— 2021 Q1 UPDATE —
Summary:
Increased inflation expectations caused a rise in interest rates which were a reason value stocks outperform growth stocks in Q1 and the systematic lowering of interest rates since the 1980’s is a major reason for increased S&P 500 valuations.
The continued fiscal support of the economy even as the economy reopens signals a regime shift away from monetary policy as the dominant force in markets to fiscal policy taking over that role.
Monetary policy fundamentally changed after the 2008 financial crises and it caused well known macroeconomic theories such as the money multiplier and the velocity of money to completely breakdown as tools for analysis.
The buildup of central bank reserves from quantitative easing are not inherently inflationary, individual banks cannot control the number of reserves in the system, and the accounting of quantitative easing transactions shows why the central bank can only indirectly affect the real economy through its operations.
Read on for our full Q1 market update and how these factors could impact the economy and your investments…
Returns:
The S&P 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies.
The NASDAQ is an index that tracks the cumulative results on a market capitalization basis of all stocks trading in the NASDAQ system.
The Russell 2000 index measures the performance of the small-cap segment of the U.S. equity universe.
Investors cannot invest directly in an index. Past performance is no guarantee of future results. Standard deviation is a statistical measure of the range of performance in which the total returns of an investment will fall. When an investment has a high standard deviation, the range of performance is very wide, indicating that there is a greater potential for volatility. Return and Standard deviation calculations performed by K2 Financial Partners and not verified by Lincoln Investment.
Equity Market Performance:
*Growth securities focus on companies with above average rates of growth in earnings and sales. These securities tend to have above-market price-to-earnings and price-to-sales ratios, as the rapidly growing sales and earnings justifies a higher-than-average valuation.
*Value securities focus on companies with lower-than-average sales and earnings growth rates. Holdings generally feature stocks with lower price-to-earnings and price-to-book ratios. Stocks generally have higher dividend yields.
Q1 of 2021 extenuated the reversal of growth stocks outperforming value stocks which has been a rare occurrence since the 2008 financial crises. On a sectoral level, there was a continued bull run in energy and financial stocks and a bear move in technology stocks. At face value, it would be very easy to backfill any narrative to explain these investment results to fit our prior beliefs. We could easily say that this was a short-term trend and growth stocks will continue their decade long outperformance over value stocks, or on the flip side we could justify why the trend has finally reversed. However, applying narratives to any investment results without understanding the fundamental dynamics of why they occurred is setting ourselves up for frustrating long-term results. Therefore, it is important to analyze the underlying market dynamics of Q1 which led to the investment results, rather than simply attaching a narrative to explain them. Understanding the causation of the investment results should amount to a higher probability of being able to accurately forecast whether these results will persist into the future or whether they really were an anomaly.
Analysis:
The main difference between Q1 and previous years was the increase of inflation expectations by market participants. (1) This is an important metric because inflation expectations are intrinsically tied to the yield curve and the yield curve is used as an input in discount rates which are used to value financial assets. One of the main reasons why inflation expectations would alter the yield curve is because investors want to be compensated for inflation to maintain purchasing power over time. For example, if I believe that inflation is going to be 5% for the next 10 years, it will not make sense for me to invest in a 10-year debt security yielding 1% per year. If I made that investment, I would gain 1% per year in nominal terms, but lose 4% of my purchasing power every year I have that investment (if I am correct about the 5% inflation). Therefore, the only way for debt issuers to entice me to purchase this debt security would be to increase the yield on the debt issuance. When inflation expectations change on an aggregate level it causes the same dynamic as in the previous example and the yield curve tends to steepen in certain areas, depending on which tenor the debt is being issued.
While this may be useful and absolutely riveting information to share at cocktail parties, as investors, we care much more about how underlying economic variables affect the return vectors of our investments rather than being enamored with the variables at face value. This begs the question, how are the return differentials between growth stocks and value stocks related to interest rate changes?
The key to the relationship lies in the way the discounted cash flow method works and the difference in timing of the expected cash flows between growth and value stocks. (2) Growth stocks are generally priced to receive the more of their cash flows, and subsequent value, further out in the future than value stocks. Since interest rates are a direct input in discount rates, which are used to discount the cash flows, the further in the future that value is derived the more sensitive a stocks valuation will be to changes in interest rates. This is known as duration risk, but it is not as widely applied to equities as it is to fixed income because equities have many more factors affecting their daily movements outside of interest rates. To fully internalize why this should happen from a mathematical perspective, here is a simplified discounted cash flow model I created which compares a value and growth stock’s valuation as interest rates change.
