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A Bubble in Everything?

10 January 2018

By Geremy van Arkel, CFA®

The prices of risk assets soared this past year, elevated by stocks and real estate performing significantly better than almost anyone expected. Even fixed income investments performed remarkably well in this risk-seeking environment, as investors were also yield takers in their efforts to store excess liquidity. Higher asset prices and strong consumer confidence did not lead to debt reduction though. Debt expanded across most segments as consumers, businesses, and governments continued to lever up. The only asset that doesn’t seem to be participating in this “everything” boom is commodities, where prices reflect low inflationary pressures – for now. And then there were some eye-popping “stranger things” this year: the volatility of stocks diminished to all-time lows, a painting was sold for $450 million dollars, Bitcoin prices approached $20,000, European high-yield bond yields dropped below those of 10-year U.S. treasury yields, and the combined market cap of Facebook, Apple, Amazon, Netflix and Google (FAANG) is greater than the GDP of the 5th largest economy in the world (UK). The simplistic reasons for these asset returns are global growth, benign inflation, and fiscally expansionary tax policy. But if we elevate our thinking, there is a much larger, all-encompassing factor that is a contributing force behind all this risk taking: coordinated global central bank policy.

If you have been paying attention, you probably know the story of coordinated global central bank policy. In the wake of the Great Recession of 2008, central banks around the world lowered short-term interest rates to 0% and initiated the controversial and unpredictable process of quantitative easing (QE). Nine years later, it could be argued that these efforts were a grand success. The global economy is strong, employment is back to normal, borrowing has skyrocketed, and so have asset prices.

While most people understand that lowering interest rates stimulates borrowing, many are not so sure about what quantitative easing is or how it works. Quantitative easing is simply when central banks buy assets from investors. When central banks buy assets, such as bonds, they pay for the bonds with newly minted money from their treasury and the seller of the bonds receives this money. Simply put: money is created and put into investors’ hands, and this transaction drives asset prices higher and interest rates lower. Higher asset prices lead to gains for investors and facilitates the real wealth effect and risk taking, and lower interest rates increase borrowing and financial leverage. So effective is this injection of capital into the economy that Milton Freidman referred to this process as a “helicopter drop” of money.

Nothing is as permanent as a temporary government policy. While this coordinated global attack on deflation was perhaps required to support the world’s economy in the aftermath of the Great Recession of 2008, when will it end?

Global economic strength is the accepted story behind the over 20% rise in global stock prices in 2017. Almost all of the world’s major economies are rolling strong, simultaneously, which is quite rare. But while the Federal Reserve Bank (FED) has at least backed up the Fed Funds Rate to 1.25% and has ended its large-scale asset purchases (LSAP), Europe and Japan continue to liquify their economies like it’s 2008. Neither the European Central Bank (ECB) nor the Bank of Japan (BOJ) have raised interest rates from the zero floor, and both have continued LSAPs into 2017. The combined value of asset purchases (stocks and bonds) by the Fed, ECB, BOJ and the People’s Bank of China (PBOC) has exceeded $14 trillion since 2008. The value of these assets held on central bank balance sheets respectively represents 23.4% of US GDP, 92% for Japan, and 38% for Europe. This staggering amount of liquidity – money created and pumped into the economy – has driven asset prices higher and interest rates lower.

Never before in history has there been such a grand scale effort to elevate asset prices. We are in uncharted territory as to the effect that this liquification has had, or will have, on asset prices and growth. Adding to this unknown, we now have what looks like fiscally expansionary tax policy, which is clearly directed at corporations, and in support of asset prices. It seems like we have entered a global paradigm where the goal of all government policies is to keep asset prices afloat.

How do the central banks reverse these policies?

The Fed has been the first major central bank to reverse its stimulus. Since December 2015, the Fed has raised the Fed Funds Rate five times to a target rate of 1.25-1.5%. Contrary to investors’ fears, this current rate hike campaign has not negatively impacted the asset prices of stocks or bonds. The table below demonstrates that during rate hike campaigns, stocks generally perform well, and it is bonds that show signs of weakness.

