There’s More Than Just an Underwater Beach Ball in Today’s Investment Pool

Had the modern beach ball existed in ancient Greece, many at that time may have had difficulty in understanding why it took so much effort to push it underwater, and why, upon being released underwater, it would jump dramatically from the water before floating in equilibrium at the surface. That is, until Greek mathematician and polymath Archimedes discovered the principle of buoyancy around the year 212 B.C. In some respects, a negative real yield resembles a beach ball being held underwater, in the sense that they are both below their equilibrium levels. Historically, real yields have been correlated with real economic growth, but in 2021 real growth is on track to post its highest reading since World War II, while real yields are at their lowest point in history (see Figure 1).

In our analogy, this would create the equivalent of a massive buoyant force on a fully submerged beach ball. In the world of physics, Archimedes’ Principle would allow us to calculate this exact buoyant force, based on factors like the size of the ball and the extent to which it has been submerged, but it is a little more complicated in the world of real yields and portfolios. The financial markets today are huge (certainly much bigger than at any time in history), and the hands pushing real yields down (the Federal Reserve and the European Central Bank) are extremely strong.

Figure 1: U.S. Real Yields are Near Historically Low Levels,
Like a Beach Ball Being Held Underwater

Two Decades of Dramatic Market Change

Interestingly, while real yields are at record lows, the supply of financial assets is at record highs, suggesting a robust demand for income. In the month of September alone, $625 billion of new supply is expected across U.S. Treasury, credit and equity markets, which is considerably greater than the $400 billion monthly average in recent years, according to BlackRock Capital Markets data, as of September 12, 2021. That fact certainly places a potential $15 billion-a-month Fed asset purchase taper into perspective (as it would represent a mere 2% of September’s supply) and it illustrates that quantitative easing (QE) in general is perhaps needlessly competing with organic demand for fixed income assets to keep yields at unsustainably low levels.

Central banks’ intent to hold the “real rate beach ball” underwater belies some of the changes that our economy has undergone in just the last two decades. As we remember the 20-year anniversary of 9/11 this month, we are awestruck by some of the changes to markets since that time. Some of those changes include, the evolving nature of e-commerce, the way we interact with each other on social media (spending three hours and 43 minutes each day on our devices, on average) and the huge role China now plays in the global economy. In fact, China has grown its GDP 17x since entering the WTO in 2001, which should perhaps outweigh the Fed taper discussion in terms of long-term investment implications, in our view.

Still, arguably the most significant change in financial markets over the last two decades has been one of the most subtle: the onset of the “Liquidity Era” (as we wrote about in The Policy Liquidity Monopoly). Pre-9/11, the real economy was the independent variable that drove financial economy outcomes. However, today it’s the financial economy that is the independent variable driving real economy outcomes. Indeed, liquidity provision has become the primary tool of global monetary policy (rather than interest rate manipulation), through channels like wealth effects, as evidenced by the more than doubling in size of global financial markets relative to world GDP over the last 20 years. It is in this context that we face a liquidity cliff today: having injected nearly $1.5 trillion year-to-date through August, the U.S. Treasury will likely make large liquidity withdrawals before year-end, which could actually transcend ongoing Fed asset purchases. Thus, the flow of liquidity is set to wane demonstrably at a time when real rates are priced through fair value.

Yet even with new liquidity injections becoming greatly diminished, the existing stock of liquidity, both domestically and globally, is historic, with investors who are sitting on cash salivating over any yield, or return potential, of reasonable quality that looks to be available. In fact, growth in cash has far outpaced growth in loan demand since the onset of the pandemic, leaving banks flush with deposits and starved for yield (see Figure 2). As a result, trillions of dollars in bank deposits continue to compete with traditional fixed income investors for relatively scarce high-quality assets.

Figure 2: U.S. Cash Deposits Have Greatly Outstripped Loan Growth

Indeed, there is so much cash (liquidity) in the world and such low yields that one might even forget that in an equilibrium state the “beach ball” floats on the surface of the water. Having posted roughly a 12% total return year-to-date, through September 14, the 60/40 balanced portfolio (60% S&P 500, 40% U.S. Aggregate Bond) is on pace to beat 2020’s handsome return of 14%. But unlike in 2019 and 2020, in which both the equity and fixed income sides of the portfolio contributed to total returns, in 2021 so far only the equity portion has made a positive contribution. The fact is that from these levels of yield, it is extremely difficult to preserve purchasing power in fixed income, revealing the difficulty in getting the “40%” of the balanced portfolio to contribute to price returns.

