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Article / 02 May 2016 at 14:29 GMT

Investment Outlook: Death to fiat money

CIO / Saxo Private Bank
Denmark
  • BoJ's share ownership raises spectre of a planned economy
  • Still, the bank will most likely continue as a passive investor
  • ECB's corporate bond buying not logical as long-term investment

By Teis Knuthsen

In Japan, the central bank is now among the 10 largest investors in over 90% of the companies in the Nikkei 225. This is a result of equities being part Bank of Japan’s quantitative easing programmes. But what does it really mean? Can you imagine the central bank to be an active investor? If the answer is yes, the step to a planned economy is a small one. 

Most likely, therefore, it will be a passive investor. But can you then imagine that it will sell the shares again? That doesn’t seem likely either, which means that BoJ through its intervention partly has increased the Japanese money supply permanently, partly contributed to an artificial demand for shares, and thereby lifted stock prices. At a minimum, one can conclude that the Japanese stock market has become part of the global financial market where prices are subject to intervention from a player that is not thinking in terms of maximizing profits.

In Europe, the European Central Bank has decided to include investment grade corporate bonds in its QE program, and has chosen to make purchases directly in the primary market. This has not surprisingly led to a significant drop in interest rates. Last week Unilever (food, consumer goods, etc..) came to the market with a 4-year bond with a coupon of 0% and a yield to maturity of 0.06%. Does it make sense to lend money to a company without being compensated for either credit risk or for the postponement of consumption to the future? It may make sense if you think that the ECB will continue to drive down rates further, and thus prices up. But as a long-term investment it does not seem logical.

Quantities not values

Knowing that the ECB in Europe, like the BoJ in Japan, will be a passive buyer in the market that focuses only on quantity and not on the price, it's not hard to imagine that a number of international issues will move towards Europe. Just consider how tempting it may be for example for American energy companies to create highly rated sub-companies in Europe, in order to take advantage of very low loan rates.

The financial crisis is still so near the mind that you should be able to remember that part of misery came from less robust mortgage loans (sub-prime) being packaged into highly rated corporate vehicles (SUVs). These were sold in great style to less sophisticated but nonetheless greedy investors in Europe (German local banks in particularly). It is tempting today to see central banks as less sophisticated, but nonetheless quite greedy investors.

What is money?

When I think about the above issues, Margaret Thatcher's famous statement from 1983 often comes to mind:

“The state has no source of money, other than the money people earn themselves. If the state wishes to spend more it can only do so by borrowing your savings, or by taxing you more. And it’s no good thinking that someone else will pay. That someone else is you. There is no such thing as public money. There is only taxpayers’ money.”

The modern monetary system is on paper (fiat money), which means that the value of money is not guaranteed by gold or other assets. Money is worth something, simply because we accept that it is true.

When central banks are printing money to finance the purchase of financial assets, it expands at first what is called base money and then, through the banking system, the money supply. If there base money increases permanently, the value of money should fall correspondingly, in the same way that a stock price will fall when a company issues new shares. When a company buys back its own shares, the number of shares is reduced and the price increases. When a central bank buys stocks or bonds, the value of the purchased assets increases, but the value of money falls, if the increase in base money becomes permanent. In other words, our purchasing power will – in theory - fall.

In many ways, QE is a trick. It works when markets are stressed and undergoing a financial crisis. It does not work as a remedy to lift the potential growth rate of an economy.

This expansion of the monetary base is combined currently with negative interest rates. A negative rate is basically a tax that you pay to own money. You are encouraged therefore to spend more money, and to save less. But at the same time it becomes harder to shift your spending over your lifespan which many of us need to do (eg. pensions). Paradoxically negative interest rates could lead to increased savings and reduced consumption.

To avoid the tax as negative interest expressed, it may be tempting to increase your cash levels. This gives the state an incentive to introduce digital money, something that many really want to see as positive. With digital money follows, however, the possibility of total transparency of citizens' financial transactions, and as is the case with the Bank of Japan's share purchases, you also here have to worry whether we are heading towards a form of planned economy.

consumption
 Empty aisles. Negative interest rates can cause reduced consumption. Photo: iStock

Capitalism without ownership

They say that capitalism without ownership is like Christianity without hell. Therefore I look with growing concern at the pervasive combination of quantitative policy programmes and negative interest rates.

I think the extension of this is that one must consider whether we are approaching the end of the paper-based money system. The exchange of "money" will become a digital transaction with a marginal cost of zero. The price of money is also called interest rate, which in this scenario will never leave the zero-bound.

When government debt is made to disappear

I also expect that we will one day see that central banks and finance ministries will offset each other's claims, so that central bank holdings to government bonds are netted out, and that government debt thus reduced. It probably starts with Japan. This symbiosis may prove surprisingly stable, with central banks and states the merely different accounts in the same accounts.

The exception is Europe, where Eurozone members do not have access to print money itself. Therefore, one must assume that we are just a crisis away from the introduction of the so-called euro-bonds (which finances national government debt).

Importantly, investors must understand that you cannot stay out of the market without incurring a cost (negative interest). Furthermore, you cannot go "short" the money system, as central banks have unlimited access to print money, at least in the medium term.

However, I also believe that one should stay in the game as they say. When global equities are trading at an estimated P/E multiple around 16, it corresponds to an earnings yield of just over 6%. This provides a conservative estimate of the return potential over a longer period. High grade bonds, however, can only be used as an insurance against troubled times.


Business cycle overview and asset allocation key
 

Total return, local currency
 
– Edited by Clare MacCarthy

Teis Knuthsen is CIO of Saxo Private Bank.

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