January 2018
It is actually different this time...
The problem - the normal rules of engagement no longer apply
While we can spend many hours contemplating the rights and wrongs of the great central bank experiment that we are living with, we can probably all agree on the consequences, namely, that risk asset prices are fully priced, bond yields are artificially low and consequently, volatility has been completely suppressed.
The confusion - where did the economic cycle go?
Most of us have been brought up on a diet of economic cycles, with booms, busts and, of course, mean reversion. In the good old days, credit growth would create excess demand above and beyond the supply-side capacity of the economy. Inflation would rise and monetary policy would tighten to squeeze out the excesses. These economic cycles would then be reflected in asset prices, with bonds and equities ploughing their furrow, according to the prevailing circumstances. However, this economic clock has been upset in the last 20 years by three key dynamics:
- The rise of the emerging markets, particularly in the sense of providing an almost endless supply of cheap goods to the developed world. This has been hugely deflationary for world traded goods prices.
- The rise of the internet, creating a highly-competitive price landscape across the globe.
- The ever-growing interference/over-confidence (take your pick) of central bankers, who have been expanding their sphere of activities like never before as we lurch from one debt crisis to the next. The famed “Greenspan put” is alive and kicking!
The result - huge distortions in asset pricing
Consequently, much of the old-fashioned analysis about mean reversion, both in an economic sense and in asset prices, has been rendered irrelevant by the smiling assassins known as central bankers. Fund managers face the daily grind of eking out returns in a world of inflated bond prices and low yields. Equity investors are left to chase stock prices higher, even though equity prices have been outstripping actual earnings for four years in a row, resulting in a huge price/earnings multiple expansion.
Any assessment of asset values must be predicated on central bankers’ actions from here. The reality is that there is no longer a free market in asset pricing, because an utterly dominant player is attempting not only to dictate economic conditions, but also to target the prices of assets! This creates huge distortions. Not unreasonably, investors might argue that equities are cheap compared to bonds, but that misses that point that bond prices are themselves skewed, thanks to these buying activities.
The distortions that these policies have created during this latest boom are there for everyone to see. Deliberately targeting lower bond yields ensures that the cost of capital also remains extremely low. As such, capital allocation is often misguided, but more importantly, this means that we are effectively borrowing from the future. When real yields are in negative territory, it makes economic sense to borrow and in that sense, monetary authorities are encouraging us to take on debt. However, spending from borrowings is a far cry from spending because you have been paid more. The debt game must be finite.
Next steps - turning Japanese
The Japanese have been waging a war against the deflationary bust which began as far back as 1990. Fiscal and monetary stimulus have had little effect on inflation and consumers still suffer from the paradox of thrift. Monetary policy began with just very low interest rates, but eventually morphed into quantitative easing; the Bank of Japan has now gone the final mile by overtly targeting the yield curve to keep the cost of money across all durations as cheap as possible. As a consequence, the Bank now owns over 50% of the JGB market (sovereign Japanese bonds). Similar actions by the Federal Reserve, the ECB, the People’s Bank of China and to a lesser degree, the Bank of England have all contributed to the idea that central bankers have our backs and that, in fact, risk assets are no longer risky.
Conclusion - you get to choose!
The idea that the activities of central banks have distorted asset prices is not really up for debate and neither are the consequences of these actions. As an investor, you need to decide your degree of comfort, or otherwise, in believing that the new role of central banks as the price-setter of risk assets is one with which you feel comfortable? If central banks remain the constant buyers of assets and the lenders of last resort, then asset prices will remain elevated and volatility suppressed.
This has huge implications for investors and fund management more generally. Without economic cycles, there is no mean reversion effect. Momentum remains the dominant feature in asset markets and hence, investors should simply stay invested in the lowest-cost market beta they can find.
If, like me, you find it laughable that we are supposedly the first generation that has found a way to tame the economic cycle by printing money, you can be forgiven for standing on the side-lines and waiting for the “Minsky moment” as, collectively, investors blink.
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Peter Toogood, Chief Investment Officer, The Adviser Centre, part of the Embark Group
