Even as talk of Fed “normalization" intensifies, financial markets are looking less and less normal. We explain why this market environment appears here to stay and what it means for investors.
Market watchers have spent much of the past week analyzing the remarks from Federal Reserve (Fed) Chair Janet Yellen at the annual late-summer economic policy symposium in Jackson Hole, Wyoming, looking for some sign about the future path of Fed policy normalization.
But even as talk of Fed “normalization” is intensifying, financial markets are looking less and less “normal.” Markets today are characterized by historically high valuations across most asset classes, historically low volatility and historically low returns, amid investors’ ongoing search for yield in a world of historically low interest rates. The chart below shows how yields for assets across the risk spectrum are at or near 15-year lows.
This issue got short shrift in Jackson Hole, despite this year’s symposium focus on “Designing Resilient Monetary Policy Frameworks for the Future.” Indeed, the main investing conclusion from Jackson Hole seems to be that today’s “not-normal” market environment is here to stay.
Fed policymakers and Fed watchers seem to disagree on when the Fed should start taking additional steps to normalize, i.e., increase its key policy rate, according to their recent comments at Jackson Hole and beyond. The debate centers around: should the central bank let inflation run hot or should it proceed already with a rate hike, given the lags with which monetary policy is known to operate. Comments out of Jackson Hole didn’t cast much additional light on what is the right next step for the Fed, or the most likely one. We expect the Fed will raise its policy rate by 0.25% by year-end, and we believe this will hardly make any difference to anything.
A lower neutral policy rate
But Fed watchers and decision-makers seem to agree on one thing: Whatever the Fed’s rate-normalization path, the end point for the “neutral” policy rate—the one where monetary policy is neither stimulative nor restrictive—will be much lower than previously thought. How much lower? The median estimate of Fed policy makers has fallen from 4.25% in 2012 to 3% now. But Yellen in Jackson Hole helpfully reminded us that given average forecasting error, there’s a 70% probability the actual long-term neutral rate would be between a few decimal points (as markets expect) and 4.75% (beyond expectations of even the most optimistic FOMC member).
In other words, it is fairly likely that the interest rate off which, directly or indirectly, every other asset in global financial markets is priced, stays rock bottom for the foreseeable future. That most issuers of safe assets are in regions with central banks pursuing similar policies compounds the problem. This means investors will be left to chase yield ever further up the risk chain and into asset classes that are much smaller than the ones currently afflicted by ultralow yields. Consider some figures based on our analysis: The whole universe of high yield bonds is only around $2 trillion and the emerging market (EM) sovereign debt universe measures around $6 trillion, while the world of negatively yielding developed market government debt measures roughly $13 trillion, according to our estimates of figures from multiple sources.
This leads not only to yield compression across the board, as intended and as evident in the chart above, but also to compression of spreads, i.e., investors are getting less and less compensated for taking extra risks. Meanwhile, we see cheap financing providing an incentive for some issuers to issue debt in corporate credit markets and parts of the EM world at levels fundamentals may not support. Another result: Some U.S. equity sectors are looking inflated, with forward price-to-earnings (P/E) ratios as high as 57. See the chart below. The chart also shows that average S&P 500 forward P/E ratios are nearing early 2000s levels....MORE
