By Dirk Stenhoff
Having grown up in West Berlin in the 70’s and 80’s, surrounded by East Germany, I was able to experience first-hand what communism was and how an economy functioned with a centrally planned economy. When the Berlin Wall fell in 1989, I believed that the concept of central planning belonged to the past. It is shocking how the same fallacies that were present at the time are resurfacing today. Central bankers have become the central planners of our time. They appear convinced that they are the cornerstones of the economy and, therefore, need to constantly intervene, via their monetary measures and market talk, for the “good” of the global economy and financial markets.
Are central bankers omnipotent?
No, of course they aren’t! However, their influence on financial markets has drastically increased over the past few years. Equity markets have become addicted to quantitative easing and to what central bankers say. We have reached an unreasonable state, where a single sentence uttered by a central banker, whether anchored in fundamental facts or not, can quickly elevate markets, or where the “wrong” choice of wording and a glimpse of monetary tightening can lead to a rapid correction. Central banks have effectively become the key driver of the financial markets, something extremely unhealthy in the medium- to long-term.
Most of our clients and regular readers already know our position on central bank interventionism. Thus, we will only briefly touch on the key problems that we are concerned about.
Artificially low interest rates at near zero levels are unsustainable, particularly when they do not realistically reflect the intrinsic risks in the economy. Yet they encourage investing in projects and assets that would otherwise not have been financeable or attractive. Asset prices are driven up across the board, and capital is misallocated to sub-standard investments.
The “day of reckoning” will arrive when interest rates begin to rise.
When central banks provide liquidity (i.e. print money), they do so through the banking system. The rationale is that through increased lending activities, the real economy will benefit from improved liquidity. However, over the past few years of unprecedented monetary inflation, banks have not substantially increased their lending activity. Instead, they have funnelled their excess liquidity toward bankable assets, thus driving up the prices of stocks, bonds and other securities.
In this context, we would like to draw your attention to the following Figure 1. This chart displays the development of the S&P 500 and the balance sheet of the Federal Reserve since the first round of QE was announced back in November 2008. The correlation is striking and underlines the direct impact that the Federal Reserve has on equity markets.
Today, generally speaking, we consider the asset class of bonds to be relatively unattractive. Even when the issuers are governments or financially sound corporations, the risk-return profile tends to be, in our view, skewed toward risk, and not on returns.
We are all aware of the excessive debt levels that most western governments have accumulated. Therefore, we consider the continuation of a low interest rate environment for some time a very probable scenario. Nevertheless, even in such a scenario where yields will remain very low, the potential for capital gains, due to yet lower interest rates, is very limited. How much lower can interest rates go? On the other hand, the potential for rising rates, and the scale of losses in bonds that will come with it, will be disproportionately greater.
Therefore, based on the limited potential for upside gains, coupled with substantial downside risk, we are generally very cautious when it comes to bonds.
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