As equity markets have continued to climb the proverbial “wall of worry,” many are trying to understand how and why markets are rebounding so quickly. How is this happening in the face of one of the most devastating economic periods in history? After all, we are still facing high unemployment, an acceleration in COVID-19 cases, and an unknown timetable of when things will return to “normal.”

Some of the gains can be attributed to progress on the vaccine front, along with the reopening of states and countries. With nearly everything shut down for months, there was pent-up demand, which is slowly working its way back into the economy. At some point, things were always going to start improving from the bottom.

Asset Price Inflation

What appears to be driving some of the rebound comes in the form of asset price inflation. When people hear the word “inflation,” they tend to associate it with the rise in prices of goods and services. Asset price inflation, however, measures the rise in the price of assets.

While inflation in the U.S. has been lackluster over the last decade, asset price inflation in stocks, bonds, and real estate has experienced a sharp increase.

What Creates Asset Inflation?

Ever since the 2008 global financial crisis, central banks have taken a more active role in the global economy. Markets tend to react positively to central bank stimulus, especially in the face of low interest rates. Because rates are low, many “safe-haven investments” offer minimal appeal. Eventually, this money works its way into other assets as investors seek a higher total return.

If you recall, economic growth remained sluggish for several years after the financial crisis; stocks, real estate, and bonds, however, rallied aggressively. Is a repeat possible? In short, yes. And the most basic rationale is that the record levels of stimulus money need to go somewhere, and the choices are a little limited for a long-term investor.

Simple Asset Inflation Example

Investment A guarantees you 1% per year for 10 years.
Investment B will likely fluctuate between -25% and +25% in any given year but will likely average 7% over the next 10 years.

Which investment does a long-term investor choose?

This is a simple example, but it is at the heart of asset inflation. Most long-term investors (institutions and individuals) are going to eventually choose Investment B.

The “eventually” in this scenario is key. Much of what we are probably seeing since April is the early returnees to the market. They assume that others will “eventually” have to come back as well.

Central Bank Balance Sheets

To put things into perspective, the Federal Reserve’s balance sheet in 2008 increased from ~$1 trillion to $2.2 trillion. This was considered massive and unprecedented at the time. Fast-forward and the Fed’s balance sheet is currently north of $7 trillion and expected to reach $9 trillion this year.

The amount of the money supply in the U.S. (also referred to as M2) sits north of $18 trillion, which includes assets that are highly liquid in addition to cash. The money supply is closely monitored, as it is a good indicator of future inflation and helps central banks form their monetary policy programs.

To be clear, this type of action isn’t coming from only the Federal Reserve, as the balance sheet for the European Central Bank, Bank of Japan, Federal Reserve, Swiss National Bank, and Bank of England total ~$20 trillion. Put another way, the Federal Reserve's balance sheet as a percentage of gross domestic product (GDP) has increased from 5% in 2007 to ~33% today, which is a staggering increase.

There are risks associated with asset price inflation, and it alone does not ensure an ongoing increase in equities, bonds, and real estate values. There is a growing contingent who argue the Federal Reserve manipulates markets, and that’s fine for them to see it that way. But what the Fed and other central banks have done is ensure that when a recovery does take hold, it can continue. Asset inflation is a result.

Stimulus

It is important to remember that the stimulus package from Congress is a completely different deal from what the Federal Reserve is doing. Congress pumped money directly into people’s pockets at a level never before seen. The impact of this is still being studied, but we plan on visiting this issue in next month’s post. By then, we will possibly know if we will see yet another round from Congress.

Discuss your situation with a fee-only financial advisor.

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