We are in very interesting times. We live what is probably the most surprising bull market in history. Excess of demand-side policies, massive liquidity injections, and low rates have zombified the economy and driven debt to all-time highs, while the economic slowdown is evident.
In the eurozone, the mirage of macroeconomic rebound is fading, with very poor figures from Germany, France, Italy, and Spain. At the same time, the collapse of Japan’s GDP in the fourth quarter proves that misguided tax increases do have significant negative implications and the estimates of the global impact of the coronavirus range between an optimistic 0.3% and a cautious 0.7% of global GDP. However, risky assets continue to soar and shrug off poor data in what seems like an endless bullish trend.
There is a determining factor in this equation of weak macro, rising debt, and incorrect policies. Financial repression covers a large part of the risks with a blanket of euphoria. With global money supply at $79 trillion and major central bank balance sheets above $21 trillion, irresponsible monetary policies continue to incentivize excessive debt and too much risk. By making the lowest risk assets -sovereign bonds- exceptionally expensive, the rest of financial assets -stocks, private equity- soar almost in unison creating an illusion of endless rising valuation and optically acceptable multiples. When the 10-year yield of most sovereign bonds is negative in real terms, multiples of equities and financial transactions rise accordingly. However, disguising risk does not eliminate it.
It is not a surprise that the world stock markets added $17 trillion in total capitalization in 2019, according to Deutsche Bank, highly correlated with central banks adding hundreds of billions in liquidity every month. Stock markets all over the world shrugged off poor macro, weak earnings’ and political risk as the ECB, BOJ, PBOC and Fed injected hundreds of billions in the market every month.
It is not a coincidence either that many politicians try to claim the good performance of markets as their doing. Politicians of all colors and ideology congratulate themselves on the rise in bonds and stocks as if it were the result of their policies, and not of the dangerous and perennial monetary insanity of central banks. This is an important problem because risk is not only disguised, reckless fiscal policies are rewarded.
The ECB’s balance sheet is already almost 40% of the eurozone’s GDP and the macro leading indicators point to further weakness. The same is true in Japan, where the BOJ balance sheet already reached 100% of Japan’s GDP. The Federal Reserve has reversed the so-called normalization and its balance has increased by 11% since August. What about China? The balance sheet of the central bank has also skyrocketed drowning the economic and financial troubles with massive liquidity injections. Unfortunately, consensus commentators see the actions of the Japanese central bank as the future, not a warning. Janet Yellen recently mentioned that the Fed should purchase stocks and troubled assets in a downturn, following the example of the Bank Of Japan. According to the BoJ funds flow report for Q3 2019, the bank now owns some 8% of the entire Japanese equity market and 77.5% of the country’s ETFs. Now Japan is close to recession again. Success.
What the market is discounting is financial repression intensifying into 2022. According to Citibank, the balance sheet of the major central banks will likely increase by the highest level since 2011 in the 2020-2021 period, almost a trillion dollars more than at the end of 2019 (this data does not include China).
What is the problem? While central banks maintain bubble-like valuations on many risky assets, investors see downward revisions of growth estimates, worsening industrial activity and corporate profits that do not warrant optimism. Moreover, faith in the placebo effect of central banks can end one day. That is why we find seemingly contradictory indicators: gold and the US dollar rise as safety assets but, at the same time, the most cyclical sectors soar in the stock market. Commodities – especially copper and oil – reflected the global slowdown even before the outbreak of the coronavirus buy, at the same time, markets take more risk in emerging economies.
The earnings season reflects this contradiction as well. On the one hand, earnings – at the close of this article – show a drop in sales of 0.50% and a decline in net profits of -0.05% in Europe’s Stoxx 600, with six sectors delivering negative growth. In the United States, S&P 500 earnings are similar, although slightly better. An increase in sales of 3.5% and profits of 1.31% with four sectors in negative growth. The reaction of stock markets is surprisingly bullish as long as the published results are mildly decent. When the lowest risk asset is extremely expensive, expensive stocks look relatively and optically cheap compared to hugely appreciated bonds.
Financial repression is also leading to “financial corporate inequality”. Multi mega-caps, big components of indices, get massively bid and their bonds are sold at the lowest yields on record, while mid-sized companies face relatively poorer demand and limited access to credit and liquidity. A large part of the excess liquidity goes directly to large stocks and big corporation bonds due to the massive purchase of passive instruments linked to the main indices.
We cannot fall into the trap of ignoring the macroeconomic reality and the trend in earnings just because “everything goes up”. Additionally, we cannot ignore monetary reality either. Market euphoria should not make us ignore major problems disguised under the monetary laughing gas, and we need to continue looking for relative value opportunities without ignoring the risks but without ignoring the monetary evidence.
Liquidity injections and rate reductions are likely to increase. The monetary history of the world reminds us that states and central banks never turn back when it becomes clear that their policies do not work, they always accelerate… Until the placebo effect stops working. Predicting when will it happen is almost impossible. We just know it does stop. Until then, falling into the monetary trap of no perceived risk is as dangerous as being out of the market. In an increasingly difficult environment, the prudent investor must constantly be aware of the risks to seek attractive long-term opportunities.