We are still reeling.
Yesterday, we reported that central banks are major buyers of stocks.
Their policy of suppressing yields on bonds has pushed them to stretch for higher returns in the stock market. A recent report by a central bank research and advisory group called the Official Monetary and Financial Institutions Forum (OMFIF) calculates that central banks around the world have lost out on $200-250 billion in interest income on their bond portfolios.
In other words, central banks are victims of their own depressed interest rates. Feeling the pinch, they move more and more of their portfolios into equities.
The OMFIF says “global public investors” – including central banks – have increased investments in equities “by at least $1 trillion in recent years.”
And we could still be in the early innings of the game. Private investors, deprived of a decent return on their savings, buy stocks. Corporations borrow from the banks to buyback their own stocks. Central banks also buy stocks.
Stocks go up.
Seeing what a success they have made, they all buy more! Has any finer system ever been developed to manipulate the stock market? Has any dumber plan, more doomed to disaster, ever been devised?
A Monopoly on Money
We hardly know where to begin…
Outraged, we sputter and spit… we search for words… we look for metaphors and narratives… anything that will put this extraordinary situation in the right light.
Let’s begin with a question: Whence cometh the money used by central banks to acquire equity stakes in real businesses?
If they got it by honest toil in the vineyards and coal mines of the banking industry, we could have no objection. It is theirs to do what they want with…
But you have already gotten ahead of us, haven’t you, dear reader? Central banks didn’t earn it honestly. They simply digitized it into existence.
And what gives them the right to create money, like counterfeiters?
When did you get out of solitary confinement, dear reader? Don’t you know?
Banks – and their central bank backers – have a government-granted monopoly on money creation. It’s the plummiest, most protected franchise ever granted.
And now, they have been pumping up the money supply far in excess of GDP growth. They create money ex nihilo – out of nothing. Not a drop of sweat fell from their brows. No muscle ached the next day. No sale was made. No profits were registered.
On this miracle of something-for-nothing rests the whole financial system. Without it, the stock market and the economy would collapse in a heap
Drunker and Rowdier
Not that we’re worried about it. We see no sign that policies are about to change.
On the contrary, there are more and more signs they will remain with us to the end of time or until the whole system blows up – whichever comes first.
A change would do us good. The longer this game goes on the drunker and rowdier the fans become. Debt… misallocation of capital… waste… dishonesty… it all gets worse by the day.
But we suspect there’s a lot more to come. The Fed has ballooned its balance sheet to $4.5 trillion. The budget deficit is just now bottoming – at under $500 billion. From here, it’s up, up, up and away. Whee!
But it’s not just America’s central bankers that are playing the game. China’s State Administration of Foreign Exchange is a part of the People’s Bank of China (PBoC). According to the OMFIF report, it’s now “the world’s largest public sector holder of equities,” with $3.9 trillion under management. And that money, too, is flowing into stocks.
As the OMFIF puts it, “In a new development, it appears that PBoC itself has been directly buying minority equity stakes in important European companies.”
Where did it get the money?
It, too, was created out of thin air. China’s businessmen and merchants earn foreign currency – itself created out of thin air – by selling goods overseas. To hold down the value of the Chinese currency, the PBoC conjures up a bunch of renminbi (again out of thin air) and swaps it for this foreign currency at a fixed exchange rate.
This leaves the PBoC with a bunch of foreign currency – mainly dollars and euro – which it then plows back into overseas assets denominated in those currencies… including stocks.
A Lot of Dough
In short, there’s a lot of money out there… and there will probably be a lot more coming.
Japan faces “twin deficits” – on its current account as well as its government budget. These, too, must be financed by central-bank money printing.
So, Tokyo issues bonds. The Bank of Japan (BoJ) creates some new yen to buy them.
The following year, the government needs to borrow more. It issues more bonds. The central bank issues more yen. Some of the new cash is used by the government to pay interest (to the BoJ) and redeem the bonds (from the BoJ) as they mature.
What’s a poor central banker to do? He has cash. He has to do something with it. Why not invest in equities?
And who’s going to complain if he buys stock?
Instead, he will get thanks from the feds, who are grateful to him for financing their deficits. He will get applause from investors, who will be pleased as punch to see their investments go up.
Managers in the corporate sector will be delighted; their bonuses depend on higher asset prices. The 1% will get richer. And the other 99% will not know what the hell is going on…
One of the elegant features of this latest hustle is that it does not benefit the hoi polloi.
Ah yes… central banks create new money… it gets passed around the financial community in many ways… and ultimately ends up in the equity markets.
Most people never see it, much less spend it. Not even the odor of it reaches their nostrils. Their hands never touch it. And consumer prices never rise.
No fussing from the lumpenelectorat. No kvetching by the commentariat. And no whining from the investoriat.
In short, a grand slam of deceit. The World Series of financial catastrophe will follow. But that could be a long way off.
This Is the Biggest Threat You Face as an Investor
From the desk of Chris Hunter, Editor-in-Chief, Bonner & Partners
You may be wondering how to navigate these grand distortions and delusions.
We are too. In fact, we believe it is the most important threat you face as an investor right now. That’s why we spend so much of our time researching and writing about it at Bonner & Partners.
The first thing to understand is that credit expansions, and artificially low interest rates, foster unsustainable booms. Inevitably, these booms are followed by crashes.
This is what happened in the Roaring Twenties… in the dot-com boom… and in the subprime mortgage boom. That’s because when central banks manipulate the information interest rates convey investors can’t help but misallocate capital – often on a grand scale.
As Austrian economist Ludwig von Mises wrote in Human Action:
But now the drop in interest rates falsifies the businessman’s calculation. Although the amount of capital goods did not increase, that calculation employs figures which would be utilizable only if such an increase had taken place.The result of such calculations is therefore misleading. They make some projects appear profitable and realizable which a correct calculation, based on an interest rate not manipulated by credit, would have shown as unrealizable.
Entrepreneurs embark upon execution of such projects. Business activities are stimulated. A boom begins.
The first duty of a prudent long-term investor is to recognize the situation for what it is: a period of false prosperity brought on by market manipulation.
The second duty of a prudent long-term investor is to protect himself from such distortions… and the day of reckoning that will follow.
This involves two things: a unswerving focus on value and an ability to resist crowd psychology.
This is why, for instance, we have been recommending emerging market stocks over their developed market counterparts, despite the negative sentiment lately toward the emerging world.
Crowd physiology clearly favors stocks in the US over stocks in the emerging world. But clearly valuations favor the emerging markets.
The US stock market is trading on a Shiller P/E (which looks at the average of 10-year earnings adjusted for inflation) of about 25. Emerging market stocks are trading on a Shiller P/E of just 14. That’s a big discount.
Added to this, real earnings per share in the US are about 50% above their long-term trend. And real earnings per share are 10% below trend in the emerging markets.
The question then is a simple one: Do you invest in a highly distorted market with relatively high valuations and above-trend profits… or a less distorted market with relatively low valuations and below-trend profits?
We think you know the answer…