We allege central bankers have created distortions in the credit allocation process. How can one expect to reach an economy's long run potential if policy makers interfere in the credit allocation process? It should not be a surprise the economy is running below its potential when policy makers become central planners. If policy makers then double down, all they might do, is to exacerbate the distortions.
Specifically, we have long argued that central banks have compressed risk premia, i.e. made so-called risk assets (really anything other than Treasuries, but risk assets tends to refer to stocks and junk bonds) appear less risky. In plain English, we believe risky borrowers have been getting a subsidy; that in turn, has distorted the capital allocation process of investors, investing in assets that have a higher risk profile than they otherwise would. A common reference is that investors are chasing yield.
What’s bad about this? What’s bad about this is that these assets are still risky, and we now depend on central banks to ‘come to the rescue’ whenever risk sentiment flares up. That is, central banks now ‘own the problem.’
Instead, the stakeholders of risk assets ought to own the problem. In our humble opinion, the way one gets those stakeholders to own the problem is to allow a market based pricing of risk, one where a risky borrowers pays a reasonable premium. What is reasonable? The Fed should allow the market to determine this; and while the market may not always be right, the opposite is, in our humble opinion, certainly wrong: the Fed cannot possibly know what the appropriate risk premium is.
Our central bankers have avoided allowing the market to price risk premia because it might render some issuers, including potentially some sovereign governments, insolvent. And to those who think this is only a problem for the Eurozone (think peripheral Eurozone countries) or Japan, we believe it’s also a problem for the U.S., where we have, amongst others, seen seismic shifts in the capital structure of corporate America. Shifts, such as a raising debt to finance share buybacks, but without an investment in future productivity.
The Game is Rigged
We have seen financial assets skyrocket with a major populist backlash because the man (and woman) on the street feels the game is rigged. The Fed disputes this because, all they do, so they might say, is to pursue their inflation target. Our analysis, though, agrees with the complaining public: the game is rigged, as the Fed meddles with efficient capital allocation to the detriment of the economy’s long run potential, as evidenced by low long term rates, in direct violation of the Fed’s mandate.
Implications for Investors
So what does it mean for investors? For many investors, it has meant that they stay on the sidelines, as they don’t like to invest in a game that may be rigged. For others, it has meant to join the ride and enjoy a rise in both equity and bond prices. To us, it means that we might have created a bubble; more specifically, we have created an environment where the traditional way to diversify a portfolio might not be effective should we ever experience a downturn again. The time to truly diversify a portfolio is when times are good.
Please register for our upcoming Webinar on Tuesday, September 22, where we expand on the discussion, but also focus on portfolio construction in the context of the election. Also make sure you subscribe to our free Merk Insights, if you haven’t already done so, and follow me at twitter.com/AxelMerk. If you believe this analysis might be of value to your friends, please share it with them.
Axel Merk is president and chief investment officer of Merk Investments.