The onetary expedition continues

The monetary expedition continues

Tactical investment outlook

In summary

  • Central bankers are facing a collusion of problems that they’ve not faced for generations
  • Traditional monetary tools are reaching exhaustion
  • A radical new approach might be required

In 1914, Ernest Shackleton led an expedition into the Antarctic. The goal was to complete the first crossing of the continent by foot. However, the conditions were more hostile than Shackleton’s crew and equipment had ever experienced. During the expedition, their ship, The Endurance, was caught in and crushed by an ice-flow. The crew had to survive on the Antarctic for twenty months before another vessel came to their rescue.

Roll forward 100 years and a series of central banking “Shackletons” from Bernanke to Draghi have navigated us through a sea of financial and economic troubles. We now face a new combination of conditions for which the traditional vessels are inadequate, and new designs are needed to keep the monetary boat afloat.

How did we get here?

Before we consider the rest of the journey, let’s look at the current environment.

  • Declining prices in commodities, such as oil and metals, have increased the probability of falling  prices of consumer goods and services (i.e. “deflation”).
  • Business investments in factories, office buildings, pipelines and other productive facilities (i.e. capital expenditure) continue to be much lower than in previous business cycles.
  • Expectations for rising interest rates have fallen significantly, undermining the ability of banks to make profits.
  • The amount of quantitative easing (i.e. electronically printing money) has reduced worldwide, to the point that central banks’ balance sheets are no longer growing i.e. they are no longer providing demand or liquidity in the bond markets.

The sharp decline in commodity prices throughout 2014 and 2015 has provided a boost to consumers’ spending power to the value of around 1.5% of global gross domestic product (GDP); each pound in the pocket can buy 1.5% more. However, the effects of this benefit will take some months to feed through. In the meantime, almost 1% of GDP has been lost due to the reduction of capital expenditure, particularly in energy, telecoms and industrial firms worldwide.

One possible solution could be the concept of “debt monetisation” by central banks which has been mooted by BCA Research. This is the process by which a central bank creates new cash (in the old days it would be physically printed) with which to buy government bonds from, for example, a pension fund. The central bank then tells the government that it no longer need pay interest or repay the capital. The debit on the central bank’s balance sheet pays no interest and is left there forever i.e. it is effectively retired. The net result is that the government debt vanishes but the money on which it was spent (e.g. infrastructure) remains in place and that money can circulate through the economy.

Sinking profitability of banks and US companies

In the meantime, the inflation environment and the responses from central banks are making it increasingly difficult for commercial banks outside the UK and US to keep their heads above water. One of the main methods of making money in the commercial banking sector is to borrow money over the long-term at relatively low rates of interest, and lend that money out at higher rates over the short-term.

This route has become increasingly difficult to follow due to near- or sub-zero interest rates, reduced differentiation between long- and short-term interest rates, and increase in defaults on loans to energy companies. So commercial banks are as keen as any for central banks to find a new solution that works.

US companies are also facing a squeeze on profitability. Their ability to increase prices of the goods that they sell is severely limited at the moment by weak growth in demand. At the same time, their costs are being increased by wages that are creeping up yet productivity is poor and getting worse.

Favourable wind

The ideal force majeure, in our view, would be inflation, wage growth, GDP growth and other economic data just strong enough to sustain pricing power and business confidence, but not so strong as to induce an interest rate rise from the US Federal Reserve (the equivalent to the Bank of England). This would gently blow the monetary vessel back on course.

Over the short-term, this is a lot to ask. But we’ve seen turbulence like this before which is why we believe in investing for the long-term i.e. at least five years if not 10. Exiting and re-entering the market i.e. “timing” the market, is notoriously difficult and tends to result in lower returns than just staying put and seeing out the storm. The spirit of endurance can often be the best guide when facing difficult conditions, not just in the Antarctic.

Important Information

The forecast of future performance is not a reliable guide to actual future results. Past performance is not a reliable guide to future performance. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed.

Any views expressed are our in house views as at 26 February 2016. Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions.

The information contained in this webpage has been derived from sources which we consider to be reasonable and appropriate and may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.

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