CFA Institute Magazine

Archimedes in the Bathtub

  1. John Rubino
Will central banks' plunge into equity markets cause massive displacement?
Archimedes in the Bathtub View this article as a PDF


Toward the end of 2016, US Federal Reserve Chairwoman Janet Yellen began expressing a casual wish with potentially huge implications: She’d like the Fed to start buying equities. As she told a group of Kansas City bankers in September, "It could be useful to be able to intervene directly in assets where the prices have a more direct link to spending decisions."

For an institution that a decade ago was limited to setting overnight interest rates—and that carried a balance sheet valued in billions rather than trillions of dollars—buying common stocks might seem like an alarming example of mission creep with myriad unintended consequences. But the Fed, should it decide to take that step, would not be alone. Several central banks are already active stock market "investors," and others, including the European Central Bank (ECB), are being urged to consider it.

The Bank of Japan (BoJ), for example, has been battling deflation since the 1990s and, after vacuuming up every available government bond, recently began buying equity exchange-traded funds (ETFs). By year-end, it is forecast to be the largest shareholder in 55 major domestic firms.

Also, the Swiss National Bank (SNB), in an attempt to manage its too-popular currency, has become a major shareholder of Apple (15 million shares) and Microsoft (20 million shares), among many other global blue-chip stocks. The bank’s stock portfolio grew by 41% over the 12 months ending June 2016 to a value of about $127 billion, close to 20% of its total foreign currency reserves.

Why are these central banks behaving like hedge funds? Because "The current iteration of QE has reached its limit," says Joseph Gagnon, senior fellow at the Washington, DC–based Peterson Institute for International Economics. "[The BoJ and SNB] now own most of the available government bonds in their territories." Yet, their economies still require monetary stimulus, so those central banks are moving on to the next big, accessible asset class.

Now, a rising chorus of voices—including the Fed chair herself—is urging the world’s two biggest central banks to follow suit. "You don’t want to tie your hands when you don’t know what you might need your hands for," says Gagnon. "And, it’s possible that the most neutral monetary policy is not one in which a central bank only holds Treasury paper but one in which it holds a market-weighted basket of all securities—corporate bonds, REITS, equities, anything that trades on exchange."

A Fire in Need of a Spark

Will 2017 be the year in which the Fed and the ECB start buying equities? Probably not, says Nick Kounis, head of macro and financial markets research at Dutch bank ABN AMRO: "When equity valuations are depressed and markets are pricing in large systemic risks, central banks buying equities can have a significant impact." But with share prices near their all-time highs in early 2017, "you'll have a less significant impact and greater concerns about what impact you do have," he says.

So, what would it take for the Fed and ECB to join the equity-buying party? The following three scenarios, all of which seem possible (and are perhaps even probable) before decade's end, could create the right conditions:

  1. ANOTHER RECESSION. The current global expansion began in 2009, which makes 2017 its ninth year. According to the National Bureau of Economic Research, the average expansion lasts just under six years. If history is a guide, this average suggests that the present expansion is likely to end fairly soon, to be followed by the usual equities bear market and related financial disruptions.
  2. A BOND SHORTAGE. During the next downturn, the ECB and Fed will find that, since they already own such a large part of their countries' sovereign debt, QE on the necessary scale might quickly soak up what's left. In any event, "as central banks have recently discovered, adding reserves to commercial-bank balance sheets during a recession is not an efficient way to boost lending," says Kounis.
  3. THE ZERO BOUND. Pushing interest rates below their current historic-low levels will be either impossible or counterproductive, predicts Gagnon: "We're not going to see 10-year bond yields go much below zero, because people will just hold cash rather than government bonds that yield a big negative number. That means monetary policy is constrained at the zero bound and [central banks] need other tools." This constraint is especially true for Europe, where rates are already below zero in many cases. But, the US is not far behind.

The result? "In the next bear market, buying equities, whether we like the idea or not, will be part of the policy mix," says Michael Kretschmer, CFA, chief investment officer at Dutch investment firm Pelargos Capital.

