Things are likely to get bumpy and a “time of reckoning” is coming for global markets and economies, David Marsh, co-founder and chairman of the Official Monetary and Financial Institutions Forum (OMFIF), told FS Insider June 6.
Marsh and his team at the OMFIF track the investment behavior of 750 large institutions around the globe, which control an estimated $36 trillion in assets and have a major influence on global markets.
In a high-level summary of the recent report, Global Public Investor 2018, Marsh explained on our podcast many of the building concerns he and others now share, especially as central banks start to tighten up on monetary policy.
Leaning Against the Markets
Sovereign funds and pension agencies have become completely fed up with bonds paying low-interest rates and have piled into less-liquid and riskier real estate and infrastructure positions.
Traditionally, these investors have served as stabilizing forces, but conflicting incentives have been created. Central banks are particularly conflicted because they are trying to make money on their reserves while at the same time maintain stable financial conditions, and this situation has only gotten worse.
“The curve towards the destabilizing function of central banks has actually become more important,” Marsh stated. “They have (now) become more of a threat to the stabilization of financial markets than an underlying guarantor.”
Fiendish Cocktail of Problems
Central banks have increasingly played a destabilizing role precisely because of the distorting effects of quantitative easing, Marsh stated, which has completely thrown off bond and asset prices, particularly in Europe.
“I'm rather fearful that now that they've started this great surge of moving into less traditional assets, more risky assets, that it's going to be very difficult to get out,” Marsh said. “Particularly since some of the bonds that they've been purchasing for the quantitative easing … are actually very expensive and sometimes negatively yielding, and will almost certainly bring losses.”
This distortion has left public pension funds in a predicament. Quantitative easing and depressing interest rates have undoubtedly supported the world economy, at least in the short term, Marsh noted, but that growth has come at the cost of creating long-term problems. Now, these pension funds are holding more equities in a search for yield, but they have not been able to make the returns in equities that would compensate for the much lower interest rates on bonds.
Meanwhile, they have to maintain payout rates for aging populations, and so we’re left with short-term stimulus to the economy, Marsh stated, measured against a long-term possible bankruptcy of the pension system in Europe.
“If you then throw in the problems of just illness, bad health, Social Security … and also paying for healthcare, you've got a fiendish cocktail of problems waiting down the line,” Marsh said. “The pension funds are not able to generate the returns needed to cope with this elderly, fast-depleting population.”
Trial of Strength Coming
All of these distortions created by stimulus have “won time” for world economies, Marsh noted. But a reckoning is coming.
The end of monetary stimulus will mark this period. When interest rates start to go up again, which is already happening in the United States and is bound to follow in the rest of the world, debtor countries will be subject to much greater stresses and strains that they have been when interest rates have been unnaturally low.
Ultimately, politicians will put pressure on the central banks to not do what they would normally have to do, Marsh stated, which is raise interest rates. Coupled with the inevitable return of inflation, central banks will want to raise rates but will be unable to do so.
Central banks, particularly outside the United States, face a debt trap and political pressure to keep interest rates low. This could mean the outright end of central bank independence. We’ll probably see issues begin to take hold sometime around 2019, Marsh added, and things will probably get bumpy in the next 12 to 18 months.
“As world economic conditions tighten, we’ll have a boom followed by a bust probably in the United States,” Marsh said. “The central banks will be asked, yet again, to take action to alleviate the short-term problems, and they might find again that this goes against their mandates of encouraging stability. So it's been a good time to be a central banker in the last 10 years because you'd be like a master of the universe helping to protect the world from a downturn. It’s not going to be so great to be a central bank in the next 10 years when this time of reckoning starts to raise itself and become doubly apparent.”