The Covid-19 crisis has inflicted a triple whammy on the global economy: a demand shock, a supply shock and a financial shock. It has also forced a moment of reckoning for key central banks who have been obliged to overplay their hands.
The US Federal Reserve’s balance sheet has ballooned tenfold since 2007 – out of nowhere. Bailing out junk bonds, buying high-yield ETFs and lending directly to corporate America has pushed the Fed well out of its comfort zone to stave off a 1929-style market meltdown.
The resulting blatant disconnect between financial markets and the real economy is yet another sign – if one were needed – of the over-financialisaton of advanced economies.
Historically the primary role of equity markets has been to channel capital from savers to enterprises that want to grow their businesses. Savers were thus issued shares that were meant to provide a claim on the future profits of the borrowers.
Over time, however, trading in such claims itself has become more profitable than the reward for holding them, giving rise to two other outcomes: a vast growth in financial activity via derivatives trading; and the conversion of investment returns into a monetary phenomenon, influenced far more by top-down central bank action than by bottom-up securities selection.
The perception that the Fed would always intervene if markets tumbled has become deeply ingrained in investor psyche since the 1980s. With every slide, markets have welcomed back their sugar daddy with open arms.
After the 2008 crisis, central banks reduced the interest rate to near zero, then brought in quantitative easing, then issued “whatever it takes” type statements, then more QE – all in a vain attempt to reboot their economies and rekindle inflation.
And now, an over-reach: not only more QE and yield curve control, but also direct lending… No wonder markets are delighted. The prevailing narrative is “bad news for the economy is good news for risky assets”. Why? Because central banks would be forced to open yet more financial spigots.
Of course, monetary stance has always been a factor in the short-term cyclical movements of asset prices. ‘Short term’ has now lasted for decades, giving rise to moral hazard as investing has become a one-way bet.
Notably, however, the majority of respondents in the 2019 Amundi–CREATE* survey believed that the central bank stimulus has long since reached a point of diminishing returns. Each boost only gives a temporary sugar high while adding to market fragility.
The current crisis will be a true test of the old refrain “don’t bet against the Fed”. Some investors are relieved by its jaw-dropping action. But many more fear that markets will become even more distorted and fragile. Before long, therefore, they will be forced to learn to stand on their own two feet via painful adjustments. Time will tell.
I have covered this topic more fully in my FT article, published today (3rd June 2020). If you are a subscriber, you can access it here.
Amin Rajan – Research Update 