2013 – Limited growth and new monetary policy regimes

As 2012 draws to a close, three things about central banks and monetary policy are becoming more apparent. Firstly, central bankers are concerned that they are being expected to fix all the ills in their economies and they believe monetary policy cannot achieve such ambitious targets.  Messrs Bernanke and King have both recently expressed concerns about the limits of what monetary policy can deliver in the face of fiscal austerity.  Secondly, successive doses of Quantitative Easing (“QE”) are generating diminishing impacts on markets and on the real economies.  This is a problem that the Bank of England has recently been highlighting about QE in the UK.  In the US, the recent, and fourth, QE announcement from the Federal Reserve, which will mean over $1 trillion of money printed every year until further notice, saw the US stock market fall on the day, in contrast to all previous QE announcements.  Thirdly, Central Banks are exploring new policy targets: in the US tying policy change to the unemployment rate; in Japan seeking to increase the inflation target; and in the UK discussing the idea of a nominal GDP target in place of an inflation target.   As 2013 begins, investors need to take into account the above developments in their investment strategy.

There are two distinct scenarios for 2013.  In the first, economic recovery and job creation continue to disappoint, in which case it appears increasingly likely that governments will tell Central Banks to concern themselves much less about inflation and more about unemployment.  If so, they would be doing this just as the Central Banks are coming to the conclusion that their current policies to boost growth, are not working very effectively.  The results would be monetary policies that are far more inflationary in intent than has so far been the case since the crisis – this would be a significant regime shift for monetary policy.

Investors therefore will need to seek greater protection from the risk of such a regime change.  This requires heavy weighting to assets that would do well in the face of a generalised increase in investor inflation expectations.  These assets would be index-linked bonds and gold.  The performance of company shares in a scenario of rising inflation expectations is mixed – over the long term company profits would be expected to rise with higher nominal growth, but in the shorter term, rising inflation tends to lead to lower valuations.  Conventional bonds would suffer very badly in an environment of higher inflation.  Commercial real estate would, in the very long term, be expected to act as a form of protection against inflation (as rents rise with inflation).  However, a combination of high unemployment and the shift towards virtual retailing is acting as a significant dampener on demand for office and retail space.  Short term prospects for returns are limited to current rental incomes alone.

In the second scenario, where the global economy does improve enough for unemployment to fall at a rate that was satisfactory to policy-makers, the response from financial markets would also be likely to be higher yields on conventional bonds, together with higher company share prices.  Given these two scenarios (of which the first, disappointing growth, is more likely ), the preferred investment strategy is to be at least neutrally invested in shares, heavily under-invested in conventional bonds and heavily-invested in the “insurance policies” of index-linked bonds and gold.

Returns on cash will remain very low in 2013 and in fact are likely to decline further if further monetary easing takes place – the aim of the Central Banks being to over-supply liquidity to the financial system.  Given the exceptionally low yields available on government bonds, it is difficult to imagine a scenario in which they deliver strong returns.  Corporate bonds, which performed very well in 2012 as credit risk perceptions declined, still offer higher yields than government bonds.  However, they no longer have the potential for significant gains from a further narrowing of the yield premium (over government bonds).  Other areas of the bond markets where the yields are still attractive relative to their risks, are emerging market local currency bonds and short duration, high yield bonds in the US.

The Eurozone economy, the UK’s largest trading partner, looks most likely to continue to disappoint next year, and so create problems for policymakers. Its key economic issue (and Mrs Merkel’s favourite trio of statistics) is that it boasts 7% of the world’s population, 25% of the world’s GDP but 50% of the world’s social spending.  This is at the same time as its demographic patterns are about to deteriorate significantly in the face of a very weak birth-rate and a rapidly expanding population of pensioners.  The sense of existential crisis about the euro may have passed for now, following the ECB’s promise to be prepared to act as purchaser of last resort for sovereign government bonds, but the danger for the euro in 2013 is more likely to come from the streets of Greece or Spain, as continued austerity bears down even harder on the public.  The Italian election is also likely to see a strong performance from anti-austerity parties.  The Eurozone enters 2013 in recession, and its financial system woefully undercapitalised.  For Eurozone markets to perform well in 2013, the ECB will need to be seen to be actually printing money – this is still an unlikely prospect, given the deeply conservative approach to monetary policy of many of the ECB members.

The Japanese economy starts 2013 with a newly-elected Prime Minister who campaigned on a promise to stimulate the economy aggressively and have a higher inflation target.  A weaker yen would be enormously helpful to Japanese industry regaining competitiveness, and after a 23 year long bear market, the stock market may finally be in a position to move higher.

The US economy, still by some distance the largest and most important to the world economy, should continue to grow modestly, but not at a rate that is likely to bring down unemployment sharply.  The short term is clouded by fears over the “fiscal cliff” negotiations, the results of which are likely to produce some modest austerity, which, if European experience is any guide, will cause some damage to growth prospects.  Expect a mediocre year for returns from US assets.

