A compendium of economic news from 2016 would read more like a Harry Potter novel than a traditional text book; foreboding and mysterious but lacking a real crisis. Investors have had to contend with central banks using almost any measure to get things moving, inflation expectations see-sawing and a volatile commodity rebound. Then we have the added volatility from Brexit shocks and the rise of Donald Trump, both showing the public’s distaste for the status-quo.
In more recent weeks, we have witnessed a further shift in sentiment as concerns about deflation changed to worries about the concept of imported inflation, especially in the U.K. This makes a very interesting pretense, whereby a lower currency should mean more expensive imports, with the first clear signal evident by a cost pressure feud between Tesco (TSCO) and Unilever (ULVR) – aka Marmite-gate. This is supported by a recent uptick in headline inflation combined with a series of inflation expectation adjustments showing inflation is on its way.
From our view, this outlines the importance of owning investments with a strong moat. For example, our equities research team sees greater pricing power for Unilever as a producer rather than Tesco as the distributor, because predicting the short-term direction of inflation is a futile task.
Watching these proceedings will be the central banks, especially the Bank of England, as targeting 2% inflation is its key mandate and the main determiner of policy direction. Any change to monetary policy treads a fine line between providing additional stimulus and raising concerns about inflation. It is worth noting that the practical roll-out of the Bank of England’s stimulus package has thus far been dwarfed by other central banks, which may prove utilitarian if inflation does rise.
Japan Takes an Aggressive Stance
Leading the way in the aggression stakes has been the Bank of Japan, followed closely by the European Central Bank. It has been amazing to observe this undeniable commitment, with the Bank of Japan deciding to put an effective cap on bond yields until inflation overshoots their 2% target. Whether the Bank of England will adopt a similarly aggressive policy only time will tell.
Of course, the purpose behind the programmes are persuasive. Primarily, the desire of the Bank of Japan to increase inflation and steepen the yield curve should help promote full employment and increase economic growth. This then has the potential to help the financial sector, which can theoretically ignite lending activity and hence push the economy further.
While such policy measures create an enormous amount of comment and news-flow, they have less impact on the fair-value of assets. Rather than being a mechanism to increase the fair value of an asset, these measures primarily impact current prices, thereby reducing the future expected return from the asset classes affected by the policy. Consequently, we do not get involved in central bank speculation, however we do consider the sustainability of the stimulus programmes as it is an integral function to market risk.
Bond Purchasing is Limited
The ability to purchase more bonds is becoming limited. More specifically, the Bank of Japan has already purchased more than $3.3 trillion in securities, equivalent to an estimated 30% of non-financial corporates plus government holdings. It is also a top five owner of more than 80 Japanese companies in the Nikkei 225. If the stimulus continues for an extended period, the Bank of Japan could easily create concentration risks and limited liquidity.
The ECB has similar restrictions, with a self-imposed rule that 25% of purchases should be German Bunds, however only 29% of German Bunds yield enough to be eligible for the programme. Therefore, an effective trading range in Bunds appears a reality amid a supply/demand imbalance imposed by the ECB.
The central bank balance sheets have grown aggressively. The Bank of Japan now holds debt on its balance sheet equivalent to $34,750 per person in Japan. The ECB also holds $11,160. This is a significant debt burden when looked at holistically, stretching what has been known to be a sustainable holding. The question turns to whether there is a catalyst for a ‘central bank balance sheet shock’, and if not, whether the debt burden will act as a drag on growth rates.
Therefore, there is a lot at stake for the Bank of Japan and ECB. If the programmes succeed, it will look like a masterstroke move as it could help trigger sustainable inflation and lower employment. However, if it fails the concern is that the central banks have ballooned their balance sheets which leaves an abundance of risk on the table and could act as a further headwind to any future recovery. It is a true case of “good times give us memories; bad times give us treasuries”.
