Peter Dixon, Global Equities Economist, considers a world of increased uncertainty in which it is proving ever more difficult for financial investors to make decent returns and in which many old certainties no longer hold.
The economic and financial collapse of 2008 was a defining moment in economic history in more ways than one. Not only did it mark the bursting of a massive debt bubble which caused a huge market rupture, but it sent a shockwave which unleashed forces threatening the stability of the global economic architecture. It caused central banks to think in radically different ways to ensure the stability of the global monetary system which in turn helped to support financial markets. But as the initial support has faded, we find ourselves in a world of increased uncertainty in which it is proving ever more difficult for financial investors to make decent returns and in which many old certainties no longer hold. Welcome to the new normal.
A long economic haul
Even before 2008 the evidence suggested that recessions associated with financial crises were more severe and longer lasting than those triggered by other kinds of shocks. Indeed, the 0% global GDP growth rate in 2009 was the weakest since 1946 when the global economy was transitioning from a war footing to a peacetime setting. It was the weakest peacetime growth since the 10% contraction registered between 1930 and 1932 as the Great Depression took hold. But there were considerable variations across countries, with US output falling by 4.2% from the peak in late-2007 to the trough in mid-2009, whereas China continued growing at a rate in excess of 9%.
However, it is the subsequent weakness of growth which has put most pressure on policymakers in the western world (see Chart 1). For instance, it took more than three years for US output to get back to pre-recession levels and five years in the UK, whilst Italian output is currently still 9% below its pre-recession level. It is against this backdrop of weak output growth and high unemployment that central banks have been encouraged to open the taps in a bid to provide some economic stimulus. However, this has happened at the same time as governments have been tightening fiscal policy. Across the OECD, governments have tightened fiscal policy by 4.5 percentage points of GDP between 2010 and 2015. In policy terms this is like pressing a car accelerator whilst keeping a foot on the brake: it is one thing to give plenty of gas, but it is only ever going to be fully effective when we stop holding back.
Chart 1: A less sharp dip than in the 1930s but a slower rebound
Providing monetary stimulus – but to what end?
It became obvious in 2009 that interest rates had hit the lower bound and that alternative methods of monetary stimulus were required. This came in the form of quantitative easing (QE) – central bank purchases of government debt on a huge scale, which it was hoped would (a) directly inject liquidity into the system and (b) reduce bond yields to the extent that investors would be forced to buy higher-yielding assets, which in turn would push up prices and unleash a wealth effect. It is questionable how much impact quantitative easing has had in stimulating a recovery. The direct liquidity provision channel has not worked because the banking sector remains impaired, and is being forced to deleverage at least partially due to government regulation designed to reduce the risks posed by an overly large financial sector.
UK estimates suggest that QE equivalent to 13% of GDP resulted in a decline of 150bps in bond yields which in turn led to a rise in output of around 2% although the estimates are highly uncertain. Subsequent evidence, however, suggests that additional QE produces less of a boost to activity than the initial phase. As a result numerous central banks have attempted to drive interest rates into negative territory in a bid to provide even more monetary stimulus. Broadly speaking this implies that financial institutions are charged a penalty for holding reserves at the central bank, thereby boosting incentives to provide further lending to the domestic private sector. This policy is proving highly contentious, for a number of reasons.
First of all, there is no evidence to suggest that negative interest rates boost lending. After all, this is an action only on the supply side of the balance sheet – if households and corporates are not willing to borrow, there is little that central banks can do, and in a deleveraging environment where balance sheets continue to be reduced (see Chart 2), economic agents will need a much bigger incentive to be persuaded to take on additional borrowing. Moreover, if banks are unable to boost lending for whatever reason, a negative interest rate policy simply puts additional pressure on bank profit margins which might in turn prompt them to be more cautious in their lending policy.
Chart 2: Households are still deleveraging
Concerns that central banks have lost a degree of control have been exacerbated by events in China, where the economy is losing momentum and the markets continue to slide despite the best efforts of the PBoC (see Chart 3). The Chinese slowdown in turn has led to a significant collapse in commodity prices, although there is increasing evidence that oil prices have come off their lows as US output, in particular, has lost some dynamism. US monetary policy actions have further contributed to the sense of drift in the Emerging Markets (EM) space following the Fed’s action in December to raise the funds rate by 25 bps – the first such move in almost a decade. Since the EM boom in recent years has at least partially been driven by cheap liquidity in the industrialised world, any sense that the era of cheap money is coming to an end was always likely to trigger some form of adverse reaction.
Chart 3: The current collapse in Chinese equities mirrors the Nasdaq in 2000-01
All these factors have conspired to produce a belief in the markets that central banks are running out of ammunition and that they simply do not have the policy tools to get the economy back on its feet. Although central bankers express surprise when it is put to them that they are out of ammunition, it is not difficult to see why markets should view the world in this way.
Picking a path through the maze
One consequence of a world of low interest rates has been the hunt for yield which has forced investors to overweight equities, where total returns are significantly higher than bonds for the first time in over 50 years (see Chart 4), and to look more closely at alternative assets such as property. It has also forced investors to cast their geographical net wider, which is one of the reasons for the surge in liquidity into EM. The wall of money flowing into equities has significantly distorted valuations with the result that on certain measures, such as the P/E ratio, equities look very expensive in a long-term historical context. But in a world of low interest rates the traditional metrics are distorted because investors are prepared to pay more to access the higher return on stocks given the lack of fixed income alternatives. Similarly, low interest rates raise the discounted value of future earnings so that the traditional dividend discount model also justifies higher prices. With short-term rates likely to remain low for a considerable period of time, the traditional methods of equity valuation are likely to remain distorted for some time to come.
