A safe assets bubble

The financial history of the 21st century is the story of bubbles and the after-effects of bubbles in different asset markets. In March 2000, the TMT bubble burst leading to a near 80% decline in the NASDAQ Composite Index over the next few years. The response of the Federal Reserve took interest rates down to 1% and held them there until it was clear that the economy was recovering – this policy of very cheap US dollar borrowing led directly to (i) the US housing market bubble and (ii) explosive growth in the financing of a wide range of assets, the emergence of the “shadow banking” sector and a bubble in the credit markets. The Global Financial Crisis in 2008 burst those bubbles and led to a severe global recession as the world’s financial system seized up. The Chinese government decided to seek to offset the damage to its economy with an enormous surge in infrastructure spending which created bubbles in their equity market and in many commodity markets. The weakness in global growth since then has meant that the recovery expectations of central banks have been consistently disappointed and led to them pursuing Quantitative Easing (QE) in ever-increasing amounts.

To date the 21st century has suffered bubbles in developed market equities, real estate, credit, emerging market equities and commodities – all assets that are to some extent seen as risky in investors’ portfolios. However the continued and repeated application of QE has now created a bubble in government bonds – the quintessentially “safe” assets for investors.

The hallmark of a financial asset bubble is when traditional valuation concepts are ignored by investors and the bubble asset is purchased because of a belief in the greater fool theory – that is confidence that when you want to sell there will be a buyer prepared to pay an even higher price – in these situations asset prices tend to rise to far higher levels than sensible investors can imagine.

The FT last week calculated that some $13.4 trillion of global government bonds now offered negative yields – a negative yield means that investors are paying to lend money to governments. They know that buying these bonds will result in them losing money if they hold them to maturity. Their rationale for continuing to hold them must be either (i) they are forced by law or regulation to hold them, (ii) they will suffer worse negative yields if they sell them and try to deposit the cash or (iii) they believe they will be able to sell them at a higher price (and more negative yield) to another investor in the future. Most of these negative yields are in Europe and Japan but even in the UK and the US most government bonds yield less than 1% and all global index-linked government bond yields offer negative real yields.

With central bank QE programmes continuing to be forced buyers of government bonds, the marginal buyer of these bonds is not price-sensitive and so a case can be made that prices of these bonds may go even higher, but investors should be aware that these are bubble valuations in government bond markets.

The bubble is most likely to be burst by the very success of these QE programmes. They are designed to raise the rate of nominal growth in the economy, which to date has not occurred, and if that happens then investors will once again demand higher and positive yields than are available today. The scope for losing money in safe government bonds will then become manifest. As an example the UK Treasury 4% of 2060 was issued in late 2009 at a price of £96.25%, in October 2015 was trading at £136.65% and last week traded at £195.57%. Investors who bought it last week would receive an income yield of just over 2% and know that the bond would be redeemed in 2060 at a price of £100%, losing 95 points of capital value over 44 years.

As each bubble in risky assets in this century has burst, investors have flocked to their safe asset, government bonds. This is the asset class that has not disappointed since interest rates peaked under Paul Volcker in the US in 1981 – this 35 year bull market has delivered extraordinary returns for relatively little risk. The future will not, though, be the same as the past – instead government bonds will increasingly offer return-free risk. When this reversal occurs investors will need to unlearn the lessons of the last 35 years in markets and deal with a new reality – a return to inflation, rising yields and falling government bond prices.

A tide in the affairs of men

Over the last 100 years there have been two turning points in the evolution of the main economic philosophy that have supported economic policy in the UK and the US – the third such turning point appears to be now in progress.

In 1936 Keynes published his General Theory of Employment, Interest and Money in which he demonstrated that the economy could be in a state of equilibrium but with very high levels of unemployment. His policy prescription that the government make up for insufficient private sector demand by borrowing to fund public sector investment spending was the first time that an economist had argued that there was a key role for government within economic policy. This prescription was adopted in both the UK and the US (Roosevelt’s New Deal) in the next few years to deal with the Great Depression of the 1930s. The post-war economic policy conventional wisdom was that governments had a legitimate and necessary role to play by intervening in the economy in order to boost growth.

