The global ship of state has navigated a narrow fiscal straight aided by quantitative easing but if the QE plug is pulled there are likely to be many near-term and longer-term casualties
Ancient Greek mariners feared sailing into what was then the uncharted western Mediterranean. Legend had it that there was a narrow stretch of water that held considerable peril. On one side was a monster, Scylla, that would devour seafarers, and on the other was an enormous whirlpool caused by a second sea goddess, Charybdis.
The global ship of state has had to navigate carefully through a narrow fiscal strait. Huge deficits and debt levels in many developed countries have strained government finances. Broadly speaking, governments have adopted a mix of two alternative strategies to manage deficits and minimise economic damage.
The first, quantitative easing, finances much of these deficits by using central banks to print money.
According to Ovid, Scylla was a beautiful nymph who turned into a horrible monster, devouring anyone coming too close to her lair. Could QE be going through a similar metamorphosis, changing from a much-applauded stimulus for a devastated economy into an immense economic problem?
Equity markets love QE. Global and US markets have risen in anticipation of each of the last three QE programmes. In 2013, releases of Federal Reserve minutes, one in February and then in May, both suggesting that QE might end early, have caused two market wobbles.
QE helped keep US interest rates low and the economy recover from the 2008 credit crisis. Unfortunately, QE also reduced market pressure on the US government to agree on politically difficult decisions of how to cut the deficit. These decisions have, arguably, not yet been made. Other developed countries, notably the UK and most recently Japan, have highly aggressive QE programmes and, at least in the case of Japan, painful decisions on how to cut the deficit have yet to be made.
Early victims of QE were retirees looking to buy annuities to fund their retirement. The problem caused by QE, extremely low annuity rates, is particularly acute in the UK where, upon retirement, people retiring generally have to put their lifetime pension savings into an annuity. In the UK, single life annuity rates are now close to record lows – being linked to QE-suppressed gilt yields that recently fell to the lowest levels recorded since the early 1700s, although they have rebounded since Fed chairman Ben Bernanke’s latest statement suggested that QE tapering appears likely.
Anyone looking for a steady income has been pushed by QE-driven reductions in yields on government bonds and related high-quality debt into less safe investments because these may be the only assets earning any meaningful yield. A desperate search for yield on the fixed income side appears to be matched by heavy demand on the equity side for high- yielding stocks. The net effect is that yields are being forced down across all asset classes.
While only pensioners looking to buy annuities and those dependent on income from high-quality fixed-income instruments may thus far have been devoured by the Scylla of QE, this will not go on for ever. When QE ends, the prices of securities that now provide above-average yield may decline sharply, imperilling yield-hungry investors who have bought what may prove to be artificially over-priced higher-risk assets just because they provided an income stream.
Moreover, once QE ends, governments will lose an important buyer for the new bonds they issue to finance their yawning deficits. The fixed-income market will need to absorb this issuance. This is likely to raise interest rates noticeably and will, in turn, increase government deficits as the interest cost component of the deficit rises. Additionally, given the positive attitude that equity markets appear to have to QE, they are likely to react negatively to a withdrawal of the facility.
QE has produced huge excess reserves in developed nations’ central banks. These must not be allowed to flow into the economy once economic conditions improve because this is likely to lead to high demand pressure on the economy and excessively high inflation.
While recent comments from the Fed have attempted to take some of the wind out of Bernanke’s recent remarks, it still looks as if QE will end relatively soon. So, if the ship of state moves to decrease reliance on QE, there are likely to be significant near-term and longer-term casualties as the Scylla picks off her victims.
The alternative strategy to managing deficits – implementing the Charybdis of austerity – also has its risks. The eurozone is a major, highly indebted, developed market to focus on fiscal austerity measures to reduce deficits. This is what probably caused it to fall into recession. In response to deteriorating economic conditions, individual eurozone nations are significantly reducing deficit reduction measures. EU Economic and Monetary Affairs Commissioner Olli Rehn has said fiscal consolidation (austerity) will be slow. Too great a reliance on austerity may drag the ship closer to a whirlpool – deflation.
In Homer’s legend the hero Odysseus managed to sail through the narrow passage between Scylla and Charybdis but not without losing members of his crew. Investors hope the global ship of state will be similarly successful. Nonetheless, it is unlikely that it will make it through without casualties.
Andrew Harmstone is managing director at Morgan Stanley Investment Management