About four years ago, the state of the European economies was so divergent that the markets were pricing in defaults across almost the entire periphery. Risk premiums were pushing half of Europe towards insolvency, and Germany was refusing to allow Draghi to flood the south of the continent with cash. The countdown to the break-up of the EU was underway, and that is what we warned at the time on Gurusblog. However, against all odds (at least as far as we were concerned), Draghi ignored the calls from Schäuble and began to expand the ECB’s balance sheet, just as the Fed had been doing since 2008. That marked the start of a journey into the unknown for the group of developed economies.
Today, four years on and with the Fed’s QE programme either ended or on hold, the majority of analysts now argue that the financial system should never have been flooded with electronic money in order to impose this financial repression. The side effects of the massive asset purchases by central banks and negative interest rates go beyond the condemns investors. These are side effects that are already very evident and are beginning to cause serious harm to insurers and pension funds, among other key players in the financial system. The flight to yield by these institutional investors is as reckless and devastating as the lack of returns on their investments if they stick with their usual portfolios. But that’s just the tip of the iceberg; the currency war is now in version 2.0, cash is being penalised, and yet money is circulating less than before, even though fixed-income prices remain in bubble mode. An irreversible blunder without chaos.
Over the past four years QE almost global investors have traditionally conservatives they are taking risks they can’t even imagine. Many have followed the advice of fund managers and advisers who are simply unaware of any conservative alternatives beyond traditional fixed-income investments. Others, however, aware of the risk of global insolvency, have continued to buy assets subsidised directly or indirectly by central banks for fear of going against the tide, of going against those who have the power to create money. All of them have taken, and are taking, a fundamental risk that combines insolvency with political (in)decisions. It is true that so far their gamble has paid off, as bonds from insolvent countries and companies have risen in price to such absurd levels that they generate zero or even negative yields. And this has provided them with additional returns on top of the coupons, which central banks have religiously ensured can be paid. But this investment profile, which drifts with the currents of central banks and the market in general, cannot be described as conservative simply because it does not invest in the stock market and has come out unscathed to date.
It is true that those of us who have warned of the risks of investing in insolvency and monetary policy, and have positioned ourselves to avoid these distorted assets, have incurred a certain opportunity cost. And that other, more solvent assets have not provided, over the last four years, the consistent returns enjoyed, for example, by holders of peripheral debt or banking products also based on the goodwill of central banks. But the guiding principle that no investor should ever lose sight of is the value and soundness of the assets in which they invest. Not their short-term returns. In the current situation that central banks have landed us in, both the carefree pursuit of returns and the stubborn insistence on achieving them are a one-way ticket to losses. And until the market has been thoroughly shaken out, conservative investors should focus more on preserving their capital than on growing it, unless they are prepared to take risks that are unsuitable for their risk profile.
The policy of kicking the can down the road has favoured debt over cash, undermined solvency in favour of insolvency, and, in short, ignored fundamentals in favour of the bubble. And the current financial crackdown is already having unsustainable consequences that no one knows how to mitigate, since taking one’s foot off the accelerator (raising interest rates in the US or scaling back QE in Europe or Japan) will lead to severe turbulence in markets that are trading at unrealistic levels. Such turbulence will in turn generate immeasurable imbalances in currencies and exacerbate the already tremendous political and monetary tensions that exist today. A scenario that will spiral out of control for the all-powerful central banks the moment they attempt any correction to their interventionist drift. And the fact is that this outlook catches us in Apache territory, given that the financial system has never been as distorted as it is today. With so much chaos, its inertia and reactions the moment we take our foot off the accelerator are completely unpredictable.
We do not know how much longer the house of cards that began to be built almost a decade ago can hold up. But it is clear that four years ago its frenzied construction accelerated, and its height and instability are becoming more uncontrollable with each passing day. When the turbulence begins to affect the prices of the most inflated assets, it will be precisely the portfolios of the misnamed «conservative» investors that will suffer further permanent losses, since only another similar bubble created by central banks could bring fixed-income yields back to their current levels. For their part, investors who have sought value in equities will also suffer losses, but these will be only temporary, as money will reasonably flow back into stocks offering sufficient returns once the panic subsides. Let’s not let the volatility blind us to the bigger picture.
The result of this absurd situation is that, paradoxically, the most conservative members, who over the last four years chatting in tandem with their assets held by central banks, they may fall into a deathly silence the moment a butterfly flaps its wings and turbulence destabilises this unsustainable equilibrium. That the silence of the Conservatives would be just as macabre as Jodie Foster’s lambs in the Oscar-winning film about the fearsome Hannibal Lecter.