Low interest rates are a borrower’s best friend, a fixed-income investor’s worst nightmare, and one reason many people suggest the integrity of global stock markets is in serious jeopardy.
It’s one thing when a group of individuals opt out of bonds, CDs and money markets that yield close to zero, or worse, like they do today, and into higher-reward, higher-risk equities. For years, rock-bottom interest rates have triggered this very natural, logical rotation and it’s become more apparent than ever in recent months.
Nearly $11 trillion, or roughly one-quarter, of global fixed-income assets yielded below zero at the end of last year. So, it’s no surprise that in the first two months of 2017, investors yanked $41.5 billion from bond funds while almost $70 billion flowed into NYSE-traded stock funds, according to Bank of America Merrill Lynch.
You might presume that consumer confidence, a robust stock market and growing economy are additional driving forces behind the shift. However, is all this elation justified?
Financial analysts and gurus suggest the answer is “no”, that there’s nothing natural or logical happening in the stock market, courtesy of central banks. Over the past several years, there have been more actions by central banks to keep stock prices up than ever before, such as adjusting monetary policy, quantitative easing programs, and keeping interest rates low.
But, the new practice of buying stocks to stimulate an economy can be downright dangerous.
Today, many banks across the world are throwing caution to the wind by dumping low-yielding, liquid positions for riskier stock funds—a major no-no in the eyes of the investment industry.
Central banks are under pressure to grow and diversify foreign currency reserves, and there are a lot of them. At the end of 1995, they totalled $1.4 trillion. By the third quarter of 2016, reserves exploded 10-fold to $11 trillion, according to the International Monetary Fund.
So, we’re talking about large chunks of money injected and withdrawn from global markets on a regular basis with little concern for fundamentals.
That’s the definition of “rigging” say the experts. While one force driving the change in banks’ investing habits is the hunt for higher returns, another school of thought says it’s to create a “wealth effect”, with the hopes that stock market gains will encourage citizens to spend and, in turn, grow a country’s economy.
We can look to the Bank of Japan as one of the most prominent and recent examples—which as of this writing owns two-thirds of all Japanese ETFs. In an effort to cure Japan’s economic hangover from a massive credit bubble in the early 1990s, the country has switched from a stimuli-creating strategy (increasing inflation expectations with negative rates) to blatantly attempting to raise stock prices so that consumers see a healthy market and growing assets as a green light to spend.
The BOJ now holds a large share of stocks listed on the Tokyo Stock Market, causing many investors to focus on the stocks it is buying rather than on company fundamentals where it should be. The bank purchases ETFs according to the market weights of Japan’s Nikkei 225, the Topix and the smaller JPX 400 indexes. These asset purchases have essentially weakened the correlation between the US dollar and the yen. Typically, a decline in the yen versus a strong US dollar would cause Japanese stocks to rally; and a rise in the yen caused stocks to fall. That’s no longer a given.
The BOJ buying program is designed to favor companies with good corporate governance such as those that have complied with the Tokyo Stock Exchange’s corporate governance code and reducing or eliminating holdings in other “less honorable” companies. The bank is now one of the top five owners of 81 companies on Japan’s Nikkei225 Index and is fast becoming the number one shareholder of more than 50 of those firms, according to various estimates.
Opponents say all of this buying is artificially inflating valuations, reducing liquidity and will eventually result in volatility or worse. Unfortunately, Japan is not the only offender. The Bank of England has a corporate debt purchase program worth $13 billion, and the European Central Bank has a similar one.
The Swiss National Bank has taken asset buying programs to a whole new level. In 2009, equities only made up seven percent of the SNB’s reserves, four years after it started buying them. Now they are 20 percent, including investments of $1.7 billion in Apple Inc., $1.08 billion in Exxon Mobil Corp., and $1.2 billion in Microsoft Corp., according to third-quarter 2016 Securities and Exchange Commission filings. The bank manages $643 billion in foreign reserves.
Although there’s industry-wide concern that this practice will eventually result in an increasingly inefficient market in which a lack of liquidity makes it very difficult for investors to sell stocks, it appears that there’s no end in sight to central banks buying equities.
According to a recent study by Invesco that polled 18 currency reserve managers on central bank investments, nearly 80 percent of respondents said they planned to invest more in stocks, and 43 percent in corporate debt. They cited low government-bond returns as their motivation.
So, if this so-called charade continues and higher asset prices are merely a result of central banks’ willy-nilly buying strategies, the bottom could fall out of the current bull market faster than you can spell c-r-a-s-h.
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