Central bankers have a clearly stated policy of encouraging risk-taking within financial markets by setting interest rates at negative levels in real terms. This policy, which has now been in place for some time, has had a significant impact on the beliefs and biases of many investors. Negative yields on long duration sovereign bonds are now being accepted as normal, with riskier assets trading at record levels. Within equity markets, we have seen the introduction of low volatility strategies, 'smart' beta and exchange-traded funds (ETFs), with market conditions clearly playing a part in the appetite for such products.
In this article, we explore whether this 'new normal' is in fact approaching its sell-by-date, and if so, the potential implications for stock picking. Given how important central bank policies are for the pricing of assets, our focus has to be on what they do next. If debt monetisation were to occur, leading to a more inflationary scenario, it would have significant implications for equity investing in terms of duration, leverage, geographical and political risk and asset intensity.
Is the Bank of Japan a first mover for alternative policies?
Since the monetary experiment of zero rates has been long-standing in Japan, with a negative interest rate policy (NIRP) also now underway, the Bank of Japan may be a good place to consider what comes next. In our view, Japan's implementation of quantitative easing (QE) has been largely unsuccessful in engendering an improvement in the money multiplier. The introduction of negative rates on certain reserve balances in Japan appears not to have changed this, with the propensity to save remaining high. This has raised the question of whether more radical policies are now required to ensure that consumers remain confident that the economy will achieve sufficient growth to enable the servicing of the mountain of sovereign debt that already exists and continues to accumulate. With the private sector largely disregarding the guidance of the Bank of Japan (BOJ) and continuing to save, it would seem likely that more direct involvement by the public sector is likely. The recently announced fiscal stimulus is a prime example.
The market is currently debating how this fiscal spending will develop in future and whether QE will evolve into something that is deemed permanent and hence a catalyst for a shift in inflationary expectations. Recent suggestions of 'helicopter money', swapping Japanese government bonds (JGBs) into zero-rate perpetual bonds, and other alternatives are understandable but we have no doubt that some of these are likely to be only 'trial balloons' from policy makers. The key factors we consider when assessing the likelihood of some of these more radical policy moves include the following:
- The BOJ owns a significant portion of issued JGBs, making asset swaps easier to enact. However, the impact on the balance sheets of the private sector holders of these securities, if the value were to be written down significantly or entirely, is a significant limitation.
- The maintenance of a capital surplus for the BOJ will be challenging if there is a major correction in the bond market resulting from new policies, with the Yen 450 billion reserves created to date providing a limited buffer. Improvements in the value of gold positions or foreign reserves will likely mitigate the impact, albeit only with significant associated Yen weakness.
- Direct financing of government debt would clearly be a crossing of the Rubicon that would require regulatory changes. In our view, it is debateable whether there would be sufficient motivation to enact such changes without an actual crisis justifying a breach of monetary principles that have existed for decades.
- Debt monetisation involves a generational transfer of wealth from the elderly to the young as the real value of savings is eroded. The political will to create inflation that may be difficult to control is likely to be lacking given the demographic profile of the average voter and politicians.
- Whilst the solvency of a central bank is never really under threat given its unique potential to create money, the efficacy and durability of monetary policy could be called into question if the bank's credibility begins to be eroded. In this regard, it is essential that the net present value of the seigniorage (profit made by issuing currency) that the BOJ can deliver is greater than any balance sheet implications that may result from greater inflation being priced into financial assets.
Given these various obstacles, we believe that the debt monetisation debate will remain theoretical for now and the government and BOJ will continue to focus on incremental solutions around the scale of NIRP and fiscal stimulus. This, however, is the scenario that most closely fits current consensus. As a result, we think it is necessary to consider a 'what if' scenario for debt monetisation and the likely implications if it did occur.
Stock picking implications in the event of debt monetisation
It is clearly difficult to be exact on both the timing and implications of radically new monetary policies. Our educated guess would be that any further radical policies that have the stated intention of creating greater demand and inflation would have the following consequences.
Duration: Long duration returns are being valued using low discount rates (negligible inflation premium). Growth stocks and businesses with stable earnings will have vulnerable valuations as a result. This duration challenge will also be reflected in a preference for cash flows dictated by regular re-pricing versus irregular (for example, general insurers versus life insurers).
Asset intensity: Asset turnover will improve more notably for asset rich businesses. Of course, this will be an inflationary illusion as and when assets require replacement. However, given that there has been little regard for real returns in a world dominated by disinflation, investors' willingness to capitalise on an improving stream of nominal returns should not be underestimated.
Leverage: The value of cash holdings will be significantly eroded if inflation ensues, while long duration, fixed debt will be prized. High leverage with variable rates, however, will be less attractive given the inevitable upward trajectory of the whole yield curve in tandem with any inflationary expectations.
Asset age: Young assets may be valued more highly than those with already stretched asset lives.
Political risk premiums: The adoption of inflationary solutions will have varying effects on different parts of society depending on income profile and demographics. This is likely to result in the public support for existing political parties evolving, with possible shifts in voters' acceptance of free markets and capitalism. Profit shares versus income shares within economies may be placed under even greater focus as a result. In addition, greater involvement of politicians and policy makers in the operations of the private sector has historically been accompanied by lower levels of productivity and depressed equity valuations.
Asset class preference: In a relative sense, equities will provide greater inflation protection than bonds. However, given that all risk assets have profited during the era of QE, the benefits from a switch out of bonds may prove temporary and lower valuations for all financial assets will be a persistent headwind.
Geographic risk: The willingness to adopt an inflationary prescription is far from uniform and heavily dependent on the existing level of indebtedness and political expediency. As a result, currency divergence between 'inflators' and others may be large, with implications for net exports and a consequent shift away from free trade back towards protectionism.
Future quality in a more inflationary scenario
Our focus when picking stocks is to identify 'future quality' businesses which are stewarded by a strong management team, where the future cash flows are both growing and in excess of the cost of capital, and where the valuation of these cash flows is too low. We believe that these principles assist us in picking businesses that can endure through all market cycles. However, the businesses that can deliver growth in real cash flows in an inflationary scenario may differ from those favoured in a deflationary environment and the hurdle rate for returns will likely rise. We have always assessed companies using real cash flow return on investment valuation models and as a result our process would be unchanged.
The implications we have outlined above do not and cannot take into account all the expected complexities of any actual new policies and hence it is important that pragmatism at the stock level is maintained. The prescriptive nature of some investment philosophies, particularly if they have evolved and been back-tested in the disinflationary era during which most investors' careers have developed, may provide less value-add than currently assumed in a more inflationary environment.
Benchmark investing equally may come under the spotlight. Indices, in our view, reflect a survivorship bias for businesses that do well in prior eras. Given the increasing proportion of assets deployed in passive strategies, there are many investors who will be constrained by the dominance of deflation survivors within indices. Conversely, active investors should have significant opportunities if they correctly assess the implications of an inflection point created by policy makers.