By Greg Ip
To veterans of financial bubbles, there is plenty familiar about
the present. Stock valuations are their richest since the dot-com
bubble in 2000. Home prices are back to their pre-financial crisis
peak. Risky companies can borrow at the lowest rates on record.
Individual investors are pouring money into green energy and
cryptocurrency.
This boom has some legitimate explanations, from the advances in
digital commerce to fiscally greased growth that will likely be the
strongest since 1983.
But there is one driver above all: the Federal Reserve. Easy
monetary policy has regularly fueled financial booms, and it is
exceptionally easy now. The Fed has kept interest rates near zero
for the past year and signaled rates won't change for at least two
more years. It is buying hundreds of billions of dollars of bonds.
As a result, the 10-year Treasury bond yield is well below
inflation -- that is, real yields are deeply negative -- for only
the second time in 40 years.
There are good reasons why rates are so low. The Fed acted in
response to a pandemic that at its most intense threatened even
more damage than the 2007-09 financial crisis. Yet in great part
thanks to the Fed and Congress, which has passed some $5 trillion
in fiscal stimulus, this recovery looks much healthier than the
last. That could undermine the reasons for such low rates,
threatening the underpinnings of market valuations.
"Equity markets at a minimum are priced to perfection on the
assumption rates will be low for a long time," said Harvard
University economist Jeremy Stein, who served as a Fed governor
alongside now-chairman Jerome Powell. "And certainly you get the
sense the Fed is trying really hard to say, 'Everything is fine,
we're in no rush to raise rates.' But while I don't think we're
headed for sustained high inflation it's completely possible we'll
have several quarters of hot readings on inflation."
Since stocks' valuations are only justified if interest rates
stay extremely low, how do they reprice if the Fed has to tighten
monetary policy to combat inflation and bond yields rise one to 1.5
percentage points, he asked. "You could get a serious correction in
asset prices."
'A bit frothy'
The Fed has been here before. In the late 1990s its willingness
to cut rates in response to the Asian financial crisis and the near
collapse of the hedge fund Long-Term Capital Management was seen by
some as an implicit market backstop, inflating the ensuing dot-com
bubble. Its low-rate policy in the wake of that collapsed bubble
was then blamed for driving up housing prices. Both times Fed
officials defended their policy, arguing that to raise rates (or
not cut them) simply to prevent bubbles would compromise their main
goals of low unemployment and inflation, and do more harm than
letting the bubble deflate on its own.
As for this year, in a report this week the central bank warned
asset "valuations are generally high" and "vulnerable to
significant declines should investor risk appetite fall, progress
on containing the virus disappoint, or the recovery stall." On
April 28 Mr. Powell acknowledged markets look "a bit frothy" and
the Fed might be one of the reasons: "I won't say it has nothing to
do with monetary policy, but it has a tremendous amount to do with
vaccination and reopening of the economy." But he gave no hint the
Fed was about to dial back its stimulus: "The economy is a long way
from our goals." A Labor Department report Friday showing that far
fewer jobs were created in April than Wall Street expected
underlined that.
The Fed's choices are heavily influenced by the financial
crisis. While the Fed cut rates to near zero and bought bonds then
as well, it was battling powerful headwinds as households, banks,
and governments sought to pay down debts. That held back spending
and pushed inflation below the Fed's 2% target. Deeper-seated
forces such as aging populations also held down growth and interest
rates, a combination some dubbed "secular stagnation."
The pandemic shutdown a year ago triggered a hit to economic
output that was initially worse than the financial crisis. But
after two months, economic activity began to recover as
restrictions eased and businesses adapted to social distancing. The
Fed initiated new lending programs and Congress passed the $2.2
trillion Cares Act. Vaccines arrived sooner than expected. The U.S.
economy is likely to hit its pre-pandemic size in the current
quarter, two years faster than after the financial crisis.
And yet even as the outlook has improved, the fiscal and
monetary taps remain wide open. Democrats first proposed an
additional $3 trillion in stimulus last May when output was
expected to fall 6% last year. It actually fell less than half
that, but Democrats, after winning both the White House and
Congress, pressed ahead with the same size stimulus.
The Fed began buying bonds in March, 2020 to counter chaotic
conditions in markets. In late summer, with markets functioning
normally, it extended the program while tilting the rationale
toward keeping bond yields low.
At the same time it unveiled a new framework: After years of
inflation running below 2%, it would aim to push inflation not just
back to 2% but higher, so that over time average and expected
inflation would both stabilize at 2%. To that end, it promised not
to raise rates until full employment had been restored and
inflation was 2% and headed higher. Officials predicted that would
not happen before 2024 and have since stuck to that guidance
despite a significantly improving outlook.
Running of the bulls
This injection of unprecedented monetary and fiscal stimulus
into an economy already rebounding thanks to vaccinations is why
Wall Street strategists are their most bullish on stocks since
before the last financial crisis, according to a survey by Bank of
America Corp. While profit forecasts have risen briskly, stocks
have risen more. The S&P 500 stock index now trades at about 22
times the coming year's profits, according to FactSet, a level only
exceeded at the peak of the dot-com boom in 2000.
Other asset markets are similarly stretched. Investors are
willing to buy the bonds of junk-rated companies at the lowest
yields since at least 1995, and the narrowest spread above safe
Treasurys since 2007, according to Bloomberg Barclays data.
Residential and commercial property prices, adjusted for inflation,
are around the peak reached in 2006.
Stock and property valuations are more justifiable today than in
2000 or in 2006 because the returns on riskless Treasury bonds are
so much lower. In that sense, the Fed's policies are working
precisely as intended: improving both the economic outlook, which
is good for profits, housing demand, and corporate
creditworthiness; and the appetite for risk.
