MD, Salt Funds Management
When historians look back at the impact of Covid-19 on financial markets and economies, a key feature will be the extraordinary fiscal and monetary policy firepower that has been unleashed globally. NZ is no exception.
We have seen the OCR target slashed to 0.25% and aggressive Quantitative Easing (QE) employed to control interest rates across the curve. QE is the first cousin of money-printing, with the difference being that the RBNZ buys bonds in the secondary market rather than newly minted securities directly from the Treasury. Unless there is a realistic intention for the RBNZ to ever sell those bonds back out again, then money has effectively been printed. In theory, lower interest rates should then stimulate investment and decrease the future debt servicing burden from the massive and necessary fiscal expansion.
This monetary expansion has clearly found its way into financial markets, with prices of financial assets booming after their initial bust. A retail investing boom has been ignited which rivals 1987 in intensity. Is this what policy-makers intended or are they concerned chiefly with limiting the wider economic damage from shutdowns? Whether by accident or by design, the impact on equity markets is clear.
Financial markets are merely an intermediary channel to facilitate economic activity but the RBNZ has been surprisingly explicit in its desire for investors to be forced out of term deposits and put the money to work in equity markets. RBNZ Deputy Governor, Geoff Bascand was quoted on interest.co.nz as saying:
"Deposit rates have been declining and that's part of what we have to do in a monetary policy sense to reduce the cost of funds to banks so that they can reduce the cost to borrowers. And I guess it also encourages savers to look at other areas to divert those funds….It reduces the cost of equity if they shift their funds from a deposit into an equity instrument, it pushes up those prices and reduces that cost in a different way to the equity funders. They could put it into other assets... so hopefully seeing that saving used closer to supporting the economy."
So, the NZ equity boom seems to be an explicit goal of the RBNZ rather than a mere by-product. This is despite there being no evidence that this novel approach helps the real economy. Indeed, the experience post 1999 and 2008 suggests that the after-effects of a blown equity market bubble caused by overly loose monetary policy are very harmful to the economy. We see three further concerns.
Firstly, the key transmission channel for monetary policy has traditionally been bank lending. If banks shed deposits as the RBNZ wishes, then this will inevitably impact their capacity to lend. The experience of negative interest rates in Europe and Japan is salutary, with their economies being mired in torpor for many years. The RBA and even the Fed have wisely shown considerable reluctance to go down the negative rate path given the real-world evidence but the RBNZ seems unnervingly keen.
Secondly, the push to buy equities is coming at a time when valuation ratios are already through the stratosphere. Using a consistent set of Jarden data, the core one year forward PE (ex Air NZ, property, Infratil) for the NZ market is a mind-blowing 37.0x as this is written. You have to pay $37 for $1 of earnings. Maybe the market is just looking further forward, but even using our internal Salt Funds estimates for three years out, the PE is now above 32.0x. The average since 2001 is 20.5x.
Listed companies and their investment bankers have been trampled in the rush when they have needed to raise equity in recent weeks. Why NZ equities might need further encouragement from the RBNZ is unclear. The cost and availability of new equity is simply not a problem.
The third issue is that current policies are forcing people to take inappropriate risks. Friends who are pharmacists, doctors, film directors and artists have all taken a sudden never-before seen interest in equities. Everyone seems to be punting on shares on their newly minted broking account and sharing hot tips on message boards. If only the TAB could get these clients.
So far, the effects of QE/money printing appear to be working wonderfully well. Recession forecasts are shallower than a few weeks ago and markets are on fire. Has a new form of alchemy been discovered or do the same historical limits that have constrained money printing for the last 2000 years still apply?
Political and social limits do exist. What equity markets seem to be experiencing is a “Cantillon Effect”. When the French engaged in an ultimately disastrous bout of money printing in the 1700’s, Richard Cantillon observed that the resultant increase in prices doesn’t happen evenly when money is pumped into the economy. Those who were “close to the money” such as the aristocracy benefitted disproportionately from rising asset prices but everyone else suffered a reduced standard of living in real terms due to rising prices.
This ultimately didn’t end so well for the French aristocracy. As Blackadder so eloquently put it, “the peasants are revolting”. The point is that printing money has distributional consequences and that there is a social limit to how far Wall St can be rescued while leaving Main St in the lurch. There are shades of this in the US right now.
The other key limit on central banks is if their QE/money printing does eventually start to generate inflation. In a small open economy such as NZ, this would see the NZ$ fall, driving inflation higher in a feedback loop unless the central bank rapidly reverses course. This is highly unlikely in the near future given the initial disinflationary pressures of Covid-19 but it will surely occur at some point. As eminent macroeconomist Ken Rogoff put it on Bloomberg last month:
“So the probability is, for the foreseeable future, we’ll have deflation. But at the end of this, I think we’re going to have experienced an extremely negative productivity shock with deglobalization. In terms of growth and productivity, they will be lasting negative shocks, and demand may come back. And then you have the many forces that have led to very low inflation maybe going into reverse, either because of deglobalization or because workers will strengthen their rights. The market sees essentially zero chance of ever having inflation again. And I think that’s very wrong.”
To conclude, the RBNZ’s policies are encouraging a boom in NZ equities. This is wonderful for share-brokers and fund managers but the cost of equity is simply not a problem holding back NZ’s recovery. Maybe the boom is just something to be accepted as a side-effect of the RBNZ holding down interest rates to enhance the affordability of loose fiscal policy.
However, it is odd that the boom seems to be an explicit goal of NZ monetary policy in itself – one day, this will reach its limits and a whole new set of issues will be created.