The Strategist

Are the Global CB's Actions Causing a New Crisis?

07/16/2015 - 16:35

The global CB’s actions could trigger a new crisis, according to CEO of GAM Holding Alexander Friedman.
As he notes in his article on the Project Syndicate, unprecedented measures, taken by central banks to stimulate the economy, will eventually become the cause of the global crisis.

In his book that won the Pulitzer Prize, the economist Liaqvat Ahamed tells the story of how four central bankers, trying to be faithful to the policy of "gold standard", turned the world upside down and caused the Great Depression. Today central bankers generally share a new conventional theory that loose monetary policy is beneficial. Is the monetary authorities are willing to change the world again?

In the orthodox monetary policy, the gold standard is no longer considered a saint. In the 1920s, a similar attitude of central banks had led to mismanagement of interest rates, which led to the global economic crisis, and ultimately paved the way for the Second World War. However, an unprecedented period of co-ordinated soft monetary policy, which began during the financial crisis in 2008, can cause the same problems. It have enormous visible effect on the financial markets.

The primary effect is obvious. Institutional investors grew difficult to obtain a positive real rate of return on those investments that have traditionally been considered a "safe haven." For example, life insurance companies with great difficulty fulfill their obligations under a guaranteed level of return. According to a recent report by Swiss Re, if government bonds traded at levels close to their "fair value", the insurance companies in America and Europe could earn an additional approximately $ 40-80 billion in 2008-2013 (under the condition that the share of investments in fixed-income instruments is typically 50-60%). Pension funds could increase its annual revenue by $ 40-50 billion in the same period if bond yields were higher by only 1%.

The response of investors in the near-zero interest rates were unprecedented changes in the order of asset allocation. In most cases, they have increased the share of investment in riskier assets. To begin with, they shift into riskier credit instruments, which led to contraction of spreads on corporate bonds. When the yield on commercial paper fell to historically minimum levels, investors decided to switch to the stock market. According to a recent survey conducted by State Street, about 63% of global institutional investors increased their investments in shares of companies from developed countries during October 2014 - March 2015. However, about 60% of them are waiting for the market correction of 10-20%.

Even the most conservative investors of the world agreed to take unprecedented risks. Pension funds in Japan, including the largest pension fund in the world, has fallen off the local bond market to a record low rates. In addition to increasing investment in foreign stocks and bonds, they have increased investments in shares of Japanese companies the fifth consecutive quarter.

These investment decisions are very clear on the background of a negligible yield, which can be obtained from investments in fixed income instruments, but the subsequent secondary effect of this policy may eventually prove to be very destructive.

"Bullish" sentiment on the stock market have been retained for six years. Even after the market volatility that followed the crisis in Greece and the fall in the Chinese stock market, the valuation of companies remains high. The S & P 500 exceeds the level of 2008, stocks are traded at a ratio of 18 to their revenue.

Until the wind of global quantitative easing, cheap oil and the continuing inflows from institutional investors blows, the rally will continue in the stock markets. But at some point, the real market correction has to begin. And when that happens, pension funds and insurance companies will suffer from fluctuations in stock markets more, than ever before.

This excessive reliance on stock market arises when demographic trends are working against the pension funds. For example, in Germany, where over 20% of the population are over 65 years, the number of adults of working age will fall from about 50 million today to only 34 million by 2060. In developing countries, the trend of rapid increase in life expectancy and declining birth rate is likely to lead to a doubling of the population over 60 years old in China by 2050, which means that an additional half a billion people will be in need of support because of their disability.

The combined effect of significant losses on the stock markets and the growing proportion of people in need of support can lead to difficulties in meeting their obligations by pension funds. In this case, Governments, if they can, of course will have to provide support. Since 2007, public debt as a percentage of the volume of world GDP increased annually by 9.3%.

In Europe, for example, Greece is not the only country mired in debt. In 2014, the level of public debt in the euro area continued to grow, reaching almost 92% of GDP - the highest figure since the introduction of the single currency in 1999. If not only the pension funds, but the governments are not able to support the older generation, the continent will experience a growing social instability - a large-scale version of the saga unfolding in Greece.

New "masters of finance", apparently successfully achieved many of the goals set by the financial crisis that broke out seven years ago. They deserve praise for this. But when there is an emergency, massive political response always leads to unintended consequences, as a rule, sowing the seeds of the next full-fledged crisis. Given the recent shake-up in the market, we can ask, whether this new crisis already begun.