Global ETFlash – November 12, 2012


Central Banks: Back to the “No Change” of Much Change

By Wilfred J. Hahn , co-CIO

The U.S. election is over and markets are again looking further ahead. What do they see? While uncertainties about the so-called U.S. “fiscal cliff” are shading the short-term outlook for equity markets, there is nothing much new. It is “no change” as far as the eye can see. So say many pundits.

No change? Yes, in our view also. But only in the sense that this will mean a continuation of the following:

  • The proverbial can to be kicked down the road as far as possible. Politicians don’t want austerity and tough decisions to impact constituencies on their watch.
  • Policies to promote ultra-low interest rates for a long time as well as higher elevations to financial markets than normally might be the case.
  • U.S. government deficits (and that of other nations, too) will stay high. As it is, in any case, the so-called Keynesians are winning the policy debates. They emphasize that direct government spending has the best multiplier for economic growth and corporate profits. They are right (but that is only part of the story).
  • Continued bouts of periodic financial market volatility (serving to throw most investors off the trail at times).
  • European tremors. We anticipate that problems in the European periphery will move back onto the front burner.
  • Continuing international “currency wars” and competitive monetary policies.
  • Households continuing to want to avoid financial risk, especially as populations continue to age.
  •  In the meantime, the hunt for yield … any yield … will continue.
  • Economic activity worldwide to still decelerating. This is mostly attributable to a sinking European economy. Yet, within that global torpor of slow growth are some modest counter-trends currently. U.S. activity has firmed in recent months, and there appears to be a modest rebound underway in China. The problem here, however, is that the apparent “positives” have already been discounted and neither of these countries will experience a sustained economic surge, in any case.
  • And finally this: An even greater reliance upon unconventional actions of central banks. We definitely expect more … and not just another “quantitative easing.” It is important to recognize the alluring slights of hand that are yet possible. We will explain further.

In conclusion, what this all means is “more of the same”; more uncharted waters; and lots of potential changes of the unconventional sort. We are stuck with the “no change” of recurring economic decelerations that are likely to prompt repeated bouts of government interventions and monetary stimulus (these increasingly of the variety of “psychological confidence games” and “monetary flimflammery”.)

Moreover, if the U.S. election signified anything, it is the confirmation of a widening polarization … the parting constituent ships of “two Americas.” What this likely will mean is that there will be even more pressure on the central bank to take the helm while a U.S. political process is grid-locked. For different reasons, this same type of reliance upon “unconventional” monetary policies is also observed with the European Central Bank (ECB).

But, just what do we mean by “unconventional”? After all, one should anticipate an onus upon central banks to consider the unconventional. We think this term gives rise to some wild-cards many investors are not yet thinking about at this time. A number of developments both facilitate and drive their adoption. Given the fact they we are experiencing “uncharted waters” alone opens the horizon to such possibilities.

We must rely on “behavioural truisms” for the answers, and there are some very important ones to note. Firstly, the Homo Erectus will downshift their expectations during economic adversities. Admittedly, this is usually a painful process. For example, today, no one would think to expect 15% investment market returns every year as was the experience in the mid-1990s. Or, nary an economist anywhere today believes that economic growth rates of 3 to 4% are possible anytime soon in developed nations.

As such, great relief (and even optimism) is triggered currently simply on the assurance that economic growth will remain between 1.5% to 2.0%. Even though global growth has continued to decelerate modestly to date this year, comfort is taken from the fact that growth remains positive and is “stable.” Five years ago, such an outlook would have deflated equity markets. Not today.

Our point? In the same way, financial markets are fading their convictions about the dogmas of established monetary policy tools. They are no longer concerned about the prospect of run-a-way price inflation resulting from the massive balance sheet expansions of the major central banks. In fact, markets seem to celebrate this if anything. They have become inured to these new polices and are open to any new polices, no matter how inventive and unconventional, so long as they will work in levitating financial markets for at least one more good trade.

Blinded By Convention

Crucially (this being the key point that we have been wanting to make) just as societies can change their consensus views with respect to new fads and morals (no one makes a big deal about long hair and facial piercings any more these days), so the accepted norms of monetary protocols. Most certainly, this changing of the “monetary morals” is already well underway. Many don’t see this as they assume that central banks will someday unwind their interventions. Moreover, they are blinded by the accepted conventions of central bank accounting.

To demonstrate this optical occlusion, consider this question: If the U.S. Federal Reserve (Fed) buys up U.S. treasury bonds, is the debt-to-GDP ratio of the U.S. actually being lowered? We predict yes. How so? The Fed pays for the U.S. treasury that it buys with new created money. It simply adds a liability to its balance sheet and shoves money out of thin air into the banking system. The Fed has a cost of capital that is virtually nil. Yet, it now collects the interest payments earned by holding the U.S. treasury bonds. What happens to this income? It is added to the profitability of the Fed. At the end of every year, this central bank transfers its profits to the federal government.

