Repeat after me: There is no recovery in corporate earnings. There is only an explosion in debt, driven by central bank policies that have produced no growth and wasted time. Time is the most precious resource of all. Its misallocation is a tragedy.
Yes. It’s a mouthful. But it more or less explains where we’re at and why stocks are having trouble rallying from here. And to be fair, except for the last part (about time) none of the above analysis is original. You just haven’t heard it enough lately, given the post-Brexit joy in UK financial markets.
Take this from William White, the former chief economist at the Bank for International Settlements, writing in the Financial Times this weekend (finally, something worth reading in the FT!):
The monetary stimulus provided repeatedly over the past eight years has failed to produce the expected expansion of aggregate demand. Debt levels have risen, especially in emerging market economies, constraining expectations of future spending and current capital expenditures. Consumers have had to save more, not less, to ensure adequate income in retirement. At the same time, easy money threatens two sets of undesirable side effects.
I’ll get to that basket of undesirables in a second
But there are two more immediate points worth making. First, the Bank of Japan (BoJ) tripled the size of the country’s monetary base in the last three and a half years (to over $4 trillion) and it didn’t do a thing to create the 2% inflation targeted by BoJ governor Haruhiko Kuroda. Zero. Zilch. Nada-san.
The expansion in the monetary base did finance a lot of stock, bond, and real estate purchases. That drove up financial asset prices. And that’s good for people who already own financial assets. But everyone else? And inflation? Not a thing. And why?
That’s the second point worth making. The BoJ believed that by increasing the quantity of cash in the system, and increasing the velocity with which it moved, it would generate movement. Movement equals inflation. Inflation equals spending. Make people think things are moving, and people will begin to move.
Except that’s not what happened at all. It turns out that the more uncertain people are about the future, the more conservative they become during the present. What does every animal do when it first realises it’s being hunted? It freezes to take stock of the situation.
Targeting inflation expectations with tough words, negative rates, and more quantitative easing (QE) caused people to lose confidence in central banks, not in cash. Lack of confidence does not encourage activity.
It encourages fear
There’s a bit of irony in that. Talk inflation from Central Banks works like inflation with everything else. Each additional word of policy and future guidance diminishes the value of all the other words. People stop listening to what you say. They only pay attention to what you do. Eventually, if you say too much your words lose all value and meaning and people no longer trust you.
Thus the bank abandoned its expansion of the monetary base last week when it released its comprehensive review of QE. Instead, it will now target ten-year Japanese government bond yields. I predict it will be similarly ineffective. Targeting longer-term interest rates is just another example of price tampering at its finest.
If anything, you can expect the BoJ to get more explicit. Ultimately, the only effective way to influence inflation expectations and tamper with prices is to undermine the trust and confidence people have in physically possessing cash money. Tampering with the price of money (interest rates) isn’t enough. You have to make people want to get rid of it.
Think of money as if it were fresh vegetables or fish you bought at the market. You know if you don’t spend it within a few days, it rots. It’s worthless and useless (except for throwing at politicians). That’s the basic concept behind cash that expires.
Zero growth and systemic risk
But let’s get back to the case of Mr White, in the FT, with the critique of QE. He’s shown that QE actually influences inflation expectations in a negative way. The more you talk down money, the more people hoard it. Meanwhile, low rates create massive instability in the banking system. White writes about two undesirable side effects of current central bank policies:
First, current policies foster financial instability. By squeezing credit and term spreads, the business models of banks, insurances companies and pensions funds are put at risk, as is their lending. The functioning of financial markets has also changed, with market ‘anomalies’ indicating hidden structural shifts, and many asset prices bid up to dangerously high levels. Second, current policies threaten future growth. Resources misallocated before the crisis have been locked in through zombie banks supporting zombie companies. And with neither financial institutions nor financial markets functioning properly, real misallocations since the crisis have been further encouraged.
It’s hard not to think of Deutsche Bank when you read that, isn’t it?
German banks have been especially hard hit by low rates. Why? They depend heavily on deposits as a source of funding. When savers can’t make money in savings accounts, they take their money from the bank and do something more useful with it, like stuff it in a mattress. Or, they invest it in something (anything) with a yield.
Deutsche Bank wouldn’t need a possible government bailout (from Germany) if another government (in America) wasn’t threatening it with a huge fine. And if global central banks, implementing monetary policy in harmony with treasuries and elected governments, hadn’t crushed global interest rates unnaturally low, Deutsche’s very business model wouldn’t be at risk.
But it is
And not least because the bank, like all banks, undoubtedly has billions tied up in investments and debt. It’s boom times again for global debt, according to this morning’s Telegraph. The paper reports that global corporations have issued over $5 trillion in new debt this year. Corporate debt issuance is on pace to exceed the record in set in 2006 of £6.6 trillion.
And really, if you were a non-financial corporation with the capacity to issue investment grade debt that central banks were practically salivating to buy, why wouldn’t you? Today, in fact, the Bank of England (BoE) begins its 18-month £10 billion programme to purchase the bonds of non-financial corporations.
It’s bad timing for the BoE and Mark Carney. They’re entering the war on deflation in the UK just as the BoJ has declared defeat. QE as we know it hasn’t worked. QE as it’s never been – in the form of helicopter money – is still “the big one” in the policy playbook.
But it’s a tattered and ineffectual playbook
And the players in the financial market know it. Richard Hodges at Nomura Asset Management had this to say about the BoE’s new programme: “This will almost certainly become another example of a failed attempt by a central bank to generate growth and inflation. It just means we will all be buying more expensive assets and taking more risk by extending further along the yield curve and down the credit-quality curve.”
PS White’s diagnosis of the economic problem is correct. His prescription is dubious. He calls for “paradigm shifts” in economic thinking and new legislation. Because that’s what we all need now, more laws. The most likely result, once QE is acknowledged as a failure (and the market corrects/crashes to reflect this), is a larger government deficit and nationalisation of parts of the banking system. More borrowing, orchestrated failures and restructurings of troubled financial firms.
Category: Central Banks