The Chinese economy, the single largest contributor to global growth, appears to be seeing a pick-up in its growth rate after the below-target 7.4% report for third quarter GDP growth.  Growth is unlikely to return to the double-digit growth rates seen in the last decade, but should be of higher quality for stock market purposes.  Instead of relying on exports of low-cost labour manufactured goods and state-sponsored investment spending, Chinese growth in the future is more likely to come from satisfying the increasingly demanding Chinese consumer.  China is also in the fortunate position of having considerable scope to ease monetary policy in conventional ways should its growth prospects deteriorate.  These more conventional methods are generally more effective in the face of weak demand, than the unconventional methods that Western Central Banks are currently forced to use.  Asian equity markets are once again expected to be the best-performing region of the world in 2013.

The UK economy remains buffeted by the trends from the European, US and, to a lesser extent, the Chinese economies. The government’s fiscal austerity programme bites a little harder in 2013 than it did in 2012, but the change in Governor at the Bank of England is likely to lead to a wider discussion about monetary policy means and objectives, which may support the UK bond and equity markets better than those of the Eurozone.  Expect a modest year for returns from UK assets and a weaker Sterling following its surprising strength in 2012.

In conclusion, global economic risks are, in our opinion, biased to the downside for 2013. If these risks are realised, the clamour for a policy response will be very great.  The shift from the 2008 conventional policy responses of lower interest rates and higher government spending to the less conventional 2009-2012 policies of QE may well then develop into a shift to very unconventional policies.  These have not to date been openly discussed, but could include such ideas as (i) using QE to buy shares rather than government or mortgage bonds, (ii) using QE to buy foreign government bonds (equivalent to deliberately pushing down the exchange rate), or (iii) pushing new money more directly into the real economy by for example printing money to pay a “citizen’s dividend” in the hope that it would be spent.  These are all theoretical ideas that would normally strike inflationary fear into the hearts of Central Bankers, but may appear next year as the logical next steps in monetary policy.

 

A layman’s guide to Quantitative Easing

Until very recently, Central Banks generally conducted their monetary policy through changing their key reference interest rate, which was generally the rate at which they would lend to the commercial banks on a short term basis supported by acceptable collateral. Thus the economy was regulated by changing the price of money. Theoretically, by increasing the rate of interest in the economy, the desire to borrow and spend would be reduced and the desire to save would be increased, and economic growth and inflation should fall back. Conversely, reducing interest rates should help to boost economic growth. It is generally accepted by monetary economists that the impact of changing interest rates takes between one and two years to have its full effects on the economy.

However in late 2008, the shock to the global economy from the financial crash that most Central Banks cut interest rates to the lowest practical levels (somewhere between zero and 1%, depending on the system), but still felt that they needed to ease policy further to offset the strong recessionary forces that were being experienced.

Thus, they turned from easing through changing the price of money in the economy to easing through changing the quantity of money in the economy (hence the rather ugly term “Quantitative Easing” (“QE”)). The Federal Reserve and the Bank of England began their QE programmes in April 2009, but in fact the Bank of Japan had been engaging in QE policies since 2003, its rates having reached zero in the previous global downturn.

Until this century, QE had only ever been seen as a theoretical tool in the Central Banker’s arsenal. It was a lesson that some (most notably Ben Bernanke) learned from the Great Depression, where once interest rates reached a low point, the Central Banks felt that there was nothing else they could do. There is thus no history or experience to examine to determine if it works or how it works. The current policy is therefore a live economic experiment.

The manner in which Central Banks have indicated they expect QE to work is as follows. The Central Bank goes into the financial markets and buys securities, typically government bonds, although the Federal Reserve has also bought mortgage-backed securities, and the Bank of Japan has also bought equities and REITs. To finance this they create the money (digitally) and use it to pay the seller of the security (typically a bank). The bank’s assets now consist of more cash and less securities. Typically the income return on the cash will be lower than the income return on the securities they have just sold, and so they have a decision to make. They could choose (i) to maintain the lower income stream, because they might have a great need for liquidity, (ii) to go back into the securities markets and buy some other securities to maintain their income, or (iii) increase their lending to companies or households. Choosing (i) has no impact on the real economy and choosing (iii) clearly has a major impact because it is helping directly to boost demand and spending in the economy.

In practice, what has happened is that banks have chosen (ii), and have sought to maintain their income stream by investing in higher-risk securities. Thus yields have fallen first on government bonds, then on investment-grade corporate bonds and finally on high-yield bonds. This then gives companies the opportunity to borrow at lower rates of interest in the financial markets, which could be used to fund investment. QE, to date, has been a policy that has clearly supported financial markets – it is difficult to see a direct effect on bank lending and economic growth, but it is likely (and claimed by the Central Banks) that economic growth would have been much weaker without QE.

