What Next? Investing in a Changed World

By John Apruzzese | February 26, 2021

Sky-high asset prices and record-low yields make for a dramatic investment landscape, a far cry from the one that global central bankers set out to shape years ago when they embarked on sweeping stimulus efforts, first to recover from the ravages of 2008-2009 and more recently to manage the economic fallout of the pandemic.

Instead, the contrasts have become only more extreme, with stocks trading at 22.3 times forward earnings and all investment-grade fixed income securities, from 30-year Treasuries to investment-grade corporate bonds and municipals, now generating yields below the expected rate of inflation.

Other factors are at play, of course. But there is one main reason why the stock market, and for that matter, all asset classes, are so high and interest rates are so low – massive government deficit spending financed by central banks. The U.S. Federal Reserve, the European Central Bank and the Bank of Japan have pumped a combined $7 trillion of liquidity into the global financial system since mid-2020. While much of this deficit financing was necessary, it may have already gone too far. Indeed, contrary to perceived wisdom that stimulus is inflationary, the empirical evidence of recent years suggests that the more a country’s debt represents of its GDP, and the more that debt is assumed by its government, the lower the country’s prevailing inflation rate.

Japan’s government debt is now 238% of GDP, and the Bank of Japan, holding much of that debt, has assets of 126% of GDP; the compound annual inflation rate in Japan over the last ten years is 0.5%. The Eurozone has the next highest level of government debt financed by the central bank, with government debt at 97% of GDP and European Central Bank assets at 55% of GDP; the compound annual rate of inflation in the Eurozone over the last 10 years is 1.2%. Here in the United States, we appear to be heading down a similar path, with 99% of government debt to GDP and Federal Reserve assets at 34% of GDP. Our consumer price index rate of inflation is a relatively healthy 1.7%, healthier relative to those of Japan and Europe, but a far cry from the Fed’s stated goal of 2%.

In other words, all this monetary inflation has produced only asset inflation, not an increase in consumer inflation. Brian Pollak addresses this subject here.

Of course, an investor would receive a solidly positive real return over the next year or two in long-dated investment grade fixed income if long-term interest rates in the United States collapse to zero or go negative, as has happened in Europe and Japan. This seems to us possible but not likely: Federal Reserve officials have made it clear that they want to avoid negative nominal interest rates. If long-term interest rates do instead grind higher, the returns of long-dated fixed income in the short-term will be negative even before adjusting for inflation.

Up on the peaks of this investment landscape, the S&P 500 now sells for close to a record-high valuation at 22.3 times expected earnings over the next 12 months, or slightly more than in 2019 before the pandemic. Earnings are expected to grow an additional 15% in 2022, which would bring next year’s forward price-to earnings ratio down to a multiple of 19.5, but still well above the long-term average of 16 times. At the same time, some areas of the equity markets are experiencing levels of speculation – and related valuations – reminiscent of previous market peaks. However, as we’ve discussed a number of times in Independent Thinking, it seems to us reasonable for the market as a whole to sell considerably above long-term historical average valuation levels in this low inflation and interest rate environment.

Talk of another stimulus package in the United States – this time to the tune of $1.9 trillion, although that is likely to be watered down by the nearly balanced Senate – has given rise to more talk of inflation. Again, recent evidence suggests that the reverse will hold true and inflation will remain suppressed. But this dynamic could change if there is a reversal in one or more of the global deflationary forces, including population growth, innovation, high debt loads and globalization, or if the Fed simply throws all caution to the wind in its determination to increase consumer inflation by bypassing the banking system and sending newly created dollars directly to consumers.

Appreciable gains in inflation and interest rates could drag down stock market valuations closer to the historic average even if earnings continue to grow at an above-average rate for the next two years. The valuation levels on all financial asset classes, from fixed income to leveraged real estate, would come under pressure from rising inflation. We will be watching closely for the early warning signs of accelerating inflation, hoping to distinguish the real signals from the noise. Reports of a rise to about 3% year-on-year inflation in April and May should be understood in the context of the global shutdown last year; the early signs of sustainably higher inflation are likely to include rising oil prices, accelerating wages and significant deterioration in global trade.

We will also be watching for further evidence of improving productivity, as described below. Increased productivity growth could fully justify the high valuation of the stock market and allow for attractive returns in the future.

We remain confident in our asset allocation in current market conditions. We will continue to adjust individual portfolios to meet each client’s long-term goals and risk tolerance.

Potential Productivity Peaks

One trend could fully justify the high valuation of the stock market and generate attractive future returns: increasing productivity growth. Indeed, the rapid deployment of technological innovations into the economy might allow for the kind of rapid productivity growth last witnessed in the 1990s with the deployment of the personal computer.

Of course, we all knew that it was possible to do more with the technology at our disposal. But it took the urgency of the pandemic response for us to take advantage of it. This new openness and the associated potential productivity advances could very well accelerate economic growth and increase our standards of living fast enough to keep inflation under control and allow the economy to grow into the current high debt levels. We believe that the elevated valuation levels of the stock market would then be more than justified by the earning growth of the innovators.

At the same time, we are also close to an inflection point in energy when the cost of sustainable alternatives falls below that of fossil fuels. This will likely create attractive returns on large capital investments in electronic vehicles and in the solar and wind capacity to generate the power.

– JA

John Apruzzese is the Chief Investment Officer at Evercore Wealth Management. He can be contacted at apruzzese@evercore.com.

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