Whilst I'm sitting at home contemplating the next steps in my career path it occurred to me that with all the time spent looking at financial data for personal reasons, it may be worth sharing my thoughts via a blog. Who knows, I may even get a following out of it!
I've spent quite a bit of time since my enforced retirement reading the thoughts and advice of financial gurus such as Bill Gross (chief exec of PIMCO - don't think he's any relation), trying to gain a greater understanding as to what exactly is going on within the markets following the period now known as 'The Great Recession'.
Interest rates are currently at record lows and seemingly not going up anytime soon, whilst most developed economies continue to only chug along keeping their heads just above water in terms of GDP growth (that is if they are even growing at all). However equity markets are continuing a march towards record levels and beyond, with the S&P 500 and Dow Jones in the US hitting new index level highs in the past few weeks. The FTSE 100 in the UK also got to within 0.8% of the all time high of 6,930 set during the tech boom in 1999. In a normal recession you would traditionally look towards the equity market rising as an indicator that we are on our way to an improving economy (cause everyone assumes institutional investors know something the rest of us don't!). Here the buoyancy with which the market has gone towards highs does not seem to be a reflector of this. Various market analysts are suggesting that stocks are still "cheap" with respect to the earnings that have been posted (both in the past year and predicted) but this doesn't really tally with what is going on in the real world and the man on the street.
However a lot of the commentary around the reason for this renewed spike in equity markets centers on the fact there simply isn't enough "safer" investments for investors to put their money into which are also going to give a level of return above inflation. This is due to traditional safe haven assets such as US Treasuries and UK Gilts having their yields pushed to close to zero, so investors are having to look elsewhere and look towards more risky assets classes to get any return, the most traditional of those being equities. This is as a result of an effort by the financial guardians (central banks) to try to stimulate the economy, which has been going on for a few years now.
Traditionally, using monetary policy, the main way to stimulate the economy is to reduce interest rates (which in effect should discourage people from saving as they get nothing for their money and instead invest it in various activities which in turn hopefully leads to an increase in production). However with the existing recessionary period, interest rates are already at all time lows (and in many cases close to zero) so this as a policy is no longer working on its own to encourage investment. (This is a by product of the current recession also having a banking crisis but I fear going into any more detail on that one unless we have a 20 page blog!! Maybe another time.) As a result, some of the leading central banks (the main actors being the Fed in the US, the ECB in the Eurozone, Bank of England & Bank of Japan) have resorted towards a measure known as QE (That's quantitative easing, not Queen Elizabeth - although some might say she'd have just as much chance of reviving the world economy!).
In a very small nutshell, QE is where the central banks use a set amount of money each month to purchase additional assets to those they would normally buy in creating money supply. Normally the central bank would control interest rates through the purchase (or sale when looking to increase interest rates) of short term government bonds. With QE, the central banks are now purchasing a set amount of more risky assets such as longer term bonds and even Corporate Bonds and Mortgage Backed Securities (think things which helped caused the credit crunch). This results in an increase of the money supply each month which in turn should be used by the banks to increase lending which in turn it is hoped will lead to greater investment in real assets. If it all goes as planned, then hey presto, the economy grows and you can start reducing central bank intervention (and QE) and going back to how things were.
Potentially the biggest problem created by this is how the central banks pull back from QE once (or if) the economy is back on enough of a forward footing (or indeed if inflation starts to get out of control). As I've already mentioned, this extra money into the economy has served to assist in driving the stock market over the past couple of years in the lack of any substantial positive corporate data to back it up. Most commentators agree that QE has worked with respect to stopping the various economies from completely spiraling out of control and has acted to ensure that a prolonged depression hasn't occurred. Eventually there will need to be an easing off of QE, before it is withdrawn completely. This could happen sooner rather than later with murmurings coming through that the Fed is already considering scaling down it's bond buying scheme (there still remains fear of the long term inflationary effects of the policy). The issue is, even just with these whispers from certain Fed board members, equity markets have seen falls of 1-2% on those days that such news came out. If it starts to become a more real possibility of a reduction in QE then the prospect is that equity markets would begin to fall even further to the point where we could start to see an adverse effect on the real economy. The Fed then without having had the opportunity to begin to raise interest rates again is forced to go back to a renewed bond buying program in order to restore confidence in the economy (and the markets) and round we go again. Except perhaps this time even more stimulus is required to encourage investors that central banks won't withdraw support so "quickly" next time, becoming even harder to withdraw that support in the future.
It seems to me that we may have created a financial system where we have given it so much support it feels unable to cope on its own. Compare it to the situation where you are teaching your kid to ride a bike. The first time you take the stabilizers off he falls and hurts himself after a short cycle. He's then afraid so you agree to hold on for a bit longer this time, but when you let go he is too afraid and wobbles and falls off again. The next time he wants you to hold on for longer and this time when you let go at the first wobble you grab the handle bars again to prevent him getting close to falling. By now, he's so afraid that he's always going to fall over that that you can't let go at all because if you do he fears he'll fall over straight away.
It's not the greatest analogy, but it's kind of where we are at now. The trouble is with many of the steps the central banks (and governments) have tried to take to stabilize things, investors feel they now cannot survive without the lifeline that's been provided. When Lehman Brothers collapsed the financial world went to the brink of the abyss because governments gave the impression before that (with Bear Sterns, Fannie Mae, Freddie Mac etc.) they would always assist in stopping large financial institutions going bankrupt. After the collapse they then had to act to show they wouldn't let the same thing happen again. The same with the euro crisis where the mistakes weren't learned. Greece could have been made an example of (as the first one) but instead gave the impression that any country would be rescued even if it would drag the euro down. In fact it has even now got to the point where Mario Draghi (ECB chairman) has said they would "do whatever it takes" to save the eurozone.
And so with QE, what was a necessary measure to stabilize the global economy at the time, must one day, and relatively soon, be removed from the bike so that the wheels can turn on their own and speed can be generated by the real economic actors on the ground. Investors must realize that the economy was able to grow and function effectively before without the hand-holding parent. The only way it can do so again is if we let the parent take their hand off the handlebars so we can pedal, steer and balance all on our own. If investors panic too much then the fear of falling off will drive us to the ground again. We just need faith we can guide ourselves with the distant knowledge that the Central Banks have powers to help if we really need it again.
In the words of Bruce Wayne's father in Batman Begins - "why do we fall, so we can learn to pick ourselves up". Yes the global economy and financial markets have had quite a fall, but the central banks have acted to help to pick ourselves up again. It will soon be time for them to let go of that helping hand, and investors must show the faith and belief that they can pick themselves up on their own and be stronger for it. Otherwise I fear we face an inescapable cycle of a lifetime of support.
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