Be wary of the unintended consequences of policy, warns Newton manager Harries
Investors need to be aware of the unintended consequences of policy designed for emergencies, being kept in place for years, says James Harries, manager of the Newton Global Higher Income fund.
He considers that the now familiar pattern of crises leading to bail-out announcements, market intervention and liquidity injections, which in turn, boost markets, looks set to remain for some time.
“It is noticeable, however, that each so-called stimulus has a progressively weaker effect,” he added. “The problem with these initiatives is that they are aimed at providing temporary relief for the symptoms of what ails the world economy, rather than tackling the structural problems of too much debt and severe imbalances in competitiveness, set in an environment of deteriorating demographics.”
Driving interest rates and bond yields ever lower from their current rock-bottom levels is unlikely to make much difference to the real economy, and arguably can create more problems than it solves.
“Unintended consequences abound when policy designed for an emergency is kept in place for years: savers and investors become increasingly disillusioned, ‘risk’ is mispriced, capital gets misallocated and capital markets, increasingly subject to state intervention, become increasingly dysfunctional and distorted,” says Harries (pictured).
One of Newton’s investment themes is ‘deleveraging’, which suggests that credit-driven excesses, which are at the root of the current crisis, are a global phenomenon.
But Harries said there remains “an underlying denial of the problem, a belief, for example, that financial markets are simply treating Spain unfairly, rather than seeing this as an indication that the bad debts in the system may be much worse than the authorities might be willing to admit”.
With 10-year bond yields of 6% or so, Spain is currently borrowing at rates in line with its traditional borrowing costs, explains Harries.
The difference from much of the last 30 years, however, is that interest costs are rising. He says a similar denial is at work in the UK, “where the population is already turning against apparent austerity (even though public spending has continued to rise) and there are calls to choose growth!”
“History shows that sovereign debt and banking crises in economies that rely on external funding, such as those in developing economies in Latin America and Asia, have tended to be ‘acute’, in other words, short, sharp and extremely painful.”
Where authorities and/or electorates have a choice, they are likely to delay painful adjustments, implicitly choosing a ‘chronic’ form of crisis — less painful but much longer running.
“It is clear that economies in the developed world are, for now at least, generally choosing the latter route over the former, for fear of another banking calamity,” said Harries. “The inevitable deleveraging is likely to be a long, drawn-out process.”
While global monetary and fiscal policy is “set to sustain the unsustainable”, Harries will retain a cautious approach, especially since slower economic growth is now clearly affecting the developing world.
Real (inflation-adjusted) returns from major government bond markets will be negative in coming years. Equities may look reasonably valued in the context of recent earnings, but expected returns from equities are below the historical average.
“We continue to attempt to strike a balance between the need to generate an income and return for clients, and an awareness of the substantial risks inherent in the outlook,” he explains.
“Current prospects in aggregate look distinctly unappealing, (but) they are also dynamic. Financial market volatility, in our view, should continue to provide opportunities for active and flexible investors to add value,”