Il punto sui mercati finanziari / I

Questa è la prima parte di una conferenza del mese scorso tenuta in Svizzera. Si rivolge agli investitori istituzionali, più precisamente ai fondi pensione. Seguirà la seconda parte che mette a fuoco dei problemi particolari.

At the origin of Quantitative Easing: Japan and United States

• Japan has not joined depression in the Nineties, when the debt bubble has burst, but has only experienced a zero growth, because the Japanese understood where was the problem. We can call this problem the "strike of the debtor." No one in Japan wanted the credit, whatever might be the interest rate, because he had to repay the accumulated debt. Monetary policy becomes therefore ineffective. It remains to public spending to save things. The financial requirement of the State does not push up bond yields, because the private sector does not ask for more, so long as it needs to reduce its debt.

• This point of view leads to a very important conclusion: do not be tempted to reduce the public deficit until you are confident that the economy will come back to ask for credit. To avoid depression Japan has accumulated a public debt of more than 200% of GDP, twice that of the United States and the Eurozone. Despite its consistency Japanese debt costs almost nothing.

• The temptation to consider public debt a "not-a-problem" is therefore very strong. For when it is huge, in the end it costs nothing, and, in any case, the Central Bank, if necessary, acts to buy it. If the debt is not a problem, then you can expand public expenditure for the period necessary for the recovery. But there is a limit to this bailout policy based on public debt bought by the Central Bank. The growth of the public debt will come at some point to weigh too much on all the financial assets of individuals.

• In the United States, unlike in Japan, the debt accumulated over the past decade has not been that of non-financial firms, but that of thouseholds, especially in the real estate, particularly through mortgages packaged in the form of bonds.

• Hence the dual action of economic policy. The public deficit a few years ago has been expanded to a “Greek” level, in order to balance the possible fall in private demand, linked to greater savings needed to pay the debt.

• This deficit was partly financed by the Federal Reserve, which bought Treasuries. Not only that, the FED has also bought the bonds full of mortgages. By doing so, the FED has brought down the cost of mortgages and therefore has eased the interest's burden for families.

• To say it shortly, the Federal Reserve Bank has followed and extended the option of Japan, which has become popular with the infamous name of Quantitative Easing.

Why the Eurozone has not had the same economic policy?

• In the Eurozone there was not much private-sector debt -in the case of Japan of the companies, in the United States of the households. And for a deeper reason.

• What is the difference between the State budgets of the Eurozone and the States of United States? The single state budget deficit in the United States can not have deficits, except for expenses such as those for infrastructure. It follows that the only budget that can go in deficit is the federal one. The constraint exists to prevent the states from turning to "the mad joy" in spending, because they would hope that the central government will save them.

• The Eurozone countries can instead go into deficit, but within the constraints of Maastricht pact. Germany -and other countries, the so called “virtuous countries” - do not guarantee the debt of the other States - the so called “vicious”. When European States fall into significant debt, without giving signs to be able to repay the accumulated burden, it is expected that the financial markets would "punish" them, i.e. applying for a risk premium. The higher the premium, the higher the cost of the debt, with the latter that pushes to restore public budgets.

• The states of United States are bound to a balanced budget, while the Eurozone countries are bound to honour the Maastricht constraints through the control of the financial markets. In the USA, only the central government can go into deficit and only he is judged by the financial markets.

• The Eurozone does not have a system of federal transfers. In the Eurozone you may have a central deficit, if all member States have a balanced budget. When, finally, the budgets of the States would be in balance, then you would have a common deficit, jointly funded with Eurobonds.

• Fiscal policies in the Eurozone may be partially loose, in the bond of Maastricht deficit above 3%, only for the time necessary to help the recovery (the famous "flexibility"). However, the long-term trend of the public budget must be in the direction of zero deficit.

• Therefore remain monetary policies. These, on the traditional side - managing the cost of money -have long been ultraexpansive. The European Central Bank has finally announced activism in its purchases of corporate bonds. The latter can help the recovery of the credit cycle.

• In the Eurozone policies do not lead to the purchase of public debt. The purchase of government securities squeezing the cost of debt would lessen the incentives to reform the economy. The recovery has to come from the improvement of the conditions of the offer, i.e. a better market for products and labor. More precisely: a large deficit in public spending with a parachute of purchases of Treasury securities (issued to finance the large deficit) bought by the Central Bank would give strength to the "party of spending," thereby helping to delay the need to make reforms.

The QE impact on financial markets

• Under normal conditions, the demand for risky assets by individuals decreases with the yield offered decreasing. Individuals buy for a rising premium to balance the increased risk. Under normal conditions, the supply of risky assets increases with the increase in the yield. If the return that covers the risk raises, then even those that were too risky (for investors) can enter the market with low levels of risk premium.

• Let's put in the reasoning the Quantitative Easing. The offer is always the same, but the demand is in part supported by the Central Bank. The amount of purchases available for private investors, therefore, is reduced. The price of risk is now lower. That is, individuals who still want to hold the assets, once the Central Bank has taken off the market a certain amount of them, buy them at higher prices (lower yields). This behavior is not however of balance, because the supply reacts. The supply of risky assets is demanded by individuals and by the Central Bank at a lower yield, then the supply comes on the market almost all at a lower yield. The supply curve therefore becomes almost vertical. The low-risk assets and very risky ones offer, in the end, a similar yield.

