Commentary | Jan 07, 2021

Running to Stand Still?

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2020 in a Nutshell: Markets Crushed by Covid-19. Saved by the Fed.

The behaviour of financial markets in 2020 was atypical by almost any measure. Both the speed at which financial markets plummeted during the early stages of the pandemic and their astounding recovery were unprecedented.

Notwithstanding these extremes, 2020 can be easily summarised as follows:

  1. Markets were crushed during the initial stages of the pandemic as investors began to price in a depression-like scenario for the global economy and asset prices.
  2. Central banks and governments, led by the Federal Reserve, sprung into action with a broad array of policy responses of unparalleled magnitude.
  3. These initiatives caused asset prices to rapidly recover their earlier losses, and in many cases propelled them to new highs.

Requiem for 60/40

Central banks and governments did what was needed to stave off what they feared could metastasise into economic Armageddon. Unfortunately, it is likely that there will be future payback in the form of lower portfolio returns.

With sovereign and high-grade bonds currently yielding next to nothing, it is highly probable that conventional, 60/40 balanced portfolios (60% allocated to stocks and 40% invested in bonds) will deliver returns that are significantly below their long-term historical averages. Unless stocks knock the lights out and offset the drag from bonds, balanced portfolios will deliver returns that are lower than what investors have historically experienced.

The King is Dead: Long Live the King

Rather than settling for lower returns in the future, you can simply decrease your allocation to the asset class with lower expected returns (bonds), shift the proceeds into the one with higher expected returns (stocks) – problem solved!

Of course, there is the problem of the higher risks that accompany such a reallocation…. or is there?

The Fed Put – Alive and Stronger Than Ever

The term “Fed put” originated when the Fed, under the leadership of Alan Greenspan, cut interest rates in response to the 1998 stock market sell-off following the collapse of Long-Term Capital Management. It describes the belief that the Federal Reserve is willing and able to adjust monetary policy in a way that is bullish for stock markets. The basic premise is that if markets become too volatile, the US central bank will step in and use accommodative monetary policy to boost stock prices.

The willingness and ability of the Federal Reserve to deploy aggressive policy measures to mitigate market dislocations has been repeatedly demonstrated since Greenspan’s tenure. If anything, the Fed’s tolerance for severe market declines has deteriorated, resulting in increasingly aggressive actions to curtail them.

During the global financial crisis, not only did the Bernanke Fed slash interest rates to zero, but also unleashed a spate of new initiatives to restore liquidity to the financial system and short-circuit the downward spiral in asset prices. Most notably, it launched several rounds of quantitative easing (QE) which entailed direct purchases of government and mortgage-backed bonds.

In response to Covid-19, the Powell Fed took things even further, unleashing a “shock and awe” campaign of stimulative initiatives. In addition to lowering rates and implementing Bernanke-era QE, the central bank also announced that it would purchase corporate and municipal bonds and lend directly to businesses.

Running to Stand Still

Given the Fed’s increasingly aggressive responses to economic and financial market weakness, is it possible to have your cake and eat it too? Can you increase your exposure to stocks to offset the return drag from record low rates AND sleep well at night knowing that the Fed will bail you out whenever stocks suffer severe losses?

Ironically, the Fed put can only be effective to the extent that investors don’t expect it to be exercised. Alternately stated, its success is somewhat dependent on the Fed’s ability and willingness to surprise investors. If markets have advance knowledge of how the Fed will react in times of crisis, this information will be reflected in prices when the next crisis occurs. In this scenario, any “as expected” response from the Fed will have little or no impact.

The Fed must exceed expectations to counter stock market declines. As a larger share of investors become confident in the Fed put, the central bank’s job could become increasingly difficult. There is some evidence that this is already happening. At the onset of the pandemic, investors were keenly aware of the magnitude of the Fed’s 2008 response to the global financial crisis and were expecting something similar. To surprise the market, the Fed had to do something even more aggressive, increasing its balance sheet by $3 trillion compared with “only” $1 trillion in 2008.

To bet that the Fed can and will always provide a safety net for stocks, you are counting on the central bank being continually able to beat investor expectations, which themselves keep rising as a function of policy responses that have become increasingly aggressive. As a result, the Fed put seems like less of a sure thing.

Rocks, Hard Places, and the Importance of Dividends

At Outcome Metric Asset Management, we don’t believe that you must choose between the “rock” of low returns from balanced portfolios and the “hard place” of occasional severe losses in stocks during bear markets. Since its inception in May of 2017, our Global Tactical Asset Allocation (GTAA) strategy has delivered strong risk-adjusted returns and protected our clients from large losses during the challenging fourth quarter of 2018 and in the tumultuous markets of early 2020.

Historically, there has been a strong, inverse relationship between stock market valuations and medium-to-long-term returns. With current valuations sitting well above their historical averages, the capital gains component of stock market returns is likely to disappoint for the foreseeable future. In such an environment, dividends will constitute a disproportionately large component of total equity market returns. Since its inception in October 2018, our Enhanced Dividend mandate has returned 19.8%, outperforming the TSX Dividend Aristocrats Index by 5.4%, while achieving lower volatility and drawdowns.