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Demolition Work in Progress

After cheering asset prices higher for the best part of two decades, the developed world’s central banks have dusted off their hard hats in preparation for a controlled demolition of real estate and equity prices. Much attention has focused on whether the central planners can tame inflation without crashing the real economy. Unfortunately, inflation is a syndrome—the manifestation of an interlocking set of imbalances between the real and financial economies. As such, it does not lend itself to being fine-tuned by even well-intentioned technocrats. Ultimately, the removal of monetary largess not only risks damaging real economic activity but also collapsing flimsy structures built up over 15 years of easy money.

Financial markets, among other things, act as a type of sieve that screens investments. Ideally, the riskiest tradable assets pass through to the strongest balance sheets. In practice, they often end up on the balance sheets of the most accommodating investors, owned not by those most capable of bearing risks, but rather those most willing to. A well-functioning market will tend to filter out those excesses, eliminating investors who exceed their risk-bearing capacity, while helping to ensure that those who take on too little risk see their returns shrink and their share of the capital base dwindle. On balance, this sifting mechanism helps to steer capital to its most productive uses.

In extended bull markets, however, this process tends to break down, as rewards flow disproportionally to the most aggressive, over-confident, and complacent investors. This creates a powerful feedback loop, as unbridled risk-taking is rewarded with outperformance which in turn draws more capital. Once the process gets going, it is self-reinforcing as the newly attracted capital is plowed back into the same group of assets. In so doing, fragilities increase, and the longer it persists the more distorted capital allocation becomes.

By central bankers’ own admission, their goal was to spur a positive wealth effect on spending, by pushing safety-minded investors into taking more risks, thus driving up valuations. Now we will see just how difficult the unwinding will be as the wealth effect goes into reverse.

The implosion over the last six months (at least in terms of their asset prices) of profitless growth stocks, crypto assets, and other speculative creatures of the markets is emblematic of the reckoning that can occur once excessive risk taking continues for too long. In this case, it has been slowly building for over a decade. Fears of outright deflation following the global financial crisis encouraged central banks to keep pushing interest rates lower to allow over-extended borrowers to heal, and to reduce the cost of capital for new investment in the hopes of kick-starting growth. At the same time, the total absence of inflationary pressures seduced central bankers to set aside worries about the dangers of money printing and unrestrained liquidity. By their own admission, the goal of their zero-interest monetary policy was to spur a positive wealth effect on spending, by pushing fearful, safety-minded investors into taking more risks, thus driving up valuations.1

Primary beneficiaries of this process were growth stocks, particularly the most speculative growth stocks of companies with untried business models; their multiples steadily increased, inversely with submerging interest rates. This coincided with a surge in indexation and so-called “smart beta” and factor investing, which channeled vast amounts of capital to the same group of stocks. Remarkably, for an extended period, some of these stocks were simultaneously defensive, fast growing, and relatively involatile, guaranteeing them an outsized weighting across a plethora of indices designed to track those very characteristics. Many active managers, faced with the prospect of having to beat a steadily narrowing benchmark, also piled in, overweighting these same stocks in the case of mutual funds, or owning them with leverage in the case of hedge funds. The prolonged success of these strategies encouraged yet more risk-taking, with new rafts of venture-backed startups and IPOs lacking anywhere near the prodigious free cash flows of the established tech companies. Moreover, the initial phases of the pandemic led to a late kick for tech stocks seemingly insulated from pandemic-induced disruptions to traditional commerce, which further turbocharged their valuations. The result was levitating valuations justified on the back of negative real interest rates.

The whole process was vulnerable to any shift in the macroeconomic backdrop that could prompt central banks to reverse course. The coils of that shift were arguably set by the pandemic and then sprung by the vaccine clinical trial results and rollouts which together upended consumption patterns, snarled supply chains, and reconfigured labor markets. According to the Bank for International Settlements, global growth, after cratering in 2020, accelerated to the fastest pace in almost five decades the following year.2 The subsequent conflict in Ukraine exposed the fragility of an energy supply that had been undermined by a decade of underinvestment and climate-related antipathy, applying an energy supply shock to a combustible mix.

