Why central bank stimulus has not solved the world’s structural problems
Over the past three months, global financial markets have rallied on the expectation and delivery of additional central bank stimulus, but during this time global economic growth forecasts for 2012 and 2013 have been wound back. Perpetual's Matt Sherwood examines this and concludes that while central bank policy has buoyed sentiment, it has not addressed the structural issues across the world.
One of the first things university students and market participants learn about in finance is the importance of diversification.
In essence, diversification is one of two techniques used by investors to reduce investment risk – the other is hedging.
In finance, diversification is a process of reducing risk by investing in different types of securities and/or assets and this, in turn, relies on the assumption that each security’s associated return is imperfectly correlated with its peers.
If so, a diversified portfolio will have less risk than the weighted average risk of its constituent parts.
But the benefit of diversification has been known for 3,000 years
Managing investment risks through diversification became a mainstream portfolio tool after Harry Markowitz’s 1952 paper titled Portfolio Selection, which summarised portfolio dynamics in terms of risk and return.
Despite this revolutionary piece of work, the concept of diversification was first mentioned in the Bible in 935 B.C., where the book of Ecclesiastes states ‘…but divide your investments among many places, for you do not know what risks might lie ahead’.
Diversification is also mentioned in the central text of mainstream Judaism, where it suggests splitting a person’s assets into three; one third in business (buying and selling things), one third kept liquid (gold coins) and one third in land (real estate).
The global economy is slowing across the board
While Markowitz won the Nobel Prize for Economics in 1990, the basic assumption of his work has recently been challenged by fields such as behavioural finance.
The key criterion for portfolio selection is that asset prices behave differently in the same environment, yet this was not the case during the recent global financial crisis where credit, housing, equity and commodities all declined rapidly.
Similarly in 2012, investors have witnessed a global economic slowdown across all regions, with forward-looking indicators such as purchasing manager indices having slowed; most are now at levels suggesting contraction in the manufacturing sector.
Consequently, annual global industrial production growth remains below 2 per cent, which is a level previously seen during the global recessions of 1991, 2001 and 2008.
Global industrial production should rise in 2013
The decline in industrial output growth is broad-based and has turned negative in the UK (-0.6 per cent in the 12 months to August 2012), Germany (-1.0 per cent), Japan (-3.1 per cent), France (-3.7 per cent), Spain (-6.7 per cent) and Italy (-9.9 per cent).
Meanwhile, industrial production grew by only 2.8 per cent and 9.3 per cent in the US and China, respectively, relative to 4 per cent and 13 per cent at the end of 2011.
Fortunately, forward indicators of industrial production suggest that industry output should start to rise in the next six months towards its post-1983 average (3.5 per cent), unless US budget cuts significantly alter household income.
Nevertheless, this trend growth remains consistent with flat commodity prices, as additional demand is needed each year to absorb supply increases.
A lack of diversification is hindering global growth
Consequently, there has been a distinct lack of diversification in regional economic growth, as macro drivers are widespread and issues are inter-linked.
For example, balance sheet stress is limiting growth in most advanced economies and this is having a flow-on effect to global trade, which is negatively impacting growth in emerging markets.
In addition, government spending growth is being wound back and this is likely to reduce household disposable income, moderate employment and spending growth and keep global economic growth at a sub-trend pace.
Recoveries after balance sheet recessions are always subdued
In recent times, global central banks have all stated their frustration about the global recovery.
However, central banks should have been expecting a weak expansion (and should not have been increasing interest rates as was the case in Europe in 2010) as recoveries after balance sheet recessions (which the global financial crisis was) are always subdued.
Any large debt build up in the household and government sectors takes a prolonged period to unwind as these sectors cannot raise equity in capital markets (unlike listed corporations) and save very little of their disposable income.
The weakest US recovery in history is unlikely to improve much in 2013
Consequently, it is not surprising that the current US recovery is the weakest in history with the expansion totalling 6.5 per cent in the past three years, relative to a historical average of 16.9 per cent in the 21 recessions since 1873 (see Figure 1).
Indeed the only recovery which has been similarly weak was in the early 1980s after the US economy double-dipped in 1982, and 2001 as higher oil prices in 2002 delayed the recovery.
