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Zero rates

Too much of a good thing?

The inexorable rise in asset prices caused by the seemingly never-ending era of monetary easing is calling into question long-held investment beliefs, as members of our multi-asset & macro and equities teams explain.

During the COVID-19 pandemic, global investors have gone from abject despair to euphoria

The former British Prime Minister Harold McMillan famously said in 1957 most of the nation “have never had it so good”. He was referring to steadily rising wages and productivity as the country’s recovery from the Second World War continued apace.

If he were alive today, he might have been tempted to apply the same phrase: not to British citizens, but global investors. Since the COVID-19 pandemic took hold in early 2020, investors have gone from abject despair to euphoria. Amazingly, given 2020 witnessed the deepest global recession since the Second World War, global equities returned 16 per cent to end the year at a record high.1 As for corporate bond spreads, after briefly spiking sharply higher in March and early April, they ended the year not only broadly unchanged, but beneath their long-term average despite record levels of corporate indebtedness.2,3

Figure 1: US investment grade spreads
US investment grade spreads
Source: Eikon Datastream

Monetary policy: Having it large

That risk assets performed so well was overwhelmingly explained by central bank largesse, which led sovereign bond yields to collapse. That, together with huge amounts of fiscal stimulus, has triggered a stampede into pretty much all other financial assets, fuelling what has been dubbed by some “the everything rally”.

The arrival of several effective vaccines has held out the prospect of the pandemic eventually being brought under control

Although COVID-19 continues to rage largely unchecked throughout most of the world, sentiment was helped towards the end of 2020 as the arrival of several effective vaccines held out the prospect of the pandemic eventually being brought under control.

Hopes the global economy was poised for a strong rebound in 2021, as the world gradually returned to normality, received a further boost in December when Democrats seized control of the US Congress. That could enable President Joe Biden to enact a massive fiscal stimulus programme.

Better still, financial markets are betting central banks such as the Federal Reserve will be in no rush to remove the punchbowl as economic conditions improve. While bond yields have risen over the past six months, scarcely believably investors in several markets remain prepared to pay governments for the privilege of lending to them, in real terms, for 30 years or more.4

Why investing now is harder than it looks

However, while at first glance it may appear to be an ideal time for investing, the present environment is far from easy to navigate. While momentum trading strategies, where an asset is bought and sold on the strength of its recent price action, have grown in popularity - especially among retail investors - the overwhelming majority of professional investors continue to rely on getting two basic calculations right: the prospective return on the investment, or its value, and the level of risk it entails. The scale of stimulus currently being employed means neither calculation is straightforward to perform.

The actions of central banks have made the task of price discovery hugely challenging

Take valuations. By causing the yield on risk-free assets to collapse, the actions of central banks have pushed the price of pretty much every financial asset sky high and made the task of price discovery, or assessing the real value of those assets, hugely challenging.

The extraordinary actions of central banks for the last decade have brought the benefit of traditional valuation metrics into question, forcing bond investors to redefine what is meant by the term ‘neutral’ interest rates.

“Sovereign debt markets have been heavily distorted for many years, and trying to assess value through a traditional, fundamental lens is problematic. You really need to understand technical drivers, and central bank intervention is at the heart of that,” says Mark Robertson, head of multi-strategy funds at Aviva Investors.

The disappearance of mean reversion

Historically, one tried and trusted, albeit basic, method of selecting what to buy and sell involved comparing an asset’s current value, based on any one of a series of metrics – such as a share’s price-to-earnings ratio or a corporate bond’s yield spread over comparable government debt – with its long-run average.

There is a lack of ‘mean reversion’ in all kinds of potential strategies and financial markets

Since those averages had tended to behave in a relatively predictable fashion over time, buying assets trading cheaper than the long-run average and selling those trading more expensive had been a broadly successful strategy prior to the global financial crisis. However, one of the most striking aspects of the investment landscape in the years since has been a lack of ‘mean reversion’ in all kinds of potential strategies and financial markets.

“One of the lessons most asset allocators have had to learn is that the Ladybird book of value investing may need to be put into the kids’ playroom and left there. In particular, what it has to say on mean reversion is being called into question,” explains Sunil Krishnan, Aviva Investors’ head of multi-asset funds.

The relentless decline in global bond yields, the sustained outperformance of ‘growth’ stocks relative to ‘value’ stocks, and the extreme outperformance of the US equity market versus international peers, are three of the more striking examples of the breakdown of mean reversion.

