I don't say this often, but Federal Reserve Chairman Jerome Powell is wrong. Regular readers of our investor letters and other publications will recall that we regularly cite Chairman Powell as doing the best he can with the levers he has while arguing correctly for others to do their part. In particular, he has strongly argued on many occasions that monetary policy isn't sufficient to mitigate the impacts of the pandemic and that long-term solutions require fiscal (i.e. legislative) policies. Without explicitly calling out a Congress that has heretofore been unwilling to act boldly, he made clear publicly that inaction in the Capitol will hinder any permanent recovery. But then, he said this at his press conference on Jan. 27 after the FOMC meeting that same day at which the Fed left interest rates near zero as expected:
"So I would just say that our — there are many things that go in as you know to setting asset prices. If you look at what's really been driving asset prices in the last couple of months, it isn't monetary policy. It's expectations about vaccines and also fiscal policy. Those are the news items that have been driving asset purchases — sorry, asset values in recent months. So I know monetary policy does play a role there, but that's how we look at it and I think, you know, I think the connection between low interest rates and asset values is probably something not as tight as people think because a lot of different factors are driving asset prices at any given time." [emphasis added]
He is right that asset prices are the result of many factors above and beyond monetary policy. (And he once again made the case for fiscal policy action at the same press conference. We very much appreciate his consistency.) This isn't the first time he has addressed asset prices and interest rates. In his Dec. 16 press conference, in addition to again making the case for fiscal policy (several times, in fact), he said this:
"Admittedly, PEs [price-to-earnings ratios] are high, but that's maybe not as relevant in a world where we think the 10 year treasury is going to be lower than it's been historically from a return perspective…. Non-financial corporate leverage is high. We've been watching that, but rates are really low. And so companies have been able to handle their debt loads even in weak periods because rates are quite low. Your interest payments are low."
How he got from high price-earnings ratios due to a lower 10 year treasury and high leverage due to "really low" rates in December to a weak connection between low rates and asset values in January warrants some effort to understand how these two comments can be consistent. After all, Mr. Powell has shown himself to be very careful to be consistent in his views across time. Our only explanation is that he is so focused on fundamental economic data and is deflecting questions about the Reddit/GameStop (GME, Financial) anomaly that he is missing the impact of a different but much more systemic disconnect in the markets between fundamentals and prices. Put simply, asset prices are driven by opportunity cost, and at the moment, an historically-low opportunity cost is very directly linked to low interest rates.
With the world focusing its attention on the flashy headlines of high-flying short squeezes and a stock market at new highs because of technology companies which benefited by the pandemic economy, it is easy to forget that a large percentage of investable assets are just trying to preserve capital. Many investors (and their financial advisers) are simply looking to generate a reasonable level of income, whether to spend or to compound for the future. After all, one of the first lessons one learns as a financial adviser is that compounding, especially tax-free, can mitigate the need to take excessive risk to grow one's nest egg. So it is telling that in many of our conversations with clients, we hear the same thing over and over again: How can my clients get income when rates are near zero?
The short answer is to take more and more risk. Ultimately, there is a floor on the level of income that is acceptable in a portfolio. After all, a retiree's bills do not go down just because interest rates and the resulting income did. Let's say for the sake of argument that a portfolio needs a medium-term 4% rate of income to cover expenses. Until about 15 years ago, that could be achieved by buying a portfolio of intermediate term treasury bonds. Investors could lock in the 4%+ and focus on the growth portion of the portfolio in the equity market. Since the financial crisis in 2008, however, the Fed's looser monetary policy has meant that these investors would need to step out on the risk curve a bit more. The lower interest rates intended to increase the money supply and make the financial services industry strong enough to spur the economy also meant that income seekers had to look to credit. First, that was in investment grade for a few years, with some cutting back of expenses and expectations to allow for a lower level of income going forward. But the recent pandemic-induced Fed rate policy has driven interest rates to new lows. As we can see from the chart below of average yields, investors have had to step out even further on the risk curve. High-yield bonds have found their way into core income portfolios in a way that we have never seen.
