The cocktail party scene must be unbearable these days. If there were ever a time to brag endlessly about portfolio profits, this is it. Stocks have had a massive rally, with many indexes sitting at or near all-time highs. Bonds have climbed on falling interest rates and credit spreads – both within spitting distance of all-time lows. The standard 60% stocks / 40% bonds portfolio is killing it – with relatively low volatility no less – an enviable Sharpe Ratio, the consultants tell us. Building a top-notch portfolio, which used to be considered fairly difficult, is starting to look pretty easy.
However, investors generating fabulous returns in recent years would do better to credit central banks than the person in the mirror. Extraordinary monetary policy, combined with some favorable demographic trends, has created a “perpetual profit machine” whereby financial asset prices feed on themselves in a virtuous, upward cycle. For now, the sky is the limit.
The Relentless Bid – Part 1: Bonds
So how does the perpetual profit machine (PPM) work? The foundation was laid with some favorable trends, including falling inflation rates and aging populations throughout the developed world. Lower inflation supported bond prices, while the growing number of investors who are in or approaching retirement have begun buying more fixed income as they transition from asset accumulation to the distribution phase. Combined with slowing growth rates, these trends underpinned the “great moderation” seen in bond yields from the early 1980s to 2007.
Off this foundation, and in the wake of the Great Financial Crisis, global central banks were forced to step on the accelerator. They suppressed policy rates toward 0% (or negative yields in some cases), manipulated longer-term rates by buying $17 trillion in sovereign bonds and other assets (“quantitative easing”1), and further signaled to investors that rates would remain low for an extended period of time (i.e., forward guidance). In doing so, the PPM was created.
In more normal times, lower yields would be self-correcting – investors would simply stop buying bonds once their yields became unattractive. But the machine has a virtuous cycle. With an excess of global savings, investors would have to buy twice as many bonds to generate the same income after yields were cut in half. Regulation around capital adequacy and quality required institutions to hold more bonds, while fast-growing bond indexers were indifferent to price or yield. They buy regardless. Over the last 12 years, outside of a few hiccups, these dynamics have created a relentless bid for fixed income assets pushing yields lower and driving bond prices higher. The result? Perpetual portfolio profits.
The Relentless Bid – Part 2: Stocks
Of course, historically low/negative interest rates have been a boon for global equities as well. Paltry interest rates offer little competition to stocks in spite of relatively low earnings yields (the inverse of P/E ratios2). We discussed TINA – “there is no alternative” – in last month’s note. Rock-bottom overnight rates provide for both liquidity and greater leverage from security broker/dealers. Low rates reduce the cost of capital, making debt more attractive, so firms issue debt to buy back stock. That same absurdly cheap capital allows companies to stay private (private equity “unicorns”), further suppressing the supply of public equities. Upward momentum drives the fear of missing the rally, and like bonds, the growth of indexing creates a never-ending supply of price-insensitive buyers. Cross-asset effects reinforce these upward trends: Big equity gains force asset rebalancing into bonds, while low equity volatility begets more stock buying from investors who rebalance to risk (e.g., volatility targeting3 or risk parity strategies4).
The PPM is now humming along. To summarize, low(er) rates send bond prices up while simultaneously driving investors towards equities. Rebalancing equity gains creates more bond buying further suppressing yields, and so on and so on… Stock and bond prices feed off each other, sending both spiraling higher and higher. Note that 600 words into this rant, we haven’t mentioned the global economy, security fundamentals (i.e., earnings, cash flow), or valuations. These variables don’t matter to the perpetual profit machine.
Bond Yields Offer Little Competition to Stocks
Source: Bloomberg, Natixis Investment Strategies Group, Jan. 1995 – Jan. 2020 (monthly). YTW: Yield-to-Worst.
The Most Hated Bull Market in History
We can restate the PPM through the lens of valuation. With short-term rates below inflation in most of the developed world, cash has a negative real yield. That is, cash is trash. As a result, ugly equity valuations (high P/Es, etc.) drive skittish investors to buy more bonds while unappealing bond valuations (low rates) drive aggressive investors to buy more stocks. Nobody thinks these assets are priced attractively, but investors buy them anyway because there is no alternative. No wonder the last decade is often called “the most hated bull market in history.”
Back at the cocktail party, are you really going to tell your friends you’re sitting on cash (losing purchasing power) while they make a small fortune in stocks and/or bonds? A man carrying a tray of hors d’oeuvres thinks the European Central Bank may cut rates again. Your friend who bought Tesla stock last year hands you another glass of wine and says, “Don’t fight the Fed.”
The Boom/Bust Cycle?
The secret sauce behind the perpetual profit machine is the asymmetric reactions of central banks. If global growth begins to falter or slow, central banks will ride to the rescue with lower rates, more QE, more liquidity, and more promises – all to prop up the global economy and asset prices… but mostly asset prices. Bad news effectively becomes good news for investors. However, when the economy begins to gain steam, policymakers do not take the punch bowl away. For various reasons, both real and imagined, they argue that the economy has plenty of slack and that inflation is unlikely to return. Liquidity is provided generously at the first sign of weakness, but that same liquidity is removed slowly (if at all) when growth picks up. Good news is still good news.
In effect, the PPM works because the natural market clearing mechanism is broken. Historically, massive monetary stimulus would lead to a rebound in growth and the economy would ultimately overheat. As night follows day, recessionary pressures would emerge. Markets eventually crack (portfolio losses!) on some combination of higher yields (both real rates and/or inflation premiums), central bank tightening, or perhaps a spike in energy prices.
But this isn’t happening today. Inflation hasn’t picked up. Central banks are happy to provide liquidity but refuse to withdraw it. Meanwhile, global demand isn’t strong enough to push energy or broader commodity prices up. For a decade, the global economy has grown fast enough to avoid recession, but not fast enough to overheat. The boom/bust cycle has been conquered. The global expansion never ends and asset prices only rise.
Nothing Lasts Forever
The environment above is often described as a “Goldilocks economy” – not too hot, not too cold. But this misses an important point: Like “Goldilocks and the Three Bears,” the perpetual profit machine is a fairy tale. Trees do not grow to the sky and Stein’s Law remains in effect: If something cannot go on forever, it won’t.
No one can say when the PPM will break or what will break it. There is no obvious downside catalyst…for now. Maybe inflation pressures will emerge. Perhaps central banks will tighten to constrain asset bubbles. (Don’t hold your breath.) Maybe there will be a global macro shock – a war, climate disasters like flooding or wildfires, a viral pandemic? Maybe central bank stimulus will simply prove less potent and the next slowdown will deteriorate into a full-blown recession. Who knows?
What we do know is that while stock and bond prices may continue to rise, they will not rise in perpetuity. Punitive bond yields can make stocks look more attractive, but not infinitely so. In recent years, interest rate suppression and unlimited liquidity have created a portfolio profit machine, but nothing in the capital markets lasts forever.
2 The price-earnings ratio (P/E) or price-earnings multiple is the current market price of a company share divided by the earnings per share of the company.
3 Volatility targeting is a sophisticated approach used by hedge funds to determine leverage. It is strongly related to trend following, since it is commonly used by commodity trading advisors (CTAs).
4 In investment portfolio management, risk parity is an approach that focuses on allocation of risk (usually defined as volatility) rather than allocation of capital.
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