest reasonable returns, even after taking the gains over recent years into account. However, if we do get caught up in an excessively speculative environment, leverage in the system will make the potential fallout that much worse. So what do you do?
Within the Global Asset Allocation team, we have adopted a strategy of “participate but protect.” Our outlook for risky assets over the next 6-12 months remains optimistic. However, we are very mindful of the risks that can emerge if continued price advances are not supported by improvements in underlying fundamentals. We have adjusted our portfolio strategy in three key ways to address this environment:
First, we have incorporated explicit downside tail hedges. Our goal for these positions is to identify low carrying cost strategies that can help truncate losses in the event of a sudden spike in market volatility.
Second, we are pursuing more flexible strategies within fixed income. We have already discussed the unattractiveness of interest rate risk, but we can take other more attractive risks within the universe of fixed income securities instead. For example, we believe that corporate credit spreads still offer adequate compensation for default risk, and that emerging market sovereign debt remains attractive.
Third, we are using our ongoing market surveillance to identify any signs of a deterioration in the environment for investment risks, and are prepared to actively reduce our risk positioning if signs of an inflection point materialize. At present, our market indicators remain supportive of a pro risk stance, but we are prepared to change our positioning quickly out of respect for the downside risks inherent in a slow moving and pervasive liquidity fueled asset appreciation.