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.

Recap by David Camacho, CPA

Watch the Replay

I had the pleasure of attending North Dakota State University’s virtual Navigating the Financial Markets event. NDSU partnered with CFA Society Minnesota (CFAMN) in hosting three distinguished professionals in the asset management industry: Lisa Erickson, CFA (US Bank), Mark Simenstad, CFA (Thrivent), and Robert Thompson, CFA (Mairs & Power).

The presentation kicked off with Lisa Erickson providing an overview of where she sees the economy today and some opinions on where we are going in the near future. In general, she recommends a glass-half-full portfolio orientation, where she is optimistic about the economy and markets but concerned about inflation. I certainly share her inflation concerns and so did the rest of the speakers, as it became one of the most prominent themes throughout the event.

Mark Simenstad followed Lisa’s presentation by focusing on the dramatic reduction in economic stress that we are currently seeing in the US market. Factors such as resilient consumer demand and strong manufacturing production, additionally the booming housing market provides him with optimism for the market’s short-term performance. However, he also identifies inflation concerns on the horizon. I was interested in his view of the rapid economic recovery we experienced in response to the Coronavirus restrictions. Mark pointed out the “K” shaped economic recovery we are seeing – where certain sectors are taking off (tech, industries that facilitate working from home), while others are struggling (service, non-work from home industries). I certainly agree with him in identifying this as an area of concern and have also heard others refer to it as a “Y” shaped recovery – potentially accelerating industry trends that were already set in motion pre-pandemic.

Our final speaker was Robert Thompson. I was most interested in his comments regarding permanent asset growth resulting from the Fed’s actions post-COVID. In addition to touching on inflation, he mentioned my other great concern for the US economy – maintaining the dollar’s position as the world’s currency reserve. Certainly, we experience many benefits from this status and would face much steeper challenges were this to change.

The presentations by our three speakers concluded with a Q&A from the audience, with questions ranging from inflation to housing to monetary theory. I was quite impressed by all three speakers and want to express my sincere gratitude to Lisa, Mark, and Robert for sharing their experiences and knowledge with us all. Included below is a bullet point summary of some of their speaking points throughout the event. In general, we have a variety of reasons for optimism in our economy as we emerge from this long un-vaccinated stretch. However, some of the solutions the Fed implemented to cure our sudden recession have the potential to become ills in the future.

Lisa Erickson, CFA, US Bank:

• Upfront conclusions
  • Recommend a glass-half-full portfolio orientation (optimistic on economy and markets)
    • Interest/Inflation a concern
  • Vaccination and Testing progress are key
  • Policy remains a key focus area
• Despite early challenges, vaccination progress is accelerating
• Financial Markets =/= economics
  • US moving towards expansion
• Domestic earnings are projected to trend higher in 2021 and 2022
  • 21/20 YoY EPS Growth avg 28.3%

Mark Simenstad, CFA, Thrivent:

• Dramatic Reduction in Economic Stress
  • Resilient Demand – Retail Sales (Gov Support)
  • Rebounding Employment – Claims Data
  • Resilient Manufacturing – Supply chains?
  • Housing – Boom times
• Recovery Pulling Yields Higher
• Bond Market and Inflation Expectations
  • Fed still buying 120B bonds / month
  • 10-year breakeven rate climbing, at 5 year high – market pricing in 2.5%
• Earnings Need to Validate Market Surge
  • Forward 12M P/E Ratio vs Price – growing divide
• Asset Class Universe – Returns and Yields
  • Treasuries taken a beating over 1 yr
• Building Diversified Portfolios (MPT)
  • Optimal portfolios, efficient frontier
• Market “Balance Sheet”
  • Vaccination effort in US asset, effort rest of world liability
  • Rapid economic recovery, k shaped economic recovery
  • Earnings/profit margins, supply chain issues
  • Unprecedented Fed Support, rising interest rate/inflation
  • Market breadth, historically very high valuation
  • Surging Fund Flows, Significant signs of speculation (BTC, SPAC, Coinbase)
  • Massive Fiscal Plans (Infrastructure), Potential Tax Hikes

Robert Thompson, CFA, CIC, Mairs & Power

• The Fed and Federal Debt
  • Permanent Asset Growth
  • US Debt 21.7 T, 4.8T held by the Fed
  • Since 2/26/20, federal debt increased by 4.3T, 55% of that inc. Fed financed
• Outlook
  • Economic Growth Post Pandemic
    • Fed Reserve (must maintain our currency reserve status)
    • Stimulus, Real Estate Outlook, Geopolitics, Global Debt Levels (unsustainable?), Crypto and SPACS (worried about SPACS being a bubble)
  • Market Outlook
    • Inflation (biggest concern), Interest Rates (chasing riskier assets seeking higher yields), Corporate Bond Spreads (should do well in current environment), Equity Market