While a combination of factors such as loose monetary policy and changing trends in company profitability, with winners having kept on winning, may explain the bulk of this absence of mean reversion, other forces may also be at work.

The tension between secular change and extreme cyclical distortion is hard to play

For example, many commentators reckon the growing importance of retail investors as a driver of US equities is unlikely to last. However, Krishnan says the shift away from defined benefit pension schemes in recent years may offer an alternative explanation, in which case the phenomenon might be here to stay.

“This tension between secular change and extreme cyclical distortion can be seen across a number of markets and is really hard to play. So, we’re trying to be more focused by concentrating on the deepest valuation discounts or the strongest evidence of structural change,” Krishnan says.

Mark Robertson agrees it has become dangerous to rely on mean reversion. “This absence of mean reversion is creating a dilemma for investors: namely, has something structurally broken such that we should never expect mean reversion to return, or have we simply stretched the elastic ever further so that when it does eventually snap back it will do so really aggressively?” he says.

Mind reading policymakers

Krishnan says a related challenge is that, whereas previously it was possible to draw on economic theory to make predictions about the business and investment cycles, the scale of policy intervention today means those linkages are now far weaker and therefore much less important.

“You tend to find yourself spending more time trying to mind read what policymakers are up to as opposed to understanding what’s going on in companies and households,” he says.

There is evidence of frothy markets across a wide array of financial instruments

The difficulty in valuing financial assets with confidence is being compounded by a growing suspicion that by allowing prices to become unhinged from economic reality, central banks are allowing asset bubbles to form. At the very least, there is evidence of frothy markets across a wide array of financial instruments.

Witness for example the booming sale of new securities. US corporate bond issuance last year totalled $1.9 trillion, a record,5 while the amount of money raised via global stock market listings hit a 13-year high of $300 billion.6 More than half of that was raised in the US, including by 248 special purpose acquisition companies. These so-called ‘blank cheque’ companies, which hunt for private companies to take public, raised a record $83 billion from investors and in turn the eyebrows of regulators.7

The soaring price of cryptocurrencies – as of Jan 8, the price of Bitcoin had surged 300 per cent in the space of little more than three months8 – is arguably one of the most clear-cut examples of speculative excess. More remarkable still, frenzied and coordinated buying by US retail investors using the social messaging platform Reddit helped push up the shares of GameStop, a struggling bricks-and-mortar video game retailer, by a staggering 1,744.5 per cent between December 31 and January 27.9

Figure 2: Gamestop share price (US$)
Gamestop share price
Source: Eikon Datastream

Hubble, bubble….

“I don’t think anyone looks around and thinks there are a lot of great opportunities to buy assets at reasonable prices, whether that’s high-yield credit or growth stocks. There’s not a lot cheap to buy and an awful lot of stuff that looks eye-wateringly expensive,” says Robertson.

He cites an expanding list of companies, especially in the US technology sector, whose shares are trading on multiples not of profits, but revenues. “That’s when you know you’re into bubble territory, when they’re trying to justify prices based on that sort of metric.”

Current conditions feel more like the late stage of a typical bull market than the start of a new stock market cycle

Giles Parkinson, global equities fund manager at Aviva Investors, says the level of froth in equity narratives means current conditions feel more like the late stage of a typical bull market than the start of a new stock market cycle.

“Less than a year ago, people were talking about the return of capital rather than the return on capital; can I get my money back, let alone make a profit on it. Fast forward to today, and suddenly it seems as if the actual business model hardly matters,” he says.

Given the pace of the rally in asset prices, it is perhaps not surprising to see more and more investors sounding sirens about its sustainability. One prominent equity value fund manager recently complained that the Federal Reserve had broken the stock market and compared other investors to frogs in boiling water. Another described the market’s inexorable rise since 2009 as an “epic bubble” characterised by “extreme overvaluation”.

Figure 3: S&P 500 P:E ratio
S&P 500 P:E ratio
Source: Eikon Datastream

However, Parkinson says while shares may seem expensive relative to history, the same could arguably have been said for the last five years and yet the party has continued. Moreover, the same goes for every other asset class.

“Have we gone up to a new valuation plateau or is this the new ‘everything bubble’ is a question worth asking as there is a lot riding on it. Coming up with an answer is another matter,” he says.

