Macro

Today I argue that in response to the 2008 crisis central banks and treasuries have thrown the baby out with the bathwater. Unable to tolerate the pain associated with capitalism’s most important attribute, “creative destruction” – or the cathartic process by which markets punish bad businesses and reward good ones – government agencies decided that they would take control of private market prices when the signals embedded in them wrought too much disruption. They did this by buying all manner of bonds to manipulate the short- and long-term risk-free “discount rate” that investors use to price the present value of the cash flows produced by all assets. And when that was not enough, governments bought direct stakes in companies, including many banks, and equities more broadly. Conventional capitalism that has powered prosperity for more than half a century by respecting market signals no longer exists. While it may not be socialism, it is certainly statism. I also discuss our research that shows that AMP's default risks have sky-rocketed beyond 2008 levels (see chart). Read the full column here or AFR subs can click here. Extract below:

"And since central banks and treasuries have got into the business of directly managing private market prices, they have never been able to get out. It is way too tempting to try to control your destiny rather than leaving it to the whims of capricious investors. Just ask Xi Jinping. 

Ironically given the current global trade turmoil, the West and China have never had more in common in terms of the economic policies they espouse.

After the European Central Bank committed to launching a new round of asset purchases (aka “quantitative easing”, or QE), the Fed has been forced into the same thing. The RBA is not far behind.

In the last week, the Fed has spent $US128 billion ($A188 billion) expanding its balance sheet to soothe markets. And it continues to reinvest the proceeds of the trillions of dollars of assets it bought during the crisis into purchases of bonds rather than allowing its balance sheet to shrink.

Bank of America Merrill Lynch estimates that the Fed will have to buy about $US400 billion in additional government bonds over the next year to ensure that the private sector, heaven forbid, is not lumbered with this responsibility.

Somebody has to fund President Trump’s record budget deficits, and doing so has sucked capital away from short-term financing markets, which has radically increased the volatility of the interest rates in this crucial sector.

In one auction this week, the cost of borrowing overnight in the US spiked from 2.25 per cent to 10 per cent, the first time this has happened since 2008.

Profligate fiscal policy is an emerging post-crisis thematic. When your central bank can print as much money as it wants and fund all your debt at crazy-cheap levels – as the Japanese and, to a lesser extent, the Americans do – there is no practical limit on how big your budget deficits can get.

You are insulating yourself from any market disciplines because your central bank (rather than investors) is setting your cost of capital at artificially low levels.

We live in a world where all asset prices are fake and unnaturally inflated. Even in Australia.

House prices are appreciating again not because of some underlying imbalance between demand and supply, but because the RBA is being compelled to respond to lowest-common-denominator global policies that have created a beggar-thy-neighbour currency war.

In an Australian government bond fund today you earn almost no interest after fees.

The more profound question is what could possibly reverse this new global statism? The only tractable explanation I can conceive of is inflation.

Read the rest of the column here.




Comments

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Dr Jerome Lander

Chris, spot on in terms of the essence of the economic problem and investment challenge. This rightfully should frighten everyone into rethinking the standard speculative approach to investment which is risky, inflexible and fragile in nature. Depending entirely on inflated asset prices becoming more inflated is a gambler's approach to investing in the current markets. A much more dynamic and diversified approach is necessary because the future has such a wide and unknowable spectrum of potential movement. Very few firms or investors are set up to handle the huge challenge of all this. If investors are not frightened by what is happening around the world right now, then they probably have no idea about the huge risks we are all facing - unfortunately, the risks will probably become all too obvious with time as they move to realisation.

Christopher Joye

very, very nicely put Jerome

Lloyd C

If budget deficits can be unlimited then won't nations provide the populace with benefits and increase military spending to keep the ball rolling? Highly likely. And therefore, hard assets should enjoy a period of relative outperformance as Central Banks man the pumps. In this next environment, it's difficult to see households being allowed to continue to add leverage to what is already a precariously high level of private debts. This suggests underperformance in leveraged assets such as property.