Central banks are in charge of the markets. So investors should relax.
That’s the message from an interesting column in the FT this morning.
Christophe Donay of Pictet Wealth Management argues that equities are overvalued. But he also argues that with central banks underpinning asset prices, this is not likely to change soon.
In short, even although markets are objectively expensive, investors should stop worrying, and learn to love central bankers.
This myth of central bank omnipotence is going to get us into real trouble one day.
Here’s the new version of the Greenspan put
Stock markets are overvalued, notes asset manager Pictet in the FT this morning. And that’s deliberate.
Central banks – stuck with interest rates at near-0% – have targeted asset prices. Pushing up equity prices encourages the ‘wealth effect’ (people feel richer, and more confident, and so spend more). And pushing up bond prices drives down both long and short-term interest rates. That makes it cheaper to borrow money and thus increases demand too.
Obviously, central banks haven’t spelled this out. It’s not a formal part of their remit. But in practice, it’s the way they’ve conducted monetary policy since the financial crisis.
Of course, the difference between asset price targeting and inflation targeting is that with inflation targeting, you generally have to keep inflation within a band around a central target. In other words, there’s a ceiling level as well as a floor. So the Bank of England tries to keep inflation between 1% and 3%, for example.
However, as Pictet points out, by using quantitative easing, central banks have put a floor on asset prices, but not a ceiling. This is ‘asymmetric asset price targeting’. Or what the rest of us would call the old ‘Greenspan put’ – whereby Wall Street always knew that former Federal Reserve boss Alan Greenspan would cut interest rates any time the market was in trouble.
Pictet argues that this should be very comforting for investors. As long as economic growth remains lukewarm, central banks will keep supporting the markets, and any move in interest rates will be slow and steady.
It’s all good, in other words.
The one thing central banks haven’t learned to do
There’s a problem though. Central banks are experts at blowing up bubbles, no doubt about it. The tech bubble is merely one example. And they’ve proved to be pretty good at inflating new bubbles to compensate for old ones bursting. The US property bubble was spawned from the tech bubble’s wreckage.
But there’s one thing they haven’t figured out yet. They can’t stop bubbles from popping. Once investors lose faith, they’ll rush to sell.
And there are signs that confidence is rattled out there. Apparently investment grade bond yields and equity volatility “have moved further apart than at any time since March 2008”, reports Bank of America Merrill Lynch.
What’s the problem? Credit spreads – the gap between the interest rate paid by low-risk US Treasury bonds and the rates being paid by solid companies – have moved up. In other words, bond investors are feeling jittery. Meanwhile, equity volatility is low, suggesting that equity investors are feeling calm.
The gap between the two hasn’t been this wide since March 2008. If you’ll remember, that was around about the time that anyone with any sort of foresight was getting very worried about the state of the US housing market. Not to mention the fact that a British bank (Northern Rock) and an entire country (Iceland) had gone bust.
As Hans Mikkelsen of BoA puts it: “Somebody has to be wrong here.”
Now, the bond market has become somewhat unhinged in recent years. But history and reputation suggest that bond markets tend to be the ‘smart’ money, who have some idea of what’s coming down the line. Equity markets, meanwhile, tend to be the last to wake up.
The optimists argue that there are lots of sensible reasons – other than fear – for bond yields to have risen. Companies have been keen to lock in low borrowing costs before the Federal Reserve raises interest rates (assuming it does). That means more supply has hit the market. Also, the woes of energy companies – which have been hammered by the falling oil price – specifically have driven yields up.
Trouble is, none of that should be particularly comforting. If companies believe that this is the last bite of the cherry before cheap funding dries up, then that’s not good news.
As the FT notes, “nearly half of the near-$500bn in US investment-grade corporate bonds issued this year has been used to fund mergers and acquisitions, share buybacks or dividends”.
Lose that, says Kris Kowal at DuPont Capital Management, and “you’re going to lose the big buyer in the equity market”.
In short, when and if bonds blow up, so will everything else. And who knows what steps central banks might take to deal with the fallout from that bubble? We might see even more radical action.
My colleague Tim Price has plenty of views and ideas on what those might be – you can find out more, by signing up for Capital & Conflict, our new free daily email.