Shifts in the Economic Environment (a Risk You Can Diversify Against)

It is important to understand what you are really doing when you exchange cash for an asset class. This trade is largely a bet on shifts in the future economic environment. I am referring to changes in economic growth and inflation when describing the overall economic climate. In the first chapter I emphasized that the Fed tries to minimize the volatility of the economy in terms of growth and inflation by controlling interest rates and printing money, as necessitated by prevailing conditions. These are also the key forces that impact asset class returns because they are fundamental to what makes an investment.

When you decide to convert your safe cash into an asset class, you do so with the expectation that at some point in the future you will be able to convert it back to cash at a profit. If you did not expect this, then you would not accept the risk of losing money. More precisely, you convert cash into another asset with some expectation about the future economic climate. You have this expectation because in order to profit from the exchange, you factor in what future growth and inflation will be. Your expectation of inflation matters because you want to be compensated in real terms for the risk that you are taking. You need the return achieved from taking risk to exceed the rate of inflation in order for you to improve your purchasing power. After all, you can only spend cash, and the main reason you exchange cash for another asset class is because you expect to improve your purchasing power in the future. Thus, your expectation about the rate of inflation—or general increase in future prices of goods and services—is a critical factor.

Economic growth also influences your decision. If you anticipate strong economic growth, then you would be willing to accept a smaller piece of the future (if you are buying equities) or ask for a higher yield (if you are buying bonds), all else being equal. If you feel that growth is going to be very weak, then you would demand a bigger cushion in the price paid for equities in order to give you added protection. In this scenario you would be willing to accept a lower yield from bonds because of the safety it provides.

In diving a little deeper into why it is that changes in the economic environment impact asset class returns, I will use examples that feature the two most familiar asset classes, bonds and stocks.

Bonds: Why Shifts in the Economic Environment Impact Returns

If I exchange my cash for an investment in U.S. government-guaranteed Treasury bonds, then I am in effect making a bet that I will earn more with this investment than I would by simply holding cash over the same time frame. Since Treasury bonds held to maturity have very little risk of loss due to credit impairment, they are effectively a longer-duration version of the risk-free cash rate. I have a choice of low-risk investments: (1) hold cash and earn the variable interest rate over time, or (2) lock in a fixed rate by investing in a bond and take the risk that I would have done better holding cash. You make a similar decision when you are deciding on a home loan. You would select a variable rate loan if you wanted to take the risk that short-term rates will average less than the fixed rate you can guarantee today. In the case of buying a bond, you essentially are taking the other side of the transaction. Instead of being the borrower you become the lender, and the choice between a fixed or floating rate is a similar decision and is based on your expectation of future cash rates.

The key insight is to appreciate what would cause cash rates to shift over time. Changes in economic growth and inflation result in a reaction by the Fed to adjust interest rates (as was discussed in the first chapter). Thus, the price of the Treasury bond will change between now and maturity based on what transpires in the economic environment relative to what was expected at the time you purchased the bond. As the Fed lowers rates in response to falling growth or weak inflation, then the price of the bond rises. More precisely, what really matters is how cash rates shift relative to the path that was reflected in the price when you bought the bond. If cash is yielding 3 percent and the bond 6 percent, then rising interest rates are already discounted in the price. The fact that they rise is not necessarily a negative for the price of your bond because that eventuality was already factored in the price. That is exactly why you got 6 percent instead of 3 percent for your investment. The key is how the future path of cash varies relative to the path that had been priced in at the time you made your initial investment, which was based on a certain expectation of future growth and inflation outcomes.

Stocks: Why Shifts in the Economic Environment Impact Returns

I now turn to another example of the same dynamic to further clarify why shifts in the economic environment affect asset class returns. When you decide to invest in a broad portfolio of stocks, you are also making a statement about future economic growth and inflation. If you get 5 percent per year economic growth over time and the market was only pricing in 2 percent growth, then you are likely to do well with your stock investment. Companies generally earn more money when the economy is growing faster, and when they earn more the performance for shareholders normally improves. That is, you might expect higher than the average excess return during these periods. Logically, the opposite also holds true. If the market discounts 5 percent growth and only 1 percent growth actually transpires, then there is a good chance that stocks will underperform their average return as companies earn less than expected.

Likewise, shifts in inflation impact returns. Rising costs negatively affect stock prices because of the inability to pass on the entire cost increase to customers, resulting in lower profits. Again, this is all versus what was expected at the time the price was set. If high inflation was already priced in and we experience low inflation, then that is a huge positive for stock prices. Putting shifts in inflation and growth together and how both relate to prior expectations will provide you with a better sense of the key drivers of returns over time.

