“Nothing is so permanent as a temporary government programme,” according to Milton Friedman, the 20th century free-market economist. His views echo the deeper concerns of pension plans worldwide, with the US Federal Reserve now shifting into overdrive.
The scale and speed of its latest over-reach has no parallel: monetising government debt and providing a credit backstop for corporate America were essential to cushion the blow from three simultaneous crises: a pandemic threatening human life, a large-scale lockdown causing a massive supply shock and freefall in the oil price rocking the commodities markets.
The Fed did what the Fed had to do: pull out all the stops to stave off a 1929-style depression and a gut-wrenching market meltdown. While welcoming this decisive response, investors also know there is no such thing as a free lunch.
“The Fed and the Treasury have essentially created a new moral hazard by socialising credit risk,” says Scott Minerd, chairman of New York-based Guggenheim Investments. “The US will never be able to return to free market capitalism as we know it.” He also questions how the Fed’s purchases can turn bad debt into good debt.
The resulting price distortion will further serve to suppress the self-healing powers of financial markets already weakened by the last decade’s quantitative easing programmes in the West.
Hailed as a temporary crisis-era measure at the outset, QE is now just another item in the central bank toolkit. Not only did it fail in its original intention to tackle sub-par economic growth. It also put a rocket under all asset prices, decoupling them from the real economy. The sheer scale of the ensuing convictionless trades was evidenced by their rout in March.
“On one level, you can’t really blame central banks for doing what they do in a crisis,” says Paul Sheard, senior fellow at Harvard Kennedy School. “They have been given a job to do by society and feel obliged to do whatever it takes.”
But he does question whether it makes sense that central banks are given this job as if they are the only game in town. After all, monetary policy works through financial markets. By its very nature it distorts financial activity, causes asset bubbles and accentuates income and wealth inequalities. Looking ahead, therefore, pension plans are grappling with three sets of emerging concerns.
The first relates to debt monetisation in America and Europe. Public debt is set to go through the roof as governments have rushed to provide extensive support to businesses and their employees. With central banks buying this debt, interest rates will be anchored in the zero-bound range for a long time, with the attendant mispricing of risk.
For pension investors, lower rates mean their bond portfolios will no longer deliver a decent income to fund their monthly pension payouts at a time when the first and largest cohort of Baby Boomers are entering their golden years. Worse still, lower rates also mean that the discounted value of their future liabilities will rise.
More than that, there are real fears that debt monetisation could eventually wreak havoc on pension finances, if overzealous governments pursue growth-at-any-cost policies that sow the seeds of a toxic double-digit inflation, like the one in the West in the 1970s.
That leads to pension investors’ second set of concerns: whether economic growth will resume soon enough to sustain the current earnings multiples and reduce market fragility. Will governments continue to rely on central banks to do the heavy lifting, or will they finally tackle the structural faultlines that condemned advanced economies to sub-par growth in the last decade? For too long, thorny supply-side issues around immigration, taxation, education, innovation and social welfare have been kicked into the long grass. The spectre of secular stagnation has haunted many developed countries.
That connects with the final set of concerns: whether investors’ traditional navigation tools — such as mean reversion, correlation, diversification, risk premia, time premia, fair value and yield curve — may become even less relevant. Their worth was diluted in the last decade where markets were moved more by the utterances of central banks than by developments in the real economy.
Indeed, “don’t bet against the Fed” was a common refrain. Perhaps no longer: some pension investors now hold that the power of the Fed has been seriously exaggerated by the markets. And after the current crisis, asset prices will increasingly reconnect with their fundamentals, as markets enter a prolonged era of volatility.
Yet, others subscribe to the Friedmanite view, in the belief that markets are now so addicted to Fed largesse that they will struggle to kick their old habits. The current crisis will be the defining test.
Amin Rajan is chief executive of Create-Research
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