Among the many reasons being cited for the current global equity market sell-off, one jarring realisation is that the promise of more central bank stimulus does not appear to be working any more. Not only is it not working, it is arguably now detrimental to stock market health as near zero- and even negative – official interest rates undercut the ability of banks to make money.
For starters, forcing banks to pay for the right to park excess funds in central bank vaults – negative official interest rates in Japan and Europe – has not really encouraged banks to lend all that much more, but is simply rather taxing them for being awash in funds as a result of the other arm of central bank policy, quantitative easing (QE).
By hoovering up Government and corporate bonds – and in the case of the Bank of Japan even Japanese equities – central banks stuffed banks with what are called “excess reserves” left sitting in central bank deposit accounts. The idea is that these excess reserves would then encourage banks to boost overall lending so that these excess reserves would eventually decline as percent of credit outstanding back to more normal levels. At the same time, central bank bond purchases would help drive down longer-term interest rates.
So much for the theory. QE has been successful in lowering long-term interest rates. Indeed, Japanese 10-year bond yields only this week touched a record low of negative .05%. US 10-year bond yields touch a three year low this week of 1.55%.
QE has arguably also been successful in pushing up equity prices, if only because low interest rates at first pushed up price-to-earnings valuations as investors searched for yield. The S&P 500’s price to forward earnings ratio rose from a low of 10.8 in late 2011 to a high of 17 earlier last year (compared to a long-run average of 14.5). But with the threat of higher US interest rates looming and a flattening out in US earnings growth, the PE ratio beat a retreat through last year, which in turn helped account for Wall Street’s relatively poor performance.
Most importantly, QE has not been too successful in achieving its main goal – pushing up global inflation via a credit-fuelled boost to demand. To the extent inflation has lifted, it’s only been via currency depreciation – which from a global perspective is a zero-sum game. Japanese and European inflation is arguably higher than it would have been thanks to earlier weakness in their currencies against the US dollar.
But that was fine while America was growingly solidly and could withstand a higher currency, but with the collapse in the US oil sector and broader competitive pressures on its manufacturing sector, it now seems the US economy can’t take much more across the board exchange rate strength.
As we’re seeing this week, despite the best efforts of both the ECB and BOJ to further trash their own currencies, they are rising against an embattled US dollar. In turn, that’s partly because the US Fed has now seemingly scaled back its own interest rate hike intentions out of concern for US dollar currency strength. So the tit-for-tat global currency war continues.
Meanwhile, the fact that credit growth has not ballooned means banks are still left with excess reserves sitting on their balance sheet. The move to negative interest rates in Japan and Europe is now a tax on the fact banks can’t or won’t boost lending. In the United States, super low bond yields are now leading to fears that banks can’t generate enough of an interest margin to sustain profits. US bank stocks outperformed on Wall Street last year in part because of the expectation of higher US interest rates – and fatter interest rate margins – this year.
Yet by February 11, US financial stocks has fallen 19% so far this year. Japanese banks are down almost 40%, while European banks are down 25%.
Of course, other factors are also at play. The collapse in oil prices is leading to concerns over defaults among highly indebted (particularly US) energy companies, and there’s even new concerns over Greece’s ability to meet its latest bailout package. Then there’s China and the commodity price rout.
And here’s yet another problem: the US economy could already be reaching its capacity constraints, which will limit the ability of earnings to grow much further. As it stands, America’s labour market continues to do well – with the unemployment rate pushing down to 4.9% and wage pressures starting to percolate. That makes it hard for the Fed to simply leave interest rates on hold just because Wall Street is demanding it for the sake of a weaker US dollar. One way or another it seems, US growth and corporate earnings must slow.
We’re left with the following quandary: the locomotive of the global economy, the United States, is running out of track. And despite their best efforts to stoke their own furnaces, Japan and Europe will struggle to take up the slack.
It’s hard to see how equity markets can overcome all these concerns easily, and the line of least resistance in such circumstances may well be to push valuations back down to compellingly cheap levels. We’re not there yet.