Rinse and repeat… indefinitely

The story of the post-global financial crisis world has been one of crisis… response… improvement… complacency (CRIC), then repeat, says Iain Stewart, Real Return team, Newton. But can central banks ever break free from their stock response to financial economic stress?

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The CRIC crisis response was originally observed by the economist Robert Feldman in 2001 in relation to post-bubble policymaking in Japan. Since the global financial crisis, each subsequent crisis – be it the eurozone debt crisis, taper tantrum or commodity bust – has seen one central bank or another react by ramping up the scale of its asset purchases.

The ensuing chain of causality is important to note. On each of the three occasions central banks have topped up the liquidity punchbowl in the face of financial economic stress, first markets, then economies have improved. While the textbooks will tell you the market reflects economic fundamentals, we would suggest in the post-crisis world of hyperactive central banks it has actually been markets which have led.

In 2017, a bid to enact a turning point in post-crisis economics has seen central banks mount a third major attempt to wean investors off liquidity injections: The Bank of Japan has abandoned quantitative easing in favour of yield-curve control while the Federal Reserve in the US has started balance sheet reduction. Even the ECB is set to taper its programme of asset purchasing through 2018.

While some take succour from the fact the Fed is only going to begin tapering its balance sheet by US$10bn per month – small beer relative to the mammoth US$4.5 trillion balance sheet – if the relationship between financial asset prices and central bank liquidity provisions that has been evident over the past nine years holds true, the tabled reductions in liquidity may well bring about declines in equity markets and a widening of credit spreads.

Indications that earnings growth slowed in the third quarter of 2017 compared with the first half of the year could be a sign the latest sugar rush administered to the global economy is beginning to fade.

There is little guarantee investors recently wooed into emerging market assets will stick around if global financial and economic conditions start to look less rosy. Whether coerced by central bankers or not, it is hard to dispel the notion that an air of complacency now reigns among financial-market participants, despite the fact that market risk has been ratcheting higher. Such complacency has arguably been 30 years in the making, with asymmetric monetary policy having conditioned investors, companies and households to embrace debt.

Debt, glorious debt

The growth of debt has had a material impact on assets through two channels. The first is the direct impact on asset prices from debt-fuelled demand. Most of the increase in the world’s stock of debt has not been used to fund spending on goods and services; rather it has been used to fund the purchase of financial assets. Across the developed world, assets and financial liabilities are both at all-time highs relative to GDP.

While not without its drawbacks, GDP provides a useful measure of the total income that is generated by an economy over a given period of time. The fact that the value of financial assets is at an all-time high relative to GDP is consistent with aggregate asset valuations also being at all-time highs.

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The second impact of debt on asset valuations is that the structural trend of rising economy-wide leverage has been one of the factors forcing the trend in lower interest rates. We see it as impossible for rates to return to ‘normal’ levels with leverage at such abnormal levels. By enforcing an ever-lower ceiling on rates, rising leverage has helped sustain asset valuations far above ‘normal’ levels.

However, high levels of debt have been shown to have a deleterious impact on both economic growth and financial stability.1 Rising leverage increases the sensitivity of the real economy to interest rates, and is a contributing factor to why economies are so sensitive to what goes on in financial markets.

While one of the objectives of the central bank response to the financial crisis was to reduce the real burden of debt through higher inflation, not only has inflation failed to materialise, but easy money policies have encouraged even more leverage. Unfortunately, in relation to future economic and financial stability, the rise in leverage is well-established and shows no sign of abating.

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As valuations have ratcheted higher, the consensus has also argued that low interest rates ‘justify’ a continual re-rating of cash flows. But this argument only considers the discount rate aspect of lower rates and not what they imply for the growth of future cash flows (or for that matter the stability of the financial system).

Bear market

In a recent article, Robert Shiller, Nobel Laureate and Professor of Economics at Yale University, argued the US stock market towards the end of 2017 (characterised by an unusual combination of very high valuations, following a period of strong earnings growth, and very low volatility) looked a lot like it did at the peak before all 13 previous ensuing 12-month price declines of 20% or more.2

From the second quarter of 2016 to the second quarter of 2017, real earnings growth was 13.2%, well above the historical annual rate of 1.8% going back to 1871. However, as Shiller argues, this high growth does not reduce the likelihood of a bear market. In fact, peak months before previous bear markets also tended to show high real earnings growth: 13.3% per year, on average, for all 13 episodes.

Those commentators pointing to better earnings over 2017 as a reason for a benign outlook are therefore going against history. Low market volatility over the course of 2017 is held up by the bulls as another reason to be sanguine; certainly, average stock price volatility – measured by finding the standard deviation of monthly percentage changes in real stock prices for the preceding year – has been extremely low at 1.2%, nearly three times lower than the long-term average between 1872 and 2017. But stock-price volatility was also lower than average in each of the years preceding the 13 previous US bear markets.

With the cyclically adjusted (10-year average) price-to-earnings ratio (CAPE) in the US standing at just above 30 as of Q3 2017, the US equity market looks expensive relative to the long-term average CAPE of 16.8 going back to 1881.

Many investors agree that equity markets are expensive and many of those same investors point towards robust earnings growth and low volatility in 2017 as the basis for a benign outlook. However, Shiller’s analysis should serve as a warning against complacency. Investors who allow faulty impressions of history to lead them to assume too much stock-market risk today may be inviting considerable losses.

1. http://www.bis.org/publ/work352.pdf.
2. https://www.project-syndicate.org/commentary/us-stock-volatility-bear-market-by-robert-j--shiller-2017-09.

This is not investment advice. Regulatory Disclosure