Beware what comes after the easy money binge

A potent catalyst for equity and credit markets in recent months has been the combination of ultra-loose monetary policy from central banks and huge spending by governments. It has inspired a sense of confidence in financial markets that has turned into euphoria, notably in big US technology stocks. This week, such shares finally started showing signs that they were hitting their limits.

Given the current US policy mix that penalises investors sitting on the sidelines and holding cash — given they are earning next to nothing in interest — any cooling of a red-hot market is easily framed as an opportunity. For many, it is another chance to “buy the dip”. Plenty of asset managers argue that aggressive policy actions to support asset markets compel them to stick with equities and credit over the medium term.

Such thinking is backed up by historical evidence that equities move higher well ahead of an extended economic recovery. Money managers’ current annual return expectations of around 5 per cent over the next five years for the S&P 500 stock index may not look that exciting. But that performance starts to look a lot better in a world of sustained ultra-low yields on fixed income.

But financial history also offers cautionary tales. After an initial boom, “whatever it takes” policy responses can leave equity markets languishing in their wake. Asset-price bubbles in Japan, South Korea and Taiwan during the late 1980s, and in Thailand, Malaysia, the Philippines and Indonesia in the 1990s, are reminders of the long downsides that can follow.

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Take, also, China’s huge spending in the wake of the financial crisis, which culminated in an equity bust in 2015. Today, the CSI 300 sits a tenth below that high water mark, even after Beijing’s renewed efforts at stimulus this year. Excluding technology, media and telecoms, China’s share market performance has lagged global peers since 2011, according to BCA Research.

Some strategists blame huge spending initiatives over the past decade that have created a vast misallocation of capital and stalling productivity in the world’s second-biggest economy, which continue to cast a shadow over equity market performance.

Arthur Budaghyan, chief emerging markets strategist at BCA, argued that, over time, excessive stimulus and easy money policies led either to asset bubbles or a burst of inflation. Both outcomes “bode ill for share prices in the long run”, he said.

No other economy and equity market stands out more in this regard than that of the US. The latest official projections show a federal budget deficit of $3.3tn this year, or 16 per cent of gross domestic product — the largest since 1945. Government debt is forecast to exceed the size of the economy next year, before going on to hit a debt-to-GDP ratio of 107 per cent in 2023. That is the highest in the nation’s history, according to the Congressional Budget Office.

This debt binge, which extends to many US companies too, is encouraged by expectations of very loose monetary policy over the longer term. A rapid expansion of the Federal Reserve’s balance sheet to $7tn — up from $4.15tn in March — appears only the start, given the renewed focus of central bank officials in boosting inflation and reducing unemployment, while paying less attention to the potentially nastier consequences of stimulative policies.

So where does this leave investors?

In one respect, the possibility of disappointing US equity returns over the coming five years cannot be dismissed, given how quickly Wall Street has rebounded in recent months. Plenty of good news is priced in to the S&P 500’s current 12-month trailing price-to-earnings ratio of 27 times, which implies a substantial pick-up in earnings growth and productivity.

Some are hopeful this can happen. James Paulsen, chief market strategist at the Leuthold Group, expected the scale of fiscal and monetary support around the world “can break the trend of global stagnation and deflation”.

The importance of such an outcome for Wall Street is underscored by the high ownership of US equities among both domestic and international investors. This kind of positioning in dollar assets looks vulnerable, should the current US policy mix continue to weaken the buck, even testing faith in its reserve currency status.

BCA’s Mr Budaghyan conceded that a period of higher productivity that boosted capital returns and lifted output beyond demand could keep asset bubbles and inflation at bay. But such an outcome “is easier said than done”, he cautioned.

US policymakers have a formidable challenge ahead to ensure that stimulus policies do not overstay their welcome. Meanwhile, investors must hope that technological advances will indeed lift the efficiency of the broader economy as it recovers from the Covid-19 shock. 

michael.mackenzie@ft.com