In March 2001, the Bank of Japan (BoJ) introduced a policy of quantitative easing. This was reserve targeting by another name. The intention was to provide enough liquidity for the banking system to maintain the BoJ’s zero interest rate policy until such time as the year-on-year change in the core consumer price index was judged to be positive on a sustainable basis. Quantitative easing was in part facilitated by the increase over time in the BoJ’s purchases of long term government bonds. These purchases helped to push long term interest rates down to below one half of one percent by 2003. The BoJ’s policy of quantitative easing ended in March 2006 and the ZIRP ended a few months after that.
Japan’s commercial banks also received capital injections but not until some eight years after the bursting of the bubble. The first round, in 1997, was aimed at helping the international banks boost their capital adequacy ratios and the second round was intended to do the same for the regional banks to encourage lending to small and medium sized businesses.
Once again, the forces of economic contraction have been unleashed by the bursting of a bubble - a credit bubble (not to mention the commodity bubble) - and the risk is that these forces are not only disinflationary but ultimately deflationary. But whereas the policy makers in Japan failed to understand early on the nature of the risk confronting them, there has been no such misunderstanding on the part of today’s policy makers, and certainly not on the part of the Federal Reserve.
Both the BoJ’s ZIRP and policy of quantitative easing came well after deflation set in. Not only that, the BoJ’s target policy rate continued rising after Japan’s asset bubble burst at the end of 1989. It wasn’t until mid-way through 1991 that monetary policy began to be relaxed. It then took the BoJ four years to lower its target rate to 1 percent. If we look at what the Federal Reserve alone has done, it has taken a little over a year to lower the federal funds rate to 1 percent and this was done against a backdrop, at least until recently, of rising inflation.
The Fed has been impressively astute in other ways. Aside from its existing lending facilities (the Term Auction Facility, the Term Securities Lending Facility, the Primary Dealers Credit Facility), the Fed has also introduced three other facilities designed to fund the purchase of commercial paper and certificates of deposit (an Asset Backed Commercial Paper Money Market Mutual Funds Liquidity Facility, a Commercial Paper Funding Facility and a Money Market Investor Funding Facility). These latter facilities represent a form of quantitative easing.
Yesterday the Fed announced two additional programmes - the Term Asset-Backed Securities Loan Facility (TALF) and another funding facility intended to buy up the debt of the Government Sponsored Enterprises and mortgage-backed securities. The former is a new lending facility designed to support the ‘issuance of asset-backed securities collateralized by student loans, auto loans and credit card loans’. As with all the other facilities, the Fed’s latest programmes are intended to open up the lending channels, narrow the spreads in the credit markets and prevent recession from developing into something worse.
Of course, the Fed isn’t alone in lowering rates. The chart below shows how interest rates in the developing and in the developed economies are coming down in concert. What it doesn’t show is that monetary policy is being complemented by expansionary fiscal policies in the developing as well as in the developed world.
With one exception, all these efforts have been uncoordinated. At the time of writing China has cut interest rates by 108 basis points. Policy makers in the developed and developing worlds have not been coaxing each other on the need to stimulate growth. Their independent but collective action is motivated by a like mindedness in recognizing that what’s at stake is the risk that something bad, like recession, might turn into something worse, like Japan’s deflationary malaise.
There has been plenty of talk about deflation. Commodity prices are falling as quickly as they rose. This means that inflation will drop rapidly from now on. The lower inflation will provide a stimulus for demand. It will help relieve the squeeze on real household incomes and on profit margins that, in part, led to recession.
But the disinflation might go too far and then what? The central banks still have plenty of ammo and this includes the Fed. Its scope for conventional easing is limited but it still has its biggest ace up its sleeve. This is an overt operation to reflate the economy by buying up some or all of the government bonds that will be issued to finance a widening budget deficit. By pushing yields down and flattening the yield curve, the commercial banks might then have little choice but to look beyond the US Treasury for more profitable lending.
I think the enormity of the policy response will prevent a recession from degenerating into something worse, like the deflationary malaise that afflicted Japan. But with investment you hedge your bets - as always. If you believe the deflation story then buy long dated low coupon conventional gilts. But if you don’t believe the story - and I don’t - then buy short to medium dated stocks if you are not up to weight in gilts.
The gilt market will have to ingest a huge quantity of stock this financial year. In the UK the Debt Management Office has indicated that gross issuance of gilts will rise to a record £146.4 billion from the £80 billion expected at the start of the financial year. That increase in supply would ordinarily push yields up but the overwhelming influence on the gilt market is likely to be the impact of recession on inflation and interest rates, both of which are set to fall sharply.
