e believe that asset price bubbles occur when a flood of newly printed money collides with a fundamental economic rational for higher asset prices. Global financial markets may experience just such a confluence of events in 2021. The result could be a year of extraordinary market gains and a series of historic asset price bubbles.
Despite a global pandemic, economic recession, and unprecedented challenges to the US electoral process; 2020 saw stock markets and home prices break out to new all-time highs. Asset prices were driven higher over the past year, in our opinion, by overwhelming fiscal stimulus financed by the Fed’s injection into financial markets of $3 trillion in freshly printed dollars.
Financial markets are likely to receive a similar boost from fiscal and monetary policy in 2021. However, economic growth in the New Year is likely to switch from being a headwind for financial markets to being a gale-force tailwind. The combination of aggressive money printing and accelerating economic growth could fuel bubbles in equity, housing, and commodity markets.
In contrast to prior bubbles, we believe the Federal Reserve and other central banks around the world will be reluctant to deflate emerging asset price bubbles. That could allow bubbles to float higher and last longer than has historically been the case. If we are correct, then almost every asset class except bonds and oil could enjoy an extended period of inflated prices and artificially boosted returns.
Historically, asset bubbles have occurred when two conditions have been in place:
1. A big injection of newly printed money
2. A fundamental economic rationale for higher asset prices.
We believe these two conditions were present in every bubble, from the Dutch tulip mania of the 1600s to the US housing bubble of the mid-2000s. For example, the 1990s technology bubble inflated, in our opinion, because fears of Y2K disruptions prompted the Federal Reserve to pump extra money into markets.
This infusion of cash pushed markets higher at a time when emerging internet technologies helped investors rationalize those higher prices.
As we enter 2021, global financial markets are awash in central bank supplied liquidity. As shown in the chart below, 21% of every US dollar ever printed was printed in 2020. That excess liquidity is the fuel that can ignite an asset bubble.
The tight connection between printed money and equity prices can be clearly seen in the chart below. The so-called FANG+ index (10 of the most popular technology stocks) has gone up in lockstep over the past 5 years with the money being printed by global central banks.
Although equity market did well in 2020, the extraordinary gains associated with a bubble were concentrated in a handful of companies with a fundamental rationale for higher prices.
Companies that benefitted from the restrictions put in place to combat COVID (FANG+ stocks like Facebook, Amazon, Netflix, etc.) skyrocketed while companies facing the challenges of a global recession have been largely left out of the market rally (see chart below). We believe that a powerful economic recovery in 2021 will supply a fundamental economic rationale for higher prices across a much broader array of companies.
President-elect Biden has nominated Janet Yellen to be the next Treasury Secretary. Jerome Powell will continue as Chairman of the Federal Reserve. This means that economic policy will be driven by two of the most vocal advocates for immediate and aggressive economic stimulus. Both are on record as believing that the policy risk is doing too little rather than too much to stimulate the US economy.
Both believe the economy can sustain low levels of unemployment without inflation. In fact, Yellen has written that such a “high pressure” economy is essential to lift wages of low income workers. The philosophical alignment between the Treasury Secretary and Fed Chairman suggests that fiscal and monetary policy will continue to be highly coordinated, with lots of government spending and lots of money printing to finance that spending.
Congressional negotiators are hopeful they can pass a $900 billion stimulus package before the Christmas break. President-elect Biden has promised that the $900 billion will only be a down payment on his “Build Back Better” spending initiatives.
If Republicans retain the Senate, then Biden’s most ambitious plans will probably die in committee. However, broad bipartisan majorities support big increases in infrastructure spending. Even with a Republican Senate, Congress is likely to pass about $1 trillion in infrastructure spending to add to the $900 billion lame duck stimulus bill.
Given the staggering budget deficit President-elect Biden will inherit, financing more spending will likely require the Fed to maintain its current policy of printing money and buying government bonds (see chart below). Economists justify big government deficits financed by printed money through a policy framework known as Modern Monetary Theory (MMT).
Chairman Powell set the stage for a continued embrace of MMT and more money printing in 2021 with the Fed’s December policy statement. The Fed committed to printing, at a minimum, an additional $120 billion per month “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.”
The December statement reiterated that the Fed’s price stability goal is for inflation to rise above its 2% long term target “for some time”. This means that the Fed will keep the printing presses running until it sees a significant increase in inflation. The Fed appears unconcerned that such an acceleration in inflation might prove difficult to contain.
