The second point is that the whole line has been shifted down about three points relative to the equilibrium level. This combination is exactly what Bernanke has been trying to accomplish. By pulling down both today’s cash rate and the market expectation of future cash rates, the Fed has increased the relative attractiveness of pretty much all assets other than cash and, as a consequence, their prices have risen. Since 2009 it has been difficult to avoid making money in the financial markets. Nominal bonds, inflation linked bonds, commodities, credit, equities, real estate – everything – has been bid up as a consequence of the very low expected returns of cash. And this gives today’s markets a vulnerability that has not existed through most of history. Today’s valuations only make sense in light of low expected cash rates. Remove that expectation, and pretty much every asset across the board is vulnerable to a fall in price, as the rising real discount rate plays no favorites.
We have known this for a while, but the trouble is that there is no easy way to resolve this problem. There is no asset class you can hold that would be expected to do well if the real discount rate rises from here. Under normal circumstances, a rising real discount rate would probably come on the back of rising inflation or stronger than expected growth, which are diversifiable risks in a portfolio. But May’s shock to the real discount rate came not because inflation was unexpectedly high or because growth will be so strong as to lift earnings expectations for equities and other owners of real assets, but because the Fed signaled that there was likely to be an end to financial repression in the next few years. And because financial repression has pushed up the prices of assets across the board and around the world, there is unlikely to be a safe harbor from the fallout, other than cash itself.
I would like to say that having warned investors of this problem, we were able to spare our clients losses in this environment. But most of the reason we have been complaining about this issue as loudly and continuously as we have is that there is no good way out. During the market hiccup, we certainly did not do as badly as some other investors who have invested without regard to the risk of a shock to real discount rates. But to avoid taking any losses in a situation like this, you really need to know when it will occur. Avoiding losses as real discount rates rise requires sitting in cash, and we know cash offers no return today, while other asset classes are priced to give positive returns, even if lower than their historical averages. We have held more short-duration assets than normal for the last couple of years in asset allocation portfolios where that is appropriate, and that did help cushion the blow a bit, but did not save us entirely. The scatterplot in Exhibit 2 shows that investors are getting paid to move away from cash if things revert to normal over 7 years. If things are going to revert over 2 years instead, cash suddenly becomes a pretty appealing asset by comparison, but we don’t know that that will happen. As a result, we own assets that we know will get hit the next time markets are shocked by the prospect of discount rates normalizing.
In honor of the currently scorching temperatures, I’d like to put our current positioning in terms of a summer camp metaphor. We’re in a canoe race to the other side of the lake. We know all of the canoes are old and a bit leaky in the best of times, and there’s a storm coming. If we knew the storm were going to break now, we’d just stay in the cabin and laugh at everyone else as they were forced to turn around and trudge back to the cabin, sopping wet and half drowned. But we don’t know when the storm will break or even if it might miss us altogether, so we’ve stuck an extra guy in the middle of our boat with a bucket instead of a paddle. We know it will slow us down, but it will go a long way to help ensure we don’t sink along the way, even if we’re resigned to the likelihood of a long slow paddle in the rain, sitting in water up to our ankles.