The way out of that [the recession] was for (1) the fiscal authority to step into the breech and borrow money from the newly risk-averse, putting it to work to recapitalize the banking system and on Main Street in support of aggregate demand; and for (2) the monetary authority to drive the interest rate on money to zero and promise to hold it there for an extended period, making holding cash very painful while reducing uncertainty, re-exciting investors’ risk appetite.
Fiscal and monetary authorities around the world have done exactly that over the last year, and since April, in the words of the G-20, it has “worked.” Well, at least on Wall Street, where risk appetite is in full bloom. Whether or not that renewed risk appetite finds its way to Main Street is the key question beyond the immediate horizon.
We here at PIMCO think it will, but only in a muted way, not a big-V way. We also recognize, however, that markets can stray quite far from “fundamentally justified” values, if there is a strong belief in a friendly convention, one with staying power. And right now, that convention is a strong belief in a very friendly Fed for an extended period. Thus, the strongest case for risk assets holding their ground is, ironically, that the big-V doesn’t unfold, because if it were to unfold, it would break the comforting conventional presumption of an extended friendly Fed.
Simply put, big-V’ers should be wary of what they wish for. U’ers, meanwhile, must be mindful of just how bubbly risk asset valuations can get, as long as non-big-V data unfold, keeping the Fed friendly. But that’s no reason, in our view, to chase risk assets from currently lofty valuations. To the contrary, the time has come to begin paring exposure to risk assets, and if their prices continue to rise, paring at an accelerated pace.