Perhaps a helpful way to better appreciate the impact of shifts in the economic environment on the returns of stocks is to review U.S. stock market history. I will begin with a memorable time period for many of today's investors. The greatest bull market in the history of U.S. stocks took place from 1982 to 1999. The market averaged about 13 percent excess returns per year during that stretch (cash also earned about 5 percent per year for a total return of around 18 percent per year!). It was an age in which vast fortunes were created. The unforgettable events that defined this extraordinary run included the curbing of the runaway inflation that had plagued the nation the previous decade, interest rates that fell from the highest levels in history, sustained economic growth for nearly two decades and, to top it all, an Internet bubble that far exceeded expectations.

The more precise reason the stock market performed so well was because the U.S. economy grew faster than most people had expected, and inflation declined much more than anticipated. In short, investors were expecting a much worse economic scenario than what actually transpired. Given these sets of conditions, which represent the ultimate tailwind for equities, it should be no surprise that stocks fared so well.

The previous two decades had effectively set the stage for the success of the 1980s and 1990s. A completely different experience plagued investors from 1963 to 1981. During this 18-year phase the United States suffered through the worst increase in inflation in its history. Interest rates rose more than ever before (surging from 4 percent to 15 percent) and inflation peaked at nearly 15 percent. All of this occurred concurrently with slower than discounted growth. The economic scenario of high inflation and low growth tends to be a terrible backdrop for equities. Predictably, risky stocks earned the same return as risk-free cash for over 18 years! Imagine the investors who had bought stocks for the long run, lived through all the ups and downs of the 1960s and 1970s, and had nothing to show for it. Certainly such an experience would dampen future expectations. Such widespread pessimism was captured on the cover of BusinessWeek in 1979 as it infamously proclaimed “The Death of Equities.” Of course, these low expectations sowed the seeds for the great run during the aforementioned 1980s and 1990s.

The stagflation (a period of high inflation and weak growth) of the 1970s was nothing when compared to the devastation that had roiled the economy and markets several decades earlier. From 1929 to 1949, the U.S. economy suffered through one of its worst periods in history. These 20 years were characterized by a major depression and deflation—a completely different set of conditions when compared to the 1982 to 1999 environment. Thus, stocks performed dreadfully as should be anticipated given these difficult conditions. During one 33-month run the stock market fell 84 percent! Those who lived through the Great Depression and much of the 1930s and 1940s never were the same again. The horrors of the severe market and economic downturn had scarred them for life.

Sadly, the recent environment from 2000 to 2013 is not much different from the experience of the 1930s and 1940s. Growth severely underperformed expectations and has caused equities to do much worse than many had thought possible 13 years earlier. The past decade included two periods in which the value of the stock market fell by half (2000–2002 and 2008–2009). The bursting of the Internet bubble, an extraordinary housing collapse, and the 2008 credit crisis that pushed the economy to the brink of another great depression caused devastating market downturns. Consequently, stocks barely outperformed cash for the first 13 years of the new century, a reality that extremely few market experts had predicted at the height of the Internet bubble.

The lesson from these historical experiences is clear: The economic environment by and large drives the returns of stocks. The market outperforms during better times and underperforms during periods dominated by weaker economic conditions. More succinctly, when growth outpaces market expectations and when inflation comes in lower than discounted, the stage has been set for significant upside in equities and vice versa.

Shifts in Risk Appetite (Not a Diversifiable Risk)

Shifting risk appetite represents the second fundamental driver of excess returns. Think of risk appetite as the amount of excess return above cash you would be willing to accept to take the risk of investing your cash in asset classes. If you are feeling optimistic and your animal spirits are stirring, then you may be willing to accept a lower expected return for a certain level of risk than during more normal times. Alternatively, if you are really concerned about the future and think we may be headed for challenging and uncertain times, then you may require a higher expected return to part with your cash. The fact that you may demand a different level of excess return above cash depending on the environment should sound intuitive. Imagine if I approached you at the depths of the 2008 crisis and asked you to invest in my company at a price that offered a return of 4 percent above cash over time. Compare that to considering the same offer in the early 1990s as the momentum of strong economic growth was in its early stages. You would certainly reject my proposal in the first case and may seriously consider accepting it in the second. After all, both offers come with uncertainty, but you may reasonably conclude that the first has much greater downside risk. Your general fear about the uncertainty in the global economy would likely cause you to demand a higher excess return to part with your safe cash.