In 1976, the UK was forced by the weakness of its economy, to go and borrow money from the IMF and put in placer what would now be called policies of austerity. Most famously, the then Prime Minister, James Callaghan said “We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists …”. This was also the year that Milton Friedman received the Nobel Prize for his work on the importance of the money supply in generating inflation and marked a key change in mainstream economic orthodoxy which led to the rise of Thatcher and Reagan who looked to roll back the influence of government in the economy and re-focussed the target of central banks’ policy on containing inflation rather than supporting growth. Terms such as economic liberalism and free market capitalism also reflect the same direction of economic thought and in particular the deregulation of the financial sector that has marked economic policy in both the UK and the US from that point. Globally, free trade was a concept that dominated international policy-making as it was seen as both containing inflation and boosting growth.

In 2016, it appears that the tide of economic ideas is once again turning, and once more it is led by the UK and the US (with the UK again just a little ahead). The motto of the Brexit Leave campaign to “take back control” and of Donald Trump’s campaign to “make America great again”, are both calls to move away from the economics of free markets and the philosophy of free trade.

As in the 1930s, this follows a period in which a laissez-faire philosophy has not delivered improved living standards for the average person, but instead seen the share of wealth amongst the very richest in society rise sharply, boosting inequality. Interestingly is the right-wing of political thought that have understood and sought to exploit this. Trump’s calls to fight immigration and renege on trade deals have strong appeal to the (white) working classes who have suffered most the globalisation of the world economy. Even in the UK, the words of the incoming prime minister have pointed to the need for business to work for all sections of society, rather than the elites. Central banks around the world have for a few years now quietly been pursuing policies designed to increase inflation rather than contain it, though without success to date.

We have passed the point of “peak free markets”, and changes in the direction of the dominant economic meme tend to be long-lasting (40 years going by recent experience). We should expect governments to become increasingly involved in the affairs of men.

For investors, the key correlation to note at these tide-turning points is for interest rates and bond yields. The history of greater government action in economies is marked by rising interest rates and inflation, with real returns from government bonds the key outcome. These were disastrously poor from 1936 to 1976 but have fabulous from 1976 to 2016. A long period of very poor real returns from government bonds is now at hand.

Is “Europe” more important than democracy or the rule of law?

The desperation of Europe’s leaders to protect their banking systems from the effects of the sovereign debt crisis is leading to startling decisions and actions which call into question their commitment to the principles of democracy and the rule of law.

Last year Merkel and Sarkozy made it clear that Europe required Italy and Greece to install technocratic leaders in order to force through the austerity and structural reform measures that Europe deemed necessary if it was to consider continuing to support these countries through their financial crises. When the previous Greek Prime Minister suggested holding a referendum on adopting austerity measures last November, he was told in no uncertain terms by Germany and France that this was unacceptable. European referenda have a nasty habit of delivering results that the political elites do not like.

Then last week, Wolfgang Schauble proposed that Greece should postpone its general election due in April and extend the life of  its technocratic government. The sub-text was very clearly that Germany feared an inappropriate result that might lead a new Greek government to renegotiate the terms of the E130bn bailout after it had been agreed and Europe had committed substantial sums of money. From the rulings of the German Constitutional Court in recent years, it is quite clear that if anyone tried to push the Germans in similar ways, the reaction regarding the primacy of German sovereignty and democracy would have been extremely forthright. To a great extent these demands resemble the power battles between debtors and creditors in a failed company, where the creditors can take full control of a company’s assets when it cannot meet its obligations, but countries are not companies and voters are not shareholders that are automatically disenfranchised upon bankruptcy.

Perhaps even more worrying is the ECB’s action to ensure that it has greater rights than any other owner of  equivalent securities in the financial markets. By demanding that its Greek government bond holdings be converted into other bonds that will have priority over all other Greek debts, a few weeks ahead of a plan that will see all other Greek government bond holders lose approximately two-thirds of the value of their holdings in a “voluntary” haircut, the ECB is at the very least flouting financial market convention that all holders of a security should be treated equally. At its worst interpretation, in a situation where there will be limited assets to repay the debts, it can be construed as theft.