Recession helps conventional gilts outperform index-linked stocks but the degree of outperformance has been sizeable already and relative values have moved in favour of linkers. As the chart below shows for the UK, yields on conventionals have dropped to the lows seen earlier this decade and the yield on index-linked stocks has risen to the highs.
There is a buyer’s market for index-linked stocks. When the deflation story abates or if and when the Fed extends its open market operations to a bond buying programme, linkers are likely to be the prime beneficiaries because the story will then be all about inflation.
There is also a buyer’s market for corporate bonds and equities. The top chart on the next page, which relates to the US experience but applies more generally, shows the extent of the capitulation around. On the one hand, the differential between the yields on below investment grade debt and triple A debt is as wide as it has been for the period shown (solid line). On the other hand, the analysts’ earnings revisions ratio of upgrades to downgrades (for the earnings estimates) has not been lower (dotted line - rhs).
The inverse correlation between the two is no coincidence. The analysts’ revisions ratio reflects the recession that is underway and the fact that, with profitability suffering, default risk is rising. Risk assets have been adjusting for many months to the shock from a financial system that increasingly lost its capacity to function. The shock waves are now hitting earnings. But risk assets are also being troubled by the concern that the process of de-leveraging induced by the credit crisis will inhibit a robust economic recovery from taking root.
My view is that, in time, the concern will diminish. I think the financial crisis will be resolved - like a bad note between two riffs. The recession may prove to be long and deep but then the Western World has seen nasty recessions before. Those who were around will remember that the recession of the mid 1970s and the back-to-back recessions of the 1980s were no fun.
I think risk assets present a long term buying opportunity. As the lower of the two charts below shows, world equity markets are strategically oversold, more so than at any time in the past 23 years.
What can be said about valuations that we haven’t said in these notes before? Well, one thing we can say is that they are better! The dividend yield for a global index of equities is well above the yield on 10-year US Treasuries, as the top chart on the next page shows.
Also, as the chart below shows, world equity markets (solid line) have given up pretty well all of the gain they made between the spring of 2003 and the summer of 2007. To relinquish the gain of an entire bull market is to suggest that a lot of bad news is in the price. The bull market of the noughties has come to nought.
The earnings underlying global equity markets are down some 15 percent from their peak (dotted line in the chart below (rhs)). For earnings to return to the level at which they started their recovery from the trough of the previous cycle in the spring of 2003 would mean a further fall of some 55 percent from today’s level. If that happened world equity markets would end up on the rating they stood at before the Baghdad Bounce.
I just don’t think earnings are going to come back by anything like this. Thus, while equity markets are not quite as inexpensive as they appear on the basis of existing p/e ratios, they are still more attractively valued than they were at the trough of the dot com bust, and that is even allowing for a further sizeable drop in earnings.
I think the policy response across the developed and developing economies is unique and will end up being eventually a powerful stimulus for global growth. I think the Fed is determined to prevent deflation. I think the authorities in China are equally determined to promote the growth of domestic demand and hence the aggressive action being taken by the PBoC and the fiscal stance of the government. Because of this, I think that China will regain its status as the engine of global economic growth. I think concern about deflation will give way to concern about inflation but I also think the central banks will be acutely sensitive to the winds of change. I think it will all work out for the better and if it doesn’t you and I will live for ever after in the impoverished world of do dah land.
For those who ask whether policy makers will succeed with all their effort, especially all the Fed’s efforts to ‘normalize’ the credit markets, the answer is; if you don’t try you don’t find out. The Fed, among others, is surely trying and determined to succeed. And so are the policy makers in China. Neither is pulling any punches.
To conclude, here’s what we suggest for an investment strategy, based partly on the recommendations of BD’s Asset Allocation Committee. At the very least be up to weight in government bonds. Split the weighting between short to medium dated conventionals and index-linked stocks.
On risk assets, look for a suitable investment grade corporate bond fund. For equities, favour shares where the conviction about dividend growth is strongest as this is a purposeful route to a defensive equity strategy. A number of selections are set out in a recent note produced by the Research Department (see Safer Income Ideas 20 November 2008). For a bit of beta on stock selection, we can point to the recovery or special situations type vehicles which are on the Action List. This theme might also be pursued through a fund.
Overall, the recommendations favour being marginally overweight in the allocation of corporate bonds and equities combined, and being underweight cash, hedge funds and commercial property.
*