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Break with unconvention

Unconventional policy will further distort bond markets and continued volatility is all but guaranteed

The past 18 months or so has seen the use of an unprecedented arsenal of conven-tional monetary policies from policymakers in the developed world in an attempt to stimulate and sustain econ-omic growth. However, these have been all but exhausted and unconventional policies such as quantitative easing seem to be the order of the day.

We, like central bankers, have no real idea whether such unconventional approaches will ultimately be successful in triggering a self-sustaining recovery in the real economy, given the structural headwinds that face economies.

We already have rock-bottom interest rates in the US and UK and it is difficult to conclude that pushing them just a little bit lower will make a material difference or indeed compensate for the longer-term ramifications of printing more money.

However, we can be fairly sure that more unconventional policy will further distort bond markets and capital allocation in economies far and wide. Such policy is likely also to boost investor interest in real assets (such as gold) and ultimately undermine the value of, and confidence in, the world’s reserve currency, the US dollar.

Meanwhile, the response from Western authorities in the aftermath of the credit crisis has had a profound effect on the developing world, in which growth rates, demo-graphics and balance sheets are generally more favourable than those in the West.

A combination of falling absolute yield levels, narrow-ing yield premiums over developed markets and the effect of pegging currencies to the US dollar has seen most emerging economy borrowing costs fall substantially.

Understandably, growth in consumption in the developing world is widely regarded as the world’s most exciting longer-term growth opportunity. As a result, capital has been channelled into these regions, causing their equity markets, real estate sectors and, in some cases, currencies to rise.

The overwhelming consensus among investors is that this trend will continue and that, if more money is printed in the West, developing world assets, along with the commodities they need to fuel their growth, will be the foundation of the world’s next financial market bubble.

However, rising consump-tion in the developing world and moves towards wealth and currency parity will not happen overnight. The rebalancing of economic models is a multi-year process, not least because, on both the developed and developing world fronts, making adjustments (such as consuming less and saving more in deficit economies and exporting less and consuming more in surplus economies) is likely to hamper short-term growth. There will undoubt-edly be significant bumps along the way.

The most obvious risk facing investors is that overtly reflationary policies succeed in creating inflation. This is already the case in the developing world, where policymakers are often reluctant to raise interest rates, fearing that this will lead to further capital inflows and currency appreciation – something no economy seems to want in the current climate.

Post-crisis policies are likely to lead to isolated “inflations” in both the developing world and “real” assets, rather than generalised consumer-price inflation. At the same time, generalised inflation will be held back by weak domestic wage growth in the developed world. Ultimately, though, more widespread inflation is likely if policymakers feel compelled to continue supp-orting flagging economies with printed money.

In the words of Ben Bernanke, chairman of the US Federal Reserve (and archproponent of money printing), the outlook is “unusually uncertain”. Deflating credit bubbles have a habit of leading to deflating asset prices and economies, as Japan has discovered in the last 20 years. In response to the threat of deflation, the world is witnessing a reflationary impulse, the like of which has never been seen before. All sorts of market scenarios are possible but continued volatility is all but guaranteed.

Iain Stewart is manager of the Newton real return fund


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