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Economic Insights

As economic narratives go, this one appeals to the populist zeitgeist that you can’t trust the governing elite or authority figures.

Noble prize-winning economist Robert J. Shiller describes economic narratives as the “viral spread of popular narratives that affect economic behavior.”  In a recent column, I discussed a shift in the U.S. recession narrative.

In this column, I’m going to look at another surprising market narrative, i.e., a strong belief that risk assets cannot do well without the U.S. Federal Reserve (Fed) increasing the money supply and adding to its balance sheet (i.e., quantitative easing). The narrative is as follows:

A fractional reserve system (one in which only a fraction of bank deposits are backed by actual cash on hand and available for withdrawal), as operated in the United States and mostly everywhere, cannot handle zero interest rates. A good chunk of the world has negative rates already and, as believed in this narrative, the United States is headed for negative rates one way or another – either another recession happens, pushing the Fed to zero rates, or the United States gets dragged down by secular stagnation (a condition in which there is negligible or no economic growth in an economy.)

The narrative continues: Once interest rates turn negative, the banking sector is doomed – the negative rates destroy the business model of banks, and the government is unwilling to go to a fully reserved system (one in which banks would be required to keep the full amount of each depositor's funds in cash, ready for immediate withdrawal on demand) to fix the problem. As a result, the Fed will keep expanding its balance sheet until everything collapses. Therefore, you need gold and bitcoin.

The narrative has hints of today’s populist zeitgeist – you can’t trust the governing elite and other authority figures. For many people, that’s part of the attraction of bitcoin – it is a means of payment that is stateless and not dependent on possible government manipulation of a fiat currency. As Robert Shiller argues in his recent book Economic Narratives, there are hallmarks of 1896 in bitcoin: the bimetalists of the 19th century were heavily indebted populists who wanted the currency devalued to escape their debts as well as the tyranny of East coast financial interests.

Today, a major manifestation of this narrative comes from strategists who closely watch the weekly growth of M2 (a measure of the money supply that includes cash, checking deposits, and easily convertible near money such as savings deposits).  M2 data are available with a two-week lag from the Fed and are closely watched not only as a measure of money supply but also as an indicator of future inflation and as a target of Fed monetary policy.  

Setting aside the theoretical argument that using M2 growth as a means of judging the viability of risk assets does not make sense, would this even work as a trading strategy? That is, would it be reasonable to take “risk off”1 (lower the risk exposure of a portfolio) if the Fed lowers the money supply or vice versa, to add risk if the Fed increases the money supply?

A common suggestion is to use a rolling 26-week percentile rank of M2. For argument’s sake, let’s devise a trading strategy where a portfolio is 10% overweight the S&P 500® Index (used here as a measure of “risk-on” assets) when M2 year-on-year growth is above the 90th percentile rank and 10% underweight the S&P 500 Index when M2 year-on-year growth is below the 10th percentile (and neutral otherwise). Looking at the cumulative returns in Chart 1, such a strategy would have resulted over time in a lot of underperformance.

 

Chart 1. A Hypothetical Trading Strategy Would Have Resulted Over Time in Underperformance
Strategy based on 26-week percentile of M2,* Long when percentile is > 90th, short when percentile is <10th (1980-2020)

 

Source: Bloomberg, Lord Abbett. *M2 is lagged two weeks to reflect reality.             

 

Historically, there has been no correlation, at any reasonable lag, between year-on-year M2 growth and the return on the year-on-year S&P 500 Index – that is, until 2010, when the correlation between year-on-year M2 growth and year-on-year S&P 500 Index return seemingly increased and the strategy has seen a few good upticks. No doubt, this has helped to strengthen the narrative.

Should we reject the longer history of performance of M2 as a poor signal of the viability of this risk on/risk off strategy and presume that now things are different?

 

Chart 2. Neither a Monetary Easing Nor a Monetary Tightening Has Been an Obstacle to Risk Assets
Returns* on selected indexes in periods of Fed tightening and easing (2013-2020)

 

Source: U.S. Federal Reserve, Bloomberg.  * Returns normalized to 2013.

 

Even an inspection of the Fed balance sheet against the S&P 500 Index and Bloomberg Barclays High Yield indices (see Chart 2) suggests that neither a monetary easing nor a monetary tightening has been an obstacle to risk assets.  (Special thanks to Lord Abbett Partner Giulio Martini for this insight.)

Here’s where the narrative leaves us: Even though the Fed isn’t currently engaged in quantitative easing (by buying duration through its Treasury bill purchase program), if the market believes the Fed is implementing quantitative easing is that all that matters to add risk? I don’t know, but the market wants to believe.

 

1"Risk-off" assets are viewed as so-called “safe haven” investments that tend to advance in price when expectations turn bearish. By contrast, "risk-on" assets are growth-oriented, and typically rally when positive news sparks increased. 

 

Glossary of Terms

The Bloomberg Barclays U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.  If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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