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Riding the central bank stimulus

The major issues today are how fast the recovery will be, how widespread will it be, and how much permanent damage will remain.

The major issues today are how fast the recovery will be, how widespread will it be, and how much permanent damage will remain.

Charles Stanley

in Features Fiduciary news


Bulls in the stock market are excited by the recovery cycle. It now looks as if all the major economies have passed the worst of their troughs in output and incomes brought on by lockdowns and social distancing policies. An issue today is how fast the recovery will be, how widespread will it be, and how much permanent damage will remain.

Optimists still think there can be a near V-shaped recovery, getting back to previous levels quite quickly. Pessimists think it will take time, with large sectors like travel, shop retail, tourism and hospitality not getting back to previous levels of activity this year or next.

There has been a V-shaped recovery in some stock markets, led by the US. Others are still below their March peaks, hesitant owing to the mix of companies and investments in their indices. An index that has plenty of technology, food, healthcare and other basics has been doing better than one with plenty of banks, retail, oils and cyclical industry. Governments around the world have decided they need to offer subsidy and support to foster faster recovery and to avoid further rises in unemployment and bankruptcies. Central banks have been very accommodating, sure that inflation is not an immediate problem but the collapse in output is.

There has also been some inclination by investors to see continuing bad news about the real economies as good news for stock and bond markets, as it means more or continued monetary and fiscal stimulus is likely. In the US, another fiscal stimulus package is being planned. The CARES Act measures expired recently, with both Democrats and Republicans looking to renew some of the measures. 

Passable impasse?

There remain disagreements, with Democrats keen to route more money to the individual states of the union where their Governors can have more say on spending, whilst Republicans are keener on direct payments to individuals and companies through tax holidays, business loans on easy terms and unemployment supplements. A deal is likely, as neither party will want to have their run-up to the November presidential election marred by allegations that they are preventing the stimulus.

In the EU, a €750 bn borrowing facility has been agreed to spend on recovery, but it will not take effect until next year and will be spread over maybe three years as projects are worked out and approved. They have also agreed on an expanded budget for the seven years from 2021. Individual member states will also add some voluntary and involuntary fiscal stimulus as their own budget deficits come to reflect the lower tax revenues and higher spending brought on by the lockdowns and their aftermath. They are likely to exceed the 3% Maastricht Treaty limits, arguing cyclical pressures. Germany announced a €130 bn stimulus package on June 4th, as it had scope within existing budget rules.

In Japan, the government will allow a higher budget deficit and will promote infrastructure-led spending as part of its efforts to recover from the severe reductions in economic activity recorded in the second quarter. A large stimulus of measures was announced in May. China too has embarked on some reflationary boosts to spending, with a 3.6 trillion yuan budget package.

The central banks have been in overdrive. The advanced country Banks have taken rates down to around zero, whilst China has cut its average bond repo rate to 1.89% and her one-year prime loan rate to 3.85%. China has lowered her banks' reserve ratio three times, allowing 1.75 trillion renminbi of extra credit to be advanced by the banking system. The Governor of the People's Bank has recently stated their policy as "expanding aggregates (money), securing supply, promoting growth, lowering interest rates, adjusting structure and protecting market entities". The result has been a useful acceleration in Chinese money growth to 11% by the end of June (M2), with 12.8% loan growth.

Fed leads the way

The Fed in the US has been the most expansion-minded of all the leading central banks. Money growth, M2, was up 22% in the year to 3 August. The major boost came between March and May, but the pace of growth remains high by historic standards.  The commercial banks mainly have scope to expand their lending, with required CET1 ratios of between 7% and 13.7% being below their actual balance sheet positions. 

The Bank of Japan continues with large quantitative easing programmes designed to keep the ten-year state borrowing rate at zero, with some buying of equity ETFs as well.  The Fed, the Bank of England and the ECB all have substantial quantitative easing programmes underway. The ECB has now accumulated holdings of €2.796 trillion in bonds. The Bank of England is out to complete a £745bn portfolio. The central banks are keen to keep the corporate bond markets open and supplying substantial new capital to wounded giants whilst at the same time allowing commercial banks to extend more credit, given their generally strong balance sheets.

With all major central banks keeping rates down and money relatively easy, it is a favourable background for equities to get more expensive. Optimists look through the rising PE valuations and declining yields to better earnings as recovery improves. They also argue that with interest rates so low you should expect dearer shares. Pessimists argue the growing gap between values and likely profits and earnings is getting too big and there needs to be a correction. That is only likely to happen if the central banks and governments slacken off the stimulus too quickly or too abruptly. It is true they are currently slowing it. We need to watch out in case that reaches stall speed.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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