Investors right to see through the gloom to economic upturn

It is richly paradoxical. Both the S&P 500 and the Dow Jones Industrial Average indices hit record levels earlier this week. At the same time, the US economy is struggling to recover, the jobs market is weak and both the public and private sectors are racking up record levels of debt thanks to a devastating pandemic.

The imminent expiry of policy safety nets in the US points to yet more unemployment along with rising corporate defaults next year. The story is much the same across the developed world.

It is tempting to call the investor mood Panglossian optimism. Yet the market is right to look through this apparent amplification of the disconnect between stock prices and the real economy. Since the coronavirus-induced panic in March, equities have been driven by heavily expansionary fiscal and monetary policies. Taken together with recent good news about vaccines, that pretty much ensures a powerful economic upturn in 2021.

Chris Watling of Longview Economics points out that the US corporate sector generated spare free cash flow in the second quarter of this year despite the economic downturn, which typically marks the start of new economic cycles. Households around the world, he adds, have considerable levels of excess savings, amounting to 7.5 to 10 per cent of gross domestic product — enough to spark high levels of potential spending and economic stimulus.

Investors should nonetheless recognise that a market that is substantially driven by policy is often storing up future trouble. This is certainly the case here because the ultra-low interest rates resulting from the central banks’ asset-buying programmes have unhinged the normal relationship between risk and reward.

One obvious example relates to the discipline imposed by bond market vigilantes when excessive government bond issuance threatens a return of inflation. There is simply no point investors refusing to absorb government paper if the central banks will mop it up regardless.

In his General Theory of Employment, Interest and Money, John Maynard Keynes talked of the euthanasia of the rentier where investors relying on interest income would struggle to survive as rates fall. In today’s world of low and negative interest rates we are witnessing both the euthanasia of the rentier and of the bond vigilante.

By forcing investors into a search for yield, the central banks have also ensured that credit risk is being mispriced. A striking example this week was Peru issuing sovereign debt with a 100-year term and a coupon of 3.23 per cent immediately after a constitutional crisis. Peru is not Argentina but this is still taking a very generous view in this historically default-prone region.

The most insidious consequence of unconventional central bank policies is moral hazard. Ultra-low interest rates provide an incentive to borrow because they take the pain out of debt servicing. The result has been an extraordinary debt binge. The Institute of International Finance, a finance trade body, estimates that global debt will rise more than $20tn from 2019 levels to $277tn by the end of the year, equivalent to 365 per cent of GDP.

This accumulation of debt appears to have a diminishing ability to generate growth. This is worrying because the complementary monetary policy toolbox is close to bare. Earlier this month Gita Gopinath, chief economist of the IMF, wrote in the Financial Times that we are in a global liquidity trap. That is, interest rates are so low that households and companies hoard cash. When that happens, monetary stimulus ceases to have much impact on the price level.

Hence many passionate speeches by central bankers calling for fiscal policy to take up more of the burden in addressing the pandemic. Yet in the US plans for further fiscal expansion are gridlocked on Capitol Hill, while in Europe, Hungary and Poland are holding up ratification of the EU budget and proposed coronavirus recovery fund.

It is hard to blame the central banks for their actions since the great financial crisis of 2007-08. Without them a depression would have been inevitable. The snag is that the world will be increasingly vulnerable in due course to inflation because central banks will be reluctant to destabilise the economy and financial system by raising interest rates when debt is at unprecedented levels for fear of jeopardising their independence.

Equities are on heady valuations. In the short term the market will toss and turn in response to coronavirus and vaccine news. With fund managers’ cash holdings now back down to pre-coronavirus levels, according to the Bank of America global fund managers’ survey, a wobbly period may be due. But long-term investors should sit it out. News on fiscal policy will probably improve and a recovery is undoubtedly coming.

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