To be clear, this isn't all bad. We manage a short duration portfolio of carefully selected high-yield bonds with the thesis that if one does deep credit work and aims to eliminate the unexpected downside of issuers not behaving in a long-term sustainable way, the resulting portfolio can have credit risk characteristics more like investment-grade portfolios but with higher yields. But the phenomenon we see in the marketplace right now is not limited to a handful of carefully selected bonds or shorter durations where the credit risk can be more fully evaluated or ESG portfolios where entire categories of risk factors are avoided intentionally. The current phenomenon is driven by the market's tendency to invest in asset classes rather than securities. Entire cross sections of the high yield market are being purchased through indexed mutual funds and ETFs which offer portfolios that are not intended to avoid bad credit. On the contrary, these portfolios and the indices they aim to mirror are intentionally inclusive of all credits within the high-yield asset class: the good, the bad and the ugly.
Stepping out on the high-yield risk curve, therefore, starts to introduce a risk that was previously not as prevalent in core fixed income portfolios. Moving from treasuries to investment grade meant primarily introducing downgrade risk, which would result in a mark-to-market but only in extreme cases would a bond not get repaid at maturity. But moving from investment-grade to unmanaged broad market high yield means introducing default risk, which is a permanent loss of principal. To be clear, this risk exists in all fixed-income portfolios, but in this case, we are not talking about one holding in a portfolio at risk; we are talking about a large percentage of broad market high yield indices at risk.
The natural result of this desperate move for income is an exploration by investors and managers to seek out other types of credit risk (mortgages, leveraged loans, complicated structured products, illiquid private lending). But it has gone even further, with portfolios full of other types of risk that investors can convince themselves (or managers can convince their investors) is acceptable and comparable. These include SPACs, derivative-based income strategies, income-producing equities or maybe even just the stock market itself. Why? It comes down to opportunity cost. What is the alternative to taking the risk? At the moment, because of low interest rates, the alternative is zero. That what we would earn if we just kept the cash.
And this doesn't just motivate people to take risk. Importantly, it motivates them to buy the risky assets up to a level where the expected return represents a reasonable spread to the risk-free alternatives, which are zero. We can lament the decline of investment grade and even high-yield coupon rates and income all we want, but the reality is that, with rates expected to stay low for a long time, investors will naturally buy those bonds and tighten yields until credit spreads reflect their perception of the risk. With rates near zero, companies are indeed servicing their higher debt loads, so low rates are also making the perceived risk appear low.
This is the real issue with Mr. Powell's statement. We don't just believe he is wrong. We believe he is wrong three times. Low rates motivate risk taking, which impacts asset prices; low rates also motivate lower expected returns or yields, which impacts asset prices; and finally, low rates make companies appear less risky, which impacts asset prices. There are indeed many factors that drive asset prices, but three of them are low interest rates, low interest rates and low interest rates. We can accept that the market is also rallying because of vaccine euphoria, but monetary policy is complicit. Because we think so highly of Chairman Powell, we must assume that dismissing this link is due to a focus on fundamentals over market factors. We can empathize, but after 2020, we can also say with certainty that he does so at his peril. As he also said:
We'll be held accountable for what we saw and what we missed. So we work very hard at it.
We hope that hard work will recognize these links before market bubbles bring the economy to its knees again.
Note that none of this has motivated these investors to buy GameStop at a high valuation hoping it will go higher. That had different motivations and drivers that have been distracting but ultimately separate from the impact we are writing about here. That opportunity cost is not income; that opportunity cost is something else entirely. When many of the recently initiated day traders can go back to socializing in bars, watching movies and traveling, we expect the opportunity cost of day trading may get high enough that those who didn't lose substantial amounts of money will simply look back on this period as a fun story to tell, not unlike that vacation to Iceland they all took a few years back. (No really, all of them. Remember Wow Air?)
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Zeo Capital Advisors is a fundamental investment manager to a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
For more information contact Zeo directly at 415-875-5604 or visit www.zeo.com.
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