The ‘New Relationship’ In The Current Macroeconomic Climate

I’d like to speak about a by-product of the current macroeconomic climate which has been getting little attention relative to its significance. PIMCO popularised the term the ‘new normal’ to describe an era of below-average growth following the financial crisis. I’d like to talk about what I refer to as the ‘new relationship’. In actual fact, the characteristic should frighten investors of the traditional asset classes for when we enter into the next economic market cycle – an equity price correction, most likely to come from the weening off and comedown from the drug that the global economy has had a constant feed to known as loose monetary policy and quantitative easing, where the equity bubble bursts and pricing comes back down to reality. 

I began with this hypothesis in 2013, the research got published in 2016 and is still relevant today as we begin 2020. In 2013, my hypothesis was that the increase in money supply coming from zero lower bound monetary policy was in a liquidity trap; not getting used for capital expenditure and expansionary projects but rather being held in cash and invested in the stock market instead. The big difference in this round of monetary policy was how low interest rates went and how long they were low for. This meant that equities kept rising and got to a stage where they were very expensive/over-valued, investment went in to fixed income until they were yielding negative real returns (the Fisher effect) and then investment went in to other asset classes in a pattern that was inconsistent to the natural economic pattern of the past. Essentially, I hypothesized that the correlations between the major financial asset classes have changed as a byproduct of the long and loose monetary policy. Furthermore, my hypothesis of this change in correlation was fundamentally magnified by the Quantitative Easing initiative/program of the FED. If we take a quick tour back in time to our Finance 101 or Investment 101 class, the book will tell us that major equity markets and their respective 10-year Government Bonds have a high negative correlation to each other. This is fundamentally driven by the risk-on, risk-off relationship of the two markets. When investors are risk-on, they withdraw money from their safer, lower yielding fixed income investment and invest that cash in to the riskier, higher yielding equity market. When investors are risk-off, we get the opposite investment flow between the two markets, keeping that high negative correlation relationship intact. What changed with that relationship? The short answer is the Central Bank. The slightly longer answer is that investors were buying up equities not by withdrawing from their fixed income investments but from cheap cash provided by the increase in money supply at near 0% interest rates. At the same time, there was a ‘new investor’ - the US Treasury - who were buying up bonds from money that they printed themselves through the quantitative easing program. That risk on, risk off relationship between the two markets had changed.

The above analysis was conducted and found that the hypothesis of a change in correlation was correct. My published paper shows that the relationship of the S&P 500 and the US 10-year Bond changed from a high negative correlation to a low negative correlation (there were similar changes among other major regions). My research also tested for whether there was a significant change in volatility within the equity markets due to changes in monetary policy rates while within the zero lower bound range inferring that monetary policy has become a significant driver of the equity markets. This was also found to be true. (For those interested in the math, methodology and full set of results from the analysis, the full published paper is available upon direct request.)

I’d like to finish off this post by touching on why this ‘new relationship’ in the current macroeconomic climate is so significant to traditional asset class managers and investors alike. Prior to this ‘new relationship’, investors and managers would have significant investment in the bond market for two reasons:

1. A safe and profitable yield level

The average US 10-year Bond yield towards the end of 2019, since 1964, is 4.89% - based on data downloaded from the Federal Reserve Database. Given the safety of the market and inflation, a 4.89% yield is a reasonable return, especially when you consider it comes with point (ii) below.

2. Equity Correction Protection

The equity correction protection is a byproduct of the traditional high negative correlation between the US 10-year bond market and the S&P 500. When the equity market goes down, the bond market increases. Earning a real return (back to the Fisher Effect) while having equity correction protection is a win-win scenario for managers and investors.

Now let’s take a look at the ‘new relationship’ in the current macroeconomic climate. The two points from above have changed to:

1. A safe but low yield – the US 10-year yield is around 1.88% at the time of writing

Due to our zero lower bound environment, yields have plummeted to levels which frankly aren’t worth investing in if you consider inflation as part of your investment equation. Despite this non-profitable yield, should investors still have significant holdings in bonds due to point (ii) from above?

2. Low/Uncorrelated Market

The second aspect, the significantly more important aspect, is the loss of investor’s correction protection. This is a byproduct of losing the highly negative correlation. Instead of the bond market increasing when equities fall, they are closer to uncorrelated. That means that the bond market could either go up, down or sideways when the equity market bubble bursts. The loss of this equity correction protection, given how artificially inflated current equity markets are, is what should be keeping traditional asset class investors and managers up at night in fear.

The above paragraph speaks to the warning of how portfolios will be significantly affected when the next market cycle comes. My next post will study how this ‘new relationship’ and changed current macroeconomic climate has affected multi-asset class performance during the past 10 years – before getting into an equity market correction. Stay tuned to see how the above ‘new relationship’ and macroeconomic climate has affected multi-asset class performance during the equity market bull-run.

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Karl Rogers is Founder of ACE Capital Investments

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