In a world of subdued economies despite record stimulus, central banks have turned to unconventional methods to lift growth. Initially, the use of quantitative easing was justified as necessary to alleviate deflation risks.
QE has primarily been about lowering exchange rates
However, as price risks are tilted more towards inflation than deflation, and with interest rates being close to record lows in all markets, the rationale for further quantitative easing (QE) can only be seen in trying to realign global exchange rates.
Most major advanced economy central banks have increased the size of their balance sheet (by electronically printing money) and have used the funds to alter interest rate differentials.
In early September the US Federal Reserve announced a continuation of Operation Twist as well as an open-ended quantitative easing program totalling US$40 billion per month until the US labour market outlook improves.
How that is precisely defined is anyone’s guess, but the program is estimated to be worth nearly USD500 billion per annum and could go on for several years
Central Bank’s balance sheets will keep expanding until at least 2014
The US Federal Reserve has already increased the size of its balance sheet by over three times since the start of 2007 and this could increase to four-to-five times before QEIII is ceased.
This increase was warranted given the increase in the assets by other central banks, which would have exposed the US dollar to appreciation risk.
Looking ahead, if central banks increased their balance sheet in the next two years by the same percentage as the US Fed, the total assets of the G4 central banks (US, Europe, Japan and UK) would end up rising four-fold in the seven years to end-2014 (or by USD10 trillion).
Meanwhile, talk about the Reserve Bank of Australia (RBA) intervening in currency markets to depreciate the Australian dollar has escalated, but the RBA does not possess a large enough balance sheet to undertake this.
Consequently, the RBA may need to provide some further interest rate relief to support the domestic economy or risk domestic income declining beyond the impact of lower commodity prices.
Will it work?
While the liquidity actions of central banks are sizable, none of the structural headwinds (such as debt and competitiveness) have been addressed.
Households continue to have excessive debt, European banks remain stressed and governments continue to implement austerity globally at a time where their economies need more support, not less.
In addition, the US Fed’s 2012 program is much smaller than previous QE programs and with the US Government’s fiscal consolidation set to begin in 2013, the US growth outlook remains subdued.
Meanwhile, Europe appears recessionary and Asia is moderating, but remains relatively strong.
Who will win the battle?
After a strong rise from the June quarter lows, global share markets have been more cautious in recent weeks as investors alternate between being concerned about the global outlook and signs that troubles are brewing in Europe again, and being optimistic about the extraordinary actions of central banks.
However, investors seem reluctant to push the rally any higher and will need signs that the economic recovery is accelerating to move market indices beyond current levels.
The key question now is whether market sentiment is dominated by the stimulus or the global outlook over the remainder of 2012.
As the former has not addressed the structural issues around the world, the impact of stimulus is likely to wane and (unlike 2009) subsequent investment returns could be below-average as valuations have already expanded, earnings growth is moderating, credit spreads have already tightened and China is still slowing.
Nominal economic growth has been greater than earnings in most regions
The flow-through from the economy to earnings is not a straightforward one, as earnings in only China, the US and UK have expanded at a faster pace than nominal GDP growth since 2006.
The rational for the US and UK outperformance is a combination of large offshore earnings, productivity improvements (in the US) and depreciating currencies since end-2006.
Conversely, Europe, Australia, Canada, Japan and Asia (ex-Japan and China) have all underperformed. With global growth likely to remain subdued, investors are more likely to remain cautious and focused on valuations and income (in both share and bond markets around the world) than optimistic and focused on capital gains.
Implications for investors
There is a clear lack of diversification as economic growth moderates around the world.
A key for investors in this environment is determining what growth moderations are short-term and which are likely to be sustained over the long-term.
Balance sheet issues (in the household, government and banking sectors) are long-term structural issues that are likely to limit growth.
In this climate, companies with strong balance sheets, a dominant market position, good cost control and sustainable margins should be well positioned, as they can provide sustained yields with potential income growth in a lower-returning world.
However, a steadfast focus on valuations of these long-term wealth-creating firms is also important, as moderate capital gains mean investors have less capacity to ‘over-pay’ for earnings risk relative to the halcyon ‘leverage’ days prior to the global financial crisis in 2008.
In this way diversification still matters, as do income and valuations.
Matt Sherwood is head of investment market research at Perpetual Investments.
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