Download October 31, 2015 — Market Comment

Wells Capital Management
A different kind of “new normal?”
October 31, 2015
Grappling with an “asset-driven” economic cycle
Assets ascendant. Nearly lost in the debate over the timing of the
Fed’s first interest-rate hike has been the risk of heightened asset-price volatility and its threat to economic and financial stability—
a surprising oversight after housing’s universally accepted role as a
catalyst for the deep recession seven years ago. Nearly a decade of
aggressive monetary stimulus since then has been a double-edge
sword in supporting housing and other interest-sensitive sectors
while distorting asset values, investing and borrowing decisions at
home and abroad. Asset-price increases driving wealth and spending
have been inflated by an investor rotation from less attractive Treasury and other “quality” securities to stocks, non-investment-grade
bonds and other highly charged, often opaque assets in a worrisome
replay of the excesses ultimately contributing to the financial “meltdown” in 2008-09. Low yields also have inflated liabilities, spurred
by ample, low-cost financing from yield-hungry investors to highly
charged sectors at home and abroad, leaving overseas borrowers
exposed to the same currency risk that sank Asian economies during
the financial crisis in the late 1990s.
stimulus supporting credit-sensitive sectors and, more importantly,
asset-price inflation to boost wealth and spending, has exposed the
economy to many of the same imbalances contributing to the turmoil
seven years ago.
“Hockey-stick” economic cycles. Debt- and asset-driven cycles
leave the economy more exposed to a deep recession followed by
a weak, drawn-out recovery—not unlike that traced by the current
cycle’s hockey-stick-like pattern. Exceptions to the rule have included
an “artificial” variant—a steep, economic decline triggered by announced
credit controls in March 1980, followed by a temporary burst of
growth after controls were lifted that July. Another occurred briefly
during the Great Depression, when double-digit growth in 1934-36
following the early-1930s stock-market crash and economic slump
was cut short by restrictive monetary and fiscal policies.
Why have asset prices become so potent in shaping the economic
cycle, in effect eclipsing goods and services inflation as a key driver of
economic activity? The groundwork was laid well before the turmoil
seven years ago, triggered, ironically, by the same prolonged decline
of inflation fostering “The Great Moderation” of subdued economic
cycles in the decades leading up to the financial “meltdown” in 2008-09.
Multi-decade “disinflation” undercut traditional, inflation-driven catalysts
for cyclical change, including bottlenecks and inventory swings, a
squeeze on “purchasing power,” credit tightening and higher interest
rates. It also ushered in the era of financial assets through a secular
decline in interest rates producing equity-like bond returns during
the market’s thirty-year “golden era” through 2014 almost triple the
3.5% average of the 1950s through early 1980s. Low interest rates and
increasingly “rich” bond prices also lifted stocks by allowing the market
to accommodate higher valuations, reinforcing earnings growth.
Yields ultimately fell enough to encourage an even broader search
for better performing—but riskier—assets, stoked by “accommodative”
monetary policies encouraging portfolio leveraging with cheap,
short-term funds. That leveraged reach for return has contributed to
a series of asset “boom-bust” cycles over the past 25 years in stocks,
housing, commodities and other assets, as “fundamentals “ driving
market performance have been reinforced by waves of investment
propelled by ample liquidity. The stock market’s rise and fall in the
late 1990s through early 2000, played a limited role in the mild 2001
recession, but the more leveraged “boom-bust” cycle soon thereafter
was central to the deep economic slump in 2008-09 touched off by
housing’s great “unwind.” The resulting economic and financial “meltdown” set the stage for the Fed’s ultra-stimulative policies of near-zero
interest rates and quantitative easing (QE) since 2008. Monetary
Gary Schlossberg
Nonetheless, the nature of asset-price swings leaves the economy
more vulnerable to deep corrections and to slow recoveries. Changes
tend to be “pro-cyclical,” reinforcing wealth-related spending gains
rather than countering economic strength through growth-dampening
increases in inflation and rising interest rates squeezing “purchasing
power” and adding to borrowing costs. Moreover, low inflation,
abundant funds and subdued borrowing costs, capable of muting
economic swings through traditional channels as they did during the
Great Moderation, risk aggravating asset-induced slumps by inflating
their values. Low-cost leveraging to super-charge returns works just
as well in magnifying declines, as rising interest rates force aggressive
asset sales with a debt unwind.
More importantly, asset boom-bust cycles pose more of a threat to
credit availability, capable of a more wrenching effect on economic
activity than more gradual, inflation-driven changes in credit costs.
Unraveling asset values expose lenders to sizable capital losses, via
steep declines in household and business net worth and, typically,
over-leveraged balance sheets. Seemingly ample “liquidity” (or funds
availability) fuelling the rise in asset prices can be even more fickle,
abruptly disappearing as risk tolerance diminishes. Uncertainty over
the availability (as opposed to the cost) of credit encourages cash
hoarding by businesses and consumers behind abrupt declines in
demand and deep economic slumps like that in late 2008-early 2009
(and, for that matter, immediately after credit controls were enacted
in March 1980). Deleveraging reinforces the spending pullback in a
race to the bottom with slumping asset values, adding to pressure on
the economy and on banks’ loan quality, capital and lending capacity.
