- How can central banks normalise interest rates without puncturing the recovery?
- Will long-term capital smooth the economic cycle?
- What does “qualitative easing” mean for equities?
Last month saw the release of a report by the OMFIF - Global Public Investors - the new force in markets. These quotes are from their press release:-
Central banks around the world, including in Europe, are buying increasing volumes of equities as part of diversification by official asset holders that are now a global force on international capital markets. This is among the findings of Global Public Investor (GPI) 2014, the first comprehensive survey of $29.1tn worth of investments held by 400 public sector institutions in 162 countries.
The report, focusing on investments by 157 central banks, 156 public pension funds and 87 sovereign funds, underlines growing similarities among different categories of public entities owning assets equivalent to 40% of world output.
...one of the reasons for the move into equities reflects central banks' efforts to compensate for lost revenue on their reserves, caused by sharp falls in interest rates driven by official institutions' own efforts to repair the financial crisis. According to OMFIF calculations, based partly on extrapolations from published central bank data, central banks around the world have foregone $200bn to $250bn in interest income as a result of the fall in bond yields in recent years.
...The survey emphasises the two-edged nature of large volumes of extra liquidity held by GPIs. These assets have been built up partly as a result of efforts to alleviate the financial crisis, through foreign exchange intervention by central banks in emerging market economies or quantitative easing by central banks in the main developed countries. But deployment of these funds on capital markets can drive up asset prices and is thus a source of further risks. 'Many of these challenges [faced by public entities] are self-feeding', the report says. 'The same authorities that are responsible for maintaining financial stability are often the owners of the large funds that have the potential to cause problems.'
The report looks at Sovereign Wealth and Pension Funds as well as Central Banks but the trend towards diversification into equities should not be a surprise. In many countries official interest rates are below even official measures of inflation. It is a long time since government bonds were capable of providing sufficient income to match long-term liabilities, but the recent fall in interest rates since the great financial recession has forced these institutions to diversify into higher-risk assets.
China's SAFE (State Administration for Foreign Exchange) has now become the world's largest holder of publicly-traded equities. They have established minority stakes in a number of European companies. Central Banking Publications found that 23% of Central Banks surveyed said they own shares or plan to buy them. Back in April the BoJ said it will more than double investments in equity exchange-traded funds to 3.5 trl yen this year. Abe's third arrow is looking feeble - buying a basket of Nikkei 225 names would be an expedient solution to his political woes.
The BIS - 84th Annual Report - released last week, focused on the need to move away from debt:-
The main long-term challenge is to adjust policy frameworks so as to promote healthy and sustainable growth. This means two interrelated things.
The first is to recognise that the only way to sustainably strengthen growth is to work on structural reforms that raise productivity and build the economy's resilience.
...The second, more novel, challenge is to adjust policy frameworks so as to address the financial cycle more systematically. Frameworks that fail to get the financial cycle on the radar screen may inadvertently overreact to short-term developments in output and inflation, generating bigger problems down the road. More generally, asymmetrical policies over successive business and financial cycles can impart a serious bias over time and run the risk of entrenching instability in the economy. Policy does not lean against the booms but eases aggressively and persistently during busts. This induces a downward bias in interest rates and an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy - a debt trap.
... In the longer term, the main task is to adjust policy frameworks so as to make growth less debt-dependent and to tame the destructive power of the financial cycle. More symmetrical macroeconomic and prudential policies over that cycle would avoid a persistent easing bias that, over time, can entrench instability and exhaust the policy room for manoeuvre.
The BIS doesn't go so far as to promote the idea of central banks buying common stock but neither does it imply that this policy would meet with many objections from the central bankers central bank.
For a more radical argument in favour of central bank buying of common stock I am indebted to Prof. Roger Farmer of UCLA - Qualitative easing: a new tool for the stabilisation of financial markets. In this speech, given at the Bank of England -John Flemming Memorial Lecture last October, Prof. Farmer elaborated on his ideas about "Qualitative Easing":-
...When I refer to quantitative easing I mean a large asset purchase by a central bank, paid for by printing money. By qualitative easing, I mean a change in the asset composition of the central bank.
...In this talk I argue that qualitative easing is a fiscal policy and it is a tool that should be permanently adopted by national treasuries as a means of maintaining financial stability and reducing persistent long-term unemployment.
...My proposed policy tool follows directly from my research findings of the past twelve years. Those findings demonstrate that, by trading in asset markets, national treasuries can and should act to prevent swings in asset prices that have had such destructive effects on all of our lives.
...asset market volatility and unemployment are closely correlated and I will argue that by stabilising asset markets, we can maintain demand and prevent the spectre of persistent unemployment.
...Although there are very good arguments for the use of government expenditure to repair infrastructure during recessions, we should not rely on counter-cyclical government investment expenditure as our primary tool to stabilise business cycles. Qualitative easing is an effective and more efficient alternative.
