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Monetary policy delivers for markets - Economies, not so much

15 September 2020 Prescient Investment Management
Bastian Teichgreeber, Head of Asset Allocation at Prescient Investment Management

Bastian Teichgreeber, Head of Asset Allocation at Prescient Investment Management

Prescient Investment Management remains cautious on risky assets due to the poor economic environment, as well as very stretched valuations.

If global central bank stimulus was delivering its intended effects in terms of economic support, creating growth and jobs and reducing inequality, rather than ever-inflating asset prices, a growing number of analysts and investors would sleep more soundly.

According to Bastian Teichgreeber, Head of Asset Allocation at Prescient Investment Management, an independent investment management company, central bank stimulus reaches markets to support asset prices in two ways: “Central bank stimulus finds its way into asset class returns in a very direct way through the purchase of government bonds, corporate issues, or even exchange-traded funds (ETFs); but also in a more indirect way, through the lowering of interest rates, which leads to tighter credit spreads and the justification of higher valuation multiples.”

He points out that there has been a lot of debate around the efficacy of monetary policy and its ability to continue to support the global economy. However, Teichgreeber says it’s important to differentiate between the economic impact and the impact on financial markets. “While we see evidence that the economic impact is limited at this point, and that the continued decrease in the velocity of money is offsetting large parts of the stimulus, asset price inflation is inevitable. The more money is printed, the more this will support returns.”

The slowdown in the velocity of money refers to the slower circulation of money in the economy as economic participants spend less. The tendency has been for individuals and business to prioritise the repair of their balance sheets, rather than spending.

Sometimes described as a “balance sheet recession”, this happens when individuals and businesses would rather pay down debt than expand their balance sheet, no matter how cheap credit is.

The slowing volatility of money also mostly explains the disconnect between markets and economies in that most of the cash created ends up on central banks’ balance sheets. “To get the animal spirits going for corporates to invest and for consumers to spend, we need improved economic sentiment. In economics it’s all about sentiment, confidence and the private sector’s willingness to take calculated risks,” says Teichgreeber.

Whether markets are set to correct again or are pricing in an optimistic future is difficult to say since everything we see in monetary policy nowadays is unprecedented.

“We’ve never been through a period during which interest rates have been as low as they are today,” says Teichgreeber. “Traditional financial valuation metrics must therefore be questioned. However, we resist the temptation to say ‘this time is different’, and remain cautious on risky assets due to the poor economic environment as well as very stretched valuations.

“As long as we see central banks flooding markets with liquidity, risk asset prices will remain supported. We do think though that at some point, markets will have to face a reality of lower growth for longer, huge fiscal deficits and still stretched valuations. We remain cautious.”

Interestingly, Prescient’s base case doesn’t assume rising inflation on the back of record fiscal and monetary stimulus. “The reason for the disconnect between money supply and inflation is best explained by the stall in the velocity of money. Money is created, but it mostly ends on central bank balance sheets and doesn’t really enter the real economy. This breakdown has held inflation in check and will most likely continue to do so,” says Teichgreeber.

He agrees with the view that weak demand could continue to put downward pressure on prices, “especially since the global population is ageing, inequality is rising, and these are all factors holding inflation back structurally. That said, we see the risks to inflation in South Africa more to the upside. Especially administered prices will have to rise and we envisage inflation long term within the target band of 3% to 6%, but more towards the upper end of the band.

“Internationally, we’ve adjusted our long-term capital market assumptions to reflect a period of prolonged disinflation, rather than not deflation. Inflation in the US will return closer to the Fed’s target of 2%. The challenge, however, is created by the fact that nominal interest rates are much lower now, and priced to stay much lower for longer. Therefore, the real return assumptions on all cash-linked asset classes must be adjusted downwards significantly.

 

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