The writer is the founder and co-CEO of Elliott Management
Despite recent jitters over the Omicron variant, global stock market prices remain at or near their highest valuations in history. Bond prices reflect the lowest interest rates in history. And is it any surprise that inflation has broken out of the boundaries of the last 20 years, given the stated goal of policymakers to create more of it? Across the market landscape, risks are building, many of them hidden from view.
Yet, in a surprising twist, a growing number of the largest investors in the world — including socially important institutions such as pension funds, university endowments, charitable foundations and the like — are currently lining up to take on more risk, which could have catastrophic implications for these investors, their clients’ capital and the stability of broader public markets. What is driving this behaviour?
In the main, it is driven by the radically expansionary monetary and fiscal policies undertaken by developed-world governments since the end of the global financial crisis, which were accelerated after the Covid-19 pandemic rattled markets and depressed economic activity last year. And in part it is driven by benchmarking — the practice of institutional investors measuring their performance against a benchmark such as the S&P 500.
As monetary and fiscal policies have pushed securities valuations to new heights, institutional investors have been tempted to overweight their portfolios to stocks, even at record-high prices, for fear of missing out on extraordinary gains. The buying pressure created by these strategies is only driving prices higher and herding capital into risk assets.
At present, risks are at, or close to, the highest levels in market history. For instance, the market capitalisation of all domestic US public and private equities is now at 280 per cent of gross domestic product, much higher than the previous peak of 190 per cent just before the collapse of the dotcom bubble. And household equity allocations are at an all-time high of 50 per cent.
Eventually, rising inflation, rising interest rates or some unforeseen turn of events could cause a substantial stock and bond market decline, perhaps in an unpredictable sequence. What then for the institutional managers when the rush for the exits begins?
One answer might be that the authorities will never allow a sustained downturn in asset prices to happen again. This points to one of the key problems with the current set of monetary and fiscal policies in the developed world: they mask and minimise risks while preventing stock and bond prices from performing their indispensable signalling roles.
Currently, policies across the developed world are designed to encourage people to believe that risks are limited and that asset prices, not just the overall functioning of the economy, will always and forever be protected by the government.
Due to this extraordinary support for asset prices, almost all investment “strategies” of recent years have made money, are making money and are expected to keep making money. The most successful “strategy,” of course, has been to buy almost any risk asset, leaning hard on the latest fads, using maximum leverage to enhance buying power and buying more on the “dips”.
So it is no wonder that under these manufactured conditions, investors would “move out on the risk curve” — investor-speak for taking on more risk unconnected to expected returns. Most investors who say that they are willing to bear more risk do not actually mean that. What they really mean is that they fear missing out on the higher returns experienced by other investors — in other words, missing their benchmarks.
However, the ability of governments to protect asset prices from another downturn has never been more constrained. The global $30tn pile of stocks and bonds that have been purchased by central banks in order to drive up their prices has created a gigantic overhang. With inflation rising, policymakers are reaching the limits of their ability to support asset prices in a future downturn without further exacerbating inflationary pressures.
With all this in mind, it is puzzling that a growing number of otherwise sober money managers are in the process of boosting their allocations to riskier assets, rather than trying to figure out ways to make some kind of rate of return without giving back years of capital accretion in the next crash or crisis. Investors who have upgraded their risk levels, relying on policymakers to protect the prices of their holdings, may suffer significant and perhaps long-lasting damage when the government-orchestrated music finally stops.