22 June 2020

QE-addicted markets will not get us out of this crisis

By Bill Blain

Financial markets have been the cornerstone of capitalism’s success by allocating efficiently scarce capital to the best businesses. Private enterprise was disciplined to ensure returns to attract capital. Markets worked. The private sector proved vastly superior at generating wealth than government bureaucracies which squandered it, and the failure of command and control economies from Russia to France highlighted just how attractive market economies could be.

But, over the last few months of coronavirus, we’ve seen the complete breakdown of the financial markets as efficient allocators of capital. They have become little more than parasites, feasting on government bailouts and central bank QE Infinity programmes. The massive disconnect between the damage to the real economy and looming recession versus frothy global stock markets is unprecedented. Rising stocks suggest record earnings, while tumbling bond yields send the contradictory signal of impending economic calamity.

The chaos should be a wake up moment, but markets aren’t making rational decisions. They are simply chasing the money.

Equity players are no longer focused on the strength of company managements, their earning potential, their credit worth or their ability to pay dividends. All that matters is how much prices will continue to rise as governments rescues and central bank money buoy them up through unlimited monetary policy distortions.

Fund managers are blithely buying corporate bonds, junk bonds and emerging market debt on the expectation they will all tighten, rising in price, as a result of Central Bank QE. They aren’t particularly worried about the massive looming coronavirus recession, or whether it will be V, U, W or L shaped. They don’t particularly care about company risk metrics either. As long as the central bank is prepared to buy, then they are effectively guaranteed against default.

The result is every financial asset – even those not directly covered by QE programmes – tightens and rises in price. It’s Financial Stagflation – bonds and stock prices rising despite the global trade slowdown, virus recession and the growing sense of economic unease.

As long as central banks pump in liquidity by buying bonds, then all prices rise. But that means yields decline, meaning investors have to take greater risk to garner any meaningful returns. Eventually, when C-minus junk bonds are yielding the square root of nothing, investors decide to seek returns in equities – which have been equally inflated by this yield tourism, and the boost they’ve been getting from stock buybacks (funded by ultra-low interest rates in bond markets).

The consequences of financial repression will be high. Twenty years ago, a £1 million pension pot could pay you £100,000 a year. Five years ago, It might have got you £40,000. Today, your same £1 million pot will probably pay you £10,000 – which will feel very unfair when final-salary government pensions will be bankrupting the nation.

As markets fail to function, the effects on growth will be long-term.

If you are a new company looking to finance the next great technological innovation that could boost the UK economy, forget the markets. They are focused entirely on arbitraging QE Infinity.  If you require debt finance to build wind turbines, solar farms and tidal energy flows to green the economy, you won’t find the banks very responsive – unless of course they can boost their own environmental credibility by slapping a ‘green bond’ label on it so they can flog it to central banks.

There a host of pernicious side-effects – including rising inequality stemming from failing markets. The loss of market discipline means junk bond buyers end up sustaining and enriching the owners of private equity owners issuing zombie junk. The markets disconnect from reality means retail investors start to believe dangerous concepts such as Tesla being worth $1000, or an electric truck maker that hasn’t sold a single car being worth more than Ford.

The collapse of financial markets into irrelevance has not happened overnight. It’s a direct consequence of the last Global Financial Crisis when QE and “do whatever it takes” saved the global economy. But now markets are utterly addicted to it. The choice now is stark – either we effectively let Governments run the economy – with all the attendant bureaucratic dangers that creates, or we wean markets off the QE heroin – which is going to hurt!

The reality is that markets are not going to cure this crisis. That is now entirely up to governments and central banks.

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Bill Blain is market strategist and head of alternative assets at Shard Capital. He writes a daily market commentary called The Morning Porridge (www.morningporridge.com).

Columns are the author's own opinion and do not necessarily reflect the views of CapX.