Ignacio de la Torre. Professor. IE Business School
22 September 2016
Several central Banks are sending out the first signals of the beginning of the end of the lax monetary policy that caused the biggest financial bubble in the last few decades.
On October 23, 1942 the Allied forces commanded by Field Marshal Bernard Montgomery launched a ferocious assault in Egypt on Italian and German positions, the latter famously referred to as the Afrika Korps. What later became known as the Battle of El Alamein rattled Hitler, who personally called Field Marshal Erwin Rommel to abandon his convalescence from a serious illness to lead the German troops.
In the event the best Rommel could pull off was a hastily organized retreat into Libya after his defeat. El Alamein was the first major Allied victory over Germany in the Second World War, and in a speech in November of that year, Churchill famously said: "This is not even the beginning of the end, but the end of the beginning". Two and a half years later the war was won.
In early September, one investor described current share prices as "the biggest financial bubble of the last thirty years." When I look at the erratic behavior of the market since then, Churchill’s words come to mind: we face the beginning of the end of the bubble.
I'm afraid that’s where we are.
For many years share prices were based on assessing their fundamental value. For example, ten-year government bonds often traded at a yield close to the nominal growth expected of an economy (e.g. 4% in the United States), the stock market at an average PER of about fifteen times, or households at about seven times the income of families. After the financial crisis, the massive programs of quantitative easing by the central banks began to impact negatively on share prices.
Because central banks concentrated on buying government bonds, these reached their highest price in its history (we’re talking about prices over centuries), prompting investors to move their savings into corporate bonds, the stock market and real assets, all of which have also seen tremendous increases in their valuations, far greater than their fundamental value (the economic price, as Adam Smith would say).
It is true that the price of something is the money someone is willing to pay for that something (what I would call the financial price), and for a wholesale buyer like a central bank the ability to manipulate (understood as the price distortion between financial and economic) market price) can be significant. But history teaches us that in the long term, the financial price converges toward the economic price.
Furthermore, the ability of a central bank to buy assets has its limits. The banks focus on assessing whether the extraordinary measures they have implemented are achieving greater economic growth at the expense of two risks: first, the central bank must ensure that its policies do not bring about inflation, which would lose it credibility with consumers, and secondly, the central bank must ensure it does not create financial instability.
Increasingly, the question is whether the benefits outweigh the risks. Hence, for the first time in many years, it seems that growing numbers of central banks are concerned about whether their lax monetary policy has reached a turning point toward either less lax or more restrictive measures.
As I said in July, the Fed is signaling that because the US is already approaching full employment, it is going to pursue a tighter monetary policy. In turn, Mario Draghi surprised the markets by stating that a possible extension of the ECB’s bond-buying program, which ends in March 2017, "had not even been discussed".
Meanwhile, Japan’s central bank, which has carried out what is possibly the greatest exercise of quantitative easing in history, even using negative rates, with no apparent result, has now prompted speculation as to whether it will announce the end of negative interest rates, which has made the markets very jittery.
China’s central bank should combat the economic weakness of its country by lowering rates or the cash reserve ratio, but does not because any liquidity injected into the economy quickly disappears via capital flight.
Finally, although the Bank of England says it will introduce further quantitative easing to combat the effects of Brexit, the bond markets don't believe it, and bonds are now being traded at pre-Brexit levels.
In a scene of the first movie version about the sinking of the Titanic, (the black and white one) a naval engineer explains how water has already flooded four-fifths of the hold. "The Titanic can withstand two fifths flooding, and at a pinch, three fifths; however, with four fifths flooded there is no alternative but to sink."
Similarly, when central banks move towards less lax monetary policies it is very dangerous for the market, given the irrational valuations this can prompt. But if this process occurs in several central banks at once, then the consequences are terrifying, as it means driving the price of shares down, with the concomitant financial and economic implications.
A month after the Normandy landings, in July 1944, several senior German army officers saw the end of the Third Reich coming and conspired against Hitler. He survived their attempts to kill him, but ordered the execution of all those suspected of involvement. Rommel could not be murdered, given his enormous prestige, but was forced instead to commit suicide to prevent the Gestapo taking measures against his wife and son. Germany had moved from the end of the beginning to the beginning of the end.
I think something like El Alamein is happening in the markets. The question now is how many casualties there will be between the end of the beginning and the beginning of the end of the biggest financial bubble in history.