Given the strong performance of stocks over the past year and the past decade, investors might be forgiven for enjoying a sense of calm. Regardless of what one might believe about underlying fundamentals and valuation, it is hard to dispute that whenever markets have run into trouble, central banks have provided ample liquidity to get them back on track. Although maintaining exposure to risk assets in such an environment can hardly be called investing in any conventional sense, it has been profitable to do so.
The main problem with such a benign outlook is that it rests on the assumption that central bankers will be both willing and able to protect markets by way of monetary policy. The bad news is that when all the ongoing challenges are considered together, it becomes clear just how complicated and difficult the task will be to keep markets afloat with monetary magic. The good news is that it is easy to identify those challenges by just reflecting on the last year and a half or so.
One big challenge that shows up on the radar is China. In September 2018 I wrote that Chinese residential real estate is "The most important asset class in the world." Much like in the US in the mid-2000s, a housing boom in China has been fueled by cheap and easily available credit. The only major difference is that the excesses in China's real estate market have not yet been resolved.
While the pattern of resolution is likely to be different in China for a variety of reasons, the implications are very similar. The main one is that the process is deflationary. The reason is that the resolution of bad debts both reduces money supply and tends to put downward pressure on prices until excess supply gets worked off.
Importantly, these deflationary pressures are unlikely to be neatly contained within China's borders. Given China's disproportionate influence on incremental global economic growth, any declines will be felt broadly. The persistent weakness in copper prices is one important indicator.
Another big challenge will be contending with the structurally lower demand for Treasuries outside of the US. I highlighted Russell Napier's thesis in "Dollars and nonsense, Part 2" which explains that the halcyon days of persistently rising foreign exchange reserves, forced buying of US Treasuries from abroad, and artificially subdued interest rates are over.
Going forward, US savers will bear a much greater burden to buy Treasuries, and that burden will be made even greater yet by fiscal policy that allows massive deficits. The result is that US savers will need to either sell other assets or save more in order to fund growing government debts. This in turn will impede economic growth and significantly complicate monetary policy.
Yet another factor that threatens to complicate monetary policy is the Eurodollar system. I noted in "Dollars and nonsense, Part 1" that shadow banking in general, and the Eurodollar system in particular, create all kinds of headaches for policy makers. In this system, money supply is a function of capital markets and falls outside the regulatory purview of central banks. In addition, money created through the Eurodollar system is largely a function of global trade and therefore vulnerable to geopolitical risk. As a result, the Fed has virtually no control over this money and only vague ideas as to its quantity.
In addition, a factor that can present serious challenges is the potential for severe capital controls to be implemented in a major emerging market. Although such measures are typically reserved for only the most extreme monetary challenges, they are always a policy option. Such controls can create immediate liquidity challenges which can spread quickly and widely.
The set of unhelpful consequences of monetary policy itself is yet another complicating factor. While policy prescriptions like low rates and asset purchases may provide some short-term benefits, they also come with longer-term costs. After ten years, the costs are accumulating, and the clock is ticking. Low and negative rates in Europe and Japan have destroyed the profitability of banks and eroded their ability to build strong capital bases. This can't go on forever.
In addition, low rates induce companies (and consumers) to take on more debt. Increased burdens substantially reduce the margin of error by which companies operate. Any modest decrease in revenue, increase in interest costs, or increase in other costs (e.g. labor) can erode operating profits. With such fragile conditions for success, corporate financial health can decline quickly.
Indeed, such pressures are already being felt in a number of industries. For example, bankruptcies have been rising in the energy sector through 2019 and new capital is all but unavailable to these companies. Transportation companies are also feeling the pinch. Thus far financial stress has remained fairly localized, but the pressures are mounting.
With all these factors fresh in mind, it is easier to see just how complicated the task will be for central bankers. Because many of the issues are global in scope, the Fed will need to coordinate successfully with other major central banks, even as their objectives and priorities increasingly come into conflict.
At the same time, central bankers will need to maintain a balancing act between providing just enough stimulus to keep markets afloat but not so much as to further increase the risks of financial instability. Low rates undermine bank profitability and encourage over-consumption of debt. Excess liquidity encourages risk-taking. All these measures have costs and those costs are coming due.
If these aren’t problems enough, the ability of monetary policy to keep markets afloat is largely dependent on investors' perceptions. In this symbiotic relationship, the ability of monetary policy to calm markets is at least partly determined by the belief of investors that it will work. In other words, maintaining this belief system takes on even more importance than fixing problems.
Unfixed problems can only persist for so long, however, before people start to notice and protect their wealth accordingly. When this happens, the power of central banks can unravel quickly. Importantly, a number of these unfixed problems are already revealing themselves in the forms of increasing bankruptcies, greater deflationary pressures in China, and the risk of a big bank in Europe or Japan failing.
Finally, the belief that stocks will keep going up because central banks will keep supporting them is based largely on the simple belief that since it has worked for ten years, it will continue to work. This, of course, is a fallacy and a misread of statistical probabilities. Such harmful, but common, tendencies are why the investment warning that “past performance is no guarantee of future results” has become so familiar.
Will the monetary magic wear out this year? It is impossible to say with certainty, but we do know a few things. One is that central banks cannot continue to implement policies with short-term benefits and long-term costs forever. Another is that the balancing act is getting increasingly difficult. Yet another is that we are closer to the end of the road this year than last year. So, if investors want to join (or remain in) the stock rally, they should do so with the full knowledge that they are playing with fire.