For a neat summary of where we are and how we got to such a crazy place, this is pretty good ..... just don't look for the answer to all our ills

Thursday 18th August 2016

For a neat summary of where we are and how we got to such a crazy place, this is pretty good ..... just don't look for the answer to all our ills

ref:- "Has the power of politicians and central bankers reached its limit?" by Simon Nixon of the Wall Street Journal, and in the Times Business

OK then, where are we? Stock markets are surging (with US equities hitting record highs recently) at the same time as global government bond prices soar (and yields collapse)  --  in NORMAL circumstances, stock and bond prices are expected to move in different directions. So which one do we believe? Equity markets which suggest growing confidence in economic recovery, or bonds with their flattening yield curves that reflect negligible borrowing costs even at the longer end of maturities, and that point to the absence of any such recovery?

It's a dilemma for our time all right, but it's certainly not the only one : that favourite hedge against inflation, gold, up 30% this year although there is no inflation to speak of and certainly none to worry about. More than that, long-term swap rates are signalling that inflation will stay low for years. And if you needed another example that seems to make little sense, just why are European markets so strong when the banking sector faces potential crisis and bank shares are trading at lower levels than at the height of the financial melt-down (yes, really)?

All right all right , we get the picture ..... the world's gone a little bit mad, and the reason for it? Well, the chief suspect and the one examined by Mr Nixon is the distortion created by unprecedented central bank activity. The massive bond-purchasing programmes embarked upon by the Bank of Japan, the European Central Bank and the Bank of England have driven bond prices up and yields down so far that all other assets suddenly look attractive.

We can all say that equity prices look overvalued. It instinctively feels that way and with US stocks priced at 25 times earnings such a judgement would be justified, historically speaking. But an earnings yield of 4% doesn't look so pricey compared to Treasury yields of well under 2%.The argument is -- and it seems irrefutable  --  that markets are being driven by central bank buying and importantly expectations of more of it to come, rather than any fundamental rationale.

Mr Nixon points out that one way of looking at things is that there's only a small amount of demand in the world, and this limited and highly sought-after commodity is being pushed around between nations via fluctuating exchange rates. In other words and by way of an example, the BoJ and the ECB were able to effect modest recoveries because their stimulus packages (cutting rates) devalued their currencies and so rendered their economies more competitive. This came at the expense of the US, where slower growth forced the Fed to postpone much-trumpeted interest-rate hikes ...... which in turn caused the dollar to weaken and the Yen and Euro to rise once again and stop the cautious recoveries in their tracks ..... which in turn prompted another bout of BoJ and ECB stimulus packages ..... and so on, and so on.

All of which is not really a criticism of the central banks ..... this is what happens if you place your economic well-being entirely on them and on their monetary policies. And whilst it's undoubtedly true that a very unhealthy proportion of investors have come to rely on central banks far too heavily to support asset prices, there have been some successes if you look at the wider picture. Easy monetary policy in the US has led to growth fuelled by a pick-up jobs and consumer spending. And in China, massive central bank intervention has managed to stabilise what seemed a highly dangerous situation.  Europe is finally showing encouraging signs though performance is worryingly patchy. Overall though, global growth is flat at 3.1% and inflation in the developed world remains way below target.

Which begs the question, to all intents and purposes has monetary policy (i.e. the central banks) reached the limits of what it can achieve? Or indeed of what it should be attempting? President of the San Francisco Fed John Williams seems to think so. He's caused quite a stir in a recent paper by arguing amongst other things that ultra-low rates are the new norm, driven by a number of factors that include aging populations (those pesky savers), lower productivity (those pesky oldies again) and emerging market demand for safe assets (not their fault this time). In the face of such low returns on savings, he argues, if companies won't invest to drive further growth then there's not too much more that central banks can do about it. It seems to us he has a point.

There's been scepticism about the efficacy ultra-low and particularly negative rates for a long time, and the trashing of Eurozone bank shares is offered as an example of such policies doing more harm than good. It's not just a question of the health of the banking sector. If banks respond to shrinking profits by in turn shrinking their balance sheets instead of making more loans , the over-accommodative monetary policy will have had precisely the opposite effect of the one intended.

What's to be done? Well, it's back to the old monetary stimulus -v- fiscal stimulus debate ( or more accurately , monetary stimulus -v- fiscal stimulus AND structural reform). Whatever the views about monetary policy, there's a growing consensus in the markets that more action on the fiscal and structural reform side is essential. That's all very well, and Japan and a post-Brexit UK will take steps down that route, but the politics of the US and the Eurozone suggest that it is much less likely in those areas. Which might well leave us back at Square One  --  relying too heavily on ever-easier monetary policy but unsure of how much more it can achieve.

If you're out of ammunition in the one area you chose to fight your battles, you'd better hope for a smooth passage. Unfortunately, it may be anything but ..... a November election in the US and a myriad of upcoming crucial votes across Europe mean that politically we're facing something of a powder keg and this time the central banks may be powerless to rescue us if it all turns nasty. Mr Nixon suggests that such a worrying scenario may account for why investors have been stocking up on gold. Well ..... it brings us nicely back to where we started and may even be partially true ........