Onwards and upwards (Archived)

Increased state intervention – and the greater use by governments of the cheap funding available to the public sector – seems inevitable in 2017 and beyond, says Real Return team leader Iain Stewart. In the minds of policy makers, the transition from low interest rates to no interest rates and the shift from buying government debt (QE) to purchasing other assets appear to represent a logical and seamless progression of monetary policy.

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The distortions caused by policy interventions are again being seen most clearly in financial markets. When central banks explicitly connect the rising prices of risk assets with prosperity, and provide cheap money and near-zero deposit rates to make it happen, unsurprisingly markets oblige.

The narrative of policy makers was shown to be spectacularly misguided in the last cycle. This narrative held that easing financial conditions, loosening credit constraints and boosting asset prices can mechanically lead to increased spending power and a virtuous cycle of rising spending and incomes. Asset-price manipulation also misses the important point that, in market economies, price is the signalling mechanism for economic activity.

The corporate debt markets exemplify the distortions that have arisen. According to Citigroup’s credit strategist Matt King, 1 with central banks now large buyers of corporate debt as part of their own QE programmes, normal relationships have been turned on their heads.

Distortions and dysfunction

No longer do corporate credit spreads appear to widen in response to, for example, a pick-up in defaults. Neither do they appear to widen as a reaction to rising corporate leverage, falling government bond yields nor to mounting policy and economic uncertainty. Instead, it becomes all about monetary policy and this, King believes, is leading to growing distortions and dysfunction.

Although central banks deny that their policies are producing adverse effects on financial stability, similar distortions can clearly be seen in other assets, such as equities and real estate – perhaps it is in evidence in all assets. Expectations, as embedded in market valuations, seem to have diverged from the reality of a still-weak outlook for economic activity.

Further interventions may in due course transmute into hybrids between monetary and fiscal policy (such as ‘helicopter money’ or variants of ‘people’s QE’ – for people instead of banks). Key to such a transition is the acceptance that injecting money into economies via the financial system (not surprisingly) enriches asset owners and exacerbates trends in wealth and income disparities set in train by globalisation. In this sense, policy settings are the UK’s referendum on EU membership, the extraordinary nature of the US presidential race and the rise in populist politics generally.

Unorthodox measures that were meant to be temporary have turned out to be unceasing. Potential bad news for the financial markets has tended to be associated with ever more stimulus; the UK’s EU referendum in June 2016 proved to be no exception. Central banks globally were prepared with liquidity provision around the time of the vote on 23 June 2016.

Brexit, what Brexit?

The Brexit ‘rollercoaster’ (market weakness and subsequent euphoria) led the popular press in the UK to prematurely to declare Brexit a success. Arguably, this speaks more to policy-inspired market distortion than it does to rational discounting of what Brexit inevitably means. Moreover, much of the late 2016 rebound seen in the broader UK equity indices reflected the initial devaluation of sterling.

It seems that the UK may be on a path towards a total break with the EU (exiting both the customs union and the single market) in 2019. While there is now some clarity about the likely ‘when’, the enormity of the task still remains daunting and the range of outcomes highly uncertain. Whatever the ultimate impact of Brexit on the UK’s prosperity, in the near term, the UK seems likely to be poorer (in GDP and currency terms) and to experience heightened economic volatility. 

From an international point of view, the UK offering to the rest of the world has been a stable, business-friendly, English-speaking gateway to the world’s largest consumer market. This has resulted in inward investment that has helped to offset the UK’s persistent current account deficit. Without that connection with Europe, we cannot expect international business to allocate as much capital to the UK as it might previously have done. Further pressure on the currency should be expected.


Policy may succeed in dragging future demand into the present but ever easier market conditions also encourage supply of goods and services. Indeed, it is highly probable that current monetary policy interventions are actually exacerbating the challenges to pricing power faced by the corporate sector and thus thwarting policy makers’ quest for higher inflation. Put simply, persistently cheap money may be deflationary rather than reflationary.

A clear example of this is that the loosening of financial conditions prevents weak and overleveraged businesses from failing; after all, weak fundamentals are no impediment to raising cheap funds in the corporate credit markets. The desperation for income encouraged by zero and even negative interest rates has loosened covenant restrictions on borrowers and enabled maturities to be extended. Financial ‘zombies’ can now fund themselves far into the future. Moreover, ultra-loose conditions also alter their behaviour. Rather than profit maximisation, ‘zombies’ set prices to achieve cash flow and market share. In a world of plentiful supply, healthy companies have to respond by mirroring these price reductions or face a drop in sales volumes.

Technological change

Technological change is immune to monetary machinations, although the extent of disruption can be accelerated by policy. In a world struggling to generate growth, we have increasingly witnessed a scramble to invest in growth stories. Ever larger funding rounds at higher and higher valuations extend the effects of technological change more rapidly than would otherwise be the case. Consumers benefit from the advance of better, and often lower cost, goods and services. The challenge, however, is to incumbent capital and employment. Once again, the consequence is a greater loss of pricing power for both.

An investor’s currency base is likely to be increasingly important, although the effect of aggressive monetary policy on foreign exchange rates reduces the ability to express strong positions. The inevitable push to do ‘more’ and the need to retain extremely low real yields (on account of extreme levels of debt) makes exposure to precious metals attractive to those mandates which can hold them.

The fragile and challenging growth backdrop and pricing environment emphasise the importance of cash-flow generation, strength of balance sheets, and the ability to sustain pricing, or adapt to lower prices. We believe companies that are able to sustain and grow their franchises without the need for support from a generalised cyclical upswing in demand can be expected to continue to command premium valuations. While valuations have become more challenging for many steady ‘bond-like’ compounders, the absence of a catalyst for a significant upswing in bond yields suggests that this differential can remain.

With little real change in the investment landscape, we do not think the trend to ever more manipulation of financial asset markets is likely to end well and this tempers our attitude to risk.

Video Transcript

What to watch in 2017

  • The transition towards fiscal policy.
  • Further weakness in sterling.
  • Continued investor appetite for growth stories driven by the weak yield environment.

1. Citi European Credit weekly: ‘Seven signs markets are deeply dysfunctional’, 19 August 2016

This is not investment advice. Regulatory Disclosure