A Song For Europe
A long time ago in a bar far, far away (Yokohama actually) a former colleague introduced me to a song called ‘The cow kicked Nelly in the belly in the barn’. The attraction of the song, especially to those with a little Dutch courage, lies in the chorus.
‘Next verse, same as the first,
A little bit louder and a little bit worse’
From an initial whisper, each verse grows a little bit louder and a little bit worse and eventually reaches a final crescendo at the limit of the singers’ lungs.
It is definitely not ‘Nessun dorma’, although the famous aria’s meaning of ‘None shall sleep’ is appropriate enough.
And it’s not a very edifying sight.
Which brings me to the financial version of the song being performed by the central banks of Europe (ECB) and Japan with others joining in.
We have already seen several verses of quantitative easing which are aimed at stimulating modest inflation and improving economic growth by lowering interest rates. But they haven’t been very effective. And it’s clear that central bank thinking is not that the policy is wrong, rather that not enough has been done.
So the ECB and others still want to be a ‘little bit louder and a little bit worse’.
And to achieve they are beginning to charge commercial banks for holding deposits with them. That charge is effectively a negative interest rate since the depositor gets a negative return on their money i.e gets back less than they started with.
In turn, the commercial banks are passing those negative rate costs onto their institutional and corporate clients with the largest deposits.
This BBC article by Andrew Walker does a good job of explaining what negative rates are and where they exist in a bit more detail.
Why push rates negative?
By imposing a cost on deposits, central banks are encouraging the regular banks and indirectly their largest clients to find better uses for their money, either in riskier investments or another currency. But it’s not that easy to find suitable debt or equity to invest in.
The earlier verses of quantitative easing have already distorted asset prices as returns have fallen due to artificially low interest rates.
As just one example of how this works, large companies in the US have gorged on cheap debt to buy either their own shares or those of other companies. That has supported equity prices to extreme valuations by some historical measures. And with that extra debt there are now just two companies left that have the safest credit rating, triple A – Johnson & Johnson and Microsoft.
For banks, the problem is not just where to lend. There is the added problem that it may be difficult to pass their negative interest rate costs to all their depositors. I explained in my last article that in order to implement negative interest charges with a bank’s retail customers you’d also need to limit access to cash, which is politically very difficult.
So profitability is likely to be affected at banks across Europe that are still repairing their balance sheets.
Negative rates and negative bond yields also change to whole basis of analysing how an investment performs over time. So they also affect those with long term liabilities such as a pension funds or insurance companies. And you’ll see that reflected in news of growing pension funding liabilities in Europe and elsewhere.
Germany is already pushing back against what it sees as an aggressive policy change. But the ECB headed by ‘Super’ Mario Draghi rightly points out that it sets policy based on the whole of Europe.
He is also quoted in today’s FT as stating that low interest rates are also the result of a savings glut not just ECB policy. But by competing with that savings glut with the ECB’s own printed money he’s clearly and openly driving rates lower than they would otherwise be. And the ECB hasn’t abolished risk as we saw in the collapse in the oil price and the debt of related companies.
So while to some the investing world might appear to be in equilibrium and seem like business as usual it really isn’t. Central banks are playing a huge role in setting asset prices and they are still singing loudly. And there are several verses of policy changes, some quite radical, that they could still employ.
I’ll cover those in a later blog.
The danger for investors in this environment is that you start chasing investment propositions that seem to offer a reasonable yield, but where the underlying risk is not well understood.
The fact that something has worked well to this point or that the crowd is recommending it is not necessarily risk analysis. Nor is a fancy brochure or a nicely designed website with a fat investment return on it.
Unsecured retail loans, volatility trades, aircraft leases and catastrophe bonds, to name just a few, all offer yields that individuals can now get exposure to. But they are all forms of underwriting and proper risk assessment is very difficult. And I’ve considerable experience of debt and volatility trading.
It’s also important to understand liquidity, which is the ability to get access to your money.
Your current investments may prove to be far less liquid and more complicated and risky than you think. And that’s where serious errors can occur, either in unanticipated losses or your response to them.
The role of your adviser is, in large part, trying to make sure you avoid those mistakes.
Another ‘Song For Europe’
I am sure there are worse ‘Songs For Europe’ out there…but here’s Father Ted’s spoof.
- past performance is no guide or guarantee of future returns;
- the value of stock market investments can rise and fall over time, so it is quite possible to get back less than what you put in, depending upon timing;
- this blog does not constitute financial advice and is provided for general information purposes only.