Failed monetary policy raises the stakes for issuers and investors
Inflation and geopolitics have become the primary concerns of global public investors, supplanting the phasing out of central bank asset purchase programs. However, findings from an OMFIF survey of reserve managers, previewed at the Public Sector Debt Summit, show that many seem relaxed about the challenges arising from an environment inflationary not seen for at least three decades.
Speakers at the summit gave several reasons for the collective composure of reserve managers. One that became a recurring theme at the summit was that the majority of professionals in the investment management community find themselves in terra incognita. Few have experience of operating in anything other than an abnormal monetary policy environment. This has kept interest rates extremely low well past their sell-by date.
There is a more tangible and quantifiable explanation for the apparent serenity of investors. It’s that their performance over the last decade at least may suggest that their asset allocation strategy is robust enough to withstand the turmoil currently rocking the global economy.
The head of strategy at a major European investment bank noted in a discussion of the implications of rising inflation for the bond market that even reserve managers following a very conservative asset allocation policy have been able to outperform inflation since the eve of the global financial crisis. Those largely confined to cash and short-term bonds, he said, typically returned 2%. Managers whose mandates allowed them to diversify into the broader bond space had increased those yields to 3%. Adding a relatively low allocation kicker to equities had taken those returns to around 5%.
For sovereign wealth funds and others with higher risk appetites, actual returns hit close to 10%, which the strategist called “rather staggering.” His summary was that “if you were a central bank concerned with the protection of capital, the last few years have been very easy. Even those with a conservative portfolio have been able to generate triple the rate of inflation.
But, as summit speakers warned, investor performance over the past 15 years has been largely the product of circumstance rather than strategy. “We all know these returns were driven by an exceptional period of accommodative monetary policy, low interest rates and quantitative easing,” the strategist said.
Even before the Russian invasion of Ukraine, it was becoming clear that reserve managers could no longer rely on this benign environment to dampen their returns. One panelist said he viewed the final months of 2021 as a transition period heralding the onset of high and prolonged inflation.
This is the legacy of a prolonged period of failed monetary policy. A prominent economist at the IDS summit said the period since the global financial crisis had been characterized by a series of “deadly sins” by central banks. The most serious of these has been the reluctance to use interest rates to counter soaring asset prices in financial markets and real estate, coupled with the extent of quantitative easing. “This meant that the biggest buyer of long-term and sometimes even short-term debt in many countries was a non-commercial actor, namely the central bank,” he said.
“It is difficult to predict where inflation will settle, but I think it becomes inevitable that we will see a sharp global slowdown with technical recessions,” he added. “There could even be deeper recessions if fiscal and monetary policy responses are inadequate. Thus, the direction of monetary policy must be tighter and central bankers will have to behave more sensibly than they have for the past 12 years.
This may require central banks to step up action in a number of other areas beyond monetary policy. “Unfortunately, central banks are not some of the best communicators,” said one speaker, saying they needed to focus on more effective communications to avoid market disruptions and volatility. It was echoed by participants who expressed disappointment and surprise at the language used by Andrew Bailey, the Governor of the Bank of England, who recently called rising food prices “apocalyptic”.
Another added that in the case of the Bank of England, more diversity is needed within senior management to counter groupthink. He also noted that the Bank’s independence has been exposed as illusory, with the increase in quantitative easing corresponding directly to the increase in government spending in the UK last year. ‘Independent? Who are we laughing at ? He asked.
As for the practical implications of the current global macroeconomic backdrop for reserve managers, none of the summit delegates expressed confidence in the prospects of a soft landing. Nor do they hope for a return to the accommodative macroeconomic and political environment that has guaranteed their returns for most of this century.
This implies that reserve managers will have to work harder to generate positive real returns. In other words, it can be a payback period for investors who have probably had it too easy for too long. One investor on the panel said reserve managers who have never experienced a tightening cycle or losses on their portfolios may have to behave more like pension funds. Specifically, they will need to more actively manage their currency exposure and duration.
The catch is that traditional asset allocation models will be less effective in an era of high rates, high inflation, and little or no growth. Historically, said one speaker, diversification has provided reasonably robust protection against downturns and increased volatility. But in the corrosive environment of stagflation, diversification alone is unlikely to generate positive returns. “It’s definitely the toughest environment for investors as they’re taking losses on fixed income as well as equities,” he said.
As correlations turn positive within bond portfolios and between bonds and equities, it will become increasingly difficult to achieve the capital preservation buffers managers have enjoyed for decades.
Philip Moore is editor-in-chief at OMFIF.