January 7, 2013 10:55 am
Beware the ‘central bank put’
Mohamed El-Erian asks how far central banks can divorce prices from fundamentals
The investment recommendations made by many financial commentators are now dominated by cross-asset class relative valuation rather than the fundamentals of the investment itself. A typical refrain runs something like this: buy X because it is cheaper than other things out there.
This is an understandable approach as unusual central bank activism has artificially elevated certain asset prices. Yet the dominance of this increasingly popular advice comes with potential risks that need to be well understood and well managed.
Several asset classes now have highly manipulated prices due to experimental central bank activities, both actual and signalled. The more this happens, the more investors come under pressure to migrate to higher risk investments in search of returns.
Ben Bernanke, Federal Reserve chairman, said as much at his latest press conference, noting that the aim of policy is to “push” investors to take more risk. True to his wish, many pundits seem eager to discard fundamentals in favour of searching for (and levering) anything that “yields” more.
This situation is reminiscent of 2006-07, when hyperactive liquidity factories also pushed some asset prices to artificial levels, thus contributing to a generalised and indiscriminate compression of risk premia. In the process, investors were comforted by the then-popular notion of the Great Moderation (the belief that central banks and governments had conquered the business cycle). We all know what happened next.
This historical parallel is not perfect, however. As I wrote in March 2007 in the Financial Times, the liquidity factories then were endogenous to the markets. Leverage was created by private participants (particularly investment banks) taking on greater risk.
Today, the major liquidity factory is exogenous to the markets. The sizeable balance sheet expansion is in the official sector, most importantly, central banks. Just a few weeks ago, the Federal Reserve announced it is targeting a further $1tn in asset purchases in 2013, representing a third of its existing balance sheet. Other central banks – particularly the Bank of England, the Bank of Japan and the European Central Bank – are also expected to expand their balance sheets again in the months ahead.
This makes the current cycle relatively less dangerous given the greater inherent stability of a central bank’s balance sheet. Unlike private sector institutions, it is hard to force a central bank to delever without some dramatic combination of exchange rate, inflationary and political pressure.
But, critically for both economic prospects and investors, greater relative stability does not guarantee absolute stability. There is a limit to how far central banks can divorce prices from fundamentals. Moreover, as illustrated in the minutes of the latest Fed meeting, there is already discomfort among some policy makers due to the costs and risks of unconventional policies.
Also, at some point, and it is hard to tell when exactly, the private sector will increasingly refuse to engage in situations deemed excessively artificial and overly rigged.
This is particularly relevant for asset classes (such as high yield corporate bonds, equities and certain highly leveraged products) outside the direct influence of central banks – an influence that is applied through direct market purchases and forward-looking policy guidance. With the weaker central bank impact, prices need to have greater consistency with the realities of balance sheets and income statements.
In such a world, investors should expect security and sector selections to get repeatedly overwhelmed by macro correlations. Since a growing number of asset classes are now exposed in a material fashion to the belief that central banks will deliver macroeconomic as well as market outcomes, investors have assumed considerable macro-driven correlations across their holdings. Moreover, with seemingly endless liquidity injections, the scaling of such exposure can easily disconnect from the extent to which prices deviate from fundamentals.
Investors should also expect greater volatility in their portfolios as a whole. With the Fed’s move to quantitative thresholds, and particularly its use of historical unemployment data (as opposed to the forecasts that will be used for inflation, the other threshold), routine data releases will lead to greater fluctuations in asset prices.
Have no doubt: central banks are both referees and players in today’s markets. With 2013 starting with so many liquidity-induced deviations, investors would be well advised to take greater care when pursuing opportunities that rely mainly on the “central bank put”.
Mohamed El-Erian is the chief executive and co-chief investment officer of Pimco
Copyright The Financial Times Limited 2013