Worse still is the implication for any other sovereign European bonds that happen to be owned by the ECB. The greater the ECB ownership, the worse-off are all other private holders of other European debt as their rights to repayment now rank below those of the ECB (in credit markets this is known as subordination). Thus the creditworthiness of all European debt in which the ECB has a stake has been even further reduced. This is likely make it more expensive for these issuers (Portugal, Ireland, Italy and Spain) to raise money for a very long time to come. Future sovereign crises are now in danger of setting off vicious cycles of ECB intervention buying sovereign debt in the secondary market leading to private sector investors selling down their positions as they become less creditworthy so worsening the crisis.

To be sure there are no easy choices in solving  the euro sovereign debt crisis, but the longer term costs of some of the solutions that are being called for and implemented may well be far higher than currently understood.

PS – it also appears that Greece’s creditors will take over the national  gold reserves too.

Is Quantitative Easing reaching its sell-by date?

Nearly 3 years ago the Federal Reserve and the Bank of England, having taken interest rates to  just about zero but still believing that they needed to make policy even easier, announced a new policy of Quantitative Easing (QE) as their preferred route to help their economies recover. Recovery did followed, although in keeping with previous post banking crisis environments, this recovery has been weak and inconsistent. This unconventional policy was pursued because the conventional interest rate tool had reached its physical limits and with fiscal debt and deficits so high, so too had fiscal stimulus as a policy. The unconventional policy, QE, was the only thing left.

There are good grounds now for believing that the QE approach adopted to date is also approaching sensible limits. In the UK, the Bank of England will shortly own over a third of all UK government bonds outstanding – amazing as it might appear with a  trillion pound national debt which has doubled in just 4 years, there is potentially a shortage of government bonds. This is due to new, post-crisis rules on capital adequacy for both banks and insurance companies which drive these institutions towards holding many more government bonds. With many gilts also held as the underpinning of pensioner annuity payments, a continued steady reduction in the budget deficit could mean that there are simply not enough gilts available to be bought if the Bank judged that much more QE was necessary

In the US the enormous market in mortgage bonds issued by what are effectively government entities makes this less of a problem than in the UK, but it was very noticeable that the second round of QE in the US in 2010/11 resulted in a surge in commodity prices, including gold, which pushed up inflation in the US, reduced disposable income and contributed to a weakening economy, as opposed to the economic stimulus that was intended.

So if further Quantitative Easing of monetary may now be either not implementable or counterproductive, then what can the Central Banks do if they decide that their economies require further stimulus. Both the Bank of Japan and Bernanke have previously suggested that a further tool that could be deployed is for the Central Bank to buy equities in the secondary market and so push up equity prices. Terrific for shares and all those executives with share options, but it is not clear that this then leads onto companies raising new equity finance in order to invest which is the rationale for such a policy.

The problem for all monetary policy approaches post a banking crisis is that there are two economies, a financial economy which requires reliquefication, recapitalisation and write-offs of bad assets and a real economy which cannot gain finance from the financial economy and produce growth until the financial economy is cleansed and functioning again. In economic jargon, the monetary transmission mechanism from financial sector to real economy is broken and so QE although in theory a logical policy, in practice only gets adopted when things are so bad that it will not work.

The aggressive Quantitative Easing solution, which Central Banks have not yet adopted is “helicopter money”. This is where the government prints new money and drops it out of helicopters (or via tax cuts and higher welfare payments) into the real economy. This is very likely to work in boosting the economy in the short term (people have more money in their pockets and so go out and spend some of it), but it will not be long before there is an inflation problem. This is clearly an economic policy beset with risk and the reason that Central Banks prefer to work through the financial system, even though it does not function well – in Zimbabwe this policy led ultimately to the printing of Z$100 trillion notes.

Quantitative Easing is near its sell-by date – something different will be tried next, and whatever that policy is, it will mean more government interference in the economy and more (long term) inflation. Stay long of gold!