Walking a Tightrope: The Credibility of Central Banks and the Risk of Crisis

As we begin 2014, economies in developed countries are gathering momentum and central banks are retaining accommodative monetary policies, which extend support for risky assets. U.S. corporate capital (CAPEX) expenditure is being revived, marking an improvement necessary for upgrading the overall economic growth. In this respect, recent disappointing figures on the job market seem more of a transient occurrence than a trend reversal. Nevertheless, key macro figures are still under close watch amid concerns that the economy is actually getting stronger and can withstand the gradual withdrawal of the exceptional monetary stimulus.

Slightly improved economic conditions in Europe are adding to a more upbeat sentiment in the financial system as the Banking Union is bringing back investment flows in the periphery. This recent trend seems to confirm the beginning of a rotation of investor portfolios toward the equity market, especially in its high-dividend component. Central banks’ commitment to maintaining zero interest rate policies is keeping both credit spreads and yields near historical lows. Here, the search for yield continues to increasingly push investors to exploit pockets of value into riskier and less liquid segments, a tendency that is not too different from what we saw before the 2008 crisis. Not surprisingly, emerging markets (EM) stand out as the weakest spot in 2013, as most investors refrain from entering countries with high current-account deficits (Argentina, Turkey and other Asian countries are again under the spotlight) or with political uncertainties, putting the skids on overdue economic reforms.

None of the recent sources of volatility have dramatically changed our constructive view on risky assets, especially equities. However, it is worth focusing on the main risks that may undermine our investment strategy: notably a change in investor expectations on monetary policies and deflation, particularly in Europe.

Investor Sentiment on the Effectiveness of Monetary Policies

Since 2009, extraordinary monetary injections have been perceived as a positive stimulus for the economy and consequently for risky assets. At the same time, the Federal Reserve’s (Fed) early stance on the tapering process in May 2013 was not seen as good for risky assets, especially for EM. Then, tentative evidence of a stronger global economy and steady growth in corporate earnings helped financial markets overcome the early fears about tapering. Admittedly, the Fed did the right thing by guiding market expectations, clearly separating (in investors’ minds) the official start of the tapering process and the first rise in interest rates. However, playing with market expectations is not an easy task and we have already expressed some doubts if “forward guidance” would work effectively for a long time. In our view, the Fed is walking a tightrope and there is some risk of disappointing the markets.

Deflation – Hardly a Healthy Condition for the Economy

Until a few months ago, risks to price stability seemed to be more on the upside, amid investor concerns that overly loose monetary policies could spark inflation. Admittedly, we are still in uncharted waters in assessing the long-term effects of the unprecedented monetary stimulus. Inflationary spikes cannot be completely ruled out, but deflation has recently attracted much more attention, especially in Europe.

Deflation, strictly speaking, means a broad-based decline in (mostly) consumer prices, which has not happened often in the U.S. – only six deflationary events affected the U.S. economy just 10% of the time in the past 80 years. Deflation is hardly a healthy condition for the economy. In fact, deflation tends to defer consumption and investments, aggravate the debt burden and, as a result, dampen economic growth. In short, deflation can put at risk all the efforts made to stimulate the economy, a great concern of central bankers. But, for the last 100 years, we have seen that financial repression and inflation have been a way to reduce the debt burden. And, given the current debt levels in developed countries, some inflation would be desirable. Therefore, the absence of it creates some apprehension for both policymakers and investors on the long-term sustainability of debt, both public and privately held. Being in a low inflation/disinflation scenario or in outright deflation can make a significant difference for financial markets and for an investment strategy favoring risky assets.

Recent statements from European Central Bank (ECB) chairman, Mario Draghi, suggest they are aware that deflation is a risk worth watching closely. The key points here are if and how the ECB, which was established as an inflation watchdog, is willing to intervene to avoid expectations tilting towards deflation. We believe the best remedy would be a dual monetary policy, which is not possible in a monetary union. So, the ECB needs to decide which is the lesser evil: avoiding deflation in the periphery, while allowing for some inflation in the core, or sticking to an “anti-inflationary” orthodoxy, which is going to kill the hopes of an economic recovery. All in all, we believe that the market has not fully realized nor priced the risk of the ECB’s lack of a plan to counteract deflation and that political disagreement will lead to a prolonged standoff on the course of action.

For a more in-depth perspective, download the complete CIO Letter.

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