That isn’t a bad analogy for investors to ponder at the moment.
A very happy hour
There is always liquid refreshment available given the world’s major monetary policymakers are all pointing in the same direction. The Federal Reserve, Bank of England, Swiss National Bank, European Central Bank, Bank of Japan and People’s Bank of China (PBoC) are all involved in policies aimed at supporting the financial system and arguably all, except perhaps the ECB, are attempting to encourage growth. So, when your local central bank is closed, don’t worry one in the next time zone will be keeping the liquidity taps open.
In the last month the PBoC has cut its Required Deposit Reserve Ratio for a second time since December. The Bank of Japan has announced an inflation target for the first time ever. The ECB has conducted its second Long Term Refinancing Operation (LTRO) which proved even more popular than its first one. And the only dissents at the last Bank of England’s Monetary Policy Committee meeting were for even more quantitative easing than was actually enacted.
We still need to respect the intent of those in command of the printing presses. We also need to remember the intent behind the quantitative easing and Operation Twist being conducted by the Bank of England and Federal Reserve. The central banks want investors to stop buying government bonds and buy something else instead. By being the replacement purchaser of those bonds, and by anchoring expectations for short-term interest rates to stay at de minimis levels for a long time, the central banks will keep interest rates low across the curve.
Challenges remain…
We accept that there remain significant challenges to overcome. Deleveraging across the financial, household and government sectors will cap how rapidly the developed world economy can grow. We also accept that Europe is not fixed Greece remains in a perilous state. I suspect that picking holes in the second Greek bailout is not difficult, but do not doubt for a minute that the bailout was the right thing to do. And that a third bailout is infinitely preferable to the alternative. There is a risk that the election in April will derail the process; we are getting very close to the point where the level of austerity being imposed on Greece is incompatible with a democracy.
Pragmatism is also good financial policy. First, the fear around Greece is largely that if it defaults (properly) the market will price-in a similar outcome in Portugal and Ireland, and possibly even Spain and Italy. That contagion threatens not just those sovereigns but the whole European banking system. Each quarter that goes by when it doesn’t happen gives time to those other countries to heal. Each has made progress; time allows the possibility of success.
Second, each quarter that passes allows the banking system to repair itself. The more capital that banks can replenish from operating profitability, the less it is going to cost shareholders and taxpayers to get the system solvent. Again, time has enormous value. This is particularly the case when the ECB is actively assisting bank balance sheet repair. The 29 February second three-year LTRO saw 800 banks take up €530bn of funding. The first LTRO saw €489bn going to 523 banks.
…but we are making progress
Despite the challenges we continue to think that the world looks a lot better than it did six months ago. Since the ECB’s December LTRO put a firewall around the European financial system, the risk premium has fallen on equities (and credit).Yet valuation, by any conventional measure, is still attractive for ‘risk’, though most commentators, and investors, seem loathe to argue that equities are inexpensive. Elevated equity risk premiums, for example, are seen as a function of expensive government bonds, not as a function of cheap equities. Corporate profit margins are deemed to be elevated and therefore multiples are seen as deservedly depressed. Meanwhile, dividend yields are higher than local bond yields in most of the world’s equity markets.
Discount drinks at Happy Hour has been so effective in boosting demand that the promotion has been banned in Ireland (and Glasgow). The financial market version hasn’t been so popular, even though there are lots of cut-price securities available, despite the rally in recent months. To us that suggests that the odds continue to favour markets trending higher. If they do, confidence about the recovery will increase. Heck, could monetary policy finally be gaining traction? For now, drink up.
