Will 2022 go down in financial history as the year the music stopped? After the extraordinary buoyancy in markets in 2021 the risk of a painful downturn is certainly escalating.
In weighing that risk, investors face one overwhelmingly uncomfortable fact — central banks continue to rig the markets through their asset purchasing programmes, with important consequences for private portfolios.
The expansion of central bank balance sheets started as a response to the great financial crisis of 2007-09 and accelerated when the pandemic struck in March 2020.
This monetary activism perpetuates a looking-glass world where supposedly safe assets such as index-linked government bonds yield a negative income.
While they may remain safe in the sense that they offer liquidity, they are nonetheless toxic because they ensure a guaranteed loss if the investment is held to maturity. At the same time, most nominal government bonds currently show a negative real yield after adjusting for inflation.
One implication is that a traditional well-structured, diversified portfolio — split 60/40 between equities and bonds — has long been unhelpful for retail investors because bonds have lost their traditional insurance quality.
Another is that investors have been forced to take on more risk, notably in equities, while risk across many markets is underpriced.
In effect, the central banks have subverted the markets' capacity to establish realistic prices. And as I pointed out in FT Money a year ago, bond investors face reinvestment risk whereby investments providing a good income today cannot be replaced by equally attractive investments when they reach maturity.
The flood of central bank liquidity has caused valuations to become stretched, most notably in the US where the cyclically-adjusted price/earnings ratio invented by Nobel laureate Robert Shiller reached 38.3 in autumn last year, fast approaching the multiple of 44.2 notched up at the peak of the dotcom boom.
This is the second-highest peak in 150 years, says Chris Watling of Longview Economics, a consultancy. US stock market capitalisation as a multiple of gross national product — a measure favoured by billionaire investor Warren Buffett — hit an all time record of 2.8 in the second quarter of 2021, compared with a dotcom peak of 1.9.
The symptoms of an equity bubble are rife in the US: witness the Spac phenomenon where blank cheque companies bring private companies to market while circumventing the protections afforded by conventional initial public offerings. Share prices of money-losing businesses are being ramped up, notably in the tech sector. Boston-based fund manager GMO points out that 60 per cent of the growth stocks in the Russell 3000 index make no money. And this was true even before the Covid-induced recession. Meanwhile, small retail purchases of US equity options have grown explosively in volume and speculation in crypto assets is increasingly frenetic.
While some of these bubble characteristics such as Spacs and crypto speculation are now affecting Europe, equity valuations in the eurozone, the UK and Japan are not so conspicuously stretched.
The UK, in particular, is shunned by many international investors because of a perceived paucity of growth companies, worries about Brexit-induced lower economic growth and a disproportionate number of fossil-fuel-intensive companies in the indices. Yet the bond markets in Europe and Japan are subject to the same underpricing of risk as in the US. And the rest of the world's markets will surely feel the backwash when the US equity bubble bursts.
Economists and actuaries tend to equate risk with volatility. But for mere mortals the most damaging risk is loss of capital. It is worth noting that the 2021 Credit Suisse Global Investment Returns Year Book records that from the peak of the dotcom boom in 2000 to March 2003 US stocks fell 45 per cent, UK equity prices halved and German stocks fell by two-thirds.
What might cause the bond market bubble and the US equity market bubble to burst? A new and devastating variant of the coronavirus is an obvious possibility. But in a market overwhelmingly driven by policy the more predictable catalyst is policy reversal.
Having initially argued that the surge in inflation since the pandemic struck in March last year was transitory, central bankers are now edging towards a less sanguine view. The fiscal policy boost in the US since the Covid shock has been huge in relation to plausible guesses about the size of the output gap, which records the amount of slack in the economy.
This contributes to demand pull inflation. Meanwhile, companies have found that they can pass on cost inflation arising from supply shortages relatively easily to customers. They are also conceding higher wages in a tight labour market. The same factors are at work in the UK and continental Europe, though the fiscal numbers are on a lesser scale than in the US.
There is a strong likelihood, then, that the big increase in money supply arising from ultra-loose monetary policy will be reflected in higher prices of goods and services in contrast to the period after the 2007-09 financial crisis where monetary expansion simply boosted asset prices.
In today's more inflationary environment, the US Federal Reserve and other central banks are reining back, or "tapering", their asset purchases, which have been an important prop to bond and equity markets. For its part, the Bank of England's monetary policy committee raised its policy rate by 0.15 percentage points to 0.25 per cent in December. Central bankers have long been anxious to return to a level of interest rates closer to historical norms, which would give them greater ammunition to restimulate the economy in the event of a new financial crisis or recession.
Markets appear to be anticipating that normalisation will not cause much pain. While the debate over inflation and policy tightening has raged there has been no "taper tantrum" of the kind that caused markets to fall out of bed in 2013. One explanation could be that investors think the economic recovery since Covid will remain sufficiently robust to absorb any tightening.
Another offered by Jeremy Grantham, co-founder of GMO and noted for his prescience in spotting bubbles, is that more than in any other previous bubble investors are relying on accommodative monetary conditions and zero real rates going on indefinitely. This has a similar effect to assuming peak economic performance for ever; it can be used to justify much lower yields on all assets and therefore correspondingly higher asset prices.
When will the bubble burst?
The problem for those who detect a bubble is that predicting the timing of the burst is notoriously difficult. In addition, moving into cash carries a heavy penalty at today's rates of inflation. The difficulty for central bankers is that tightening policy may prove more financially destabilising than markets now expect because of an extraordinary accumulation of debt since the financial crisis. This is a direct consequence of the low interest rates which create a huge incentive to borrow.
