Nobody cares about risk these days.
Nobody, it seems, except the Bank for International Settlements (BIS) – often known as the central bankers’ central bank.
BIS head Jaime Caruana, told the Telegraph this week that the financial system is “in many ways more fragile” than it was before the credit crunch.
The BIS was among the few institutions that actually managed to see the last crisis coming. And just as has happened this time, just about everyone else dismissed them as a bunch of doom-mongering miserable Swiss bankers.
So is history set to repeat itself? And what can you do about it?
Central bank policy hasn’t moved on from Alan Greenspan
There is lots of debate over the BIS’s view of the world out there on the internet. And if you enjoy going down the rabbit hole of macroeconomics and watching academics try to out-smug each other on blogs, then feel free to seek it out.
But I’d rather have a think about what it all means for investors.
Let’s start with one thing that the BIS has got absolutely right. Central banks are a major driver of our current problems.
As Caruana puts it: “[central bank] policy does not lean against the booms, but eases aggressively and persistently during busts”. As a result, you have a system that is biased towards taking on more risk and more debt. And in turn, that leaves the whole system more and more vulnerable.
It makes a lot of sense. As Hyman Minsky noted, stability breeds instability. If the central bank is promising to underwrite everything, then people will take more risks. That’s just logical.
If the Federal Reserve and its fellow central banks are effectively socialising risk, then you would be mad not to take lots of it. Because you get to keep the upside, while society gets lumped with the downside.
And the more risk that people take, the more vulnerable the system becomes, and the harder it is for the Fed and co to step back.
This is exactly what we always used to criticise Alan Greenspan for. The stability he created was the result of Wall Street believing that he would always bail them out – the ‘Greenspan put’. Now we have the same thing, only to an even greater extent.
You don’t have to go very far to find evidence of investors taking on silly amounts of risk for questionable levels of return. In the corporate bond market, there are more ‘covenant-lite’ loans being written than ever before.
These are loans that offer the lenders less protection than traditional bonds – they don’t have the same rights to step in if the borrower’s finances start to look a bit shaky.
Not only that, but the quality of the borrowers is falling too. You used to have to be at least ‘BB’ credit rated to get one of these loans. Now the majority are being issued by ‘single B’ rated companies, according to credit rating agency S&P.
Meanwhile, countries in sub-Saharan Africa are racing to the bond market – securing money at less than 7% a year.
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And it’s not just the bond market. On a reasonably reliable measure like the cyclically-adjusted price/earnings ratio (Cape), the US stock market is more expensive than at any time apart from during other historical bubbles.
Every day you see a new attempt to debunk the Cape, or to argue that US stocks aren’t expensive on some other metric. But this is the logic of the herd: “Stocks are going up. Therefore they can’t be overpriced.”
And investors have been well-trained by central banks to ‘buy the dips’. You need only look at the Espirito Santo story. The biggest bank in Portugal looked in danger of going under last week. We still don’t have that much clarity on the topic.
But what did the markets make of it? It was a one-day buying opportunity. Stocks briefly dipped, then everyone piled in over the next few days.
What can pop this bubble?
So how does this end? As I’ve noted before, this boils down to investors having too much faith in central banks. And the main thing that would derail that faith is inflation.
That’s because inflation could force central banks to stop being so supportive, and to raise interest rates.
However, it’s very, very clear that Janet Yellen does not want to raise rates before she absolutely has to. What I find particularly interesting is her insistence that we should be focusing on wage inflation rather than consumer price inflation when it comes to the timing of interest rate hikes.
If we go back to the olden days – back before the financial crisis kicked off – people used to talk about the ‘lag’ in monetary policy being anything from a year to 18 months. So if you cut or raised interest rates today, you wouldn’t see the full impact for at least another year.
That meant the central bank had to be ‘ahead of the curve’ – it needed to get its rate hikes in before the economy perked up too much. Otherwise you’d be playing catch up, and inflation would get out of control.
That meant that you had to keep your eye on the economic data for signs that things were getting better. And in the scheme of things, the likes of wage inflation and employment were deemed lagging indicators. That’s because companies don’t take on more staff until they need to – so by the time they’re hiring more people, the economy is already well on its way to recovery.
So in effect, what Yellen is saying, is that the Fed will deliberately be staying ‘behind the curve’. It wants to make sure the recovery is well entrenched before it does anything to scupper that. And if that means the Fed tolerating higher inflation than it normally would, then so be it.
We’ll be looking at what to do about this (and at the few assets that remain cheap) in more detail in MoneyWeek magazine later this month (get a three-week free trial here if you’re not already a subscriber).
But in the meantime, it’s always worth remembering that cash is an option when most other things are overvalued.
Yes, cash means taking a loss in ‘real’ terms after inflation. But you’re not holding it for that – you’re holding it because it gives you the option to invest at a more opportune moment in the future. And it is worth remembering that returns on cash will generally rise with interest rates – not something you can say for many assets.
I’m not saying for a minute that you should turn your whole portfolio to 100% cash. But I do think it might be a good time to take stock of your asset allocation and consider rebalancing, or increasing your allocation to cash. For more on how asset allocation works and how to build a diversified portfolio, you should take a look at my colleague Phil Oakley’s Lifetime Wealth newsletter.
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On this day in history
The discovery of the Rosetta Stone in 1799, and its subsequent decryption, revealed the secrets of the pharaohs hidden in the hieroglyphic script.