What has happened? Net, net, the interest cost of this debt has been lowered to the U.S. government (effectively, getting it rebated back). And, if the Fed never, never again sells down its treasuring holdings (maintaining them at the same level) isn’t this virtually the same as lowering the U.S. federal debt burden?

Yes, of course. It would be the equivalent of these bonds being retired. Yet, the accounting convention of the central bank will be to still show these bonds as an asset. What you see therefore promotes a structural illusion. Of course, it all depends upon the question of whether or not the Fed will ever sell down its treasury position back to the private sector. Yes … or no?
We would predict no. In fact, if global economic torpor and deflationary demand shocks continue, we would expect even more treasury purchases by the Fed (this applying to other central banks as well … i.e. the ECB). Why wouldn’t policymakers propose retiring massive amounts of government debt in this way? This would appear to be so much more pleasant than intolerant austerity policies … so seemingly painless. Of course, this perception couldn’t be more wrong, though surely alluring and easily pandered.

Assuming a continuation of slow economic growth and the continuing shift in expectations (as we have already shown are rapidly underway) and high levels of desperation, the slope will be greased for further descent in “monetary morality.” We would even say this is predictable. But how far?

The deterioration in “monetary morals” can go much further. There is not a small number of policymakers that have broached the topic of “unconventional” monetary tactics. The signs of such central banking shifts are being seen around the globe. The IMF (International Monetary Fund) explored the topic of budget spending multipliers in its recent Outlook. It argued that the “fiscal multipliers” are much higher than thought, therefore, implying that cutting budget deficits may actually lead to higher deficits. If they are not to be cut, then on this logic it follows that even higher deficit spending would even be better? But just who would be financing such endless and stupendous government deficits?

Just who has access to “unlimited money”?

Lord Adair Turner (the head of the Financial Services Authority (FSA) in Britain and possible contender to be the next head of the Bank of England) recently suggested openly that “still more innovative and unconventional policies” need to be explored. We could quote quite a few others who are auguring for policy changes in this direction.

There is one further step that could follow in this slide, and that is to have central banks directly buy the debt instruments of governments (i.e. circumventing the route of buying them in the open market). At this point, laws and statutes stand in the way of such activities. However, it is likely that necessity will pay little mind to such restrictions. We will predict that equity markets will love this for a time, though these measures would reflect total policy desperation and ruthlessness that will lead to massive wealth transfers as well as wealth deflation.

A veritable truth of the ages is that governments have a high proclivity to spend. While both households and corporations are currently reluctant to drive new loan growth through increased spending, this would not be a frigidity or hindrance that governments are likely to suffer. Increased government spending will indeed have a direct impact upon economic growth … more or less.

Our conclusion is this: Long-term developments and scenarios look challenging; and some are even grim. Yet, there remain today a few more “tricks in the bag” that central banks and governments can invoke. We are inclined to believe that the downhill slide of “monetary morality” has not finished its course given there are likely to be willing complicitors. Markets are likely to play along if it will mean at least one more tradable rally. The history of beleaguered central banks is on the side of this opinion.

We must point out that we endorse none of these unconventional policies that we have intimated. None of them make us optimistic about longer-term outcomes. The ultimate fall-out is not avoided as none of these monetary measures resolve underlying problems. Rather, they only redirect their impact to a more deceptive and unsuspecting path, thus “kicking the can down the road” headed toward to even greater disruptions and crisis. This is the path of “no change” … the twilight path.

We only suggest (predict) that such new unconventional policy measures as we have explored will be adopted due to further continuing rounds of economic slowdowns; budget pressures; and sundry crisis. Given this endgame disposition of markets, the anticipation of these policy measures will be interpreted to be a boon to financial markets. But only for a short awhile. New and greater doses of unconventional policies must be forthcoming to the keep the psychological Ponzi going. There will come a point, of course, where such monetary and economic engineering will be no longer possible nor believable.

For now, we suggest that investors and clients buckle their seatbelts and get used to this different era of “no change.” We continue in uncharted waters. Conditions are and will be unconventional; with frequent outbreaks of volatility; clamors for more monetary and interventionist relief; a continuing dysfunction of capital markets. Yet, one must not lose sight of the fact that the primary and ultimate goal in such “twilight zone” scenarios is to come out ahead “relatively.”

Absolute gains are surely possible in real terms, but not assured. The mistake that many investors will make is to jump fully into cash, thinking that this is safest bet during such times of monetary convulsion. Yes, the value of their deposit may not swing about in nominal terms as do financial market securities and commodities. Yet, their wealth seen in relative terms stands to suffer the most. Until the “trickster bag” of the central banks is nearly exhausted, stay buckled in.

In the meantime, we continue to emphasize “yield” in our portfolios wherever possible. A broad diversified mix of asset-types is held with the goal of adding a “shock absorber” function during the current times of “no change.”

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