Federal Reservations

A set of circumstances in which the ECB and Fed are forced (or freed) to buy vast numbers of equities would represent a sea change in government policy. What would this shift mean for the economy, the financial markets, and the money managers who must navigate them?

Somewhat (but not drastically) higher stock prices. "Central banking policy is shifting from lender of last resort to buyer of last resort, which means the 'Greenspan put' has become a key part of monetary policy," says Kretschmer. He envisions "a very favorable demand environment for listed equities" in which historical valuation measures such as P/E and dividend yield are less relevant than in the past.

But, at least some of this added demand is already priced in, says Patrick Artus, chief economist at French investment bank Natixis. "QE and very low interest rates have an indirect effect on equity prices [by making stocks more attractive relative to artificially depressed bond yields]," he says. "Another efficient way of raising equity prices is to weaken the currency. There's a strong inverse correlation between, for instance, the yen and Nikkei and the euro and European stocks." The ECB's aggressive QE program, by contributing to the recent big drop in the euro's value, has already boosted European equity prices.

Meanwhile, the developed world's zero interest rate policy/negative interest rate policy (ZIRP/NIRP) has resulted in much lower borrowing costs for corporations across the quality spectrum, leading to a huge burst in corporate bond issuance. Most of the proceeds — especially in the US — have gone toward dividend increases and share repurchases, which have also supported share prices. Accordingly, as shown by the chart on page 59, buybacks and dividends have accounted for a rising share of operating earnings.

All of this means that central banks' switch from bonds to equities is on balance positive for the latter, but only modestly so, because QE and ZIRP are already very helpful.

Market distortions. If stock markets exist to efficiently allocate capital through price discovery, then how does equity-index buying by central banks affect this signaling mechanism? Put another way, if public money is flowing into broad market indexes without regard to the constituent companies' relative merits, how can investors and other capital allocators separate wheat from chaff?

The answer, says Kretschmer, is that they can't: "Price discovery is to capitalism what free speech is to democracy. Central banks buying equity ETFs indiscriminately rewards public companies regardless of corporate performance. Capital market participants would then need to question whether there is still truth in price."

A related problem with central-bank index buying is that it subsidizes size. Because ETFs tend to contain the shares of established firms, buying them with public funds raises their value relative to smaller, non-favored players. This competitive advantage might be used to consolidate industries, lobby for regulations that stifle pesky newcomers, and generally constrain market dynamism. The result, predicts Kretschmer, might be "greater concentration and less innovation going forward."

Moral hazard. Does public support for equity prices encourage investors to ignore risk because they assume central banks will protect them? The short answer is yes.

"Central banks are not constrained by balance sheets, so betting against them is a fool's game and investing along with them a rational decision," says Kretschmer. As a result, "follow the public money" has already replaced fundamental analysis in the minds of many bond analysts. With equities, he says, "it's possible that investors will be encouraged to front run central-bank buying programs. And, it's fair to assume that society will take on more risk than it would or could if left to the price-finding mechanism of the market."

Back-door industrial policy? If central banks become major shareholders in — and, therefore, owners of — large companies, is the result a form of industrial policy in which governments gain the power to direct private investment and strategic planning? (Imagine, for a moment, the reaction of President Trump to the discovery that the United States owns a controlling stake in GM and Ford.)

This scenario is not currently a problem but, human nature being what it is, could well become one in the future. It's easy to picture the ECB or Fed, for instance, refusing to buy shares in tobacco or fossil fuel companies or in firms that do business with Israel or Russia. Already, notes Kounis, "the BoJ has become a bit more directive as it tries to fashion ETF baskets containing companies with favored characteristics."

Risk of loss for taxpayers. It's one thing for a central bank to own bonds issued by its own and other governments, because those instruments are generally seen as risk free when held to maturity. Stocks, on the other hand, can fluctuate wildly and sometimes evaporate completely, potentially saddling the bank — and, by implication, taxpayers — with big losses.

But this fear is overblown, says Gagnon. "[The riskiness of equities] isn't revolutionary, because central banks could always lose on their foreign-exchange reserves. And with the Bank of Japan holding 10-year bonds with a zero coupon, the best they can make is zero, while they can [if forced to sell before maturity] potentially lose a lot of money."

