New bubbles from misguided monetary policy

Have any lessons been learned following the Great Financial Crisis? Around the world, it looks like new bubbles are growing. Certainly, the crisis showed that central banks and politicians can move decisively on the threat of economic collapse. But the sequel has been years of bad policy; propping up banks, bad loans and unsustainable growth. Between 2007 and the end of 2014, the combined world-wide debt of households, governments, corporations and the financial sector actually grew. Adding in unfunded pensions liabilities of governments around the world, overall indebtedness in the world’s economy is today over 400% of global GDP. London house prices are now 50% above pre-crash levels. Should investors be worried?

Bubbles tend to creep up on investors; one of the worst credit crunches in history has changed behaviour little. It seems easier to carry on as before. Politicians need growth for re-election; investors like rising stockmarkets. Complacency rarely drives change, even as the world moves further down the slippery slope to negative interest rates. This may not end well.

There is little sign that negative bank deposit rates are flushing out a wave of new capital investment or even consumer spending. Instead, the inability to earn returns on low risk assets are threatening the business models of banks, insurers and pension funds. To date, few companies have linked rising pension deficits to dividend cuts, but more can be expected. Banks themselves are now unable to make the profits needed to rebuild capital. They enter the next economic downturn largely unprepared. And, in the weird world of government debt, even the challenged Republic of Latvia, with a bond rating of A -, now has bonds that yield almost zero.

Clearly, with such bonds the maximum upside is preservation of capital. It would be a bleak world in which that represented a win. But it may look smart relative to some negative yielding bank deposits where bail-in risks remain. It is not just Italian banks and a few European mutuals that need to re-capitalise, but some of Europe’s major banks. A thin sliver of genuine loss-absorbing equity supports these banks, with little known about how derivatives would behave in a new crisis. Already, this year we have seen how some of the exotic capital – CoCos – might be viewed when the chips are down. And remorselessly, bank balance sheets are becoming more entangled with Eurozone sovereign risk. This is not just because of ECB bond purchases, but subtler issues such as deferred tax assets. The latest European Banking Authority stress tests did little to reassure.

Investors often seek safety in the crowd. Regulation encourages this; the index or consensus is typically used as a risk benchmark. It explains current market buoyancy and low volatility. Equities seem to offer dividend yield, with an upside bet on moderate inflation returning. Meanwhile, the driving forces of long term globalisation seem weakened. Trade harmonisation was meant to boost growth, but the new proposed agreements of TTP and TTIP look dead in the water. It may take the US presidential election to finally kill these trade deals off, but it is hard to see where the next boost to global growth will come from. Instead, we can expect continuing squabbles over trade, and currency wars.

How should investors react to bubbles? For most asset managers, sitting out a rising market is not a viable business model. Those owning financial assets – whether equities, bonds or property – are the current winners from misguided monetary policy. Why worry, when the alternative is not clear?

In current conditions, portfolio protection is particularly difficult. Low volatility reduces the value of premiums that can be written on an equity portfolio. Negative interest rates limit the options that can be bought on upside whilst sitting in cash. Instead, investors may need to think carefully about diversification of assets.

Behavioural finance is often accused of simply asking people to think sensibly. But individuals typically do not believe they are behaving irrationally during bubbles. Instead, the problem posed by bubbles needs re-framed. Rather than make a simple risk-on or risk-off bet on the market, investors should assess where the biggest risks lie, and take selective action. The bank sector, for example, may be a loser whatever happens. And, given the risks in banks and derivatives, investors should monitor those areas for warning signals.

A version of this article was published in Citywire on September 19 2016

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice. I am a manager of actively invested equity funds. At the time of publication, clients of my employer held long and short positions in bank stocks.

Image credit: “Bubble Rain”, 2005, Steve Jurvetson, Licensed under the terms of the cc-by-2.0. Some rights reserved. Published on September 22 2016

One Response to “New bubbles from misguided monetary policy”

  1. Thank you Colin, lucid as always. Interesting to note from a technical analysis point of view that banking share price action is improving…

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