16 Oct What central bankers can learn from the humble Reliant Robin
After a brief excursion into US politics in the last bulletin, this edition sees a return to the issue perhaps uppermost in investors’ minds, and that is the prognosis for financial markets. But before we get to that, it is worth a reminder of what we are witnessing on the economic front as there can be no escaping the importance of this in shaping asset performance.
After a cliff-edge collapse in economic performance in quarter 2, hopes were that the following quarter (July to Sept) would see a sharp rebound. Whilst the early part of quarter 3 did look promising, the impact of a COVID second-wave, has checked this recovery in almost all economies bar, rather ironically, China. There can be no denying that the rate of recovery in most developed economies is stalling and tighter restrictions, or even ‘circuit-breaker’ lock-downs will only serve to slow things further.
Equity markets have historically been driven by the economy. Very crudely, what I mean by this is that a strong economy will feed into generally more positive company results and ultimately that will fuel share price expansion. So if economic recovery is stalling, we should naturally expect stock prices to reflect this, or at least that is the received wisdom. The reality is that markets tend to anticipate what is going to happen on the economic front months, or even years, in advance. The adage used in markets is ‘it is often better to travel than arrive’, or in essence by the time the economy returns to normal, stock prices will already have rerated.
This helps to explain why in the UK, when economic performance was at its worst, the FTSE-100 posted a gain of almost 9% during quarter 2. The following quarter saw share prices slip back by 5% as the realisation set in, that this is going to be a long slog back to economic normality. Given this prognosis, what has perhaps been more surprising is the relative calmness of markets during this time. In several of our earlier publications we talked about a period of stability for markets before recovery could truly take hold. Looking at the FTSE-100 again, 6000 is a key psychological level but over the whole of the quarter (July-Sept), there was no break-out of more than 5% from this level. In other words, the UK market has traded within a tight range. The US market has performed better than the UK, but here again volatility has subsided. This should be seen as encouraging by investors.
Central banks around the world have been in an accommodative mood, pumping the system with liquidity to safeguard jobs, prop up industries, save companies and hopefully stimulate economic activity. This is welcome and necessary but expanding the financial base so rapidly has two inevitable consequences – indebtedness and inflation. As we entered the COVID crisis, the world was already awash with debt, and this is hardly surprising given low interest rates. But the debt burden has now shifted from corporations to central governments. The enormous debt mountain has consequences for bond markets.
Bonds are effectively loans to government or corporations. Investors lend money to these institutions and in return the borrower ‘guarantees’ to repay the loan at a certain price, at a pre-determined time. Once purchased the yield (the return investors can achieve) is fixed and because of this increased certainty, bonds are used around the world as lower risk investments. The problem is that the yield on UK government debt has collapsed over the past decade. Taking the 10 year benchmark gilt in the UK, in November 2010 the yield was 3.2% compared to the current 0.18%. The key driver for this has been virtually zero inflation and lower interest rates.
Over the past decade or so, most of us have got used to very low inflation and more recently in several parts of the world, deflation. Central banks hope that expanding money supply not only lifts the economy, but creates some inflation. This is because in the same way higher inflation works against savers, it actually helps in the case of debt i.e. inflation reduces the debt in real, or inflation-adjusted, terms. So what is the connection to the Reliant Robin?
For those not of an automotive mindset, the Reliant car company which was founded in the 1930s, used to build 3-wheeler cars which became the butt of many a joke. One, was that owners were positively delighted to pick up speeding tickets as this proved their Reliant could, against all expectations, actually exceed the speed limit. The parallel with central bankers is that both the Federal Reserve and the Bank of England have said they will happily allow their respective economies to run hot and allow inflation to exceed the 2% level on a prolonged basis. This is easier said than done and is a far cry from where we are now, a bit like the Reliant driver pressing the accelerator in the hope of hitting 100mph.
But joking aside, we believe the stimulus measures will eventually have a positive impact on the economy, though this will clearly take some time. Aligned to this we are also of the opinion that we are set to see an eventual shift to higher levels of inflation than we have been used to, though not the sort of hyper-inflation we saw in the 1970s. This is important because just as inflation can hit savers, it can deal a double blow to bond-holders. Since their return is fixed at the time they buy, any build-up in inflation merely bites into this, but more importantly, they get punished again when interest rates start to rise. Bonds have unquestionably been kind to investors during low inflation and interest rates, but things could go wildly into reverse once this era comes to an end.
At CDC we have been underweight in bonds for some time now, but the response to the COVID crisis by the central banks makes us even more convinced this is the right strategy for investors. The bond market is however a broad church so we are keen to make sure any bond exposure we do have is positioned correctly. Interestingly, whilst the word ‘inflation’ might be enough to send shivers down the spines of savers, it might be comforting to know that stock markets have historically proven to be excellent at insulating them, so this is an area where we remain overweight.
In the longer term, it’s hard to avoid the feeling that this is a pivotal moment, possibly one that ends decades of almost non-existent inflation. Monetary policy during this time has largely worked, but the economy has now moved on to a point where central banks need to promise not to raise rates, even if this means we have to all get used to living with some inflation for a while.
Dr Andrew Mann