Follow Rick Rieder on Twitter

Why is Such Easy Policy Being Maintained?

Some believe that technology will eliminate jobs that were lost during the pandemic, such that job growth will slow from here, rendering a full recovery in labor force participation impossible. However, historical newspaper records show that this fear of technology “stealing jobs” has been around for centuries, as every new technology has replaced an older one, with no evidence of a decline in aggregate jobs available (in fact, they have grown in line with population growth). The reality of the labor market today is quite the opposite of this dire view: labor supply is more constrained relative to demand than ever before. There are 70% more job openings than there were pre-pandemic and 10% fewer people looking for work – the largest gap between those measures in history.

Others argue that if inflation is transitory that should mitigate risks to keeping policy easy (in other words, letting the economy run hot). In our view, while recent inflation should moderate toward historical averages over time, the risk of deflation at this stage seems even more remote, given how far above trend inflation stands today (see Figure 3). So, the balance of probabilities actually suggests a normalization of policy could be a risk-mitigant rather than the other way around, when it comes to price stability.

Figure 3: Core CPI is Running Considerably Higher than Its Pre-Covid Trend

Another, potentially greater, risk of keeping policy too easy for too long is financial asset inflation. While valuations in housing and stock markets are not in bubble territory yet, in our estimation, keeping policy too easy for too long may create the risk of financial instability going forward. Given how the financial economy has become the independent variable driving real economy outcomes, a volatile financial economy could create unstable real economy outcomes. Indeed, house prices are less affordable (relative to income levels) than at any time since the housing bubble of the mid-2000s, resulting in declining consumer confidence of late.

The main problem today is a supply shortage, not one of weak demand, and supply can’t be “stimulated” by monetary policy in the way that demand can. If central banks don’t gradually normalize policy, demand can continue to push higher, well through supply availability (of goods, services, houses, labor, etc.), creating a risky and unnecessary inflationary shock – at the very least in financial assets. Hence, we need to think about portfolio balance in 2021 in the context of drastically different environmental conditions relative to history - where supply is weighing on growth, and not demand – with demand for goods, services, and assets being pushed higher via further policy liquidity injections.

So, How do we Manage a Portfolio in Light of these Crosscurrents?

Rather than suggesting a greater risk premium be applied to equities, low interest rates and strong growth can be a powerful cocktail for risky assets. If interest rates are capped to the upside by waiting on a pre-pandemic notion of full employment, textbook financial analysis suggests that it can create powerful convexity in the terminal value of equities. Historically, risk-free rates would approximate terminal growth, both reflecting the same economy, and keeping a company’s weighted average cost of capital (WACC) somewhat in line with its terminal growth rate. But Fed policy essentially has the terminal growth rate acting as a ceiling for the cost of debt (a component in the WACC), creating massive convexity in the terminal value because the cost of debt can go below, but not above, the terminal growth rate (see Figure 4).

Figure 4: Recent Fed Policy Essentially Sets Economic Growth Rate as Ceiling For Risk-Free Cost of Debt

So, despite the 60/40 portfolio being “imbalanced” (where the 40% fixed income allocation has been underperforming relative to history), the same low-rate and high-growth backdrop that is creating this imbalance also gives us some comfort in the power of an equity allocation. We take further comfort in the fact that recent equity performance has not been just a market phenomenon – book value has also been accreting at the fastest pace in decades. In fact, the average level of S&P 500 return on equity (ROE) never dipped below 15% throughout the pandemic and it is expected to reach a record 23% by the end of 2021, according to Bloomberg consensus estimates, as of September 10 (see Figure 5). If book value continues to accrete higher at this pace, the media’s fascination with records may be satiated for a long time to come, as equity market values rise in tandem to fresh record high levels.

