Background
Coming out of the Global Financial Crisis (GFC) in 2009, developed market central banks utilized Quantitative Easing (QE) as a way to stimulate their respective economies. Generally through the purchase of sovereign bonds, the central banks were able to reduce interest rates along the yield curve, essentially making it less desirable to hold safe haven investments and consequently more attractive to favor risk assets. This action, in conjunction with reductions in key policy rates, encouraged investment and helped to revive economic growth. The new “normal” has been characterized by easy access to money via the bond market. Inflation has not returned, however, and therefore central banks have not materially increased rates. Enter COVID-19 volatility. With minimal ability to stimulate markets via lower rates, the central banks have become willing accessories to government stimulus packages, offering to buy as many bonds as needed to keep the cost of debt from rising too much and to help sustain well-functioning markets. This blurring of lines between central banks and treasury is somewhat new and is one of the features of what is referred to as Modern Monetary Theory (MMT).
Implications of a Higher Debt Load
The most recent US stimulus package has an expected cost of $2.2 trillion, which is nearly 10% of GDP, significantly higher than the stimulus during the GFC. If faced with an extended COVID-19 scenario, it appears even more stimulus may be on the horizon. These actions, in addition to the Trump tax cut package of 2017, will take the US debt burden to record absolute levels and relative levels only previously seen in the WWII era. Consequently, there is concern about our ability to service the debt and what impact these circumstances may have on all types of assets. With a de facto purchaser (the Fed), the likelihood that risk-free rates will move materially upward in the foreseeable future is low, creating a world where no risk equals no real return. Furthermore, while central banks have been seemingly unable to stimulate inflation (realized or anticipated), sustained fiscal deficits may become the catalyst for an inflationary bounce-back in the years ahead.
Asset Class Impact
How is an extended era of paltry yields on government bonds and increased money supply likely to affect traditional asset classes? Equity holders may benefit, as the driving forces of corporate profitability and growth potential should still exist. Bond holders will clearly have to adapt to a new yield paradigm, with additional credit risk likely being necessary to attain income levels previously viewed as commonplace. Shorter-term bonds and cash enhance portfolio liquidity and become increasingly valuable as opportunities come and go in periods of volatility. Real assets should do reasonably well in this environment, particularly those whose cash flow potential self-adjusts with rising inflation (TIPS or Real Estate). Commodities that have some inherent currency value, such as gold, may also thrive in an environment that questions the value of fiat currencies.
Gryphon’s Position
Eventually, central banks are likely to resist further balance sheet expansion, leading to more pure market-based yields, but how soon that will happen is not clear. In an era of unprecedented monetary and fiscal intervention the pathway to “normal” may be long and winding. Many point to the stagflation experience of the 1970’s to cautiously highlight the risk of politicizing monetary policy and believe price stability can only be achieved within the context of true central bank independence. While unexpected bouts of inflation can have severe consequences for financial assets, there is limited historical context for which to judge the outcome of deficit indifference and essentially limitless QE by global central banks. The challenge for investors is to identify an investment framework that offers the highest chance of success relative to their goals. Beholden to the time-tested benefits of diversification and discipline, we believe maintaining a long-term focus and following strategic allocations increases the probability of achieving return objectives while managing portfolio volatility.
Disclaimers:
The views expressed herein are those of Asset Consulting Group (ACG). They are subject to change at any time. This report was prepared by ACG for you at your request. Although the information presented herein has been obtained from and is based upon sources ACG believes to be reliable, no representation or warranty, express or implied, is made as to the accuracy or completeness of that information. Accordingly, ACG does not itself endorse or guarantee, and does not itself assume liability whatsoever for, the accuracy or reliability of any third party data or the financial information contained herein. Certain information herein constitutes forward-looking statements, which can be identified by the use of terms such as “may”, “will”, “expect”, “anticipate”, “project”, “estimate”, or any variations thereof. As a result of various uncertainties and actual events, including those discussed herein, actual results or performance of a particular investment strategy may differ materially from those reflected or contemplated in such forward-looking statements. As a result, you should not rely on such forward-looking statements in making investment decisions. ACG has no duty to update or amend such forward-looking statements. The information presented herein is for informational purposes only and is not intended as an offer to sell or the solicitation of an offer to purchase a security.
Please be aware that there are inherent limitations to all financial models, including Monte Carlo Simulations. Monte Carlo Simulations are a tool used to analyze a range of possible outcomes and assist in making educated asset allocation decisions. Monte Carlo Simulations cannot predict the future or eliminate investment risk. The output of the Monte Carlo Simulation is based on ACG’s capital market assumptions that are derived from proprietary models based upon well-recognized financial principles and reasonable estimates about relevant future market conditions. Capital market assumptions based on other models or different estimates may yield different results. ACG expressly disclaims any responsibility for (i) the accuracy of the simulated probability distributions or the assumptions used in deriving the probability distributions, (ii) any errors or omissions in computing or disseminating the probability distributions and (iii) and any reliance on or uses to which the probability distributions are put. The projections or other information generated by ACG regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Judgments and approximations are a necessary and integral part of constructing projected returns. Any estimate of what could have been an investment strategy’s performance is likely to differ from what the strategy would actually have yielded had it been in existence during the relevant period. The source and use of data and the arithmetic operations used for calculating projected returns may be incorrect, inappropriate, flawed or otherwise deficient.
Past performance is not indicative of future results. Given the inherent volatility of the securities markets, you should not assume that your investments will experience returns comparable to those shown in the analysis contained in this report. For example, market and economic conditions may change in the future producing materially different results than those shown included in the analysis contained in this report. Any comparison to an index is for comparative purposes only. An investment cannot be made directly into an index. Indices are unmanaged and do not reflect the deduction of advisory fees. This report is distributed with the understanding that it is not rendering accounting, legal or tax advice. Please consult your legal or tax advisor concerning such matters. No assurance can be given that the investment objectives described herein will be achieved and investment results may vary substantially on a quarterly, annual or other periodic basis. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information.
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