There are some problems with continued applications of QE. Firstly, it is generally believed by economists that QE policies have less impact as they are repeated. Since it is such an unusual policy, the first time it is deployed it has a shock effect, but later iterations do not as the financial system adapts its behaviour to the policy. Secondly, the liquidity of the underlying financial markets may be damaged. For example, the Bank of England now owns more than one-third of all gilts outstanding, and has no current plans to sell them, so the level of liquidity in the gilt market has been reduced by the policy.

The great fear that many commentators have about QE is that by creating more and more money in the financial system without greater economic output, the end result must inevitably be higher prices. In fact higher expected inflation is one of the objectives of the policy, since if people expect higher prices in the future it is rational to buy things now before they rise in price, and so boost demand in the economy today. The response of the Central Bankers would be to say that QE is a reversible policy, and the bonds that they have purchased, can very easily be sold back into the financial markets, so reducing the excess liquidity in the system, and the inflationary threat.

To date, a more realistic concern has been that there is no evidence anywhere in the world where QE has worked. It clearly has not brought Japan out of its long term stagnation, and so far neither the US or UK economies can be said to have recovered strongly. The reason for this is that the extra liquidity generated has remained within the financial system and not found its way into the real economy, and so boosted real demand. If the underlying causes of weak economic growth are that the banking system has overlent relative to its capital, that consumers feel their debt levels are too high, and both feel that they need to retrench (or in the jargon, deleverage their balance sheets), then the current policy of QE will not actually affect the desire to borrow or to lend.

A more radical policy option would be to print money and ensure that it was only used in ways that directly benefitted the consumer’s balance sheet. Thus £450 billion (only a little more than the total QE to date) could be used to give every adult in the country £10,000 to be used either to repay debt, or towards a deposit for the purchase of a first home or into a pension pot. By improving the savings to debt ratio of each adult in the country, the time at which they will once again feel happy to spend more will be brought forward.

From Heroes to Zeroes – 21st Century Central Banking

At the beginning of this century, the reputation of Central Banks in the West was at its apogee – over the previous 20 years inflation had been wrung out of the global economy by maintaining interest rates consistently higher than the rate of inflation. If inflation threatened to rise too sharply then raising rates by a few hundred basis points was sufficient to choke off consumer demand (since their mortgage repayments formed such a significant part of their disposable income) and slow the economy and inflationary pressures. Once this had been achieved, often requiring a quick recession, rates could be cut again and the restoking of consumer demand would reignite the economy. In short, it was apparent that Central Banking that had as its main target the control of inflation could be successful at only a small cost to growth. Politicians found themselves able to give up their desire to control interest rates for electoral purposes and give independence to their Central Banks. Central Bankers became Heroes!

The recession in the US following the bursting of the internet bubble and fears for the US economy following 9/11 however, saw the Fed cut US rates right down to 1% in 2002 and hold them there until 2004. 1% interest rates were much lower than seen in previous cycles and in hindsight were responsible for a massive inflation of the US housing market. Whilst the internet bubble was essentially financed by equity, since the new companies had no cash flow, the housing bubble was financed by debt. Debt-financed bubbles we now know inflate far further than equity-financed bubbles and then burst in a far more devastating fashion. Central Banks meanwhile, focussing only on the Consumer Price Inflation targets did not spot the bubble in the debt markets and so did not increase interest rates sufficiently to manage things better.

Following the 2008 meltdown in the global financial system and subsequent recession, Central Banks found that even interest rates that were effectively set at zero no longer helped to boost consumer demand. This was for two reasons, first consumers realised that they had already got too much debt and no longer wished to borrow more, even with low interest rates and secondly the all economic agents (banks, companies and consumers) had lost confidence in the future growth prospects of the economy that they did not want to lend, borrow or spend.

The Central Banks went back to their old textbooks to search for policy tools when interest rates can no longer be reduced and discovered Quantitative Easing (QE) which pushes money into the financial system in an effort to boost the demand for financial assets and thus stimulate the real economy. Many Zeroes of dollars, euros, yen and pounds have been created in this way. QE has almost certainly worked in the sense that economic growth in 2009, 2010 and 2011 would have been much worse without this policy, but it has not been enough to boost growth back onto a sustainable path. Worse still, repeated applications of QE seem to be less effective at doing this than the first effort. The scale of these interventions has brought forth much criticism of Central Banks in the US and the UK for creating the risks of hyperinflation from the creation of so much money. In Europe where monetary orthodoxy of the Bundesbank is enshrined in the ECB’s mandate, the Central Bank is criticised (outside Germany) for not doing enough to support the Eurozone economy.

For politicians, who are policy-constrained by huge fiscal deficits and debts, the only hope is that Central Banks solve their problems, but whilst Central Banks have the tools for fighting inflation, they do not have the tools for fighting deflation. They have done what they can (zero interest rates and QE) but have little more to offer bar providing liquidity to keep troubled banks alive and adding more zeroes to the money supply. The Age of the Heroic Central Banker is now behind us.