How do you go bankrupt in Europe?
It is a sign of the times when investors are asking these kinds of questions. How do you go bankrupt in Europe (or the US) when the central bank is your underwriter? Risk assets are propelling forward on the basis that the answer to this question is, you don’t! Most interestingly, central banks are not doing anything to dispel this kind of thinking. In our view, this represents a significant shift and one that cannot be ignored.
Old world bubble management
Back in 2002 Alan Greenspan, then Chairman of the US Federal Reserve (Fed), said in a Jackson Hole speech that “it was very difficult to definitively identify a bubble until after the fact - that is, when it’s bursting confirmed its existence.”
This speech sparked a debate in monetary policy circles – to “clean or lean”. According to Greenspan, the role of monetary policy was to clean up after the bubble had burst rather than attempt to extend the cycle by leaning against it.
It was with this kind of thinking that led the Greenspan Fed to hold interest rates steady until after the late 1990s technology, media and telecommunication bubble burst. Official interest rates were then cut from 6.5 percent to 1.75 percent within the space of just 12 months. Rates were ultimately lowered to just one percent by June 2003.
Greenspan ratified this policy reaction function two years later when he said: “Our strategy of addressing the bubble's consequences rather than the bubble itself has been successful”.
The new (ab)normal
The decision to lean or clean becomes more problematic when the capacity to clean is limited. This is the situation central banks face today.
With interest rates sitting at 2.5 percent in the US, one percent in Australia, 0.1 percent in Japan and a deposit rate of -0.4 percent in Europe, the ability to dramatically cut interest rates to address the consequences of a burst bubble is more limited. Remember, the Fed cut rates in total by 550 basis points after the tech boom. It cut rates by 500 basis points after the Global Financial Crisis (GFC) in 2008. Unless there is a willingness to take official interest rates into negative territory (the experience of Europe and Japan suggests there isn’t), that kind of monetary munition just doesn’t exist today.
Triggered by the prolonged proximity to zero interest rates, a new way of thinking within central banks seems to be underway. In the absence of support from fiscal policy, monetary policy cannot afford to clean. The mess associated with a market correction needs to be avoided altogether. With little alternative, extending the cycle is now the focus for monetary authorities.
It is notable that the Fed has dropped the term “patient” to describe its policy stance and have replaced it with “act as appropriate to sustain the expansion”. A similar change in tone has been evident from the ECB - “in the absence of improvement, such that the sustained return of inflation to our aim is threatened, additional stimulus will be required”. And last week, Australia’s central bank governor said Australians should “expect an extended period of low interest rates”.
The consequences of this way of thinking is illustrated in the schematic below.
Risk is priced using the assumption that the central bank will save the day. Debt levels grow and corporate behaviour changes to feed the hunger from investors for yield and income. Investment declines as a result, as resources are re-directed away from capital expenditure toward dividends, buybacks and merger and acquisitions. This sends money velocity lower and productivity growth declines. Lower inflation outcomes then spur further rate cuts from the central bank and so the spiral continues.
Chart 1: Central bank super-cycle
Gravitational pull of crowded trades
As official interest rates move lower, expected returns from investing decreases. The capital markets line illustrates this (chart 2). It is upward sloping and shows the trade-off between risk and reward for different asset classes. The starting position is the cash rate. As you move out into riskier assets, additional risk premiums are added, building up an expected return for each asset class. When official interest rates are cut this line shifts down, resulting in lower expected returns across the asset classes because your starting position is now lower (a move from line (1) to (2) in the chart).
Chart 2: Gravitational pull on expected returns
A decline in expected return can be digested if it is only for a relatively short period of time. If, however, the low interest rate environment lasts for a long period of time (the US has been living with sub-2.5 percent interest rates for over eleven years), expectations of future returns begin to come down. When expectations change, behaviour changes. Investors begin to “chase yield” and move out of their “preferred habitat” and into riskier investments in an attempt to maintain returns.
Anecdotally we are seeing this kind of behaviour everywhere. Investors are moving out the risk spectrum in order to maintain their returns. This is evidenced by the surge in retail flows into fixed income funds recently.
This creates a gravitational pull lower in yields as the weight of money compresses risk premiums. The capital markets line begins to flatten, meaning each extra unit of risk an investor takes is rewarded with less return (a move from line (2) to (3) in the chart). The lower returns this generates feeds further yield chasing behaviour and so it goes.
How does it end?
The central bank super-cycle is likely to continue because it has to – the consequences are too great otherwise. Central banks from Australia to Japan to Europe and the US will continue to cut interest rates (and/or undertake QE), bond yields will continue to move lower, and investors will continue to move more heavily into risk assets.
The cycle will end when the flow of investors out the risk spectrum reverses course and investors move back to their preferred habitats. The trigger will be a move up in official interest rates. This will create volatility as risk premiums are re-priced, but ultimately it will be healthy as yields move higher and expectations for returns are restored.
This potentially could be some way off, however. Given the heightened sensitivity of the economy to even the slightest increase in interest rates, central banks will be reticent to make the move higher until debt levels come down.
An alternative end would require greater co-ordination between the government, the central bank and regulators of the economy. Macroprudential policy was successfully implemented in Australia to ease the air out of the housing market without the use of the monetary policy sledgehammer hitting every part of the economy. This option only addressed the asset side of the equation, however. Debt levels remain.
Short of wholesale write-offs, debt levels can be managed by creating inflation. This is at the heart of another idea that is gaining traction. The notion of a “people’s QE” - that is, a more direct channelling of central bank funding to households. Rather than passing through financial markets, hoping in vain to create a wealth effect and generate consumption spending, a people’s quantitative easing would pass directly to the household sector.
Effectively this involves the government sending checks in the mail to households that would be funded by the central bank. The idea of “go big, go households” was an effective policy adopted in Australia during the GFC. This would help address the inequality issue, speed up money velocity and lift inflation. Interest rates would rise and investors would gravitate back to the risk level they are most comfortable with rather than chasing returns.
Implications for asset allocation
The narrative around how monetary policy management is viewed appears to have changed. While this narrative remains, risk assets will be supported and we will be adjusting our asset allocation accordingly.
This environment is also likely to see a rise in crowded trades as investors move to the beat of a single drum and fundamentals play only a supporting role. Investors should be aware that such positioning can be prone to bouts of rapid unwind or tantrums. Such was the case in 2013-16, the last time central banks played such a dominant role in price discovery. Under current conditions, such sell-offs would likely represent buying opportunities for investors.
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Tracey was appointed Chief Investment Officer at Escala Partners in November 2019. In this role she has responsibility for strategic and tactical asset allocation and manager selection across all multi-asset funds, and is Chair of the Escala...