GLOBAL CENTRAL BANK POLICY
“I suspect that businesses and investment committees around the world are spending an unusual amount of time discussing what central banks are likely to do next. In too many cases this discussion may overshadow those on fundamental trends, product design and relative value opportunities.” - Mohamed A. El-Erian, PIMCO
We have been in a policy-driven market now for roughly four years. Both monetary and fiscal authorities have played a heavy-handed role in the economy and capital markets over this time period. Global central bank (monetary) policy is on our Macro Radar due to its post-financial crisis impact on investor sentiment and the performance of both stocks and commodities. The chart below reflects this reality. Notice how the world equity index (blue line) has turned higher around the announcements of the US Federal Reserve’s easing programs (QE1, QE2, Operation Twist) and the European Central Bank’s long-term refinancing operation (LTRO) while turning lower around the expiration of these programs.
Source: Thomson Reuters
Central banks have worn two distinct hats since subprime first began to topple in 2007. In the early stages of the crisis they focused on the proper “functioning” of financial markets by injecting liquidity and being a lender of last resort to certain corners of the banking system that were completely frozen. This was full on crisis management mode, and policy makers were focused on preventing unnecessary fallout from a temporary state of panic amongst market participants. Once a certain level of stability returned, policy makers shifted their efforts to generating specific economic outcomes such as higher GDP growth, increased lending (go figure), lower unemployment, etc. The primary method for achieving this has been through holding short-term rates at zero and engaging in a practice widely known as quantitative easing (QE) in which the central bank creates new money and uses it to purchase assets such as long-term government bonds in the open market. The net effect of QE is lower long-term yields and an increase in the money supply which can then be re-invested in other financial assets or spent in the economy. Meanwhile savers are punished for holding cash, and there is a strong incentive to invest money instead in higher-yielding fixed income securities or even riskier assets such as stocks or commodities. The chart below reflects the large drawdown in money market assets that has occurred over the past 3.5 years – this is precisely what the Fed wanted to see.
Source: Ned Davis Research
Central bank balances sheets have expanded as they’ve printed money to purchase assets. An aggregation of developed market central bank balance sheets has tripled from 10% to roughly 30% of GDP in the past five years, and according to a recent report from Artemis Capital Management enough new money has been created to buy every person on the planet a 55” 3D television!
A core belief amongst central bankers globally is that the response to uncertainty should never be paralysis. This is a primary reason why policy makers have been so active in implementing traditional as well as experimental programs in recent years, and why we should expect even more of the same in the months and years to come. In our view, however, monetary policy is becoming less and less effective in actually producing any impact. The developed world faces a twin reality of too much debt and too little growth. Can we really fix overly-leveraged economies with more leverage, and can we really expect to spur sustainable growth by encouraging more borrowing and spending?
While central banks played an integral role in stepping the global banking system through the credit crisis, structural issues in the future will need to be dealt with by the fiscal authorities. Government deficits, debt loads and looming entitlement programs are long-term problems central bankers have no power to address. In the US, Bernanke has already begun warning congress of the potential impact of the upcoming “fiscal cliff” saying, “…there’s absolutely no chance that the federal reserve could or would have any ability to offset that effect on the economy.” Similarly, Mohamed El-Erian of PIMCO recently (and awkwardly) stated, “In the last three plus years, central banks have had little choice but to do the unsustainable in order to sustain the unsustainable until others do the sustainable to restore sustainability.” Basically all he’s saying is that monetary policy may be effective in “extending the runway” so to speak, but longer-term sustainable solutions to the world’s problems are going to need to come from somewhere else.
Whether we like it or not, we remain in a policy-driven market and carefully monitoring and anticipating central bank policy moves can give us an edge in growing and protecting your assets. Let’s briefly review the current policy of three of the more important central banks and what can be anticipated going forward.
US Federal Reserve
European Central Bank
Peoples Bank of China
Overall the balance of evidence indicates we’ll continue to see a healthy amount of monetary policy intervention going forward. In isolation this should be negative for major fiat currencies and positive for commodities, gold, emerging market currencies and even equities in general. However, accounting for central bank policy is only one piece of our macro analysis and needs to be balanced with underlying economic and fundamental realities.
Season Investments, LLC
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