NO. 7 ∙ July 2020
Back to business as usual, or is it?
AUTHOR: Michael Blümke, CFA, CAIA
Senior Portfolio Manager
Finally no more working from home. Finally no more explaining to the children that even though Mum and Dad are at home they have to work all day. Finally a proper office chair and discussions with colleagues; still with physical distancing, sure, but in person instead of via video or audio conference call. Even the various market indices are rapidly nearing a level last seen prior to the coronavirus crisis. We have almost returned to the status quo. So, all’s well again, isn’t it?
Not quite. Things have changed compared to three months ago. Not only do social distancing rules apply in the office now, but quite a bit seems to have fundamentally shifted in the investment landscape as well. Despite – or perhaps because of – the meteoric market recovery, we too are faced with the following questions:
- Is the recession over already, or are the markets completely disconnected from economic reality due to the various stimulus packages?
- Have recessionary insolvency problems suddenly gone away, or have they merely been pushed back?
- What problems will emerge in future from the flood of liquidity created by central banks that is currently having such a calming effect on the markets?
This last question in particular strikes us as the starting point for many of the incongruences raised in the previous questions. For that reason, we will now take a critical look at the role of central banks.
For hundreds of years, banks were generally the primary lender for businesses. The bond market as it exists today was not possible until the practice of securitising such debt became more common. Now, corporate bonds account for more than half of outstanding corporate debt. Put simply, the role of central banks is now to set the price of the money through short-term interest rates. Of course, this has a direct effect on the demand for money and thus also on the bond market, which puts a price on default risk by means of the respective credit spreads. This consequently means that, through the well-known mechanism of supply and demand, each company’s bond issue can be priced individually according to its creditworthiness. So the theory goes.
However, current practice turns this on its head to some extent. Not only have the now record-low central bank interest rates over time led to sharp price rises in many asset classes, but also direct market intervention by central banks – lately in the form of purchase programmes for corporate bonds – has reached a whole new level. This policy, which has been European Central Bank practice for a number of years, has now been embraced by the U.S. Federal Reserve as well. The Fed has even begun to take non-investment grade bonds onto its balance sheet. In the process, the pricing of the default risk of companies is effectively being subverted by a price-insensitive buyer. The current magnitude of these purchase programmes seems relatively small compared to the total size of the market. However, the mere declaration of intention of such powerful buyers, who can print the cash required if need be, is enough to have a lasting influence on the market. In this context, the principle known as Goodhart’s Law  has practical application for the use of targets. The law states: “When a measure becomes a target, it ceases to be a good measure”.
In the case at hand, the intervention by central banks is targeted at the measure of default risk, which thus cannot function well as a measure. It is not our intention to examine here whether the end – that is, avoiding a dysfunctional bond market in the short term, with all the consequences that entails – justifies the means. The point is rather to highlight what consequences arise when central banks are effectively prepared to assume market credit risk on a grand scale.
On the one hand, this results in companies with uneconomical business models – that is, companies that are neither growing nor making a profit – surviving, as they continue to receive external financing at terms they can afford now and in the future. An obvious result of this is that, at a macroeconomic level, a lot of capital gets misallocated. In addition, as there are a large number of value traps amongst the affected companies, the pre-existing outperformance of growth companies versus value companies only becomes further pronounced On the other hand, the lower interest rate and the underestimated credit risk tends to reward financial engineering rather than alternative and sustainable investment. The long-term consequences will be weaker economic growth and lower returns. The third consequence of these measures concerns capital investment in general, and moral hazard specifically. Again, active managers who, anticipating a severe recession and the associated higher rate of insolvency, deliberately reduced risks in their portfolios were not rewarded for this prudence. Instead, the investors who got the best returns were the ones who went all-in – to borrow a poker term – when the central bank programmes were announced. Knowing that the central banks would nationalise credit risk for a certain period of time created an incentive to buy that was completely out of step with companies’ economic reality, amounting to moral hazard par excellence.
Now, the question is, of course, how to deal with this going forward. Given the circumstances, even though the temptation is strong to jump on the central bank bandwagon and follow the crowd towards higher-yielding investments, we advise caution. We doubt that the perceived “infinite” liquidity will lead to lasting solvency. For that reason, it will be all the more important in the future to balance expected return – be it bonds or equities – with the risk of default.
So we’re happy to say that perhaps not all that much has changed after all.
 The principle was named after Charles Goodhart, adviser to the Bank of England and professor at the London School of Economics and Political Science.