Figure 5: The SPX Return on Equity Has Remained
Remarkably Strong Throughout the Pandemic

Some companies are significantly outperforming even the lofty ROE gains of the index. The equity of companies that are on the “right side” of megatrends, especially in the technology and healthcare sectors, have historically been the greatest beneficiaries of high-growth and low-rate environments (see Figure 6). And there has arguably never been a better environment for book value accretion, and hence return, for these kinds of companies. We like companies with long forward trajectories of growing cash flows and strong balance sheets that are investing significantly on capital expenditures (capex) and research & development (R&D) to drive growth. The combination of long-term investment, plentiful cash, and low debt burdens suggests a medium-term permanence to cash flow growth. Such companies have come to dominate the market capitalization leaderboard in the S&P 500 over the last 20 years. That trend is likely to continue, as technology-enabled creative destruction continues to keep opportunities open for new companies to disrupt old ones, also resulting in exciting private and venture investments on the horizon. Of course, with the many headline risks facing markets today (China worries, debt ceiling debates, Fed asset purchase tapering), alongside some supply-chain troubles and slower economic growth (at a time of year when investment conviction and risk-taking tend to be lower), the risk of equity markets pricing down 5%, or so, has moved higher. Still, we think any short-term disruption is likely to be modest before equities continue to move higher.

Figure 6: Return on Equity of Key Sectors Can be Even Greater

China is another area that we think stands out, for having an inconsistent representation in the global economy versus the financial markets. While China is slated to make up about 20% of the global economy five years from now, up from 18% today (see Figure 7), and a close second to the U.S. in its overall economic size, at $24 trillion versus $28 trillion (International Monetary Fund estimates, as of December 31, 2020), its representation in global indices is a mere 4% in the MSCI All Country World Index and a slightly better 7% in the Global Aggregate bond index. Currently, only three of the top 100 companies in the world (by market capitalization) are China-based today, yet China is the second largest source of unicorns (startups with a >$1 billion valuation), after the U.S. That suggests that places like China may offer targeted, high-growth opportunities for investment, albeit with some patience in the broader market, amidst an evolving regulatory framework. In the short run, we think it’s important to remain cautious about where and how one takes advantage of investment opportunities in China, but it’s also a time when longer-term opportunities are presenting themselves.

Figure 7: China’s Rapidly Growing Share of Economic Activity
Isn’t Yet Reflected in Equity and Bond Index Representation

The phenomenon of central banks crowding investors out of high-quality fixed income suggests that portfolio balance should indeed mean owning less of the low yielding, high-quality, part of the investment universe, with a larger allocation to yields that look more reasonable relative to inflation expectations, particularly in bespoke and less-liquid regions of fixed income, with a moderate emerging market debt allocation. With securitized markets growing again, securitized products may offer another such source of reasonable yield, especially on unique pools of assets that help with diversification (see Figure 8). We think high-quality securitized assets are too rich, but we like mid-quality paper (with proper underwriting). Taking a closer look at the capital stack, it’s evident that there are limited opportunities to take risk and still get attractive yield. One simply must work harder to find, structure, and analyze potential investments today.

Figure 8: Securitized Markets Offer Another Potential
Source of Reasonable Yield

Last month, we posed the question of what to do with high quality fixed income in this submerged beach ball environment, in order to create balance in a portfolio, and our answer was: little (as we wrote about in Being Vested in Your Investing). The Agg has returned 0.06% since August 1, 2021, underscoring that point. In high quality fixed income, we are not sure where the value is today either. The threat of submerged (negative) real yields succumbing to buoyant forces and violently returning to their position of equilibrium as policy evolution looms is causing a lot of consternation in the financial media. To us, it simply reinforces the notion of being committed to names that have some combination of risk premium, growth potential and winning track records.

Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is Head of the Global Allocation Investment Team. Russell Brownback, Managing Director, is Head of Global Macro positioning for Fixed Income. Trevor Slaven, Managing Director, is a portfolio manager on BlackRock’s Global Fixed Income team and is also the Head of Macro Research for Fundamental Fixed Income. Navin Saigal, Director, is a portfolio manager and research analyst in the Office of the CIO of Global Fixed Income, and he serves as Chief Macro Content Officer.