It is somewhat obvious to state that since 2008 monetary policy has become anything but ordinary. Yet, to fully understand the degree of which central banks globally are involved in the process of reflating credit growth and asset markets, one needs to focus on central bank balance sheets, in particular observing both their relative and absolute growth. If we look to define quantitative easing as an increase in the size of a central bank’s balance sheet through an increase in its monetary liabilities (be that base money or bank reserves), then indeed almost all of the largest central bank’s of the world are engaged in some form of QE. As shown in Chart 1, since August 2008, the eight largest central banks have increased their balance sheets by approximately US$7trn. Against a deleveraging banking environment, central bankers could see this policy response as a resounding success, especially if that benchmark can be measured as the change in market capitalization of the world equity markets, with current valuations suggesting listed world equity markets at $51trn today vs $46.5trn as of mid 2008 (though having seen a low print in this cycle of $25.5trn). But, in real terms, can we as investors measure this as successful policy, given this growth in narrow money compounds to an increase of approximately 20% per annum?
Chart 1: Balance sheets of major central banks
Source: Bianco Research / The Big Picture blog
The definition of inflation has always been a manipulative statistic that central bankers have continued to abuse over time. In as much as a basic definition would be a rise in the general level of prices of goods and services in an economy over a period of time; in reality a more correct definition should consider the fact that inflation is really an increase in the money supply, which in turn leads to an increase in price level, be that of goods or of services, or of wages or of assets. This ‘sleight of hand’ exists as central bankers can point to low levels of core inflation, during periods of technological innovation, and globalization (such as what we observed during the ‘Great Moderation’) to run expansionary monetary policy and inadvertently allow credit to expand and asset prices to inflate. Yet, when a credit bubble bursts and we experience a debt deleveraging; central bankers will now change their definition and point to contracting credit and shrinking broad money, as more reasons to run expansionary (and potentially unorthodox) policy. Leading this charge is the BoE, which continue to run an ultra-loose monetary policy (continuing to expand QE by GBP 50bn at their last MPC), with CPI printing at 3.6%, stubbornly remaining above their 2% target level. A frustrated Mervyn King can continue to write open letters to the Chancellor of the Exchequer trying to explain this monetary phenomenon, but in reality an over-indebted economic system trying to de-lever will struggle to extend this excess money throughout the UK economy, irrespective of its availability.
Recently, both the Fed and the BoJ have announced a more explicit inflation target approach as an alternative tool to fighting the deleveraging pressure in each respective economy. With the Fed choosing a long run inflation target of 2% for PCE (Personal Consumption Expenditure) or the BoJ looking to achieve a core inflation target of 1%; it bodes investors to ask the question can central banks even influence credit and money growth anymore through targeting an inflation measure of goods and services? If the transmission mechanism is broken with zero overnight interest rates, and continuous bouts of QE cannot seem to get lenders to extend credit, why should an explicit inflation target make a difference? Chart 2 below shows a recent history of headline CPI vs M3 y/y change for the US, EU, UK and Japan. Although the relationship between the two is positively correlated, CPI is statistically only mildly effective at predicting M3 growth. In reality, and especially during the period described below from the late 80s, M3 (and credit) continued to expand, as central bankers used continued disinflation over this period to cut rates, allowing credit and money supply to grow unchecked. Assuming this 1% to 2% sweet spot of inflation will allow credit to grow accordingly from here is naive and best, and dangerous at worst, in terms of potential unintended consequences.
Chart 2: Relationship of M3 and Headline CPI
Source: Bloomberg/St. Louis Fed/Federal Reserve/SCB Calculations
Meanwhile, running a QE policy mandate looking to increase asset prices and creating a positive feedback loop, can be a dangerous strategy if inflation expectations get out of hand. Looking solely at the US, one has to be impressed with the resurgence in US earnings since the depths of the crisis, and the recovery in stock markets back to pre-crisis highs. In respect to equity markets, in as much as money printing may increase earnings, an increase in inflation expectations can put pressure on bond markets, raising yields enough such that the discounting mechanism of stocks (ie the P/E ratio) will be correspondingly negatively affected. As Chart 3 suggests, P/E multiples in developed markets tend to expand when inflation readings (and expectations) are tame, and typically when bond yields are rallying. When economies see periods of high inflation or high deflation, P/E multiples typically shrink; with inflation risks targeting the discounting of cash-flows and deflation risks targeting a decrease in earnings, and less investor interest to participate in stocks. Financial repression via central bank monetization of government bonds may end up working in keeping discount factors high, but what happens when you try to wean the market off this continued stimulus?
Chart 3: S&P P/E Ratio vs US Headline Inflation (Annual Average Price vs Annual Average Earnings)
Source: Crestmont Research (www.CrestmontResearch.com)
Since the end of 2011, global central banks have embraced further unorthodox policy, and investors have reciprocated with a resounding ‘yes’ to risk asset investing. This change of sentiment has been swift, and although has been backed by better than expected data, one has to be impressed most with the policy response of the long dated LTRO’s from the ECB. With a change in President, and the subtle condition of becoming the shadow bank of last resort; the ECB has seemingly single handedly averted a European crisis; to the delight of peripheral Europe and the European banking community. Almost overnight, capital markets opened again for business; and investors rushed to get set. Looking at Table 1 below, comparing various measures of ‘risk’, we can see on a 3m basis, most measures are statistically showing mild levels of over extension (as measured by 3m Z-Score). This is not to say the ‘risk-on’ rally cannot continue, (especially since one could argue that the left tail deflation risk of a European break-up that was prevalent towards the end of 2011 has definitely been somewhat clipped), but as global equity markets have rallied between 5% to 20% and credit spreads have narrowed across the board, the easy money for 2012 has already been made here.
Table 1: Has ‘Risk on’ overextended itself in the short term?
Source: Bloomberg – as of 22nd Feb, 2012 (NOTE: *Zscore for rate/spread indices represented as -1(ZScore) to represent high positive number as “risk seeking”)
In July 2007, Charles “Chuck” Prince, the former Citigroup Chief Executive infamously said “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Given the liquidity injection central bankers are applying to global markets, investors and financial institutions will have to ask themselves the very same question: do we still want to dance? The race to keep up with the performance of your competition; be it hedge fund, real money fund, or financial institution may require you to outstay your time on the dance floor, but for me personally, I am happy to sit this one out for the moment. A lot has been priced into the market place in terms of on orderly Greek restructuring, a large second Euro 3yr LTRO and the potential for continued QE from the US, BoE and BoJ; but if there is one thing investors should recall is that even though the pools of liquidity that exist are large, the last few years have shown that they can be withdrawn quickly on the smallest of disruptive event. Relying on continued central bank policy assistance may suffice as enough of a reason to add to risk, but the recent bi-polar temperament of the market warns me to err on the side of caution.
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