The Silver Bullet | We Are Still Dancing

The music of loose central bank policy is back, and those who are dancing seem to have forgotten all concerns.

The next few months will see a chain of central bank decisions, starting today with the BoE, the ECB, the Fed and ending with the BoJ.

The Bank of England is likely to bring rates close to zero by the end of the summer,
re-introducing bond purchases and cheap funding for banks to reduce the impact of Brexit. This time around its QE programme could include more corporate bonds.

The ECB is likely to prolong the duration of QE and – later in the year – to increase the flexibility of its purchases. Supply of QE-eligible bonds is dwindling, as purchases flatten yield curves. Eventually, the ECB will have to detach itself from strictly following the capital key to allocate its purchases, i.e. shifting more firepower to buy periphery bonds.

The BoJ may be about to engage in a more aggressive combination of fiscal and monetary stimulus, also known as helicopter money.

We are now deep into the QE infinity world – where the normal rules of economics and markets no longer apply.

Over the past few years, I have been trying to describe some of the many issues that prolonged QE and negative interest rates can cause to markets and the economy:

1. One is rising inequality: asset purchases increase the gap in wealth between the haves and have-nots. Among the reasons why Britons voted to leave last month was a growing sense of exclusion from the economic system and of frustration with the current policies. Inequality has transformed the UK into a Divided Kingdom. But the same rise in populism is clear in the United States – where we think Trump could win – as well as in many other European countries and in China.
2. Another collateral effect of prolonged QE and negative interest rates is the creation of asset bubbles. This is happening already in bond and stock markets. On the surface, index prices imply that investors may have shrugged all the Brexit fears. In reality, under the hood is a search for safe yield across both bonds and stocks – utilities, telecoms, healthcare and low-volatility stocks are performing, together with government bonds. Any other assets linked to growth or inflation are far from record highs.
3. The third and most dangerous issue with QE infinity is that it can end up giving the wrong incentives to investors, resulting in over-allocation of resources to sectors of the economy that don’t need them. Economists at the Bank for International Settlements have raised several red flags about the issue of misallocation. In short, it means zombie corporates and banks that should restructure are kept alive with cheap funding, and people that should switch jobs and re-train continue to work with the wrong skillset. This is also one reason why lower unemployment is failing to jumpstart a rise in wages.

What is the endgame? We now know QE and negative interest rates are having dangerous collateral effects. Yet what we are likely to get is more of the same. Why? Because there is no alternative.

The Fed remains the only central bank trying to row in the opposite direction. The US economy is healthier than the rest of the developed world – partly thanks to balance sheet restructuring in the private sector during the crisis. Labour markets are improving, and taking the US economy in isolation, the FOMC should have already hiked a lot higher, and 10-year rates should be between 2-2.5%, according to our models.

But the reality is different, for two reasons. First, the size of the Fed’s balance sheet is now overshadowed by the firepower of other central banks combined. Second, the links between US financial markets and the rest of the world have strengthened. With low US Treasury yields, non-US corporates and sovereigns have kept borrowing in Dollars, particularly in Emerging Markets. This means the longer rates stay low, the harder it becomes for the Fed to hike without causing another tantrum. International developments continue to appear as a potential threat in Fed statements.

There are two ways out of this QE infinity trap. A good and a bad one.

The good one is a more balanced mix of policies and reforms, where fiscal stimulus combines with loose monetary policy. Long-term, a restructuring of the financial system is necessary to make it more flexible and resilient, as I have recently highlighted in a World Economic Forum discussion series. This means untying our economy from fixed debt. Less fixed coupon securities and more equity or flexible debt financing can allow for an easier restructuring in a crisis, reducing reliance on interest rates as well as the consequent collateral effects, like resource misallocation. Flexible securities include Coco bonds for banks and GDP-linked debt for sovereigns, an idea supported by the IMF, Bank of England and Peterson Institute, among others. So far, however, there’s been little evidence of coordinated action in Europe, and we can expect something in the US only after elections.

The bad outcome is that without fiscal stimulus and a restructuring of balance sheets, developed economies will end up stagnating like Japan did for over two decades. This risk is becoming real in Europe as well as in China. But while Japan was one cohesive country, Europe may be over-run by centrifugal forces and populism, under this scenario. We think European leaders are aware of that, but the question is whether they will react in time.

 

Over the coming quarters, we are likely to see the world and markets evolve between one outcome and the other. The positive set of solutions means growth and eventually inflation. It means the actions of central banks will finally work. The music will eventually stop, and those standing will be left with little value in safe-haven assets.

In the bad outcome, the result could be a lost decade where new generations end up worse off than their parents and electorates increasingly shift towards populist proposals: trade tariffs, anti-immigration policies, protectionism. In this scenario, the dance is likely to continue for a lot longer.

How can investors navigate the world of QE infinity? Avoiding herding and maximising diversification as well as asset liquidity are going to be key. Traditional asset management strategies follow market-cap weighted benchmarks divided into product compartments (investment grade, high yield, emerging markets). These expose investors to the risk of concentration in the largest issuers, and to sudden stops in trading liquidity for a single product, as we have recently seen for UK property funds.

The second important thing is being flexible. Falling into the temptation of searching for yield at all costs is easy but can lead to buying into overvalued assets. Strategies that can be neutral or short are more likely to avoid asset bubbles.

Finally, investors need to search for market-neutral returns. The wave of post-QE appreciation in all assets may continue, but most of the gains are likely to be behind us. Combining directional with long/short strategies able to extract value from dislocations can add extra returns.

Central banks are likely to continue their fight to the end, but the endgame will be decided in parliament and on the streets. It won’t be an easy ride. Like a friend of mine said: “You think you are kicking the can down the road, but suddenly the road turns uphill and the can comes back and hits you in the face.”