Example:
In this scenario, I am comparing a value stock with higher relative cash flows and a 3% growth rate versus a growth stock with lower starting cash flows and a 40% growth rate. There is a massive disparity between the growth stock P/E ratio and the value stock P/E ratio when the discount rate is at 5%.
*All growth rates, discount rates, Starting CF (cash flows), and terminal growth rates are purely hypothetical and not indicative of any real company. This is a basic example of a discounted cash flow (DCF) analysis and only the inputs and outputs of the model are being shown here. The growth rate is the rate at which cash flows grow each period for the explicit forecast. The terminal growth rate is the growth rate used after the explicit forecast period which is applied in perpetuity. The starting CF is the cash flow used in the starting period. The discount rate is used to discount the stream of cash flows back to the present to account for the time value of money. The valuation is the present value of the explicit forecast and the terminal forecast. The stock P/E ratio is the valuation divided by the starting CF.
Let us see what happens when I move the discount rate up 1%, similar to what happened in Q1.
*Projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results.
The 1% upward move in interest rates caused a 12.4% reduction in the valuation of the growth stock versus a 7.3% reduction in the valuation of the value stock. This is clearly a basic example, and the real world has countless more factors that play into the valuation of equities, but I hope this shed some light on why an upward move in interest rates would negatively affect growth stocks over value stocks when looked at in a vacuum.
On the flip side, the interest rate phenomenon that contributed to value stocks outperforming growth stocks in Q1 is partially the reason that growth stocks outperformed value since 2007 and why the valuation (Price-to-earnings ratio) of the S&P 500 has inflated in a systematic way. (3) The consistent downward pressure on interest rates from Quantitative Easing has artificially pushed the entire equity market much higher but on a relative basis growth stocks have benefited even more than value stocks.
While interest rates can greatly impact the valuation of equities, they are far from the only factor affecting their returns. There has been a systematic downward trend in interest rates and a systematic upward trend in S&P 500 valuation since the 1980’s, but growth stocks consistent outperformance streak only started in 2007. Why?
MSCI World Value Index captures large and mid cap securities exhibiting overall value style characteristics across 23 Developed Markets (DM) countries.
MSCI World Growth Index captures large and mid cap securities exhibiting overall growth style characteristics across 23 Developed Markets (DM) countries.
Past performance is no guarantee of future results.
(See Below) Long-term S&P 500 P/E ratio:
According to JP Morgan Asset Management, “In boom times investors are often willing to fund businesses that don’t make any money, but during a recession investors are historically more likely to want to own companies with strong balance sheets that can withstand a downturn.” This explanation lends itself to the idea that value stocks outperform growth during recessions and when credit expansion is not flowing as freely. Therefore, with unprecedented monetary policy actions providing liquidity to the financial markets combined with the systematic lowering of interest rates, it begins to provide a bit more clarity on why growth stocks have generally outperformed value stocks since 2007.
Overall, the underlying economic landscape affects equity returns throughout time. Inflation rates, interest rates, profit margins, monetary policy, fiscal policy, and countless other economic variables impact equity valuations. Currently, the most crucial variable to get a handle on is which direction is inflation heading because higher inflation would impact interest rates which would impact equity valuations and it would be a strong signal of a regime shift in the markets. Therefore, it is critical to understand the current economic environment we find ourselves in and how that environment is likely to impact the critical underlying variable of inflation.
Macroeconomic Analysis:
The United States is currently experiencing a wave of monetary and fiscal stimulus during a time when the economy is re-opening from an unprecedented shutdown. Looking at the macroeconomic landscape, it is relatively clear why inflation expectations began to rise in Q1. Fiscal policy appears to be on a long run trajectory of continued omnibus stimulus packages, the economy is reopening due to wide-spread vaccinations, supply chains are strained around the globe from the heterogenous levels of global reopening speeds, and the Fed is willing to monetize the government spending through mass purchasing of Treasury issuances. These conditions make inflation seem inevitable.
(See Below) The United States currently is running the largest yearly fiscal deficit as a % of GDP since WW2:
However, similar inflationary concerns were widespread after the 2008 financial crises when the Federal Reserve (Fed) began their quantitative easing (QE) program and excess reserves built up on bank balances sheets. (4) Yet those inflation concerns never came to fruition and the exact opposite problem of deflation became the bigger market risk over the past 12 years. This misread of the economic situation came from a fundamental misunderstanding of how the policy reactions of financial crises led to a regime shift in the financial markets. Regulatory change reshaped commercial banking and central banking reshaped the entirety of financial markets with QE. Essentially, after 2008, a lot of the old rules no longer applied the same ways.
