Some cities around the globe can offer a unique experience when it comes to dining out called “Dinner in the dark”. This is basically having dinner in a pitch black room which completely deprives you of using what is probably the most important sense, namely sight.
Whatever their initial intention, confusion and stress, clumsiness and at times acting by instinct are always some of the feelings that participants have in various degrees. This is the perfect comparison for the situation which financial market investors are in.
Over time financial markets have been treated as the barometer of economic changes.
For a long time sovereign bond markets have mirrored inflationary expectations. The deeper the gap between long-term and short-term yields, the stronger the fears of higher inflation. Similarly, an inverted yield curve may have signaled concerns about a possible recession.
// The broken barometer
Whatever the case, though, the golden rule was that, exceptional circumstances aside, investors are bound to look for yields that exceed inflation and reflect the issuer’s risk profile: higher risks meant higher returns.
Similarly, capital markets provided clues as to where the economy was headed, based on microeconomics. As an economy is made up of a multitude of puzzle pieces represented by businesses, changes to their financial variables would invariably translate into an adjusted outlook for the entire economy. Corporate financial results were among the first to indicate the possibility of recession or economic recovery.
Moreover, the two main financial markets presented the extremely useful benefit of diversification, as stock prices and good-quality bond prices moved in opposite directions. Negative economic outlooks were dealt with by investors reallocating assets, from high to low risks. In other words, the share of bonds in the portfolio was rising to the detriment of shares, a process reversed during good economic times.
// The printer and its victims
We are now in a completely new paradigm, where the barometer role of financial markets was shattered by central banks’ policy of unrestricted money printing.
It all started against the backdrop of the 2008 financial crisis. Terrified by the prospect of an economic crash in the aftermath of a perfect storm formed by overlapping economic and financial crises, central banks put all biases aside. They closed the economics textbooks and went on to buy their own governments’ debt by creating money, metaphorically called “money printing”.
The approach was meant to rescue the financial system by preventing a total freeze, but also to restart the economy by bringing interest rates back to lower levels, i.e. by promoting a cheap money policy. The initial purpose was met, but soon enough the side effects started to emerge.
The collapse in interest rates has led to the unprecedented situation where a unit of currency today has the same value as a unit of currency in one or five years’ time. Money collected five or ten years later has the same value as money collected today …
At the same time, the inverse correlation between bonds and shares was wiped out. The two markets ended up moving in the same direction as a market flush with cash has prompted investors to buy piles of shares out of a simple wish to put their money somewhere. Thus, the historical advantage of diversification was gone.
That pushed financial markets into more unstable territory fuelled by all classes of assets moving in the same direction. That, in turn, increased investment portfolio volatility. Bonds were no longer an effective hedge against assets. More volatile, therefore riskier, portfolios, increased investor anxiety and their reliance on central bank money injections. During the 2008 crisis and afterwards, any news relating to stopping “quantitative easing” was followed by stock market drops.
Financial markets went into withdrawal as they became addicted on valueless money. That in turn, had central banks trapped in their own unorthodox practices. Afraid of a possible stock market collapse, they reshaped their monetary policies based on investor expectations to their satisfaction. The policy of valueless money went on for years.
// Social polarization – or who gets the freshly printed money
But it did not benefit everyone. This takes us to the next side effect of quantitative easing: the financial polarization of the population.
The money that central banks printed did not reach everyone, only a small minority of people holding economic and financial assets. As a result, the cash pumped into the markets failed to translate into a large-scale increase in consumption, as a lack of inflationary pressure stands proof. It was found in inflated financial assets and real estate. This is why it only profited a minority who saw their wealth grow even more compared to the rest of the population. Indeed, polarization only extended globally after the crisis.
The bad news is that waking up from the valueless money stupor will not happen any time soon.
The pandemic has pushed central banks to new heights of despair for fear of a sudden economic crash caused by the intentional economic shutdown triggered by measures to protect the general public. The interventions after the 2008 crisis pale in comparison with the amount of money created on this occasion.
3.7 trillion USD was created in 2020 alone to finance public debt.
//Central banks – the elephant in the market economy’s china shop
Clearly, unlike 2008, the need to finance government debt in affected countries takes center stage in 2020. Central banks seem willing to go along with this king of limitless funding of government spending which makes them a party to political decisions, for what is probably an unacceptably long period of time. The separation between politics and monetary policy seems to be vanishing into thin air, a fact that is eroding central banks’ independent decision-making.
As The Economist noted “… today interest rates, so close to zero, seem impotent and the monarchs who run the world’s central banks are becoming rather like servants working as the government’s debt-management arm”.
National interests are mistaken for political interests which lead to monetary policies which may either be borderline populist or fuel populism.
Central banks are supplying money that governments decide who receives it and who does not, which industries are rescued or subsidized although they have no future, which employees continue to stay home on printed money and which are left without income.
Valueless money is, in fact, creating a huge moral hazard. Once money is free, everyone feels entitled to get it. The prospect of going under due to poor cash allocation by the government or private sector is gone because, isn’t it, more money will be printed to replace it. In the meantime, the return received by investors for high-risk investments no longer matches their risks.
At the same time, the massive presence of central banks on the sovereign and corporate bond market turns them into “mammoth marketmakers”, as The Economist dubs them and, I may add, any elephant in a china shop will eventually smash up everything around: the advantage of asset class diversification, interest rate and asset price signals, the risk/return correlation, and finally any other “lights” to plunge financial markets into complete darkness.
Confused and without decades-old benchmarks, they are left with only one choice: go with the herd. Mob mentality pushes the prices of all assets up and leads to the absurd situation where bond and gold prices go up at the same time. Inflation cannot simultaneously go up and down ….
// Socialism for the rich and powerful
At the end of the day, the big issue is that economies are losing their creative destruction ability manifest during times of recession. It is a process of economic renewal whereby unprofitable businesses go under and those which correctly identify opportunities thrive.
For fear of economic cycles, zero cost money end up artificially keeping alive companies that should no longer exist. This is bound to thwart capital allocation and we are heading towards a new type of socialism.
Ruchir Sharma, Chief Global Strategist at Morgan Stanley Investment Management, declared in Wall Street Journal: “The rising culture of government dependence is, in fact, a form of socialism—for the rich and powerful”.
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