By Susanna Gibbons, CFA
For decades now, we have been waiting for the end of the bull market in interest rates. Every conference, every article on higher interest rates looks on fixed income markets with scorn – “Now that interest rates are moving higher, what are you going to do with your bond allocation? Why would you even own bonds with rates at these levels?” And so now, perhaps – here we are. Maybe it’s over.
But that is not the era that I’m talking about. The Fed has backed itself into a corner, where aggressive inflation fighting appears to be its only option, and that certainly means higher short term interest rates. But much more significant than the end of the bull market in interest rates is the end of the Greenspan Put era.
The Greenspan Put, which became the Bernanke Put, and then the Powell Put in March 2020, is the policy of lowering interest rates to protect investors from the intolerable pain of falling stock prices. The policy was predicated on the wealth effect – that falling stock prices would cause people to reduce spending. If the Fed were to maintain liquidity in financial markets, they expected it would fend off anticipated weakness in the real economy, the world where people have to eat and live places and send their kids to school. It has worked, in a way, but at the same time the Fed has created a moral hazard, where equity investors do not have to bear the full risk of their investment choices. For decades, they have been able to rely on the Fed to provide a liquidity balm whenever valuations became excessive, and fear took over.
That era is over. Until the Fed believes that we are through the current inflation crisis, they are going to drain liquidity from the system. They are not going to be there to support equity markets. Or Bitcoin or NFTs. Or Real Estate. This is no time to buy the dip. The Fed has no capacity to rescue markets this year. And that means that risk of owning equities is increasing, and will probably continue to do so.
As market have sold off, we have indeed seen VIX march upward. We have also seen correlations break down, as is typical during times of stress. Unfortunately for most institutional portfolios, that correlation break down includes Treasuries. If long term interest rates continue to increase for some period of time, Treasury prices will remain positively correlated with equities, just as they were in the 1970s. That does not bode well for portfolio construction. Most asset allocators have added increasing amounts of equities (both public and private – I am not willing to pretend that private equity isn’t going to get riskier too, just because we aren’t marking it to market), with some of the added risk protected by long duration Treasuries. If the riskiness of equities continues to increase, and the correlation with bonds remains positive, then the current standard portfolio structure becomes pretty perilous.
I do not think, though, that we are in for a 1970s style inflation with a Volcker-like response. How could that possibly happen? In 1975, the combined Federal and Household Debt / GDP ratio was about 75%. Today, that figure is over 200%. For inflation to really become imbedded, we have to be willing and able to borrow money at higher rates, pay the higher prices for goods, just to maintain our level of consumption. Seems more likely to me that we are just going to have to stop buying Impossible Burgers and buy cans of beans instead. That is not good news for our equity allocations. Not only will profit margins need to come down from record levels, they will probably fall below historical averages.
We probably need to settle in for the long haul. As long as the Fed is fighting inflation, equities have nowhere to go. In the absence of the Greenspan Put, portfolio returns probably won’t amount to a hill of beans.