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.
Click to enlargeThis issue got short shrift in Jackson Hole, despite this year's symposium's 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 policymakers 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 ultra low 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.
Policymakers should find these developments deeply worrying. Yet few appear to believe their mandate includes taking action against this buildup of risk. European and Japanese central bankers vowed in Jackson Hole to continue doing what they have been doing until it works. Their American counterparts debated how to adapt their toolbox in a post-normalization environment of low rates, where the search for yield and its perverse effects would endure, but they didn't discuss how to keep financial stability risks in check.
Of course, the long-term neutral rate is not a given. Its evolution will be shaped by government policies and private decisions. This is why we believe it's crucial we start seeing policies that raise the productivity of investment, such as fiscal stimulus (like debt-financed infrastructure spending) and structural reforms. Central bankers, to their credit, have been calling for such policies for a while, but only recently have fiscal policymakers provided signs that they are listening. Still, these signs aren't appearing everywhere, and it may be years before we see the effectiveness of any such policy changes.
In the meantime, what is an investor to do? It is tempting to conclude, as more and more investors do, that extra risk is not worth taking in the pursuit of yield, and to retreat to the cash sidelines. But the longer this retreat lasts, the bigger the gap between actual returns and those needed to make pension funds and individual retirement savings meet their goals. So it still pays to take risk. It's important, however, to remember that there is both good and bad risk. Focusing on the former - i.e., debt or equity issuers with strong balance sheets and good growth prospects - still makes plenty of sense. Bottom line: Investors will want to keep taking risk, but not blindly.
This post originally appeared on the BlackRock Blog.