Investors have been repeatedly admonished this past year or two not to underestimate the power of central banks in driving up financial asset values. The reckless and desperate quantitative easing expansions of the Bank of Japan, the belligerent policy threats of the European Central Bank, and the “money finance” gambit of the U.S. Federal Reserve are widely thought to be unprecedented policies that uniquely define the current era.
But central bank monetary excess isn’t anything new. Can their past machinations teach us anything about today’s financial environment?
This is not the first time that central banks as a group have inflated their balance sheets. In fact, seen over the timeline since the invention of central banking (starting with the Swedish Riksbank in 1668), the recent monetary excess of central banks has actually been muted. Not only that, much greater balance sheet expansions have taken place relatively recently.
Is the past prologue?
According to a study published in May this year by Niall Ferguson, Andreas Schaab, and Moritz Schularick, the balance sheets of the 12 largest central banks in the world reached an average equivalent of approximately 405 percent of GDP in 1947. In comparison, today central bank balance sheets relative to GDP are only 30 percent or so (in the latest count, the same 12 central banks, though folding four into the ECB as of 1999).
So what’s all the hand-wringing about, if the world has survived such extreme periods before? Doesn’t the future look as bright as it did in postwar 1947?
A little bit of history here will be helpful to set up our conclusions. The researchers of the report I mentioned above point out that two types of conditions led to such extremes in central bank balance sheets: war and financial crisis.
Both led to a high level of active monetary policy but for different reasons. In the 1940s, central banks were mainly buying government bonds to help finance war expenditures. Today central banks are mainly trying to boost consumption and final demand.
The Global Currency War
The fact is that there are striking differences today from the late 1940s. I’ll mention just a few: entirely different demographics; much lower global population growth; a more extreme state of uneven wealth distribution; pre-globalization versus today’s post-globalism; postwar reconstruction and the Marshall Plan to what… austerity? A thorough comparison crystallizes our conclusions.
Consider these key facts: First, no matter the rhetoric, the reality is that there is a “beggar thy neighbor” war underway. Today this manifests in currency and monetary expansion, and it is continuing.
Secondly, it is highly unlikely that central banks will ever voluntarily shrink their balance sheets by “selling” securities back to open markets. For this group, this was not likely in the past, nor is it likely in the future.
Thirdly, a comparison of the attendant conditions of the two periods supports the conclusion that this time, central banks will not be able to reduce their balance sheets by letting GDP growth outrun their liabilities, at least not with the negative real interest rates that prevail today.
That only leaves three alternatives: 1) continued monetary and currency wars; 2) hyperinflation; 3) a final exhaustion in the form of a deflationary bust.
We can argue about the probabilities of each. This debate doesn’t need to be settled just yet. For now, what this means for investors today is that central bank largesse and policy interventions have a long way to go.
We try to identify sets of expected market behaviors that we call “behavioral imperatives.” In other words, what trends are likely to be driven by the hard-wired behavioral biases of market participants and policymakers?
Just as corporate executives have incentive to keep retiring equities (after all, the cost of debt is far below their return on capital), central bankers will, at all costs, engineer policies that seek self-perpetuation of financial systems.
Stick With Currency War Winners
Net, net, behavioral biases and the current economic structures argue the following strategy: Stay long in the equities of countries that are winning the currency wars. Buy fixed-income securities in countries that are experiencing appreciating currencies. Hedge the currency in the former; leave exposed the latter.
We think strategies of this type have a long way to run. But beware periodic episodes of volatility, requiring nimble defensive measures. After all, as in the 1940s, we are experiencing a world war—but this time, it’s a currency war.