There is potential that the fiscal and monetary response to the pandemic caused another regime shift and the markets will operate a bit different post-covid versus how they operated pre-covid. Monetary policy has essentially dominated the financial markets since 2008 through QE but it is possible that monetary policy has reached a point where it can no longer be effective the way it needs to be. It is possible we have entered a period where fiscal policy might have taken over as the dominating factor, which would be a regime shift.
To understand this potential regime shift and the consequences that might be attached to it, we need to have a deep understanding of how monetary policy has worked in the past and whether that will be able to work moving forward.
General Monetary Policy Operations:
Before the 2008 financial crises, monetary policy generally consisted of the Fed using a few tools to change interest rates levels which in turn would change the level of economic activity within the economy. These tools consisted of open market operations, adjusting reserve requirement ratios, and changing the terms and conditions for borrowing at the discount window. (5) Open market operations consisted of the Fed buying and selling treasury securities in the open market which would change the level of bank reserves and change interest rates towards their target rate. For example, when the Fed wanted to pursue expansionary monetary policy, they would buy treasury securities which would add to the supply of reserves in the banking system and lower the federal funds rate which put downward pressure on other interest rates which encouraged more borrowing.
Before the 2008 financial crises, open market operations consisted of buying/selling a relatively small amount of treasury securities because reserve balances were not much higher than the required reserves. However, during the 2008 financial crises the Fed provided liquidity to the banking system by buying longer term treasury securities and mortgage-backed securities while also aiming for a federal funds target rate of close to 0%. (5) These operations greatly expanded the Feds balance sheet and supplied reserve holdings for banks far in excess of the required amount. With the large number of reserves on the Fed’s balance sheet and an unwillingness to reverse the QE process through unwinding their balance sheet, the Fed was unable to affect the federal funds rate through buying/selling a relatively small number of treasuries. This could have led to serious monetary issues, but congress passed a bill that allowed the Fed to control interest rates by paying interest on the excess reserves held at the Fed. (6) This interest rate paid on excess reserves was aptly named the IOER (interest on excess reserves) rate. This made it so there was not the same opportunity cost for banks having excess reserves at the Fed and so the Fed could meet their interest rate targets without having to do large scale purchasing or selling of assets each time.
While this may sound like a simple fix, this fundamentally shifted the way that central banking was done in the United States. For the first time, the banking system held large quantities of excess reserves on the Fed’s balance sheet, and it led most investors to conclude that once the recession was over banks would lend those excess reserves out into the marketplace which would cause a huge influx of inflation. This mistaken belief came from a mistaken idea of how fractional reserve banking would work after quantitative easing and it came from a fundamental misunderstanding of the nature of reserve assets (more on that later).
Next this market update will cover the breakdown of vital concepts related to fractional reserve banking and it will cover why this breakdown happened in the first place.
The Death of the Money Multiplier & the Velocity of Money:
In economics, there is a concept called the money multiplier which attempted to explain the relationship between credit creation and the level of reserve requirements required for banks. (7) Economic theory teaches that changes in central bank reserves changes the amount that banks can lend under their reserve ratios.
For example, let us assume a bank has a reserve ratio 10% and the central bank increases bank reserves by $500. Under the money multiplier theory, banks would create $5000 of credit in this situation which covers the concept of fractional reserve banking as well. This concept of fractional reserve banking allowed the Fed to control the level of credit in the economy through increasing or decreasing the amount of reserves through their open market operations. If the Fed wanted to stimulate the economy, they would use open market operations to buy a relatively small number of treasuries to increase the reserves which was thought to increase the amount that banks could lend.
With this concept, it is easy to see why markets would expect inflation after the 2008 financial crises considering bank reserves went this far over the required amount:
However, instead of a tsunami of lending happening after the financial crises was over with the excess reserves, the reserves simply stayed on the balance sheet of the Federal Reserve. This caused the money multiplier to nosedive as excess reserves built up on the Federal Reserve balance sheet.
(See Below) Money Multiplier:
(See Below) Commercial Loans divided by reserves:
(See Below) Yearly Change in CPI:
Consumer Price Index (CPI) measures prices of a fixed basket of goods bought by a typical consumer, widely used as a cost-of-living benchmark and uses January 1982 as the base year.
