Another month passes, and the European Central Bank (ECB) continues to kick the can down the road. But unless the European economy sees some growth and inflation, the ECB is likely to run out of road.
Right now, we are faced with negative interest rates, a large asset purchase programme - of both government bonds and corporate bonds - and a mechanism that allows banks to borrow to make loans at negative rates too.
It’s easy to understand the intention behind these actions. They are intended to shift investors out of the government and corporate (investment grade) bond markets into riskier assets. The hope is that this will enable companies to find the finance to invest in projects, provide jobs, stimulate growth and ultimately rekindle inflation.
With German government bonds yielding 0.07% (for an investor who is prepared to tie his or her money up for 10 years) and corporate debt yielding 0.97% on average (Bank of America/Merrill Lynch European Corporates) investors – let’s call them “bond tourists” - are happy to travel further afield.
Their aims are twofold. First, they want to replace the income they are no longer receiving from (safe) government and (pretty safe) corporate debt.
Second, they need to feel comfortable that they will be able to access their principal payment at some point in the future as well.
So what are the favoured destinations for this holiday from bonds...?
Sub-investment grade bonds. Not a bad option. It meets both the income and principal criteria. However, the universe is fairly small compared to government bonds and investment grade corporate bonds. Interestingly, the ease with which high yield companies have been able to fund themselves has resulted a very low default rate when compared to the level of GDP growth in Europe. And arguably, this easily available refinancing contributes to lower inflation as more capacity stays around than would usually be the case.
Equity income. This is where it gets speculative - but interesting. Bond tourists, with their unusual customs and practices – their Hewlett Packard 12C calculators and their incomprehensible foreign languages (enhanced equipment trust certificates, anyone?) - are looking to satisfy the income and principal criteria. But in equities, this is by no means cut and dried. Dividends are under the control of management and are guided by company performance. Meanwhile, the principal value is at the mercy of risk-on/risk-off behaviour by capricious markets.
Recently, we have observed a steady rise in the dividend payout ratio – that is, how much of a company's profits are distributed. Sometimes this is due to a static level of payment while profits decline. More broadly, however, there is evidence that even when companies are managing to increase profits, dividends are also rising. On top of that, the amount of money going into equity income strategies has been rising. Company management seems to be changing its behaviour to meet the demand of these new owners of their equity – but running a business for yield is not going to help the broader economy with little incentive to invest and grow. Also, keeping your company’s cost base tight and employment as low as possible looks an unlikely strategy to escape from this period of stagnant growth and overcapacity.
With lower growth rates from companies but still-high leverage… the risks of a management mis-step are likely to be magnified.
With lower growth rates from companies but still-high leverage (often to pay for those higher dividend payments) the risks of a management mis-step are likely to be magnified with the very real potential of rising equity market volatility. This will only act to ensure the tourists insist on even more conservative management of their companies and again lower growth.
So more quantitative easing in the form of an expanded public sector purchase programme (which has extended its scope to include corporate bond purchases) could actually result in stagnant growth with low inflation, and in higher equity market volatility. Obviously, these are outcomes the ECB is very much not targeting.
The solution may be to follow the US example. Take your medicine and do not complain about the taste. In plain English, put interest rates up. Or, at the very least, stop putting rates further into negative territory in Europe - and do not crowd out the private sector from traditional savings routes such as corporate bonds.