...The crisis was caused by inefficient financial markets that led to a fear that financial assets were overvalued. When businessmen and women are afraid, they stop investing in the real economy. Lack of confidence is reflected in low and volatile asset values. Investors become afraid that stocks, and the values of the machines and factories that back those stocks, may fall further. Fear feeds on itself, and the prediction that stocks will lose value becomes self-fulfilling.
...My work demonstrates that the instability of financial markets is not just a reflection of inevitable fluctuations in productive capacity; it is a causal factor in generating high unemployment and persistent stagnation. The remedy is to design an institution, modelled on the modern central bank, with both the authority and the tools to stabilise aggregate fluctuations in the stock market.
These arguments are the heady stuff of political economy and put me in mind of the two views epitomised by the quotes below: -
"Centralization of the means of production and socialization of labor at last reach a point where they become incompatible with their capitalist integument. Thus integument is burst asunder. The knell of capitalist private property sounds. The expropriators are expropriated."
"The traditional, correct pre-Marxist view on exploitation was that of radical laissez-faire liberalism as espoused by, for instance, Charles Comte and Charles Dunoyer. According to them, antagonistic interests do not exist between capitalists, as owners of factors of production, and laborers, but between, on the one hand, the producers in society, i.e., homesteaders, producers and contractors, including businessmen as well as workers, and on the other hand, those who acquire wealth non-productively and/or non-contractually, i.e., the state and state-privileged groups, such as feudal landlords."
There is a precedent for aggressive central bank intervention in equity markets. In August 1998 the HKMA responded to the fourth wave of speculative attacks on the currency peg by buying equities. During the second half of August 1998 the HKMA, through its Exchange Fund, bought HK$118bln (US$15bln) of Hang Seng constituent stocks - 8% of the total market capitalisation. It also intervened in the Hang Seng futures market, creating a violent short squeeze. In order to further discourage speculators the HKMA mandated the prompt settlement of all outstanding trades, forcing naked short sellers to source stock loans. Having given the speculators a few days to get their stock borrow in place it then imposed a short selling ban on some of the more liquid names.
The Exchange Fund disposed of some of its holding, bringing the percentage of the Hang Seng it held down to 5.3% by 2003. By 2006 it had crept back up to more than 10%. The Exchange Fund currently manages HK$3032.8bln and is permitted to hold up to 20% in equities. According to the HKMA- 2013 Annual Report they held HK$ 153bln of Hong Kong equities and HK$ 297bln of US equities.
The Future of Central Banking
The developed world's savers are being decimated to fund the profligacy of borrowers. Polonius' advice to his son today would surely be "Never a lender, always a borrower be." Major central banks are struggling with this dilemma. Interest rates are close to the zero bound in most developed countries. These are negative real-rates of return. At some point interest rates need to normalise, but the markets are hooked on the methadone of cheap and plentiful money. Taking away the punchbowl is the central banker remedy for an "Inflation Party", closing the cocktail bar in the current environment would risk sending the world economy "cold turkey" and potentially killing the patient.
I believe we will see more central bank buying of agency bonds, corporate debt, including convertibles and finally common stock. The objective will be to maintain stability of employment in the wider economy and provide long-term capital to support economic growth. This will favour certain companies:-
- Large employers - the primary objective is "full employment"
- Large capitalisation names - even if the purchases are evenly weighted it will favour the largest stocks by market capitalisation
- Non-financial firms - the secondary objective is to supply capital to the real-economy, financial institutions are principally intermediaries
- Industries where trade union membership is higher - due to greater political influence
- Industries which are the favoured recipients of state subsidies and patronage
The "dispossessed" will be: smaller listed and non-listed companies.
Implications for asset allocation
Where the central banks lead I believe we should follow. Bond yields will inevitably rise as interest rates normalise and institutions switch increasing quantities of their assets to equities. As bond yields rise the attraction of real-estate will diminish due to increased financing costs - though I would make the caveat that property is always about "location". Equities will benefit from a worldwide, state-sponsored version of the "Greenspan Put". This doesn't mean that stock markets will be a one way bet, but valuation models need to incorporate the prospect of this newly minted "wall of money" into their calculations of what represents "value".
Remember, also, that there will be two distinct types of central bank investment: that which is designed to support domestic employment and that which is driven by the quest for an acceptable rate of return. Many common stocks now offer a higher dividend yield than government bonds, a situation which has not been seen for several decades. In a low inflation environment this should persist, but in pursuit of their inflation targets central banks are likely to distort this relationship once more. It is hard to dispute that this looks like a variant of the Cantillon Effect.
Implementing structural reform is politically difficult, mandating ones central bank to buy the stock market is much easier. There will be pockets of resistance from those who question whether it is appropriate for central banks to control the equity market but this is the least painful exit from the current impasse. The foreign exchange reserves of emerging market central banks have ballooned since the 1997/1998 Asian crisis. Their governments mercantilist policies rely on developed market consumption. Come the next major crisis, it won't be just the "big five" central banks acting in isolation a concert party of elite capital will save the day.