Stanley Druckenmiller is one of the greatest investors/traders of the last 40 or so years. He managed money for George Soros from 1988 to 2000, and was instrumental in the trade that broke the Bank of England (they reputedly made $1 billion in 1992 when the UK left the Exchange Rate Mechanism in place in Europe at that time). He has been interviewed a number of times, and when discussing his investing style, he is clear that one of the most important macro factors to understand is the behaviour of central banks. Simply put, when central banks are easing monetary policy, financial assets tend to rise in value, and when they tighten policy, financial markets tend to struggle, perhaps suffering a bear market.
We too try and understand what actions central banks are going to take, and how they may affect financial markets. We have to say that what central banks say and do seem to be different in the post GFC period, and what they should be doing (in our opinion) and what they end up doing can be completely different. We have had to contend with what UK politician Pat McFadden termed “unreliable boyfriend[s]”.
Back in June 2014, after a string of opposing signals about potential rate rises from the bank of England, Mr McFadden likened the Bank of England’s behaviour to that of an unreliable boyfriend. At the time, Bank governor mark Carney was discussing a potential rate rise, and although the timing would be fluid, it would be “driven by the data”. Over three years’ worth of data later (and another round of QE and a rate cut a year ago), the Bank is again teeing up a rate rise. Should we take this as a reliable signal that the bank has finally shifted to a path of tightening monetary policy? We guess we are still data dependent; we are just not sure whether it’s economic data or financial market data.
When we take a step back, first we have to admit that we are surprised at how calmly financial markets have been as the Fed have been tightening policy, and promising to do more. And yet we continue to believe that global stimulus will be increasingly removed in the quarters ahead, and that at some point, this will have profound effects on both the economy and the financial markets. Not only have we had rate rises from the likes of the US Fed and the Bank of Canada and now possibly the Bank of England, but the amount of global QE will be reduced significantly in the months ahead. The chart below (courtesy of Citi) shows the level of QE from the major central banks. As can be seen, monthly QE is already on the decline, and is predicted to fall to a monthly total of basically zero towards the end of 2018.
Chart 1 – Monthly QE totals from major developed country central banks
As the Fed tapered their QE in 2014, the ECB took up the reins so that global QE, having dropped from around $150 per month in 2013 to half that level in early 2015, increased back to about $150 billion per month. And after a couple of China related wobbles in August 2015 and January 2016, it seems clear now that $150 billion per month of global QE, combined with very low interest rates (even negative in Europe and Japan) and heavy stimulus from China, is enough to reinvigorate global equities (and other risk assets), as seen in chart 2.
Chart 2 – Global equities and the combined balance sheet of the Fed, ECB and Bank of Japan
So, with the rate of monthly global QE already slowing, and heading towards zero in the months ahead; and with China likely to reduce stimulus after next month’s 19th Congress, can we really expect global equities to continue their march higher? We should expect markets to face some headwinds, whilst at the same time recognise that volatility is likely to increase in this environment.
Now, at this point, we think it makes sense to consider the interchange between central bank policies and economic theory; in particular, accounting identities. With central banks printing so much new money, there appears to have been a huge surplus in global savings in recent years, and with most QE being used to fund government deficits, excess savings has to go somewhere. A good portion goes into funding increased corporate bond issuance; some even used to buy equities directly (Bank of Japan and Swiss National Bank)but in a world where there is no more QE, we fall back onto accounting identities, i.e. the government deficits have to be funded by a combination of domestic private savings and overseas savings via the current account;
Government Deficit = household savings + business savings + capital inflows
So, not only will government deficits have to be financed by the private sector in a world of no QE, we have to suspect that government deficits will only increase. We know that Trump wants to spend more on the military and try and pass some tax cuts (most likely unfunded), we know that the UK Government is on the verge of awarding greater pay increases to public sector workers, we know that Japan has a supplemental budget on average once a year to try and boost their economy, and we shouldn’t expect European governments (excluding Germany) to suddenly become fiscal conservatives.
So, within the next 12 to 18 months, we will have to change from a world flush with liquidity financing virtually anything that moves, to a world where the private sector is being asked to finance increasing government deficits with no help from the central banks. Also, on a global scale, all capital flows (current accounts) total zero, and so we have global government deficits needing to be funded by private sector savings, which is basically the household sector and non-financial businesses.
Now, we’re not trying to make any assessment of whether it makes sense for certain Governments to increase spending or not. We are simply pointing out that after years of heavy lifting by the central banks, many economists are arguing that fiscal spending has to increase to support the global recovery, and it appears that politicians are very open to this idea. And this is occurring at a time when the financing of said government deficits will pass from central banks to the private sector.
This leads to a couple of extra thoughts for the US economy. First, US non-financial corporate debt has increased significantly in recent years, as seen in chart three. As noted above, with QE financing government deficits, surplus savings had to go somewhere, and a good portion went into corporate coffers via increased debt outstanding. We think it is likely that the growth in corporate debt has to slow down, and their savings increase.
