Much as anticipated at the end of last year, positive news flow and sentiment outweighed the negative. Fuelled by the expected continued (as in the case of the US and euro zone) or enhanced (Japan, UK) liquidity support from the major central banks, risks assets such as equities and selected spread products continued to rally, with benchmark government bonds narrowly range-bound.
The markets digested political uncertainty in Spain and Italy, lackluster euro zone growth, the first installment of sequestration in the ongoing fiscal cliff saga and the apparent outbreak of ‘currency wars’, discussed in the February issue of Allianz Global Investors Insight publication. At the time of going to press, equities reached multi or all-time highs and junk bond yields all-time low yields. For 2013 we expect the global economy will continue its slow recovery with the support of ample liquidity.
Central banks balance sheets, indexed
Source: Datastream, as at 11 March 2013
Our contention that quantitative easing (QE) will continue in an aggressive manner for longer than markets anticipate is based on our conviction that we are witnessing a secular, fundamental change in the monetary policy framework in the Organisation for Economic Co-operation and Development (OECD). The 1980s, 1990s and the 2000s were marked by money supply targeting, the setting of maximum inflation rates and the creation of independent central banks.
Generally central bankers were defined by the inflation experienced in the 1970s, which made inflation the biggest evil. The experience of the ‘great financial crisis’ has led to a fundamental rethink with a new generation of central bankers at the helm who view the deflation experienced in Japan as the greatest threat to our financial system; this has led to higher tolerance of inflation and less emphasis on the money supply (particularly driven by the volatility of the money multiplier).
Consequently central bank balance sheets have expanded significantly (see chart above). It is doubtful that all of this expansion of the central bank balance sheets can be sterilised and, provided a return to more normal monetary transition mechanisms (recovery of the money multiplier), inflation should therefore start to edge up. This upward pressure on inflation should be further supported by the lessening pressures on wages as the major impact of globalisation fades and emerging market currencies appreciate.
The investment implications of the secular shift in central bank policy are significant:
- The currencies of the countries experiencing most central bank balance sheet expansion will, in our view, all other things being equal, experience the biggest currency devaluations. This is already apparent, with the country with the strongest balance sheet expansion, the UK, experiencing the weakest currency on a trade-weighted basis, and the country with the least expansive monetary policy, Japan, experiencing the strongest currency on a trade-weighted basis.
- As previously argued, expected moderately rising inflation rates, coupled with regulatory change forcing many capital market participants into so called ‘risk free’ assets, should lead to investors experiencing negative real yields for benchmark OECD bonds.
- Equities typically perform well during times of de-leveraging and rising but moderate inflation rates, further supported by substantial dividend yields, often in excess of benchmark government bonds.
- Emerging market currencies (experiencing tighter monetary conditions and less central bank balance sheet expansion) should appreciate, which supports unhedged exposure.
Therefore, despite the progress of risk assets in Q1/2013, we remain constructive but significant risks remain:
- Political risk in the euro zone area (popular backlash and so on) could still lead to renewed tensions in the euro zone and further delay the much-needed recovery of the periphery.
- There is potential for serious conflict in the Middle East, which could drive up oil prices and significantly depress global economic growth.