Quantitative easing and ultra-low rates have provided stimulus to the global economy and markets, but they are also creating distortions in the financial world. In his latest investment note, Andrew Parry, Head of Equities at Hermes Investment Management, assesses the unintended consequences of unprecedented central bank monetary policy.
Plunging gilt yields and low expected returns from real assets are threatening the long-term viability of many pension funds. Cash savers have lost most of the return from their cash savings and may soon have to pay banks just to hold their deposits, as witnessed in Germany and Japan. Meanwhile, investors are being forced up the risk scale as central banks hoover up traditionally lower risk assets.
We are seeing the unintended consequences of the greatest financial experiment in history take hold. As investors, we must carefully consider the price distortions across asset classes and factor monetary policy risk into investment decision-making.
This is not to suggest QE has been without merit. One needs only to cast the mind back to 2009, when the US economy looked as if it was about to descend into an abyss. Since then, the economy has recovered, employment is at a new high, and while inflation has not picked up, the US is safe from deflation. Yet despite its effectiveness, concerns remain over whether this is merely a palliative cure hiding deep structural problems. Its efficacy elsewhere – Japan and the Eurozone – has yet to be proven.
Normalisation will be the true litmus test
Ultra-loose monetary policy is also driving increasingly short-term behaviour by corporates. Share buybacks have long been a feature of the US markets, fuelled by a low borrowing cost which has led to net debt growing far more rapidly than EBITDA since 2014. Now a mini-M&A boom is underway globally. Such beneficial borrowing costs can be a fillip for financial returns and makes most acquisitions earnings accretive. However, there is a grave danger it makes companies transactional in nature at the expense of long-term fixed capital formation, which is only compounded by the drag from rising pension deficits.
For investors, coercive monetary policy creates a false sense of low risk and a dangerous herding mentality in the hunt for growth. A return to “normality” will be the true litmus test for QE and loose monetary policy – and deem it a success or failure. Unfortunately, as the monetary stakes are raised higher for longer, the greater the possibility of a binary outcome.
The dangerous denominator problem
Lower rates can certainly be a positive. As discount rates globally plunged towards zero, so the valuation on risk assets rose. But such low levels of interest rates give rise to a dangerous denominator problem: small changes in the discount rate can lead to dramatic swings in asset valuations. This leads not only to bouts of intense volatility, but also reflexive policy moves by central banks, fearful that asset markets cannot live without their monetary largesse; as demonstrated by the inaction of the FOMC. Even small changes in perception of policy can have amplified effects on asset prices.
Yet while this great experiment hangs over asset prices, the market has sailed on serenely after a cataclysmic January when markets decided central banks were impotent and the US was heading for recession, led by China. Since then accommodative central bankers have become efficient distillers of market bromide to soothe anxious investors. As a result, a complacency is creeping in that could be blown apart by a re-setting of risk perception. The catalyst is likely to be ‘a great and sudden’ change from policy makers who decide it is time to remove the palliative.
What happens when the tide goes out?
Another concern is the omnipotence of central banks in the asset purchases. They have become whales in markets where the tide is rapidly receding. For example, Japan owns 45% of its government bonds in issuance. It isn’t just the size of the investments that are a problem; it is what happens when the rate of asset purchases inevitably diminishes. The positions are reminiscent of foreboding episodes, such as when Bunker Hunt tried to corner the silver market in 1980 and the London Whale’s derivative trades spectacularly backfired.
One day bond markets will rediscover their mojo. The First Law of Thermodynamics states that energy cannot be created or destroyed, just transformed into other forms. Similarly risk cannot just disappear – it has been transferred from banks to other parts of the financial system, and waits for the inevitable catalyst to reassert itself.
Coercive action by central banks that forces investors, and increasingly savers, to adopt more risk than they would naturally be comfortable with – is a strategy that inevitably leads to sudden eruptions of fear, triggered by the smallest thing. In a wider context, it has potentially exacerbated inequality creating social and political tensions that generate instability.
For truly long-term investors, it is not wise to set investment strategy based on the outcome of central bank policy meetings. This is a time when fundamental analysis and long-term, bottom-up stock pickers can help navigate investors through the stormy seas that lie ahead.
Living with the ‘new normal’
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