By Jefferson V. DeAngelis, CFA, Chief Investment Officer
Repost of article
There is an apparent disconnect between the source of liquidity provided by a very generous global central banking cartel and the end user. Everyone remembers the scene from the romantic comedy Jerry Maguire in which Cuba Gooding, Jr., playing the role of a professional athlete, demands that his agent, played by Tom Cruise, “show him the money.” In a world so flush with cash, why do the animal spirits seem so subdued?
The ECB just announced another round of stimulus under the premise that if at first you don’t succeed, keep trying. The policy of buying assets from the private sector injects money into the system. Combine asset purchases with negative interest rates on deposits and the theory is that banks will be incented to lend rather than increase reserves. There are several flaws to this logic. For one, banks are reluctant to pass on negative interest rates to their depositors. As a result, they are unlikely to offer borrowers attractive rates. To do otherwise, would be to accept less profitability. Additionally, banks can avoid paying negative rates simply by hoarding cash. There are already examples in Europe where this is occurring.
While low interest rates have historically encouraged more borrowing, there appears to be limits or diminishing returns from forcing interest lower or into negative territory. In many cases, it is not the most creditworthy debtors who are applying for loans. If private lending rates were to reach negative levels, the positive carry would accrue to the debtor. Perversely, the borrower with the largest debt burden becomes most profitable and at the same time the biggest risk.
Elevated debt levels are a serious headwind to growth. Global debt to GDP levels according to the IMP now exceed 200% and are higher than before the financial crisis. Lower interest rates promote more debt, not less. Also, despite lower interest rates it is becoming more difficult to service debt. The energy patch alone has generated approximately 100 corporate bankruptcies so far. In our opinion the final number is more likely to be 500.
Negative interest rates are more likely to create more fear than opportunity. Negative interest rates discourage savings and inhibit investment. Cash becomes a relatively high yielding asset. In order to be effective, central bankers will have to discourage cash hoarding. Europe has already passed legislation to ban the 500 Euro note. The conversation in the United States involves the 100 Dollar bill. It is no wonder that smart money is moving to gold and considering bitcoin as an alternative means to store wealth.
The world of abundance is a recent phenomenon. A decade ago, we were worrying about shortages as the world forecast a rising standard of living among the populations of the emerging markets. We are very aware of the role technology has played in production. Supply is only part of the story. Demand has been surprisingly weak. The global economy behaves as if there is a shortage of income. Wages remain stubbornly low in the historical context of a recovery. Meanwhile, asset returns are becoming less attractive. Things may be abundant but sources of high quality income are not.
Central banks are about to test the limits. Quantitative easing through bond purchases is becoming more difficult as high quality bonds paying interest become scarce. The idea that the ECB can purchase bonds from banks, increasing bank reserves that can be lent to the private sector, has run its course. Further, to the extent that unwinding their bond purchases leads to losses on the balance sheet of the ECB, member countries will be on the hook.
Unconventional methods are by their nature untested, untried and uncertain. By indirectly involving the banks in the scheme, the central bank is limiting the impact of printing money on the demand for goods and services. Ironically, rather than inspiring more lending banks have been building reserves. Market manipulation is difficult because each participant in the market acts in their own self-interest. Incentives work best when all the participants are confident and greedy. Fear has a profound effect on crowd behavior. If there is a rush for the exits, you want to be the first one out of the door.
The current political environment suggests a growing shift in sentiment to a more cynical and skeptical main street. The use of financial institutions to leverage money printing has not worked and may have backfired. The average person hears the call of central bankers but does not feel their love. Where is the money? They can’t feel it or see it. All they know is that their real incomes are shrinking and their debt burdens are building. Inflation seems understated and the global economy is slowing.
As agents for the people don’t central bankers need to “show them the money?” A more direct, honest and transparent approach would be to drop cash from thirty thousand feet as Ben Bernanke once suggested. So called “helicopter money” would at least feel a great deal better. Desperate times call for desperate measures. Perhaps cash is the wrong instrument to promote demand. It would be easier to distribute Amazon gift cards and have the goods delivered by drones.
Unfortunately, there may not be an easy way out. Sure, if we can fool the markets by inflating, we can reduce debt burdens on the backs of savers and investors. It seems relatively painless and the lessor of two evils. However, market forces are more powerful than institutions and the people that run them. In the long run, we need less not more debt, higher not lower incomes, more savings and less consumption. Current short-term incentives designed by central banks point us in the wrong direction. It is time to be looking for a new approach before it is too late.
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The views expressed are those of Jefferson V. DeAngelis as of the date on this commentary and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. The information and opinions are derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. This information is prepared for general information only.
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