Tuesday, February 24, 2015

Below Zero

Today's financial world is certainly strange.  The Fed Funds rate is nearly zero.  US Treasury bonds yield a little above zero.  Five-year German government bonds yield -0.07%. 

Now some conservative financial managers anticipate something similar – or worse – for future returns on US stocks and bonds.

The conservative asset management company GMO released its most recent forecast of anticipated future real returns for several different asset classes over a 7-year time horizon.  As of Jan 31, 2015, their 7-year forecast projects negative real returns for US stocks and bonds.  Even for emerging markets the estimated future returns are far below historical averages.

Of course, these are just estimates, which GMO accompanies by the usual caveats.  But they are not alone in taking a pessimistic view.  After several years of stock market gains and artificially low interest rates, it is not surprising that nearly every financial asset class in the world is overpriced.  There have been plenty of warnings from market observers.

Markets arrive at overpriced points like this in the normal course of events, every once in a while, but this time is hardly normal.  This time the situation is entirely artificial, the result of extreme fiscal and monetary policies intended to prop up the financial markets and the real economy.  After the 2008-2009 financial crisis, only extreme measures could stop the financial world from crashing and sending the world into a deep depression.  To many people who lost homes and jobs, it was a depression anyway.

The economy is not responding as well as wanted, and so the Fed has continued to levitate markets with QE, low interest rates, and other manipulations.

The crisis was a chain of failures caused by unreal expectations and extremes of leverage.  The Fed and regulators were supposed to prevent such extremes from recurring.  Instead, they have added fuel to the fire, and financial markets are more leveraged now than ever.

If something happens, the repercussions of a crisis could be greater than in 2008-09.

We don’t have to look far in today’s world to find escalating financial risks and potential triggers:  deflation, currency wars, soaring government debt-to-GDP ratios in the developed countries, failing economic growth.  It is just a matter of time.

I wrote about issues like this until two years ago and then figured “Why bother?  I’ve said it all before.”  But the problem is still here, and it’s getting worse.  I can’t foresee the future, but there are many reasons to believe that when the markets crack, it will not end well.