You are only one investor; however, the truth is that the majority of market participants use the same logic that supports your instinct in this example (probably more so than you realize). And it is the majority that sets the consensus view, which in turn establishes the market price. The consensus, by definition, is the market. The pendulum swings to extremes over time. When the majority is fearful, the demand for higher excess returns dominates, and when it is popular to be more aggressive, then lower expected excess returns exist. Fear and greed are another way to view these changes. At times, we are greedy for a higher return than cash offers and are willing to accept less for the same amount of risk. At other points in time we are fearful of losses and will only take risk if outsized returns are offered. Interestingly, greed often follows good periods and fear comes after severe downturns. That is, emotion tends to be a reactive rather than a proactive phenomenon.

How do changes in risk appetite affect prices and returns? What does it mean when the appetite for risk goes up or down? In simple terms, your return for an investment is the price you get when you sell (Y) minus the price you paid when you bought (X). The higher price X is, the lower your return, all else being equal, because of the less attractive entry point. When the appetite for risk declines, then the price falls to compensate you for taking risk. The lower the current price, the higher the potential forward-looking return if you buy. This is how shifts in risk appetite add to volatility in asset class prices.

The impact to asset classes is most visible during extreme periods. You may know that there exist rare environments when investors are terrified of taking any risk and sell all risky asset classes in favor of cash. Two stark examples of this environment include the Great Depression and the 2008–2009 crisis. During those two periods the markets were characterized by fear and the focus shifted to return of capital rather than return on capital. There was no desire to lend during these climates, so there was little access to credit. Forced sales of assets and heightened demand for cash caused risk premiums of all risky asset classes to concurrently skyrocket.

These severe cases help demonstrate why shifts in risk premiums, or risk appetite, are not diversifiable risks. As an investor in asset classes, this is a risk you are constantly subject to and there is no way to minimize it. Shifts in risk appetite understandably and simultaneously impact all asset classes. Therefore, there is no magic combination of asset classes that will help insulate you, since they are all affected in the same direction. That is, all asset classes are negatively impacted as risk appetite falls and risk premiums rise (or positively impacted as risk appetite rises and risk premiums fall).

The final important point about shifting risk appetite is the difficulty in avoiding this risk entirely. You might argue that investors can simply own cash when risk premiums are low and wait for risk premiums to rise before reallocating into riskier asset classes. However, you should keep in mind that your future appetite for risk is highly dependent on the state of the economy, your personal financial situation, the general momentum at the time, and many other factors. Most of these important inputs cannot be known because they have yet to occur. You don't even know how you are going to feel in the future, so how can you presume to know the collective mind-set of everyone else?

Shifts in Expectations of Future Cash Rates (Not a Diversifiable Risk)

The third and final fundamental driver of excess returns is shifts in expectations of future cash rates. Earlier I explained that the rate of cash is relatively stable. The steadiness of cash returns can, however, be misleading. Although current cash rates are not highly volatile, shifts in expectations of future cash rates contribute to volatility of asset class excess returns. The reason this is true is related to a central theme that will be repeated throughout this book. With any return series, what really matters is how the future transpires relative to what was expected. This guiding principle applies to cash, stocks, bonds, and every other asset class. The volatility of returns is driven by how the future plays out versus what had been discounted to occur. If the market expected something to happen (for example, rising interest rates, a strengthening economy, or falling inflation), then that outcome is already reflected in today's price. The price will shift if and when the future does not follow the path that had been anticipated.

I will now address how shifts in expected future cash rates produce volatility in asset class excess returns. Recall that cash represents the risk-free rate. All asset classes compete with the risk-free rate since you, as a rational investor, always have the option to accept the guaranteed return offered by cash. As the rate of cash changes through time, there is a direct impact on all asset class prices for this simple reason. More technically, the yield on cash sets the discount rate used to calculate the present value of future cash flows provided by other asset classes. You invest in an asset class because you expect higher returns than cash (called excess returns) over time. Those future cash flows that you will receive for your investment can be valued at current levels by using current cash rates. The lower the cash rates, the higher the present value and vice versa. This is because a lower interest rate results in less compounding over time. Thus, as cash rates change, there is a direct impact on asset class pricing. This logic is merely the corollary of the fact that the cash rate is the risk-free rate and represents an investment option for those who wish to take no risk of loss.

