The perception of the market has been that central banks have had the market’s back by implementing easy monetary policies since the financial crisis. But we’ve seen that these kinds of central bank actions have historically ended poorly for the market.
The United States is in the final stages of its post-global financial crisis ultra-easy monetary policy but we believe it will be a slow process to unwind from this low-rate environment. We believe U.S. interest rates will stay lower for longer.
Europe and Japan’s monetary easing is not nearing that end point, but they are running out of ammunition—they’re finding fewer bonds to buy.
We believe the unwinding of ultra-easy monetary policies will create a bad outcome for markets.
The European Central Bank (ECB) cannot currently buy bonds below their deposit facility rate, which is 0.40% today. As a result, more than half of outstanding bonds fall outside of the ECB’s bond buying program. The Bank of Japan is similarly bond constrained, having already bought a significant amount of the available bonds and with bond yields negative way out on the yield curve.
The Bank of Japan recently announced additional fiscal stimulus but to a lesser degree than markets were expecting and without further monetary easing. We are also starting to hear talk in Japan about a phenomenon known as “helicopter money”.
Helicopter money is not quantitative easing. Whereas quantitative easing can be unwound at any time and, therefore, is viewed by the market as temporary, helicopter money involves the central bank buying bonds directly from the Treasury—this can’t be reversed. That permanence has a different impact on behaviors—namely, it typically leads to consumption. The temporary nature of quantitative easing tends to lead to saving.
The first stimulus injection by the Fed was a liquidity injection to prevent a freezing up of the market and a collapse of the financial system. But since then, central banks’ actions across the globe have been taken in the name of growth—and I’d say those efforts have not been successful at all.
Unfortunately, these kinds of central bank actions have historically ended poorly and have had a lasting impact on the market. Here’s a quick look back at previous ultra-easy policies and how they ended:
‘70s Oil Shock: The oil shock monetization in the early ‘70s did not prevent the S&P 500 from declining 50%.
‘80s Greenspan Put: Starting in the late ‘80s and accelerating in 2000, Alan Greenspan, the head of the Fed at that time, lowered interest rates several times, resulting in investors believing that that the Fed would always step in a crisis and provide protection on stock market prices. This culminated in Y2K (when all computer programs were supposed to stop working at the end of 1999) and the dot-com bubble. Again, the equity market went down sharply, especially the NASDAQ, which dropped 70% at one point.
2008 Global Financial Crisis: We’ve now seen about eight years of ultra-easy monetary policy, which we also believe won’t end well. It’s not that it will end poorly tomorrow or even this year or next year, but we believe it is likely not to end well and have significant ramifications on the markets.
Keep in mind that this easy monetary policy has been a global phenomenon. It hasn’t just been one country as we’ve seen in the past. It has been global in nature, and it has been ineffective. It has also scattered resources to all of the wrong places. And that’s why we believe the unwinding of these monetary policies will create a bad outcome for markets.
U.S. and Emerging Markets Outlook
The S&P 500 itself has been on a seven-year tear with little pause. That’s quite significant in terms of duration and, most importantly, in terms of magnitude. We’ve reached a point where price is above value in the U.S. and that leads us to a relatively cautious view.
We’re cautious—not necessarily negative—because the U.S. is still a significant safe haven; the least risky of the risky, the asset class and country toward which people around the world continue to gravitate. So, even though there are a lot of negative trends out there, there are other factors supporting the U.S. equity market. And that support may not stop over the course of the rest of this year.
Historically, market perception has closely tied emerging markets to developed markets, but we believe this relationship has consistently been overstated.
What about opportunities in emerging markets? Historically, market perception has closely tied emerging markets to developed markets, but we believe this relationship has consistently been overstated.
The biggest opportunity in emerging markets during the last few decades was after 9/11 when emerging markets declined significantly. This panic was triggered by the view that emerging economies would stall given the amount of trade between the U.S. and many of the emerging markets. Instead, emerging markets experienced a significant rally over time.
Today, this connection continues to be overstated. In fact, it’s probably even weaker today given the growth that we’ve seen in emerging markets. The size of emerging markets relative to developed markets has increased significantly. China was basically a non-consideration back then. Now, it is very much a consideration with a size on par with that of the U.S. Not per capita, of course. On a per capita basis, it remains much poorer than the U.S.
But, in terms of the aggregate economy, China is significantly larger and able to influence global growth in much the same way as the U.S. economy can. As a result, China will influence emerging markets as much as the U.S. has been perceived to influence these markets.
Our positive view on emerging markets is leading us to look at emerging markets and currencies, and we have slowly begun to increase our exposure to emerging market equities and currencies.
At the same time, given the ambiguous environment for central banks’ monetary policies and for global economic growth, we are placing particular emphasis on convexity—the use of options—in the portfolio today.
That means, all else equal, we currently have a preference to use options to gain exposures to those fundamental opportunities that have risk coming from stage 2 of our investment process (determining Why value/price discrepancies exist) to help protect against extreme events, while maintaining the ability to participate in the upside.