Investors should consider how they will pick stocks if central banks and policymakers attempt to kickstart the economy through so-called helicopter money, according to Nikko Asset Management head of global equity William Low.
Central banks globally have been using loose monetary policy in an effort to stimulate growth and inflation, with the Bank of England most recently cutting interest rates to 0.25 per cent and announcing an expanded quantitative easing programme.
It follows on from the European Central Bank’s aggressive monetary policy programme while the Bank of Japan has made longstanding efforts to stimulate economic growth following several decades of deflation.
However, this has led to a world where equities have been rising alongside bonds without the desired effect of inflation, as the graph below shows.
Performance of indices over 3yrs
Source: FE Analytics
Nowhere has this been more apparent than in Japan, where a negative interest rate policy is now underway following underwhelming quantitative easing results.
“The introduction of negative rates on certain reserve balances in Japan appears not to have changed this, with the propensity to save remaining high,” Low said.
He added: “This has raised the question of whether more radical policies are now required to ensure that consumers remain confident that the economy will achieve sufficient growth to enable the servicing of the mountain of sovereign debt that already exists and continues to accumulate.”
As a result, with many continuing to save rather than spend their extra money, the Bank of Japan has announced new stimulus.
As the bank already owns a large portion of the government bonds and part of the equity market as well, Low says debt monetisation, as well as other measures including helicopter money, could be enforced.
“The market is currently debating how this fiscal spending will develop in future and whether QE will evolve into something that is deemed permanent and hence a catalyst for a shift in inflationary expectations,” he said.
However, he says that obstacles including potential corrections in the bond market, regulatory changes and the efficacy and durability of monetary policy being called into question, likely make these changes “theoretical for now”.
While this is the consensus view, Low says it is important to consider the ‘what if’ scenario of debt monetisation – where governments issue bonds bought by the central bank until completion in an effort to increase the cash within the economy – and helicopter money – the act of printing large sums of money and distributing it to the public.
These would clearly have stock-picking implications, Low says, with savers being encouraged to spend the extra cash rather than save it.
The stated intention of policies therefore would be to create greater demand and inflation, something that has been lacking in recent years.
In this scenario, companies with long duration, fixed debt would be the likely beneficiary.
“High leverage with variable rates, however, will be less attractive given the inevitable upward trajectory of the whole yield curve in tandem with any inflationary expectations,” Low said.
In a relative sense, therefore, equities will provide greater inflation protection than bonds, particularly long duration fixed bonds.
This would reverse the trend seen over recent years, where investors have bought up government bonds as equities have fallen behind.
Performance of indices over 10yrs
Source: FE Analytics
Companies with high asset turnover will also benefit, as the cost of their products in the real world will be higher, leading to better top-line growth.
“Given that there has been little regard for real returns in a world dominated by disinflation, investors' willingness to capitalise on an improving stream of nominal returns should not be underestimated,” Low said.
However, he caveats: “Given that all risk assets have profited during the era of QE, the benefits from a switch out of bonds may prove temporary and lower valuations for all financial assets will be a persistent headwind.”
With inflation rising, “growth stocks and businesses with stable earnings will have vulnerable valuations as a result of long duration returns being valued using low discount rates”, Low said.
This will also be reflected in a preference for companies with cash flows dictated by regular re-pricing versus irregular, he added, such as general insurers rather than life insurers.
Exporters will also be negatively impacted, with a divergence between ‘inflators’ and other parts of the world which remain in low-inflation or deflationary scenarios.
“Currency divergence between 'inflators' and others may be large, with implications for net exports and a consequent shift away from free trade back towards protectionism,” Low said.
Additionally, there will be additional political risk to investors will need to consider when picking stocks.
“The adoption of inflationary solutions will have varying effects on different parts of society depending on income profile and demographics,” Low said.
“This is likely to result in the public support for existing political parties evolving, with possible shifts in voters' acceptance of free markets and capitalism. Profit shares versus income shares within economies may be placed under even greater focus as a result.”
“In addition, greater involvement of politicians and policymakers in the operations of the private sector has historically been accompanied by lower levels of productivity and depressed equity valuations.”
With such uncertainty in the market, the effects of debt monetisation and helicopter money could create an opportunity for active managers to significantly outperform.
While the above issues do not cover all of the complexities of the monetary policies enforced in this scenario, it is apparent that benchmark investing equally may come under the spotlight.
“Given the increasing proportion of assets deployed in passive strategies, there are many investors who will be constrained by the dominance of deflation survivors within indices,” Low said.
“Conversely, active investors should have significant opportunities if they correctly assess the implications of an inflection point created by policy makers.”