Nonetheless, low rates are no longer sufficient to justify some
asset valuations. Instead, bulls invoke alternative metrics.
Bank of America recently noted companies with relatively low
carbon emissions and higher water efficiency earn higher
valuations. These valuations aren't the result of superior cash
flow or profit prospects, but a tidal wave of funds invested
according to environmental, social and governance, or ESG,
criteria.
Conventional valuation is also useless for cryptocurrencies
which earn no interest, rent or dividends. Instead, advocates claim
digital currencies will displace the fiat currencies issued by
central banks as a transaction medium and store of value. "Crypto
has the potential to be as revolutionary and widely adopted as the
internet," claims the prospectus of the initial public offering of
crypto exchange Coinbase Global Inc., in language reminiscent of
internet-related IPOs more than two decades earlier.
Cryptocurrencies as of April 29 were worth more than $2 trillion,
according to CoinDesk, an information service, roughly equivalent
to all U.S. dollars in circulation.
Financial innovation is also at work, as it has been in past
financial booms. Portfolio insurance, a strategy designed to hedge
against market losses, amplified selling during the 1987 stock
market crash. In the 1990s, internet stockbrokers fueled tech
stocks and in the 2000s, subprime mortgage derivatives helped
finance housing. The equivalent today are zero commission brokers
such as Robinhood Markets Inc., fractional ownership and social
media, all of which have empowered individual investors.
Such investors increasingly influence the overall market's
direction, according to a recent report by the Bank for
International Settlements, a consortium of the world's central
banks. It found, for example, that since 2017 trading volume in
exchange-traded funds that track the S&P 500, a favorite of
institutional investors, has flattened while the volume in its
component stocks, which individual investors prefer, has climbed.
Individuals, it noted, are more likely to buy a company's shares
for reasons unrelated to its underlying business -- because, for
example, its name is similar to another stock that is on the
rise.
While such speculation is often blamed on the Fed, drawing a
direct line is difficult. Not so with fiscal stimulus. Jim Bianco,
the head of financial research firm Bianco Research, said flows
into exchange-traded funds and mutual funds jumped in March as the
Treasury distributed $1,400 stimulus checks. "The first thing you
do with your check is deposit it in your account and in 2021 that's
your brokerage account," said Mr. Bianco.
Facing the future
It's impossible to predict how, or even whether, this all ends.
It doesn't have to: High-priced stocks could eventually earn the
profits necessary to justify today's valuations, especially with
the economy's current head of steam. In he meantime, more extreme
pockets of speculation may collapse under their own weight as
profits disappoint or competition emerges.
Bitcoin once threatened to displace the dollar; now numerous
competitors purport to do the same. Tesla Inc. was once about the
only stock you could buy to bet on electric vehicles; now there is
China's NIO Inc., Nikola Corp., and Fisker Inc., not to mention
established manufacturers such as Volkswagen AG and General Motors
Co. that are rolling out ever more electric models.
But for assets across the board to fall would likely involve
some sort of macroeconomic event, such as a recession, financial
crisis, or inflation.
The Fed report this past week said the virus remains the biggest
threat to the economy and thus the financial system. April's jobs
disappointment was a reminder of how unsettled the economic outlook
remains. Still, with the virus in retreat, a recession seems
unlikely now. A financial crisis linked to some hidden fragility
can't be ruled out. Still, banks have so much capital and mortgage
underwriting is so tight that something similar to the 2007-09
financial crisis, which began with defaulting mortgages, seems
remote. If junk bonds, cryptocoins or tech stocks are bought
primarily with borrowed money, a plunge in their values could
precipitate a wave of forced selling, bankruptcies and potentially
a crisis. But that doesn't seem to have happened. The recent
collapse of Archegos Capital Management from reversals on
derivatives-based stock investments inflicted losses on its
lenders. But it didn't threaten their survival or trigger contagion
to similarly situated firms.
"Where's the second Archegos?" said Mr. Bianco. "There hasn't
been one yet."
That leaves inflation. Fear of inflation is widespread now with
shortages of semiconductors, lumber, and workers all putting upward
pressure on prices and costs. Most forecasters, and the Fed, think
those pressures will ease once the economy has reopened and normal
spending patterns resume. Nonetheless, the difference between
yields on regular and inflation-indexed bond yields suggest
investors are expecting inflation in coming years to average about
2.5%. That is hardly a repeat of the 1970s, and compatible with the
Fed's new goal of average 2% inflation over the long term.
Nonetheless, it would be a clear break from the sub-2% range of the
last decade.
Slightly higher inflation would result in the Fed setting
short-term interest rates also slightly higher, which need not hurt
stock valuations. More worrisome: Long-term bond yields, which are
critical to stock values, might rise significantly more. Since the
late 1990s, bond and stock prices have tended to move in opposite
directions. That is because when inflation isn't a concern,
economic shocks tend to drive both bond yields (which move in the
opposite direction to prices) and stock prices down. Bonds thus act
as an insurance policy against losses on stocks, for which
investors are willing to accept lower yields. If inflation becomes
a problem again, then bonds lose that insurance value and their
yields will rise. In recent months that stock-bond correlation, in
place for most of the last few decades, began to disappear, said
Brian Sack, a former Fed economist who is now with hedge fund D.E.
Shaw & Co. LP. He attributes that, in part, to inflation
concerns.
The many years since inflation dominated the financial landscape
have led investors to price assets as if inflation never will have
that sway again. They may be right. But if the unprecedented
combination of monetary and fiscal stimulus succeeds in jolting the
economy out of the last decade's pattern, that complacency could
prove quite costly.
Write to Greg Ip at greg.ip@wsj.com
(END) Dow Jones Newswires
May 08, 2021 00:14 ET (04:14 GMT)
Copyright (c) 2021 Dow Jones & Company, Inc.