Friday, March 25, 2016

Quantitative Easing and High Asset Prices

As you are aware, since the global financial crisis, central banks around the work have embarked on an unprecedented amount of monetary easing. During the crisis, a shortage of liquidity in the financial system caused central banks to step in with monetary stimulus to provide liquidity and restart the financial system.

The global economic shortly fell into a severe recession, which was followed by increased monetary stimulus to try to increase nominal growth. Political gridlock surrounding fiscal stimulus and structural reform has made it extremely difficult to ease economic conditions on that front. This became part of the reason for continued and increased monetary stimulus.

Monetary policy was aimed at lowering interest rates, ideally below the rate of inflation/nominal growth, (ex. 10Y German/Japanese Gov. Debt) which increases asset prices (ex. S&P 500) and pushes investors into riskier assets. By elevating asset prices, the idea was that, it will repair overly-indebted balance sheets and force investors to consume or invest in the real economy.

Interestingly, while asset prices have continued to rise, economic activity has failed to match its pace. There's probably a lag between monetary stimulus and real "main street" economic activity. After 7 or so years, you have to wonder whether things are working and when activity will truly pick up.

I also wonder, whether there are negative aspects to the distorting effect of elevated asset prices. One potential pitfall may be the creation of asset bubbles. There's already plenty of talk of extreme housing prices in many parts of the world including Hong Kong, Sweden, Canada, Australia, etc. Would a negative feedback loop also exist? For example, as expected returns from assets become lower (due to the elevated prices), people may try to save even more in order to have enough for their retirements. Secondly, stimulus works to generate demand, but it may also have a supply-side effect. Lower rates may stimulate more output and capacity than demand.

Another question is whether central banks can continue easing. In a recent G20 speech, Mark Carney, Governor of the Bank of England made a few points that I'm would like to emphasize here:

"However, the effect of QE on the wealth channel cannot last forever. Monetary neutrality means real asset prices are not boosted indefinitely by such policies; their economic effects must ultimately unwind."

"Said differently, unless an improvement in fundamentals boosts the underlying cash flows of these assets, real valuations will fall back. That structural policies have not boosted real growth sufficiently is a better justification for the re-pricing in risk markets than any loss of confidence in the power of central banks."

This puts the investor in a tough spot. Some central banks have hinted that they will support asset prices until economic fundamentals pick up and start to reflect the elevated asset prices. Yet, if fundamentals remain weak over extended periods, the market may adjust downward regardless of central bank support.

You have to make the choice of either:
1) Purchasing expensive financial assets due to explicit central bank support, but face the risk of central banks withdrawing support, or real growth failing to pick up.
2) Not purchasing expensive financial assets, but face the risk of continued asset price appreciation and miss out on a potential recovery. And also, potentially unfavourable movements in inflation or currency as monetary policy flows through these other channels.

Not sure, what the best choice is. This post really raises more questions than answers.