Aggressive fiscal and monetary stimulus will hit an economy that we believe is already primed for a period of strong economic growth. Wealthy consumers are flush with record levels of savings and cash. Big gains in the stock market and home prices have pushed consumer net worth to all-time highs, which could encourage wealthy consumers to spend some of that accumulated cash.
Wages are booming for workers in the “stuff” economy thanks to record demand for manufacturing and construction skills (see chart below). Wage gains are likely to accelerate and could benefit far more workers if, as expected, the Biden administration successfully passes a big increase in the minimum wage. Finally, we think that widely available COVID-19 vaccines will unleash pent up demand for services like travel, eating out, and attending live sporting and music events.
The 2021 economy could shock investors with an unexpectedly powerful acceleration in growth. Strong economic growth should fuel an explosive increase in corporate earnings. When this powerful rationale for higher asset prices collides with all the printed money in the system, we think that bubbles in equity, housing and commodity markets will ensue.
If we are correct that bubbles could emerge in various markets, the key questions for investors are how high could markets rise and when will the bubble eventually pop? We believe that bubbles form because central bankers inject too much money into financial markets, and they collapse when that excess liquidity is taken away.
Therefore, we think investors should ask whether global central bankers are likely to react to an asset bubble by suddenly shutting down their printing presses and aggressively draining markets of excess liquidity. We think that is unlikely.
Baby boom investors can mark almost every decade with an associated bubble:
• 1980s: Japanese equity bubble
• 1990s: Technology bubble
• 2000s: US housing bubble
Each bubble was exhilarating as it inflated but left deep economic and psychological scars when it popped. We believe that central bankers carry these scars just as much as investors. The primary lesson we believe central bankers learned from the market frenzies of past decades is not to pop bubbles.
The Bank of Japan and the Federal Reserve deliberately popped equity and housing bubbles because they feared the bubble’s long term economic consequences. The results were prolonged economic recessions and devastating drops in working class living standards. We believe central bankers have concluded that popping bubbles is far more dangerous than the potential consequences of allowing bubbles to continue.
If we are correct, central banks might avoid the dramatic cuts in market liquidity that caused prior bubbles to collapse. A more cautious, incremental policy response might allow future asset bubbles to grow bigger and last longer than history would suggest. Inflation could replace deflation as the biggest concern for investors.
The technology bubble of the late 1990s and the housing bubble of the mid 2000s are seared into the memory of most investors. The pain of the bust tends to last far longer than the exhilaration of the bubble. Investors may therefore react to our bubble prediction with a desire to sell stocks and move to cash, sitting on the sidelines until the bubble and subsequent bust have passed by. We think that would be a mistake.
Isaac Newton, the founder of modern physics, was also Master of the Royal Mint during one of the first market bubbles. As Master of the Royal Mint, Newton was at the center of British monetary policy in the early 1700s. He understood that an unprecedented expansion in money supply was causing South Sea Company’s share price to skyrocket. He believed that the stock price had risen far beyond the company’s intrinsic value. Newton liquidated his shares at a substantial profit.
In subsequent months, South Sea’s share price continued to rise at an ever faster pace. Newton knew that the company could not possibly be worth its ever increasing market value. However, watching friends and business associates rack up extraordinary paper fortunes became unbearable to him. He bought back into the company. A few weeks later the bubble burst and Newton was all but wiped out.
The point of this history lesson is that bubbles can be extremely hard to resist while they are inflating. Sitting on the sidelines while those around you are getting rich, at least on paper, can require more discipline than many of us possess. Such discipline is particularly difficult in current circumstances with interests close to zero on most “safe” investments.
Unless an investor feels that their decision making skills are superior to those of Isaac Newton, one of history’s greatest geniuses, we would suggest a different strategy toward our anticipated market bubble.
We recommend that investors, in consultation with their financial advisor, establish a risk management plan right now to help guide them as equity markets rise. If portfolio values rise beyond certain established goals, then we think investors should lock in those excess gains by moving a portion of their portfolio to cash. If the market keeps rising, then we think investors should continue this incremental de-risking process. The goal should be to participate in some of the bubble’s upside, but not risk giving everything back should the bubble unexpectedly collapse.