This came as a surprise to many investors who were taught about the tight relationship between reserve ratios, reserve levels, and credit creation. Just a simple glance at these graphs shows that the money multiplier does not work anymore and the nail in the coffin came last year on March 15, 2020, when the Fed abolished the reserve requirements completely. (8) Under the money multiplier theory, reserve requirements of 0 means infinite money supply, which is clearly something that has not happened. (7) The idea of the money multiplier dying has ramifications for other tools investors use in their analysis, such as the velocity of money.
The velocity of money measures how many times the supply of money is exchanged in a transaction for a final good and/or service in an economy. The famous formula is (V * M = P * rGDP). (9) For our purposes in applying this formula in real life, this formula is the velocity of money (V ) multiplied by the M2 money stock (M ) equals the price level in the economy (P ) multiplied by real GDP ( rGDP ). Rearranging the formula, we get V = nominal GDP / M2.
Before 2008, the velocity of money was relatively fixed at around 2 as you can see from the chart below.
Therefore, in the past, economists in the Monetarist camp believed the only way that inflation would increase would be through increasing the size of the money supply (M2 ). (9) If the velocity of money stayed the same after 2008, then inflation would have risen because the money supply was increasing. However, the velocity of money became distorted after the financial crises because the constitution of the M2 money supply changed after reserve balances spiked. Reserve balances increasing from QE had a large effect on increasing demand deposits and demand deposits are counted as a part of the M2 money supply. (10) In layman’s terms, monetary indicators that used to have relatively tight correlations broke down after QE because the economic variables underlying the indicators fundamentally changed.
Before 2008, reserve balances and demand deposits were linked together because a certain number of reserves would be created through open market operations which would allow for more loans to be created which would change the level of deposits. This consistency of this process allowed the money multiplier and the velocity of money to be relatively predictable throughout time. However, as we all know, correlation does not equal causation and even correlations with causation can breakdown during a regime shift.
You may be thinking that it the process of an increase in reserve balances lead to more lending which lead to more deposits seems backwards. Banks need customers to deposit money so they can lend those deposits out. Right?
The myth that so many economic graduates and I learned in school about banking and credit creation is that banks need deposits to create loans. This is false. Banks create money through making loans first and then a deposit gets created afterwards, this is why it’s called credit creation. (11) Banks literally create money out of thin air. When you want a loan, the bank simply puts the loan amount with a click of a button into your account as a deposit. Suddenly, money is created. Banks used to simply lend up to the point where their supply of loans met their demand for loans or they hit their reserve ratio limit, whichever one came first. Since the level of reserves in the system was relatively low before 2008, banks would generally hit their reserve ratio limit before the demand for loans dried up. This is the reason why bank deposits were usually an order of magnitude higher than bank reserves before 2008 and why reserves were generally indicative of flows into the real economy.
This reserve balance, demand deposit, and lending level connection was changed after QE and it is the main reason that the money multiplier and the velocity of money are outdated concepts in the modern central banking world. (12)
How Quantitative Easing Changed Banking:
Quantitative easing changed that relationship between reserves, deposits, and money flowing into the real economy because the nature through which deposits were created was changed. When the Fed conducted open market operations before 2008, they would still create a small amount of deposits on bank balance sheets because when they bought treasuries in the open market, the person/entity that sold that to the Fed would have money deposited into their bank account and the commercial bank would receive a reserve asset to balance out the deposit liability.
At the end of the transaction between the Fed & the non-bank entity (10):
If this same transaction happens between the Fed & a commercial bank (10):
While the first transaction between the Fed & the non-bank entity does put money back in the hands of the non-bank entity who received the deposit from the sale of the Treasury security, there is a key difference about this transaction and receiving a deposit from a loan. The difference is during QE, there is the transaction of a financial asset between the Fed and non-bank entity, which generally increases the probability that that money will go back into financial markets. (10) This is much different than someone seeking out a loan for a project in the real economy. Both a loan from a bank and QE between the Fed & a non-bank entity end up with increased deposits in the system but one generally gets invested into the real economy and one generally gets invested into the financial markets.
Looking at the simplistic balance sheet from both scenarios, there is nothing explicitly showing that the any new impetus for the bank to lend after the transaction. Reserves increased in the banking system, but this did not have a direct relationship with increasing demand for credit. Once reserves are built up to a certain level in the system where there is no reservation about lending due to reserve ratio constrains, QE’s main impact on lending is simply through the downward pressure on interest rates. This goes back to the concept of credit creation; banks do not need deposits or excess reserves to lend. Once excess of reserves skyrocketed, the main things affecting banks willingness to lend was the demand for loans, Basel III capital requirements, and the willingness to take on risk.
