Asset market returns: A simple response to Fed "tightening" or has all the juice been squeezed out?

While dip-buyers rejoice in another risk asset rally that has taken the SPX all the way back up to where we closed in November of 2014, a more nuanced of analysis of asset market returns reveals an interesting and not altogether welcome development.  Macro Man spent some time yesterday playing around with total return data for a number of asset classes and constructing a series of hypothetical portfolios for US-based investors.

He created a set of six portfolios of steadily increasing aggressiveness, with the "Safety" portfolio comprising exclusively T-Bills and US bonds, while the "Aggressive" portfolio comprises 80% equities, 20% US and global bonds, and no T-bills.   The weights of the portfolios are set out in the table below, as well as a "global portfolio" comprised of MSCI EAFE index and a global bond index.

Anyone with even a passing familiarity with portfolio theory can tell you that generally speaking, investors expect a higher rate of return for riskier investments, to compensate them for taking that risk.   Historically, this is how it has played out with the portfolios identified above; if we look at a plot of the annualized returns and volatilities of the six portfolios during the 1998-2007 period, for example, we see a series of dots moving from the lower left to the upper right of the chart:

Now, perhaps you could argue that the excess returns generated by the riskiest portfolios were insufficient compensation for the substantially higher volatility incurred versus the Safety and Conservative portfolios; indeed, subsequent events would suggest that you would be correct.   Over the last ten years, however, the basic return and risk characteristics of the portfolios have remained as theory would dictate, despite the ruptures of the financial crisis:

One thing worth pointing out about this chart, however, is that average returns for each of the portfolios has gone down versus the pre-crisis period.  Part of this is of course the residue of the financial crisis (which can be seen in the volatility of the riskier portfolios), and part of it is the lower returns on offer for the safest portfolios.

This can really be observed in the portfolio returns of the past five years, which one can broadly term the era of global financial repression- ZIRP/NIRP and QE across a number of economies impacting vast swathes of financial assets.  Observe the puny returns on offer from the safest portfolio, which were roughly a third of those on offer during the pre-crisis period.  No wonder investors moved out the risk curve and the riskiest portfolios have done well!

Over the last year or two, however, something curious has happened: investors are no longer compensated for taking risks.   Let's look at portfolio returns since the beginning of 2015, which roughly corresponds with the Fed "Lift-off Watch":

Hmmmm....the return on the safest portfolio hasn't really moved, but the returns on every other portfolio have fallen precipitously, with the two riskiest even losing money.   As you can see, connecting the dots now leads us to the bottom right rather than the top right.

Unsurprisingly, the same pattern holds for the last year, albeit with better returns for safe assets and worse return for risky portfolios:

Ditto year to date performance, albeit with pre-crisis returns for safe assets and positive returns for all but the riskiest portfolio:

Even in the current quarter, which has seen a ramp in just about every kind of asset,  investors still aren't really compensated at all for moving out the risk curve:

So the question is this: does the failure of markets to adequately compensate investors for moving out the risk curve suggest that the juice has been squeezed out of markets (i.e., there's just too little risk premium on offer with global rates so low and US P/E's relatively high), or is it a simple reaction to moderately tighter Fed policy?   The results for the latest quarter might suggest the latter; broadly speaking, the trend in Fed policy has been one of capitulation (reflected in the incessant decline of the hated dots, as well as the absence of any policy moves in 2016) since March, and the portfolios are doing better than they have in a few years.

That being said, the return curve in Q2 was very flat, and one that certainly does not suggest that there is a risk premium worth picking up by moving out the risk curve.  Coming on the heels of the prior 18 months' returns, there's certainly an argument to be made that risk asset investors have made their dough for this cycle, and there's not much point pressing their luck further.  The dismal performance of many long-only and hedge fund managers would support this argument as well.

From Macro Man's perch, there is probably an element of both arguments that have driven asset market returns.   His previous work has indicated that liquidity factors have been the primary driver of expected US equity market returns over the last several years, so it would be silly to argue that a less favourable liquidity environment would not have an impact on the riskiest assets.

Then again, policy is still easy and being eased in many countries outside of the United States, and the "global portfolio" listed above has also had a torrid time over the past couple of years in comparison to prior history:

   
(No doubt the strong dollar has had something of an impact here.)

Nevertheless, it's hard not to argue with billions and trillions of global bonds now offering negative yields, global banks looking rickety, and earnings growth terrible in the US (the "star" market), that ex ante returns for assets generally are looking ropy.  Certainly it's hard to be upbeat about the prospects for global growth (or policy efficacy) if investors are not being compensated for taking risk.  When that happens in the real economy, recession ensues.   While it seems premature to make that call in the US (consumption growth is now tracking near its highest quarterly growth in a decade), the trend in asset market returns does bear watching; the most troubling implication of recent developments is what we've observed in Europe: the failure of unconventional policy to get much if any traction with risky assets, thus diluting the impact of said policies.