Chart 4: Equity yields higher than return on bonds
But not all investors can dump their fixed income holdings. Pension funds, for example, have to remain invested in bonds. One way they are dealing with this is to move to the ultra-long end of the curve since German bonds are posting negative yields at maturities up to eight years whilst in Japan we have to move out to 15 year maturities before rates turn positive. Indeed, Japanese 40 year bonds yield less than 1% (see Chart 5). This is a startling fact. It implies that investors who buy the risk associated with such long maturities are prepared to accept miserable rewards. But this is bad news for future generations of pensioners whose savings depend on the interest income generated by bonds.
Chart 5: Investors have to move a long way up the curve for positive yield
Although negative rates in the secondary market are an increasingly common phenomenon, we have recently seen the issuance of bonds in the primary market with negative rates. A German mortgage bank recently issued three year covered bonds priced to yield -0.16% which implies that buyers are guaranteed to lose money if they hold to maturity. Given the fact that covered bonds are one of the safest types of fixed income investment, this suggests that investors are so fearful of risk that they are prepared to trade security for negative returns. In any case, since some banks now charge corporate clients a penalty for holding cash, as they are in turn penalised by the central bank, a negative yielding bond represents the least-worst option for the investor.
Negative interest rates represent a major distortion in financial markets which in our view reflects an overly negative view of the world. They may also have unforeseen adverse consequences. In addition to the problems for future generations of pensioners, life insurance companies with guaranteed payout ratios in excess of 10-year bond yields will quickly come under pressure. Low rates make the choice of an appropriate long-term discount rate very difficult, which introduces ambiguities into the valuation of assets and liabilities and raises a number of legal risks in cases where fair value is disputed. And of course the problem of risk taking is exacerbated, and raises major concerns regarding future asset bubbles, which may well increase the sensitivity of global asset prices to even small increases in interest rates.
Problems down the track when (if) rates finally rise
We have already seen what can happen in the wake of the modest rate hike. Given the market reaction to the Fed’s 25 bps rate increase, it is likely that it will proceed cautiously for fear of sparking a more dramatic market correction. Indeed, this raises a question of how central banks will act in future since the equity market rally of recent years is essentially a Frankenstein’s monster of their own making. Will they be prepared to bear the pain of slaying that particular beast? Even though the new normal is almost certainly going to produce a far lower equilibrium interest rate than in the past, any upward move in rates is going to put pressure on a market which has essentially been supported by cheap money. We will undoubtedly look back at the period 2009–14 as an exceptional time when equity markets rallied despite the unpromising fundamentals. However, events over the period 2015–18 may well be such that the average performance in the 10 years following the Lehman’s bust ends up much closer in line with the weak economic environment.
Another problem which may well emerge in the coming years is how central banks manage the unwinding of their balance sheets, which have ballooned thanks to QE. The Fed, ECB and BoE are currently running with a balance sheet equivalent to around 25% of GDP compared to little more than 5% prior to 2008. The BoJ’s balance sheet, which was at an already-elevated 25% in 2008 thanks to earlier asset purchasing operations, now stands at 75% of GDP (see Chart 6). If these holdings were to be unwound, even at a much more moderate pace than they were accumulated, this would have a major impact on global bond markets by sending yields rapidly higher.
Chart 6: Central bank balance sheets are expanding but Japan is exceptional
This is unlikely to happen, however, given the risks involved. Therefore, central banks will unwind balance sheets at a very slow pace and it could take decades for them to return to pre-2008 levels – if indeed they ever fall that low. Accordingly, this implies that a considerable amount of liquidity will continue to reside in the global banking system which – implausible as it may seem today – may eventually result in much higher price inflation in future. Alternatively, central banks may hold the bonds to maturity in which case they will, in theory, be redeemed by the government. Technically, this implies a transfer of liabilities between two public sector bodies and given the UK experience, where coupon payments on bonds held by the BoE have subsequently been transferred back to the government, it could be that debt holdings will simply be wiped out. In other words, a large chunk of government debt will effectively be monetised – something which is prohibited in the eurozone by the Maastricht Treaty.
Political risk exacerbates the tension
The new normal is not simply a market issue: Political risk is increasingly rising up the agenda, particularly with respect to the way which governments manage changed circumstances. In emerging markets such as Brazil, government corruption is increasingly an issue which results in policy paralysis. In the Middle East, ineffective governments are struggling to contain the rise of organisations dedicated to their overthrow. Meanwhile, in Europe an immigration surge coupled with Brexit fears has thrown the EU into turmoil. The simple fact is that governments have been faced with huge shocks which they find difficult to deal with, but electorates are increasingly dissatisfied with the promise of good times just around the corner which never seem to materialise. This has led to the rise of small political movements, which often have no coherent message other than to overthrow the status quo. Whilst voter dissatisfaction is understandable, it adds to the problems facing investors and increases the predilection for short-term investment decisions which are likely to lead to ongoing market volatility.
We live in a world of increasingly hard choices. Central banks will have to decide to stick or twist with regard to their monetary course; governments will have to cope with rising levels of dissatisfaction and investors will have to steer a course through the middle. We are not going to return to the pre-2008 world anytime soon. But we are increasingly at the stage where the new normal is being reinforced by policy errors – notably a refusal to use fiscal policy to stimulate demand. This puts additional pressure on central banks to further ease the monetary stance with all the adverse consequences this implies. It does not have to be a world of low growth, sluggish inflation and depressed asset returns but unless central banks get some fiscal support, it is increasingly likely to turn out that way.