Disruptions from more aggressive deleveraging, banks’ balance-sheet
consolidation and the bias toward cash tend to be more enduring
than in traditional, inflation-driven economic cycles, where lean
inventories, pent-up housing, and “big-ticket” consumer demand set
the stage for recovery earlier as adjustment winds down. The result
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A different kind of “new normal?”
tends to be more drawn-out adjustment and weaker economic recoveries as asset prices and debt adjust to changed circumstances.
Weighing the fall-out. Asset-driven cycles can affect more than
the economy’s overall trajectory, potentially shaping the pattern of
spending, borrowing and investment strategy. Upper-income families
become more of a force in consumer-led growth, affected most by
changes in household wealth at a time when weak income gains restrain spending by other households. Worsening wealth and income
inequality foster re-distributional policies typically detrimental to the
kind of growth needed to promote economic and financial healing.
Weak, drawn-out recoveries tend to keep excess capacity high and
business “pricing power” low, encouraging cost cutting through hiring and wage restraint, in turn undercutting income growth propelling dominant consumer spending.
Cycles driven by changing asset prices can be as treacherous for
corporate finances as they are for the economy. The same excess
“liquidity” driving asset “bubbles” provides ample funding to paper
over balance-sheet weaknesses through debt restructuring, suppressing default rates and market clearing of underperforming assets that
leave investments all the more exposed as interest rates normalize.
Borrowing at seemingly low interest rates leaves businesses vulnerable
both to “roll over” risk, as debts are refinanced at higher interest rates,
and, potentially, to more burdensome debt payments if a subsequent
asset “bust” pulls inflation and revenue growth below the average
interest cost of debt. Jump-starting the economy with asset values
inflated by near-zero interest rates layers on added risks, by recreating
many of the same financial distortions triggering asset busts requiring
stimulus in the first place. Artificially low interest rates also suppress
the cost of capital, distorting investment decisions and leaving seemingly viable projects vulnerable as financing costs return to levels
more in line with economic “fundamentals.”
A difficult third mandate? Navigating a “soft landing” for the asset
markets may be even more difficult for the Fed than striking the right
balance to meet its dual mandate of potential growth and price stability. Targeted, “macro-prudential” policies to contain asset bubbles
may ring-fence the problem in theory, but their practical effectiveness is
suspect. A well-timed policy shift could thread the needle in achieving
the right combination of growth and inflation. Even if the Fed is
comfortable identifying asset bubbles, by contrast, achieving stability
sufficient to defuse the threat to the economy could prove more
elusive: early “normalization” of interest rates risks unsettling the
financial market enough to short-circuit growth, while delay risks
asset and debt imbalances serious enough to pose an increasingly
severe threat to financial stability and to the economy.
Fortunately, current similarities to the last boom-and-bust cycle are
more by nature than by degree. Vulnerabilities less apparent seven
years ago do pose more of a threat now. More lightly regulated
segments of the “shadow banking” sector have filled some of the void
created by initially convalescing and, now, heavily regulated banks,
creating an element of uncertainty in the outlook. Market “liquidity”
also will be tested further by the Fed’s shift from stimulus, as securities portfolios thinned by regulation and other changes test banks’
ability to intermediate bond sales, and seemingly liquid exchangetraded funds (ETFs) face increased redemptions with suddenly
less tradable securities. The good news is that the household debt
burdens still are near a 34-year low. Bank portfolios are less leveraged
and better capitalized, investments still are less opaque and asset values
less stretched than they were on eight years ago. Still, the kindling is
there for more of the kind of financial tremors experienced in recent
years. The challenge for the Fed and other policy makers is to balance
this new, more challenging environment threatening financial and,
ultimately, economic stability with its other mandates.
New “new normal” investing? Asset-driven economic cycles have
had equally important implications for stocks, bonds and alternative
investments. Moderate growth, subdued inflation and ultra-stimulative
monetary policies encourage yield-hungry investors to tilt toward
longer-dated bonds, along with yield-oriented utility, consumer
staples and telecommunications services stocks. Low interest rates
and high bond prices also allow the stock market to accommodate
higher valuations, critical to performance in a slow earnings-growth
environment. Modest growth and subdued inflation suppressing
interest rates also foster a premium on top-line revenue gains, benefitting “growth” stocks, takeover targets and other restructuring plays.
Heightened asset-price volatility could make “risk on/ risk-off” trading
a more common feature of market activity, posing a more challenging
environment for “active” managers adding value based on assessments
of individual company, industry and sector “fundamentals.”
With yields already at historic lows, equity-like, double-digit bond
returns likely will be a thing of the past amid more limited scope for
interest-rate declines and bond-price increases. Bonds as a tool for
liability management and diversification will remain very much in
place. However, strategies for enhancing returns ultimately could tilt
from maximizing “duration” (via typically longer-term securities most
sensitive to interest-rate changes) as interest rates slowly turn higher
and, at times, from security selection during periodic risk-on/ risk-off
trading, to broader sector allocations and “yield-curve” strategies—
the latter designed to benefit from changing interest-rate differences
at various maturities. Stocks will have a leg up on bonds (in nominal,
if not risk-adjusted terms), benefitting from modest earnings growth
supporting further increases in equity prices and likely still biased
toward “growth” and acquisition-related stocks if weak pricing power
and modest unit-sales gains continue to trump a moderate economic
recovery. Common to these, alternative and other riskier investments will be a vulnerability to elevated risk premiums from out-sized,
asset-driven swings in economic activity driven by the same subdued
inflation and moderate growth often associated with economic stability.
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