Investment | 26 January, 2020

Consequences for investors of monetary policies

Joaquín González Portfolio Manager

The “Financial Repression” and its consequences for investors

1. Cause of low or negative return provided by so-called risk-free assets

After the Great Recession (2008-2009) until now, the main central banks have established ultra-expansionary monetary policies to combat the extreme de-inflationary pressures resulting from excessive economic indebtedness , the fall in labor force growth (demography) and technological progress.

Since then, the central banks have not only created new money (monetary base) for a value exceeding twelve trillion dollars, but they have also placed rates (price of money) at the lowest levels in history.

As can we see in Chart 1, 85% of government debt issues in developed countries provide a return of less than 2% and are even negative in 30% of issues. If we look at Chart 2, we see how an investor who buys a government bond with a ten-year maturity would obtain a real annual return (after discounting the estimated inflation for each corresponding country) of practically zero in some countries and currencies (United States and Canada) and negative in the majority, after ten years of holding the investment (Japan, Switzerland, Germany, United Kingdom, etc.). This phenomenon is known as “Financial Repression“.

Chart 1. Annual return (IRR) provided by total bonds of governments of developed countries (2019)

INVESTOR MONEY

Chart 2. Real annual return (IRR – Inflation Expectations) provided by bonds of governments of developed countries to ten years

2. Consequence: overvaluation of other assets

The consequence of this “Financial Repression” means that investors, knowing that they will obtain zero or negative returns by investing in risk-free assets issued by developed countries denominated in home currency, are willing to not only take on more risk by investing in other (more volatile) assets that may provide a higher return, but are also willing to pay a higher price than they would have done in the past, leading to a stark overvaluation of these assets in general. In such a way, that:

a. Stock Market:

As we can see in Chart 3, from the “Great Recession”, the return on the U.S. stock market compared with changes in the country’s GDP (Gross Domestic Product) has been much higher. The years between 1985 and 1995, and early 2000 and 2009, were the last in which an investor could buy assets on the U.S. stock market at a price similar to the historical progress of the country’s wealth.

Chart 3. Change in the U.S. stock market price (S&P 500) vs. change in U.S. GDP

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b. Real Estate:

House prices in the United States have also appreciated significantly in recent years. As we can see in Chart 4, the 1990s and the years between 2011 and 2013 were the last years in which workers could buy a home in the United States at prices similar to the change in their own salaries.

Chart 4. Change in house prices in the United States (S&P Case-Shiller) vs. change in non-supervisory employee salaries in the United States

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c. U.S. corporate bonds:

Currently a diversified portfolio of 10-year BBB (Standard & Poor’s Rating) U.S. corporate bonds are offering an investor an annual return on the U.S. Treasury bond over the same period of around 1.3%, while the levels of corporate indebtedness in the country, as we can see in Chart 5, suggest that this annual return offered should be around 4%.

Chart 5. Annual return on U.S. Treasury bonds (spread) offered by BBB U.S. corporate bonds vs. the change in indebtedness of companies in the United States

INVESTOR MONEY

3. Conclusion

The ultra-expansionary monetary policies carried out by the main central banks in the past decade “Financial Repression” have pushed investors to buy so-called risk assets at prices above the past, which is something that may be maintained over time.

However, it would be reasonable to believe that these assets may appreciate at a lesser rate in the coming years than the past decade and taking into account that these assets have a certain amount of volatility, we would recommend placing private wealth management in the hands of experts. This is to ensure that these managers can act in a consistent manner in response to changes in the conditions of the financial markets, protecting the assets that have been delegated to them and leveraging the opportunities that may arise in the future to capitalise on this wealth, through active management.