Can you remember when – suddenly – everything was different?
Photo: Douglas Tengdin
One of the biggest changes for me came when my first child was born. The labor had taken a long time, and everyone was exhausted. In the end, though, Pam and I were the proud parents of a newborn baby boy! I still remember the feeling of wonder and excitement as his little hand squeezed my finger. Boy, I thought, this changes EVERYTHING.
There are times in our lives when the world seems new: graduation, marriage, a baby, grandchildren. Our expectations and obligations are transformed. We need a new way of living, because there’s suddenly a new way of thinking. With our baby, we had a whole new set of obligations – for his health and safety, for his education, for taking care ourselves, since he was so dependent on us.
A similar thing can happen with financial markets. October 19,1987 – Black Monday and its aftermath – marked a new era. The market declined 22% in a single day, more than any single day in its two-century history. The Federal Reserve concluded that this was a “gut punch” to the economy. They guaranteed market liquidity; they leaned on major banks to keep making loans; and they leaned on the Reagan Administration to settle their budget issues with Congress. It was the first exercise of the “Greenspan Put”: interventions by Fed officials into private financial and political affairs designed to prop up the market. It clearly wasn’t the last. There was a new sheriff in town.
Alan Greenspand. Public Domain. Source: Wikipedia
In the last several weeks, we’ve entered a similar era.
In his latest speech, Fed Chairman Jerome Powell staked out some new ground. The substance of his speech wasn’t difficult or obscure, and Powell is a pretty clear speaker. He framed his comments as if they outlined a continuation of prior Fed initiatives, but there was no mistaking his intention: this was something new. The Fed will now use its tool-kit to try and engineer an average inflation rate of 2%. This is remarkable on several levels.
First, inflation hasn’t run very much more than 2% for a while, and the Covid-19 crisis only decreases any chance for an increase. An average of 2% will require greater than 2% inflation for a long time. The Fed is admitting that they were wrong when they raised rates from 2015 through early 2019. At that time, inflation wasn’t much higher than the target. Over the last 10 years, inflation has averaged 1.7%, held down by a host of secular forces – globalization, technological disruption, demographics, and excess debt, among other factors.
Fed Funds and the Consumer Price Index. Source: Bloomberg.
This leads to the second revelation: Powell’s admission of a policy error – and his commitment to make up for it – amounts to a massive level of forward rate guidance. Now they’re committed to keeping rates at zero for several years – and maybe even longer. This has profound implications for how we invest.
Traditionally, portfolios are divided between stocks, bonds, and cash. These three traditional asset classes served as three legs of a stool. For a long time, now, investors have shunned cash – bank deposits and money market funds. When the Fed’s policy rate is below the inflation rate, cash investors lose real purchasing power, even if their principal is secure. But with the Fed’s new rate regime, bonds don’t yield more than inflation either. These negative real yields are a direct result of the Fed’s new world. This isn’t an accidental blip on the screen; it’s a deliberate policy that investors need to address when they formulate their policies and make their plans.
Real yield on 10-year Treasury Inflation Protected Notes (TIPs). Source: Bloomberg.
This means that two legs of the traditional investment stool now provide negative real returns. Just as important, they’re not likely to provide diversification benefits, either. In times past, poor stock market performance could be balanced by strong bond market performance. That’s because a bad economy would result in lower interest rates, which would lift bond prices. That’s the source of the traditional 60/40 stock/bond allocation rule-of-thumb. This approach has served investors well for decades.
But now, 80% of the sovereign bonds issued around the world now yield less than 1%. They can’t appreciate in price as much anymore because their yields are already so low. Bonds may still provide stability, but they don’t reduce the portfolio’s risk in the same way.
What should investors do when a major asset class has been made ineffectual?
We have to look at alternatives – at assets that provide economic returns but that differ from the traditional stock/bond/cash triumvirate. Before we get overwhelmed with lists of random items, it helps to review a few fundamentals.
Economically, there are only three asset classes: stocks, bonds, and real estate. Bonds are a senior claim on the assets and cash flow from an enterprise. If something goes wrong, they get paid first, but their payments are contractually limited. Real estate is a claim on operating cash flows. They get paid their rent, and rents can rise over time. But tenants can move out as well. Stocks, finally, are a claim on what’s left over. If things go wrong, they’re the first to lose out. During the financial crisis, many investors got bailed out – but not shareholders. The shareholders of Bear Stearns, AIG, Fannie Mae, Wachovia all lost their entire investment, even though those companies’ bondholders were ultimately paid. The fact that there are only these three asset classes is why the ancient Babylonian Talmud recommended splitting your investments into three allocations: business (equity), property (real estate), and reserves (cash):
When it comes to alternatives, they’re all variations on this division. There are equity positions, lending positions, and real estate holdings. Alternatives are simply alternatives to traditional assets, but they still should fit into these classifications. Below is a chart of alternatives, the seniority of the claim, and a sense of their liquidity. Unfortunately, few of them are highly liquid.
Each of these alternatives could merit a discussion of its own. For now, its enough to know that a broad range of alternatives are out there, and they will be increasingly important for investors to understand and apply to their specific investment needs.
We’re not in Kansas anymore, thanks to our economic environment, the COVID-crisis, and the Fed. But it’s like when my wife Pam and I first saw our newborn son: the world may have changed, but the possibilities are (almost) limitless.
Photo: Doug Tengdin