Lending is a completely different operation altogether and this simple scenario gives credence to the critics of the money multiplier and the velocity of money who would say the concepts were generally spurious correlations to begin with.
Purpose of QE & Who Controls the Level of Reserves:
Ultimately, no single commercial bank can control how much reserves are in the banking system. (13) Banks can change their individual level of reserves through transactions with other banks and/or entities that have a reserve account at the Federal Reserve, but only the Fed decides the actual level of reserves in the system. Banks cannot directly use reserves to put money into the economy because our system is essentially a two-tiered monetary system. (14) Entities with an account at the Fed (essentially a checking account for banks, government entities) transact with each other in reserves and everyone else transacts in currency/deposits.
Therefore, quantitative easing is fundamentally geared towards managing the yield curve, providing liquidity to the banking sector, monetizing the government debt, and reconstituting bank balance sheets. Since the Fed only has indirect control over lending by banks and QE is aimed at a multitude of goals, it would be surprising if the money multiplier and the velocity of money did not break down as economic theories. Ultimately, there is a low correlation between the reserves the Fed creates in the financial system and the money supply in the real economy in this modern central banking paradigm. We can almost think of what the Fed does with QE as operating in a shadow economy. Yes, there are ripple effects to their actions in the real economy and financial markets, but the closer interest rates go towards 0% and the more reserves that build up in the banking system, the more muted their actions become over time. They could become extremely relevant again if they reversed QE, also known as quantitative tightening, but they have pushed the boundaries so far since 2008 that they have essentially exhausted their tools which has even forced Jerome Powell to ask for increased fiscal support. (15)
The Fed’s lack of control over the real economy is why the Fed struggled to increase inflation despite the unprecedented monetary support. Now that the Fed is consistently hitting the lower bound of 0% interest rates across multiple tenors combined with the public’s desire for government spending, there is a high probability we have reached the end game of monetary policy being the driving force of the markets and allow for the new dominating force to enter, Fiscal policy.
Fiscal policy has been garnering plenty of attention since the financial crises and even greater attention since Covid began. There are constant headlines about the Government’s debt-GDP ratio, fiscal deficits, money printing, and a myriad of other soundbites that cause the public to worry. However, as with most economic topics, the details are more nuanced than can be fit into a headline. In the future (possibly next quarter, way over my normal word count), I will do a deep dive on fiscal policy to try and shed some light on how a fiscal policy dominated market regime may differ from a monetary policy one. In the meantime, I hope that after reading this you are walking away with a deeper understanding of how inflation, interest rates, equities, and monetary policy all fit together, and you see how there is strong potential for a regime shift away from monetary policy as the dominating market force.
Conclusion:
Here at K2 Financial Partners, our main mission is to help you reach your financial goals. We understand that the financial markets are an ever-changing adaptive marketplace and that is only exacerbated during a time when the political noise gets turned up. Therefore, it is important to have a well-diversified portfolio and contact your advisor when you have questions, comments, or concerns. At the end of the day, we are here to help you!
- Federal Reserve Economic Data | FRED | St. Louis Fed
- Interest Rate Effects on Equities: Valuation Impacts (lynalden.com)
- Value vs. Growth Investing: Can Value Outperform Again? | J.P. Morgan Asset Management
- The Federal Reserve's latest quantitative easing may lead to disaster | Quantitative easing | The Guardian
- Open Market Operations: Explained with Examples | St. Louis Fed
- Federal Reserve Board - Interest on Required Reserve Balances and Excess Balances
- Zombie Concepts: The Money Multiplier - Fed Guy
- Federal Reserve Board - Federal Reserve Actions to Support the Flow of Credit to Households and Businesses
- Some Alternative Monetary Facts (imf.org)
- The Mechanics of Quantitative Easing and M2 - Fed Guy
- BanksCannotLendOutReservesAug2013_ (002).pdf (harvard.edu)
- Zombie Concepts: Velocity of Money - Fed Guy
- Why Are Banks Holding So Many Excess Reserves? (newyorkfed.org)
- Two Tiered Monetary System - Fed Guy
- Powell says U.S. economy needs more fiscal support - MarketWatch
The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Lincoln Investment. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. Past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss. Diversification does not guarantee a profit or protect against a loss. None of the information in this document should be considered as tax advice. You should consult your tax professional for information concerning your individual situation.