When cash rates surprise the market with a sudden increase, such an event has a negative impact on all asset classes. This is because the discount rate unexpectedly becomes more attractive. A more attractive discount rate means that all asset classes, which price versus cash, need to offer a higher return as well. In order to raise the expected future returns of an asset, its price must fall. As an example, think about the impact on bonds of rising interest rates—as interest rates rise, the price of bonds go down. Again, since cash competes with all asset classes, the higher the yield of cash, the more attractive asset class prices have to be to entice investors to exchange their safe cash for risky assets. Of course, there may be other factors that may also influence the price, but the goal here is to isolate each factor to help you better appreciate the root causes of price changes.

There are times when the Fed may unexpectedly modify the current interest rate of cash. This may occur if there are renewed concerns about inflation or growth conditions in the future. This is what happened in 1994 and 1995 when the Fed surprised the market by raising interest rates by 3 percent over a one-year period because of fears about rising inflation. This surprise move negatively impacted all asset class returns because the rate of cash suddenly became more attractive than had been anticipated. A change in risk-free rate from 3 percent to 6 percent will have a large impact in how you view the attractiveness of current asset prices. As cash rates unexpectedly move up, you would expect forward-looking asset class returns to move up as well, to remain competitive with the higher cash rate. As a result, a negative impact to asset prices will occur.

An extreme example of this dynamic should help clarify the concept. Imagine that you own stocks and are expecting to earn the historical average excess return above cash. Let's say the average excess return above cash is 5 percent. If you expect to earn 1 percent in cash during the target time period, then that means you expect a 6 percent total return from the stocks that you own. If cash is currently yielding 1 percent and the Fed suddenly announces that it has increased the yield of cash to 10 percent, then the price of the stocks you own will likely fall considerably. Why would you own risky stocks with an expected return of 6 percent when you can now earn 10 percent just by holding risk-free cash? The price of the stocks would have to fall enough to make them worth investing in. More specifically, the price would have to fall by an amount that makes it more likely that you would earn an excess return above cash similar to what you had expected when you first purchased the stocks. Thus, it is clear that shifts in the cash rate that are unexpected would influence asset class prices.

How do you know if cash rates shift unexpectedly? An easy way to assess what the market is expecting is to look at the Treasury yield curve. This curve provides a rough estimate of how the market anticipates cash rates will change over time. For instance, an upward sloping curve implies that the Fed will increase interest rates over time. A downward sloping, or inverted, yield curve means that the market is anticipating that the Fed will lower interest rates in the future. The steeper the slope—either positively or negatively pointed—the faster the expected rate of change.

Importantly, if current cash rates roughly follow the path anticipated by the yield curve, then these changes in the rate of cash are not significant as it relates to asset class returns because they are expected shifts. Recall that your focus should be on unexpected changes to the rate of cash and not those that are already discounted. It is the surprises that impact asset class returns because the expected changes in the rate of cash are already factored into the current price. This is a critical distinction that you should emphasize in your understanding. This is why the surprise move by the Fed in 1994 and 1995 had such an impact. The market had not discounted rapidly rising rates and was shaken by the surprise.

It should be noted that the unexpected shifts in cash rates do not have to create a negative impact on asset class returns. It works both ways. If cash rates suddenly fall more than expected, then that generates a positive influence on all asset class prices for exactly the opposite reasons described above. Lower cash rates produce an easier hurdle for risky asset classes versus the risk-free rate. The price of asset classes rise in order to adjust to the lower hurdle. Alternatively, a lower discount rate results in a higher present value.

What happened in 2013 is another good example of shifts in expectations of future cash yields. With interest rates at 0 percent there was quite a bit of discussion about when the Fed would actually increase rates from this floor. In early 2013 there was newfound concern that the Fed may raise rates faster than what had been expected, and as a result longer-term interest rates jumped up. This event negatively impacted the returns of all asset classes simultaneously. This happened even though the Fed did not actually change interest rates. It was the change in expectations of the Fed's future actions that led to longer-term interest rates rising. The way to think about this dynamic is that the yield curve shifted up to a steeper slope because the anticipated future rate of cash changed. This outcome had a similar impact on asset class returns as when the Fed surprised the market by actually changing interest rates in 1994 and 1995.

One final critical point: Shifts in the rate of cash, both current rates as well as future expected rates, simultaneously impact all asset class prices and therefore asset class returns. There is only one risk-free return and that is cash. Every other asset takes some risk to own, and each offers some premium for taking that risk. If the baseline cash rate changes, then all else being equal, the price of all asset classes needs to reflect this shift. This impact can be positive (if cash unexpectedly falls) or negative (if it unexpectedly rises). This is precisely why the risk of unexpected shifts to current or future cash rates is not something that can be mitigated. If you take the leap of foregoing safe cash returns to invest in risky asset classes (and all of them are risky), then this is part of the primary risk you take.