Chart 3 – US non-financial corporate debt as a percent of GDP
Second, given the historical fact that Government spending has an extremely low multiplier, especially in the later stages of an economic cycle, the accounting identity GDP = Consumption + Investment +Government + (Exports – Imports) has to be kept in mind. Taking savings away from the private sector to finance any increased Government spending (with said low multiplier) is not really going to help the economy.
Jumping back to the UK, one fact that has been widely noted is the collapse in the household savings rate, the flip side of which is higher consumption which has helped the economy perform better than expected in recent quarters. If the UK Government is about to relax the fiscal noose they have been operating with, then unless businesses start saving more (i.e. even less investment – which remains low by historical standards) or the current account deficit increases from an already large deficit (which is not sustainable), then households will have to save more, resulting in less consumption (and we also assume that new Government spending has a very low or even negative multiplier).
Chart 4 – UK Household Savings Ratio
We would just make one more point here before trying to wrap up. As noted above, from an economic point of view, QE simply creates a surplus of savings. We believe that this surplus has led to a significant misallocation of capital – a combination of share buybacks at very expensive equity prices, M&A at expensive equity prices and allowing zombie companies to remain alive for far longer than they would have otherwise.
So, as QE winds down in the next year or so, so the surplus of savings will disappear (we’re being very simplistic here to make the point). If we assume that the household sector does not shoulder alone the increased burden of financing growing government deficits, and that companies also have to save more, then share buybacks and M&A will have to slow down, and perhaps corporate bankruptcies will increase as well.
Furthermore, a world of growing government deficits and no QE (i.e. no or much reduced surplus savings) will surely co-exist with higher bond yields. As seen above, companies are more indebted than they have ever been, as are Governments. So long as central banks kept rates pinned at zero, then the cost of financing this massive debt load was relatively low. However, as rates rise, these debt burdens may actually become a problem. And although higher yields benefit creditors over debtors, rising delinquencies can become a problem very quickly. It is actually interesting to see how even for the household sector when debt to income ratios have fallen post GFC, interest costs are fast approaching the previous high after such a modest removal of monetary policy accommodation. Assuming bond yields do rise as we think possible, then the financing burden for both companies and Governments could deteriorate quite quickly.
Chart 5 – US Personal Interest Payments and Fed Funds rate
Although nobody can predict the future, we can analyse where we are today. To name just a few issues;
- We have a mature economic recovery that has benefited from the surplus savings created by global QE.
- During the recovery, corporate and government debt burdens have increased significantly and zombie companies have been kept alive.
- The surplus savings have financed record share buybacks and M&A activity.
- Financial markets have been huge beneficiaries of central bank policies.
- Low interest rates have kept debt service costs low and therefore arguably also helped keep delinquencies low.
- UK and US household savings ratios are at or near record low levels, also helping to lengthen the current economic cycle.
Central banks are now removing monetary stimulus, both QE and rates. We can debate what may happen during this process, but the simple fact is that we have no historical guide to help us know what happens when central banks stop printing money. It is simply another part of the grand monetary experiment that central banks have been conducting since the GFC. We suspect that surplus savings will decline, bond yields will rise and accounting identities will become more visible and understandable again. At the same time, both households and businesses will have to save more to finance greater government deficits, probably at the expense of consumption and investment.
For financial markets, a world of no QE, rising interest rates and growing government deficits will likely lead to both higher volatility and at a minimum headwinds to capital gains, if not a bear market. Surely, companies will have less free cash flow for financing share buybacks and M&A, and it is a fact that on net, companies have been the only source of demand for equities in the post GFC period.
So this brings us back to the reliable boyfriends analogy. With central banks setting the ground work for ending QE on a global basis within the next year or so, and raising interest rates, do we take them at face value, and prepare for a very different world from the one we have inhabited for the last few years? A world in which volatility is higher and price declines a reality, including bear markets as defined by 20%+ declines. Or do we assume that central banks will reverse course at any hint of trouble and keep printing money and keep rates low, and in some cases negative?
If you expect central bankers to stick to the normalisation path and be reliable to their current words, then you have probably already taken action in reducing risk in portfolios and increasing diversification into uncorrelated, liquid assets. For those that expect central bankers to remain unreliable and change course at the first sign of trouble, then why bother trying to add value through market timing? The last few years have proven that this is simply a waste of time when central banks are running out of control.
From we stand, we maintain the big picture view that central bankers will continue to normalise policy until something breaks, either the economy, the financial markets or both. The timing of such a break remains as elusive as ever, however, we think it has to happen within the next year or so assuming QE ends in this time period and interest rates keep rising. We also think that the break could be a lot more violent for financial markets than the vast majority imagine, which if correct, means that portfolios have to be positioned ahead of this as trying to make such changes in a period of falling prices and increased volatility will be much harder in practice than anyone can imagine.
Finally, there were no changes to our trade idea portfolio this week. We will update this next week.
Stewart Richardson
RMG Wealth Management