The Institute of International Finance, a trade body, estimates that global debt at the end of 2021 amounted to US$295 trillion, US$36t above pre-pandemic levels. This amounts to just under 350 per cent of global gross domestic product, compared with 282 per cent at the start of the financial crisis.
That tells us the extent to which global growth has been debt dependent while also pointing to a vulnerability. Rising interest rates will raise government borrowing costs and hit the large number of so-called zombie companies that are unable to cover debt-servicing costs from long-run profits but have been kept afloat by ultra-loose monetary policy. And if rate rises cause markets to plunge they could expose vulnerabilities in the banking system and among lightly-regulated shadow banks.
The problem is compounded because monetary tightening will coincide with a reduction in fiscal support. John Llewellyn and Saul Eslake of Llewellyn Consulting, a UK economic advisory company, point out that whereas in 2020 the general government fiscal balance of the G20 economies supported aggregate demand to the tune of 8.8 per cent of gross domestic product (GDP), the IMF estimates that support in 2021is likely to have fallen back to 7.9 per cent and on present budgetary plans to fall further in 2022 to 5.9 per cent. They worry that with the economic recovery not yet fully assured, this joint fiscal and monetary tightening looks premature and risky.
One all too plausible outcome is that financial instability arising from a sudden repricing of risk across the markets will cause central bankers to reverse course for fear of precipitating a harsh recession. That would entrench investors' belief in a perpetual safety net under the markets and set off a further round of debt accumulation, implying a lesser check on inflation and a bigger crisis down the road.
Equally plausible is a prolonged bout of stagflation, which is bad for investors. Looking at bond and equity returns in 17 OECD countries back to the late 19th century TS Lombard's Dario Perkins has identified episodes of stagflation, defined as years in which per capita GDP grew by less than 1 per cent and the headline CPI inflation rate was above 4 per cent. These episodes threw up significant real losses for investors. On average across the sample stagflation was associated with a 3 per cent real loss for equity holders and a 7.5 per cent real loss for bondholders.
Note, too, that in the last serious period of stagflation in the 1970s bonds and equities became positively correlated, so that bonds lost their insurance quality and became an additional source of risk.
Of the other risks faced by investors China demands attention. An overheated housing market and overborrowed property sector highlight the unstable nature of the credit fuelled growth model of the world's second-largest economy. The People's Bank of China, the central bank, moved before Christmas to ease financial conditions and the authorities still have enough fiscal capacity to stabilise a financial crisis. But flagging economic growth in the lower single figures seems likely in the light of these upsets, which will amount to a headwind for the world economy. That said, a slowdown would lead to lower commodity prices and a weaker currency, which would help the developed world cope with inflation.
For foreign investors in China the picture is complicated by Beijing's punitive recent assault on big tech and private education companies, its arbitrary interventions in markets and its clamp down on offshore financial vehicles through which companies such as Didi Chuxing, Alibaba and Pinduodo listed in the US.
As for direct investment in Chinese equities and bonds, they are at a potentially-attractive discount to developed world counterparts. The question for investors is whether the discount is sufficient relative to the risks, which include growing political pressure in the US to decouple from the Chinese economy. Another issue concerns how they feel about human rights abuses in China.
Climate risk is rising up the agenda. It poses a threat both through physical disasters such as extreme weather and potential corporate losses from decarbonisation as fossil-fuel-intensive assets have to be scrapped.
Companies' disclosure around plans for the transition to low carbon is exceptionally patchy and there is a widespread perception that climate transition risks are not efficiently priced in the markets.
This means that there are opportunities as well as risks for investors. But beware regulatory risk. There could be big losses for companies and investors if governments adopt more widespread carbon pricing.
Finally there is geopolitical risk, notably in the renewed assertiveness of Russia and China. History suggests that markets are not good at anticipating adverse geopolitical outcomes — witness the buoyancy of the London stock market before the assassination of Austrian Archduke Franz Ferdinand in June 1914.
What should the private investor do?
How should investors cope with a more inflationary environment where monetary policy is clearly changing gear and so many assets look overvalued? After years of dreadful underperformance, value stocks should do much better relative to growth stocks in the coming decade.
The big US tech stocks now confront rising regulatory risk from competition authorities around the world. It is worth recalling how in the 1960s so-called nifty fifty growth stocks eventually came unstuck. Among the supposedly nifty were the likes of Kodak, Xerox and Polaroid — tech leaders of the day that were brutally disrupted by innovative newcomers.
Emerging market equity valuations look very low by historic standards against the US and could offer interesting opportunities. The very depressed ratings of UK equities also look like a potential value opportunity.
With bonds losing their insurance quality, finding assets that offer diversification for equities is important. That points to commodities, gold and for some, crypto assets. These offer no income. That said, the first two have defensive qualities against inflation. Whether that is true of crypto is historically untested. It seems questionable whether these super-intangible, ultra-volatile assets should be regarded as diversifiers as opposed to an outright punt.
Finally, real assets such as property and infrastructure make sense in an unstable inflationary environment. Since the start of the Covid pandemic, alternative property like warehouses, care homes and student accommodation looks less risky than offices and retail. For retail investors the problem is to find the right fund through which to gain exposure to these asset classes.
The biggest challenge for investors is the one identified by GMO's Grantham, who remarked last year: "The one reality you can never change is that a higher-priced asset will produce a lower return than a lower priced asset.
"You can't have your cake and eat it. You can enjoy it now, or you can enjoy it steadily in the distant future, but not both — and the price we pay for having this market go higher and higher is a lower 10-year return from the peak."
Prepare for the proverbial bumpy ride.
© Financial Times 2022