• We have used abstract reasoning to arrive at the today markets. Suppose that anybody shares the view that financial markets are too expensive. That is to say that at this price level, they are far from a reasonable valuation. And suppose that anybody accepts the idea that markets move away from the fundamentals regularly, but when they move away too much, they tend to go back to the fundamentals.

• A buyer in an expensive market (knowing that it is) thinks he can get out in time (before the fall). That is important that there is someone who believes in the continuation of the bullish trend (remember the Ponzi chain ...). The number of those who buy in an expensive market (knowing that it is) is greater the lower the bond's yield. If the two year's bond yield is – to say -0.5%, then, if the stock market just rise of 1%, the investor has accumulated two years of earnings. To cut it short, the investor who buys an expensive market counts that monetary policy will remain expansive for a long time.

• So everything is going well? No, because it is not clear what can happen in the United States when purchases by the Central Bank of corporate bonds and Treasuries will end and when rates will go up. That is when the supply curve of financial assets will no longer be almost vertically. If the curve ceases to be almost vertical, then riskier assets must cover, unlike today and as usual, a risk premium, and therefore, given the fix coupon, it must be their prices that should fix it.

• In the Eurozone we have a QE of fact. The average cost of public debt is around two per cent: a cost sufficient to control the public debt, once a GDP increase of one per cent and a one per cent inflation materialize. A yield of two percent is not compatible with the commitments of the insurance sector. Finally the dividend yield of the major European listed companies is similar to that of the riskier private bonds.

Choose your bubble

• In 2000 and 2007, the stock market evaluations were similar to those currents the relationship between prices and profits and a high level of underpricing of the risk, as measured by the VIX index. The difference between 2000 and 2007 and today is the level of the yields of the government bonds. At the peak levels of stocks the yields were normal - 5% in the United States and 3.5% in Germany, compared to 2.5% and 1% today.

• In 2000 and 2007, one could observe with detachment the high level of stock prices, because the level of bond yields was high enough to move from the variable to the fixed income without risk. Today, however, move the variable to the fixed income is risky because bond yields are low. The next movement in bond prices will be downward.

• To put it in a more colorful language, in 2000 and in 2007 we had one market in a "bubble" and one that was not, but now both markets are in "bubble". The stock market bubble is defined as a price level greater than that which can be expected from a reasonable flow of discounted dividends with yields that are normal. Bond bubble means a level that can not be justified, once the economic growth and inflation become normal.

• In which of the two markets in bubble should one stay? If the stock market falls, the bond markets remains stationary. If the bond market falls, as happened at some point in 2013, that of stocks falls too. To put it simply, the bond market is less dangerous. That is, in terms of the divergence of the market in a limited amount of time the fixed income market, although very expensive, is less dangerous.

• In the case of a regular rise in bond yields we have a different picture. If bond's prices would go down, then the returns would go up, increasing in turn the discount factor of stocks, which would make them also drop. In this case, “cash is king”.

How to escape from a bubble driven economy

• The BIS concern is not deflation in the field of goods and services, but inflation in the field of assets. Stocks, bonds, and houses are expensive, In addition, in many countries the household debt has not been reduced in a sufficient measure. If we continue to support the prices of the assets through low, or even negative, rates and we continue with the purchasing policies of the bonds, i.e. if central banks continue with current policies, we will push up their prices well away from their fundamentals. A policy which sooner or later leads to a crisis, because asset prices will go down until they find a foundation that supports them.

• How can we get back the economic growth and avoid the bubbles? The growth can not be dull, because those who work will have to keep an increasingly aging population, i.e. those who work will have to finance a higher spending on pensions and health care. How to revive the growth? According to some there is a "lack of demand" and therefore they propose more public spending, according to others, there is a "lack of supply" and therefore they propose a liberalization of product and labor markets. For the sake of labels, we can call the first "Keynesians", and the second "Schumpeterian".

• If entrepreneurs do not trust, do not invest and do not assume. The cost of money becomes less important than the expectations around the effective demand. It follows that the cost of money, even if it is zero, becomes less important. The same goes for families, they return to consume, only if they think that in the future they will have a higher income. And here comes the idea that, in a world overwhelmed by uncertainty about the future, it must act who has a long term horizons and has no financial constraints: the public spending deficit. The state spends more than it collects in taxes generating additional demand from nothing.

• It can be argued that public spending deficit, once it has accomplished the task of reviving the economy, ceases? Public spending creates new interests that want to be maintained at the highest level. More public spending rather than being cyclical, that is functional only smooth out the variations in the economy, becomes permanent. And a high-debt economy is vulnerable to shocks.

• If government spending were not generic but dedicated - as you would with a program of investment in infrastructure financed by the European Investment Bank guaranteed by the European Central Bank, investments that would not be counted as public debt – we would have satisfied the Keynesian point of view, pointing his finger on the lack of demand. Public spending on infrastructure has also the advantage of having a high multiplier – i.e. it generates an income greater than the initial outlay. With a market of product and labor liberalized innovations should expand quickly. By doing so, we would have satisfied the Schumpeterian point of view, pointing his finger to supply shortages.

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