"The beauty of equities," asserts Gagnon, "is that you gain if you're trying to reflate the economy and your policy succeeds. That's going to kill the value of your bond portfolio, but it will boost the value of your equities. So, buying equities is more consistent with your goal."

Investing in an Index-driven World

If central banks choose to sell the mountain of financial instruments they're accumulating, the markets will obviously feel it. Perhaps because of this potential effect, they've yet to try. Instead, "most central banks buy in bad times and hold in good times," says Artus. "As a result, their balance sheets have only increased."

Is there a point beyond which a central bank's balance sheet simply can't expand? Maybe not, says Artus. "Central banks are not normal investors like pension funds, where liabilities and assets have to match. We're not on the gold standard anymore, so there is no requirement that the quantity of money is matched by assets a central bank is holding and where losses on an asset reduce the money supply." Modern central banks can — and do — create new currency out of thin air and use it to buy assets, resulting in some eye-popping numbers. "The balance sheet of the BoJ now amounts to 90% of GDP, while the Fed's is only around 25%. So what is the limit? If there is one, it seems to be very far away," says Artus.

For money managers, the real point of this discussion is, of course, how to play the entry of these new whales into the equities ecosystem. Is the situation simply "don't fight the Fed" on steroids? A broader version of the Greenspan put? Or is it a fundamental shift in the market that will produce something new?

Time will tell. But one near-certainty is that when central banks buy equities, matching the market becomes easier and beating it becomes harder, as alpha-related signals are lost in the indexing noise. This trend is already in place, however, as the rising popularity of equity ETFs coincides with continued underperformance by hedge funds — which, as a result, suffered more than $100 billion in withdrawals in 2016.

Also very likely is that predicting which central banks might support which equities will become an analytical specialty in the future. "One can't abandon basic arithmetic," says Kretschmer. "But, valuation needs to incorporate policy reaction under various scenarios and its likely feedback loops. In this market, understanding the second- and third-order effects of monetary policy is as important as researching individual companies."

A roadmap for equity analysts can thus be found in the bond markets, where central banks have dominated for the past half-decade, according to Kounis. "With European bond buying, you start by analyzing the criteria for purchases. With government bonds, it's clearly based on the 'capital key,' which is a weighted measure of relative GDP." Put simply, more bonds are purchased from the bigger markets.

Kounis calculates that if the ECB followed the same market-weighted approach with equities, "it would tend to favor the core country markets — France, the Netherlands, Germany, and Belgium — rather than the periphery, because the core countries have relatively larger equity markets." But, it remains to be seen what other criteria the ECB will use. "Would some sectors or stocks be restricted or excluded for certain reasons?" he asks. "Is it only for companies based in that market, or is it also for companies that use that market to list stocks? A number of factors can affect what kind of stocks a central bank buys."

"The secondary effects involve risk appetite," says Kounis. For example, will this flood of newly created currency help peripheral markets with high debt-to-GDP ratios, and will this in turn increase demand for local equities?

Another way QE can work is through portfolio rebalancing effects, says Kounis. If the central bank buys safe assets such as government bonds, it can push investors out of these into riskier assets, boosting the latters' price as well. Thus, buying European equities might cause investors to move outside the Eurozone to, for instance, emerging markets.

Balancing Act

If central banks' balance sheets have no obvious upper limit, does their asset buying ever have to end? And if not, have we entered a brave new world of ever-rising stock prices fueled by newly created currency?

The answer to the second question is no, says Artus, because central-bank balance sheets aren't the only limiting factor. "If you're, say, the Bank of Japan, you can peg long-term interest rates wherever you want, and there will never be a debt crisis." The BoJ simply creates as many yen as needed to buy up whatever bonds are offered.

But the game will end if local savers lose confidence in the yen because of its ever-rising supply. "In that case, there would be an enormous capital outflow as the Japanese move to foreign currencies," says Artus. "It will be like Venezuela over the past 10 years. You'll end up swapping an economic crisis for a currency crisis."

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