Option market dichotomy

Assessing risk is also far from straightforward. The Vix index – a gauge of how volatile investors expect the US stock market to be over the next 30 days, as derived from options prices – has collapsed towards its long-term average after briefly spiking in the spring of 2020.10 However, look further into the future and the prices of longer-dated options imply much choppier waters ahead.

Figure 4: Vix index
Vix index
Source: Eikon Datastream

Robertson explains that demand for long-dated call options has been partly driven by investors who, while bullish on the stock market overall, are wary they may be overpaying at current levels and want the downside protection afforded by options. At the same time, other investors have been looking to take out downside protection by buying put options, pushing up their price.

Ultimately, this buying of longer-dated options reflects investors’ belief that while markets will remain becalmed by the actions of central banks in the near term, there is more uncertainty over their long-term prospects.

If you’re too reliant on a short-term risk model, you end up carrying much more risk in the portfolio than you realise

“The danger for investors is that if you’re too reliant on a short-term risk model, you end up carrying much more risk in the portfolio than you realise and eventually things blow up. Then again, relying on a long-term model might lead to you carry too little risk. You’re trying to balance the two and scenario analysis can help bridge the divide,” Robertson says.

For investors looking to create diversified portfolios, the problem is compounded by the fact it is getting harder to find negatively correlated assets. Scenario analysis can be a useful tool to help investors understand the distribution of an investment’s potential returns, not just a central projection, giving them a more holistic perspective on the riskiness of positions.

Fed concern?

Remarks from three officials at the Federal Reserve at the start of January drew attention after they floated the idea of reducing monthly bond purchases by the end of this year if warranted by economic conditions.

Although Fed chief Jay Powell soon responded by saying such talk was premature, some commentators took the remarks as a sign the US central bank is getting concerned about the level of exuberance in financial markets.11

It is little surprise markets look frothy given financial conditions in the US are as easy as they have ever been

Some commentators are sceptical on that interpretation, believing it is little surprise markets look frothy given financial conditions in the US are as easy as they have ever been.

Robertson agrees, arguing that while excessive optimism suggests a sizeable correction may be in the offing in the first half of 2021, that would most likely be a temporary pullback.

“The Fed will keep rates low and keep talking dovish, especially if you get a wobble, so I don’t think that would be the end of it. Right now, it’s hard to see what will bring an end to the rally, but that doesn’t mean we are chasing it,” he says.

He adds the officials’ remarks were a reminder financial markets will not be able to rely on central bank support for ever.

Get up and dance

In July 2007, the former boss of Citigroup famously said, “as long as the music is playing, you’ve got to get up and dance”, when explaining his bank’s position as a major provider of finance for leveraged buyouts.

Within four months, and with the bank beginning to rack up record losses after being caught gyrating long after credit markets had started convulsing, Charles Owen "Chuck" Prince III was gone.

The dilemma facing investors today is whether to load up on risk or sit on the side-lines

His remarks epitomise the dilemma facing investors today: whether to load up on risk and expose yourself to the danger of big losses, or sit on the side-lines and miss out on the next leg of the rally.

While unearthing cheap assets may be getting increasingly hard, for fund managers who do not rely on momentum trading, their investment processes are naturally tending to draw them away from frothier areas of the market.

Parkinson believes it is important to stick to a tried and trusted investment process and avoid getting distracted by what is happening to shares your portfolio does not own.

In particular, he says the application of a constant hurdle rate for a stock to be included in his portfolio will tend to mean he avoids frothier areas of the market. He won’t invest in a stock unless he thinks the company can deliver an internal rate of return of eight per cent, because that roughly approximates the long-run real return from equities of six per cent.

It is important to stick to a tried and trusted investment process and avoid getting distracted

“We’ve found this can keep us out of trouble. We had a near record high proportion of cash going into the coronavirus crisis because we could find lots of shares we wanted to sell, but not a lot we wanted to buy,” he explains.

Parkinson says while it is still possible to unearth shares he believes to be capable of delivering this ‘magic’ eight per cent plus return, it is getting harder, hence the number of holdings in his portfolio currently stands at 30, towards the lower end of its typical range.

For now, it seems the music will continue playing for a while longer. That means investors, to quote Prince, may feel there is little option but to keep dancing. However, while it may appear as if they have never had it so good, they may want to stick close to the door. It is, after all, possible to have too much of a good thing.

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