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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 | 1 | 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. Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. WFAM includes Affiliated Managers (Galliard Capital Management, Inc.; Golden Capital Management, LLC; Nelson Capital Management; Peregrine Capital Management; and The Rock Creek Group); Wells Capital Management, Inc. (Metropolitan West Capital Management, LLC; First International Advisors, LLC; and ECM Asset Management Ltd.); Wells Fargo Funds Distributor, LLC; Wells Fargo Asset Management Luxembourg S.A.; and Wells Fargo Funds Management, LLC. Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational/informational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells Capital Management and its advisory services, please view our web site at www.wellscap.com, or refer to our Form ADV Part II, which is available upon request by calling 415.396.8000. | 2 |