Now we will see just how difficult unwinding the unprecedented asset purchase programs and zero interest rate policies will be as central bank balance sheets shrink, interest rates rise, and the wealth effect goes into reverse. Policymakers embarked on their former policies with a clear-eyed view of the clear and present danger of deflation while the uncertain contingent costs inhabited a distant and abstract future. As that future arrives, the true costs are being revealed.


1“Aiding the Economy: What the Fed Did and Why,” Ben S. Bernanke, The Washington Post (November 4, 2010).

2BIS Annual Economic Report, Bank of International Settlements (June 26, 2022).

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Does the Equity Market Know Something the Fixed Income Market Doesn’t?

Despite recent volatility the bond market has yet to lose its composure over the multi-decade high in inflation. In the US, ten-year Treasury yields have risen, but only to levels they reached prior to the pandemic, and, while ten-year real yields have been a little perkier, they are still below zero. As a result, the longer-term inflation expectations baked into today’s bond prices remain bunched up around 2% despite headline inflation running at over three times that rate. Short-term yields anticipate a series of hikes in the federal funds rate, the central bank’s standard response to persistent inflation, but even forward curves expect short-term yields to top out at only around 2.5%, within spitting distance of where they peaked back in 2018 when inflation was slumbering at 2%.

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Beauty and the Beast

The rise in passive investing is undoubtedly among the most important developments in asset management. The mass adoption of cheap, easily accessible portfolio building blocks that mimic the performance of market capitalization-weighted indices is nothing short of a paradigm shift. Indexed assets now account for over 50% of US domestic equity funds, 40% of global funds, and, despite a later start, already constitute 30% of fixed income fund assets.1 The shift is ongoing and it’s far from clear where the upper bound, if any, might lie.

Much of the debate surrounding indexing centers on the relative merits of taking an active versus passive investment approach. But the question of how indexing might be reshaping market structure is largely unexplored. The standing assumption is that, since passive investment flows mirror the prevailing distribution of capital, index trades are bereft of information and therefore have no effect on the pricing of the underlying securities; hence the overall scale of indexing is irrelevant. But this assumption becomes more tenuous as the share of passively managed assets grows. What if passive increased to, say, 100% of all equity assets? Would those investments still have no effect on prices?

It’s unclear how the widespread use of indexing may be affecting market structure; that is, at what point the sheer quantity of assets mimicking market behavior could start to change the behavior. Maybe it already has.

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A Ground’s Eye View on Inflation and Its Persistence

The pandemic sowed the seeds of today’s inflation. That much is clear. Last year, fear and government-mandated lockdowns sparked a global recession. Businesses rushed to cut production ahead of an anticipated slowdown in consumption, or were hobbled by forced plant closings, anxious workers, or snarled logistics. But the sheer sweep of the income support in many developed countries meant that household incomes didn’t fall nearly as far as had been expected based on the rise in unemployment. Unable to spend on services like eating out and travel, consumers flush with cash turned to buying, or attempting to buy, big-ticket goods and better houses.

The outsized demand for durable goods has run headlong into the diminished supply. While the springboard for price increases may have been reduced supply, the strength and persistence of those increases, which are now feeding through to labor markets, are raising the specter that aggregate demand is outpacing even normalized aggregate supply. There is precious little that monetary policy can do to counter supply-led inflation, but—Omicron willing—it is likely to be temporary. But if inflation comes to be led by stubborn excess demand, then tight monetary policy is the orthodox response, and we can expect central banks to hit the economy over the head with a brick to prevent a sustained wage-price spiral. Demand-led inflation would have significant implications for asset prices.

Inflation is notoriously difficult to forecast; even some at the US Federal Reserve (Fed) concede that it has no working model for inflation.1 We could do no better and accordingly make no effort to forecast future inflation. What we can do is talk to the companies we own or follow and tease out the impact on their earnings from the rising input costs they’re experiencing; their changing bargaining power vis à vis their suppliers; whether they are able to pass on higher costs to their customers before stifling demand; and how all that is coloring their business outlook. The following represents what our research analysts have been able to glean from those conversations.