Kristina Hooper, CFP®, CIMA® is head of portfolio strategies for Allianz Global Investors Distributors LLC. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
In many places around the world, investors are hearing a familiar sound. It’s the sound of central banks turning on the taps to increase liquidity. But don’t confuse it for the celebratory pop of a champagne bottle. Rather, it’s a warning signal that we’ve entered an era of financial repression.
In the past few weeks, both developed and emerging economies have become more “accommodative.” The European Central Bank, China, Denmark, Brazil and South Korea cut interest rates. And the Bank of England has increased quantitative easing. These major policy moves are likely to inspire mixed feelings. The bad news is that the economic outlook has worsened enough that central banks feel compelled to act, as GDP growth estimates continue to be lowered.
However, there’s an upside to the recent string of rate cuts: a less optimistic view of the global economy has prompted them to take action, which demonstrates their willingness to go on the offensive.
It’s important to note that emerging markets are cutting rates due to the slowdown in the developed world, as opposed to having excessive debt and high unemployment. Nevertheless, slashing rates and increasing the money supply should boost confidence in the economy and capital markets at a time when no other government bodies may be able or willing to act.
Central banks around the globe are also lowering their growth forecasts. The People’s Bank of China announced on Friday that weak global demand will hinder growth. The news came on the heels of the release of its second-quarter GDP number, which dropped to 7.6%, its lowest level in three years. The Bank of Korea reduced its 2012 economic-growth forecast for the second time this year, a day after it unexpectedly cut interest rates and signaled it would act preemptively to protect against slowing global growth.
The ECB last week warned in its monthly report that the downside risks for the region “have materialized” and that the fundamental outlook remains clouded by “heightened uncertainty” as European policy makers struggle to come up with a solution to the crisis before contagion spreads. And strategists anticipate that Brazil will lower its growth expectations in the next week. Elsewhere, the Asian Development Bank cut its growth forecasts for developing Asia, citing financial and economic problems in Europe and the United States that have lowered demand for exports. Southeast Asia remained a bright spot, however. We will likely hear something similar from the International Monetary Fund, which is expected to lower its outlook for global economic growth today.
Despite a weaker outlook, it’s encouraging that central banks are not sticking their heads in the sand. In this accommodative environment, and given the growing chorus of economists lowering estimates of U.S. GDP growth, there is an anticipation that the Federal Reserve will act in some way.
Further quantitative easing in developed markets will be a function of inflation expectations, however. If those expectations fall too far in the U.S., Fed Chairman Ben Bernanke will react, as he has done in the past. But the recent pick-up in soft-drink prices and a 0.5% gain in food prices within the Producer Price Index on Friday would suggest otherwise. Right now, the U.S. economy may not be weak enough to warrant another round of stimulus.
But keep in mind that monetary policy for developed markets may not be as effective as it is in emerging markets. At a time when law makers and public officials have trouble solving economic crises, or even agreeing with each other, “activist” central banks may be the only answer for a lack of faith in government. Just look at how the impasse last summer between Congress and President Obama over how to handle the national deficit shook investor confidence to the core.
A New Era
Still, there are significant implications to this central bank activism. We’ve been thrust into a state of financial repression. Interest rates for savers have become incredibly low and some inflation-adjusted rates have become negative. And the future for savers could be far more destructive when inflation increases and real rates fall further.
But what is repression for savers can be viewed as liberation for spenders and investors, who are on the other side of the trade. Spenders who have good credit can take advantage of historically low rates in order to buy a house and make other large purchases. They can also refinance existing homes in order to lower their monthly payments and improve cash flow. We can see signs of this activity in the stabilization of the housing market over the last year. In fact, the S&P 500 Homebuilders Select Index is up 55% over the last two years ending June 13. Further evidence can be found in the consumer credit numbers for May, which show a sizable increase in credit, particularly the 18-month trend of growth in “cap ex-like expenditures” such as education and car loans. And those investors with longer time horizons should move out on the risk spectrum, focusing on asset classes that have historically provided positive "real" returns such as high-yield corporate bonds, emerging-market bonds and dividend-paying stocks.
The era of financial repression is upon us. If investors are not well positioned for this environment, then they may soon find the real returns of their portfolios underwater.