Marginalia are brief notes written in the margin of a book or article. John Vandenbrink, Deputy Dean of GLOBIS University, will share his notes on topics that have caught his attention in his readings on finance, business, and economics.
I follow the financial press, trying to be an informed saver and investor, but today there is no clear path. Not for me as a dollar-investing American, nor as a yen-investing resident of Japan. Savers and investors in many of the large advanced economies of the world today face the same situation. Like me, they don't really know what to do.
Moreover, many of them don't appreciate how fundamentally uncertain their predicament is. The world's major economies are in precarious situations and central bankers have exhausted their traditional tools. They rely on new, unconventional policies, which may generate unanticipated consequences.
We all need to place some of our resources in safe assets, like bank deposits, government bills, or money market funds. Today, however, safe assets offer nominal returns near zero and real returns near zero or negative. For example, the nominal rate of return of my dollar savings account at a US credit union is 0.05%, but dollar inflation is running about 1% so my expected real rate of return is negative. The nominal interest rate on my yen bank account is even less at 0.01%, but the likelihood of minor deflation in Japan keeps my expected real return positive, though still almost nothing.
Uncompensated for risk
Most of us also want to invest some of our resources in assets with higher returns, likes stocks and corporate bonds, even though this entails risk. Today, however, because returns on safe assets are extremely low, many investors who would normally prefer safe assets have moved their funds to risk assets to secure at least some level of return. This demand for risk assets has pushed up their prices to the point that expected returns often no longer compensate investors adequately for the risks they bear. The press is full of reports of investors moving into risky assets like junk bonds and even sub-prime mortgages.
Edward Chancellor of GMO, a respected asset management firm, writes in the Financial Times about this phenomenon in the US equities market:
The S&P 500 is currently very overvalued. GMO models suggest that over the next seven years the real return from US stocks will be close to zero.
Like all market predictions, this ought to be taken with a grain of salt; but consider a real return of zero in light of the very long-term record for US common stocks. From 1900 to 2006 their average risk premium—the excess annual return of stocks over Treasury bills—was 7.6%. With three-month Treasuries returning .07% today, that suggests 7.7% would be a reasonable expected return on risk for S&P 500 stocks. But at today's equity prices, that return appears unavailable.
Traditional monetary policies exhausted
What created this extraordinary financial situation? A global financial crisis in 2007–2008 dried up lending, prompting the US Federal Reserve, the Bank of England, the Bank of Japan and other central banks to flood their markets with liquidity. Their actions almost certainly prevented a major global depression. However, to restore credit markets, they had to cut policy rates to near zero. (For very different reasons, Japan had cut to very low rates many years before, in 1999.) This robbed central bankers of their most powerful monetary tool for stimulating economic demand and growth—and this was precisely the task they faced as recession sharply set in. The Fed moved its target range for the federal funds rate to 0.0% to 0.25% in December 2008 and has kept it there since. In March 2009 the Bank of England dropped its rate paid on commercial bank reserves to 0.5%, where it remains today. Other major central banks followed different timings but also cut to very low levels and have kept them very low.
Central bankers then turned to what they call "nontraditional monetary policy tools." The most important is large-scale purchases of certain assets—government bills and bonds, government agency securities, and sometimes other market securities—in order to push up prices across a range of assets, to lower costs of borrowing and investing, and thereby to stimulate economic activity. Another nontraditional tool is purchasing long-term government bonds while selling short-term government bonds in order specifically to push down long-term rates, which supports real long-term projects and the housing market, in particular. Yet another new tool, at least at the Fed, has been clearer forward guidance on rates, to reduce investor uncertainty and to talk down mid-term and long-term interest rates.
Nontraditional monetary policies uncertain
Fed Chairman Ben Bernanke, in his speech in August to fellow central bankers in Jackson Hole, Wyoming, argued that nontraditional tools have clearly been effective and that without them, "the 2007–2009 recession would have been deeper and the current recovery would have been slower than has actually occurred." True thus far, perhaps, but we have yet to see their outcomes through even one business cycle.
One huge danger created by nontraditional policy is reaching for yield by unsophisticated or imprudent investors. What will become of the frustrated savers who, seduced by the favored investment theme of late, move all their resources into "good companies paying solid dividends"—if stock prices fall and remain low for years? What will happen to the pension fund assets whose manager, under pressure to perform, stretches into emerging markets or commodities—if those sectors then tank? Today's choices for savers and investors could push them into huge losses, with great social costs.
In his speech, Bernanke addressed the problem of reaching for yield in terms of its threat to financial stability. He then dismissed it, saying the Fed has expanded monitoring and finds nothing amiss. I didn't find that paragraph reassuring. The values of large-scale asset purchases on the balance sheets of the Fed and other major central banks have grown enormously—wholly out of proportion to historical experience—and the impact on asset prices has been great. With safe assets returning virtually zero, reaching for risky assets has become one of the hallmarks of today's markets. Credit spreads are compressed. Investors are systematically undercompensated for risk. This reaching for yield could in any number of ways quickly lead to financial instability. After the next major market move, who will need to be rescued? Insurers? Corporate pension funds? And the target asset of choice? Commodities? Emerging market stocks? Energy? We can't predict, but the ground is fertile.
On the flip side of reaching for yield, what will become of the retirees who bought fixed annuities in today's ultra-low yield environment—if inflation returns and persists? Different monetary policies favor different categories of people. Currently, savers and people on fixed incomes are the clear losers. The winners are the already wealthy, who see their risk assets pumped up in value; professionals expert in the use of leverage, such as managers of private equity funds and hedge funds; and anyone with a business in need of financing, whether the business itself is viable or zombie.
Today, our monetary and fiscal circumstances are riddled with extremes. To illustrate, here is a list of examples, borrowed mostly from Deutsche Bank analyst Jim Reid:
• In June the Netherlands' 10-year government bond yield fell to 1.5%, its lowest level since 1517
• In July the 10-year US Treasury bond yield touched 1.39%, its lowest level since 1790
• The Bank of England's reserve rate of 0.5%, which I cited above, is a full 1.5% below its previous low, going back to the bank's inception in 1694
• Central bank policy rates have never been so low in so many countries for so long
• The balance sheets of many major central bank are at record high levels relative to GDP, and increases appear likely
• US budget deficit relative to GDP is at its highest level ever in peacetime
• Japan's tax revenues cover less than half of government expenditures, with most of the balance financed by new government debt
Our circumstances today may not feel like a crisis, but fiscally and monetarily they are at the outer bounds of experience. Enduring solutions now require fiscal policies; but politicians in the United States, Japan, and other advanced economies are entangled in domestic logjams, unwilling or unable to address obvious, looming issues. Central bankers have stepped in to fill the void. In this respect, I cannot fault what they're doing. Their nontraditional polices are all that's available.
What to do?
What can savers and investors do? There are no satisfactory answers. Risk-averse individuals might choose to hold in safe assets all the resources they think they would need in the future, resigning themselves to zero or negative returns in order to guard principal; and assuming they were fortunate enough to have resources beyond their needs, they could buy diversified risk assets. Of course, individuals who have come across a productive investment idea should borrow and invest. Now is the time. Monetary policy is overwhelmingly on their side.