They remain key determinants of stock market valuations
Central banks disown any responsibility for stock markets; yet we all know they take market conditions into account. How will they respond if the turmoil resumes?
Apparently the banks want central banks to get interest rates back to “normal”. Axel Weber, head of UBS, former head of the Bundesbank and former council member of the ECB, has accused central banks of distorting markets. It is wrong, he said, to keeep interest rates “artificially low”. This warning follows similar statements by industry leaders, and even by central banks’ own think tank, the BIS.
Will they continue with normalisation?
Benoît Cœuré of the ECB has repeated that the ECB was determined to push inflation back towards its goal of close to 2 percent, adding “we have not given up”. He stoutly maintained that their actions had brought about a “tremendous improvement” in capital markets.
What are the lessons of this debate for investors?
One can visualise markets as being in a tug-of-war with central banks.
After falling steeply since the start of the year, global stock markets rallied when Mario Draghi indicated the ECB might increase monetary stimulus at its next meeting. Investors hoped this signalled similar intentions by the Bank of Japan and Fed. On the other side of the world, Japan’s Nikkei index jumped 6%! What a proof of the market power of central bankers. They may not have sought such influence but now they are stuck with it.
Inevitably, Draghi couched this in terms of the inflation target – God forbid the falls in stock markets influenced him! Yet would he have said what he did without the turmoil? I don’t think so. The same applies to the confirmation from Mark Carney of the Bank of England that UK interest rates were likely to remain at their historic lows for longer than the Bank had anticipated.
Now investors are waiting for Janet Yellen to fall into line, which may take a little time and possibly a new “pull” from the markets.
Greenspan set the precedent
To see how they got to this, we have to go back nearly 30 years.
The rot that Weber complains about started in 1987, when Alan Greenspan, then Fed chairman, rescued US markets after Black Monday, October 19, 1987 (the Dow Jones fell 23% in a day). Other central banks took the cue from the Fed’s lead. Greenspan was universally lauded in the media. The central banks, and the markets, knew the score.
That benign central bank attitude to stock markets was an essential ingredient in the historic equity boom of the next 20 years. OK, to some extent the boom was justified by fundamentals – notably the impact of the transition of countries containing most of the world’s population to market economies and their resulting economic take-off. But the central banks were always there to prop up markets if needed – as in 2001-05 and in 2007-15.
Central bankers like Ben Bernanke were praised for “saving humanity” each time they loosened policy and boosted asset prices.
No miracles now
There is nothing comparable to the China/India/Eastern Europe miracles in sight to validate stretched market valuations now. On the contrary, the world faces strong headwinds: higher debt, ageing, inequality, political turmoil, the rise of radical religious extremism, the fading of the American will to police the world, the existential threat to the EU from immigration and Brexit.
Volatility inevitable when rates are so low
According to a new book by Robert Gordon, a leading US economist, average annual US productivity growth has been slowing down for three decades or more, and there is little likelihood of it accelerating, despite the Silicon Valley optimists.
Given the slow-growth outlook, many analysts say that stock valuations are stretched, maintained by the sea of central bank liquidity and ultra low rates. Any “normalisation” of interest rates could send stocks over the edge.
This is partly because rates are so low. On simplified assumptions, an asset that is expected to produce an income of £10 a year for ever is worth £100 pounds when interest rates are at 10% and still £90.9 if rates rise to 11%. Its different when rates are low. With rates at 1%, the asset would be worth £1000; if they rise to £2% it would fall to £500.
At such low rates, prices also become highly sensitive to changing expectations of long-term future events affecting returns. So high volatility is normal.
Do central banks stand between investors and Armageddon?
So it seems. QE always set out to boost asset prices, as part of the transmission mechnaism of policy. It succeeded in that. Yet it has also increased uncertainty and, arguably, depressed real investment.
Given such uncertainty, it is no surprise that advisers are urging clients to keep their portfolios liquid.
The Japanese example
We may follow Japan. More than half Japanese household financial assets are held in currency and deposits compared with only 14% in the US. Latest Bank of Japan figures show households sitting on a cash mountain of Y887 trillion ($7.5 trillion), while company cash holdings have risen fast to Y247 trillion ($2.1 trillion). Plus an unknown amount concealed from the authorities. Why? Deflation, partial removal of deposit guarantees and uncertainty about wages and employment
High holdings of cash and bank deposits cut demand and output. There are only three respectable ways to lower companies’ cash: greater investment, increased dividend payments and faster wage growth. There is no sign BOJ’s QE is making companies do any of these.
Meanwhile, the anxiety of Japanese individuals to save has only intensified. They are worried about the future.
Regulators are however taking action that may reduce this demand in the west by a dangerous route: by spreading uncertainty about the safety of large bank deposits. On the one hand, deflation give deposits and paper money holdings a real yield; on the other, the safety net is being gradually redefined. No longer can large holders be 100% sure money in the bank is safe. Hence respectable advisers counsel larger holdings of paper (or plastic) central bank notes. (This is by the way why helicopter money drops won’t work – given deflation it is like handing out securities with a guaranteed real return).
So it is rational for investors to panic when market tremble.
The central bankers have painted us all into a corner: including themselves.
Yet they have not run out of ammo yet. Investors may be right to believe central bankers can come to their rescue one more time, before the weight of the world becomes too great for them to bear.