Summary of Past Rate Hike Campaigns

The greater potential risk to asset prices occurs following rate hikes. The rate hikes of the 80’s and early 90’s occurred, in general, when interest rates were higher and stock valuations were lower. More recently, since the early 2000’s, we have seen a significant rise in overall debt levels coinciding with high asset prices. Low interest rates have led to higher debt levels and have enabled assets to trade at ever increasing prices. This greater economic dependence on low interest rates driving increasing debt levels is likely contributing to a more amplified response in asset prices relative to changes in interest rates. The last two rate hike campaigns decimated the prices of stocks, businesses, credit, and real estate.

The Fed has also expressed a commitment to reverse QE and to slowly sell the $4 trillion worth of assets it has accumulated since 2008. According to the Wu-Xia Shadow Fed Funds Rate – a measure that takes into consideration the effects of QE – the effective Fed Funds Rate was -3% at the peak of QE. This implies that simply by eliminating their LSAP program, the Fed has removed the equivalent impact of 3% of Fed Funds stimulus. In other words: to date, the Fed has removed the effective stimulus equivalent to raising short-term interest rates by 4.25% (3% + 1.25%) since 2014.

As of October 2017, the Fed has committed to sell $10 billion in assets a month into public markets, accelerating to a goal of selling $50 billion in assets a month by January 2019. This example serves to illustrate the sheer scale of the assets that have been purchased by these central banks and what now looks like the inability to actually unwind these assets.

What does it mean to unwind QE? It is the opposite of stimulus. Real money leaves the economy and returns to the Treasury, as the Fed sells assets to investors and takes their cash in return. On the one hand, investors end up with less money and on the other, the Fed’s selling pressures prices lower. In the case of bonds, too much selling could result in lower bond prices – or in other words, higher interest rates.

Contractionary economic pressure is being applied on two fronts: rising borrowing costs and the removal of money resulting from Fed asset sales. So far, so good, though. The global economy seems strong and to date has absorbed these pressures. It is worth noting, though, that tightening has only occurred in the U.S., and that other major central banks are still running strong stimulus initiatives.

But where does the real pressure come from? Will it be the slow drip of rising borrowing costs, or is it a sudden decline in asset prices that deflates the economic balloon? At turning points, capital markets lead the economy. The millions of participants pricing assets in real-time anticipate changes far in advance of when the economy actually turns. Arguably, the last two recessions were fueled by the collapse in stock prices and the direct impact to the economy of falling asset prices. Remember, the economy was booming in 2007 and in 1999, with no end in sight, just like it is now.

Is there a bubble in everything? Let’s hope not. With hundreds of millions of baby boomers globally nearing retirement and having maximum investable wealth, asset prices are far more tied to economic growth than ever before. There certainly seems to be a coordinated effort by all parties to keep asset prices from declining, and rightfully so. While the Fed and certainly other major central banks are all in the game of maintaining asset prices, whether they admit it or not, at least the economy is on sure footing. It would be far worse if all of this central bank liquification turned out to be unsuccessful.

It is possible that central banks have not overstayed their welcome, providing too much stimulus for too long, and it might be that what has occurred was required. It is possible that, what looks like high asset prices today may actually be foretelling better times ahead. However, few investors seem to be considering the possibility that central banks may have played a heavy hand in raising asset prices.

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We present performance information for short time periods because we understand that clients and potential Investors are interested in this information, however, we recommend against making any investment decisions based on short-term performance information.
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Frontier’s performance is available on our website –
Maloney, C (2017) The Long-Awaited Fed Balance Sheet Taper Begins Today With Mortgages. Bloomberg. Retrieved from Bloomberg’s website.
Yardeni Reseach, Inc. (2018) Global Economic Briefing: Central Bank Balance Sheets
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