The OECD released their latest Interim Economic Outlook, warning that “the global economy is projected to grow at a slower pace this year than in 2015, with only a modest uptick expected in 2017”. This is another case of groundhog day, for years now these institutions begin the year with overly optimistic growth forecasts which are later revised lower.
One might expect equity markets to be rattled by this phenomenon, surely at some point lower economic growth must be reflected in valuations? What we have seen is that the weaker economic outlook has been justification for the world’s major central bankers to continually loosen monetary policy. This has in turn pushed bond yields to record lows and risk assets like equity and property – now priced off much lower discount rates – ever higher.
Should we be concerned by the fact that risk assets have continued to move higher while global economic growth has continually fallen short of expectations? Have the world’s central banks stumbled upon a new form of alchemy where valuations have no link to Gross Domestic Product (GDP), the main measure of economic growth? In other words, does GDP matter?
Almost everyone would agree that underlying economic growth does matter, but in the short run financial market participants are driven by many different factors. In recent years, the dominant factor has been central bank policy. However, over the long term the market cannot continue to move ahead of the fundamentals, just as trees cannot grow to the sky.
I read a note over the weekend, entitled “Twilight of the Central Bankers”, from Tad Rivelle, Chief Investment Officer of Fixed Income at TWC in the US, which sums up this growing risk. He highlights the precariousness of the current environment with the chart below which plots the trajectory of cumulative asset prices (stocks, bonds, and real-estate) against that of aggregate income (GDP). As you can see the chart doesn’t need much explanation.
Rivelle is scathing of central banks and their policies which have fuelled asset prices and distorted the “creative/destructive forces” that are the lifeblood of an efficient economy. “Artificially “stimulated” credit creation means marginal or even unprofitable enterprises are being fed when they should actually be starved.”
The 2008/2009 financial crisis is more often just referred to as “the credit crisis”, since the cause of the collapse in market prices was essentially driven by an expansion of cheap credit in the previous years, too much ‘easy money’. The excesses of the previous years culminated in the ‘surprise’ market collapse. The worrying development is that debt levels are back to levels, or even worse in some cases, than before the crisis.
As Rivelle points out: “The longer term consequences of policies that fixate on credit growth lead to a general, system-wide expansion of leverage ratios. Meanwhile, this credit inflation disempowers the market based mechanisms that would otherwise allocate resources to their highest, best uses. The result? Leverage goes up faster than the income available to service it. As such, the credit-fuelled expansion inevitably comes to a bad end.”
Is Janet Yellen and her colleagues at the US Federal Reserve concerned? Asked about “the global reach for yield and whether the committee saw that as a cost to its accommodative policy right now”, the below excerpt was part of her response:
Overall, I would say that the threats to financial stability I would characterize, at this point, as moderate. Not– I mean– so, I would characterize it as moderate. In general, I would not say that asset valuations are out of line with historical norms, but there are areas my colleague President Rosengren is focused on commercial real estate where price to rent ratios are very higher, or cap rates are very low. And that’s something that has caught our attention……But more generally, we’re not seeing signs of leverage building up or maturity transformation in the way that we saw in the run up to the crisis and we’re keeping a close eye on it.”
We heard the same kind of talk leading up to the last crisis. Still, no central banker will ever come out and say ‘we see another bubble building and we have to immediately raise interest rates’. The irony is that such honesty could be inherently destabilising in the short time, likely resulting in a market sell-off which would in turn feed into the behaviour of stakeholders that drive economic behaviour, i.e. economic activity would fall and unemployment would increase. Such is the balancing act faced by central banks.
While there is no denying that central banks have a difficult balancing act, there is a general sense that they have fostered too great a reliance on monetary policy among market participants, a habit that must be shaken if we are to stand any hope of avoiding another financial crisis, this one potentially more severe.
There is a complexity here that will not be of interest to everyone, but it is useful to be aware of broad developments. For investors planning for retirement, the important thing is align oneself to the most appropriate investments given one’s willingness and ability to take risk, time to retirement and overall retirement goal. Don’t base your investment decisions solely on past returns and most importantly understand what you are invested in.