Central banks distort investor expectations

In their attempt to change the world, central bankers and governments have not only distorted the economic fundamentals, they have done something far worse. They have distorted the way investors invest

Investors used to like numbers. To determine where they would invest, they would analyze, deconstruct, dissect and evaluate all sorts of numbers on the economy or on companies. They would take this vast quantity of information and put it into charts, use it to make ratios, and compare it to historical averages. With all of this information they would attempt to predict market movements. All of this has changed. In their attempt to change the world, central bankers and governments have not only distorted the economic fundamentals, they have done something far worse. They have distorted the way investors invest.

Take for example Ms Sun. Ms Sun is an investor in China. Like many other Chinese investors she did not want to invest her money with a bank because of the low interest rates or in the stock market because it is basically a casino. So she chose real estate as a safe alternative. She already owns “seven or eight homes” on the southern island of Hainan and logically was trying to diversify her investments geographically.

Ms Sun is considering investing in a development in the city of Tianjin, south east of Beijing. The project she is considering is called the World. The project is three times the size of New York’s Central Park. It was built to house over 100,000 people. But there is a problem. Only 20 homes are occupied and the developer is in financial trouble.

Most investors in this set of circumstances would run for the door, but not Ms Sun. Instead of being concerned about a price collapse, she is sure that the government will step in and make prices rise. She was “mainly worried about buying at the right time, before the government loosens policy and prices start rising again.”

It is not only Ms Sun who has faith in the Chinese government. This week China reported the slowest inflation in 19 months and industrial production growth near a two-year low. Now such news might indicate a steep fall in economic growth and possibly even a recession, but are economists worried? Not at all. They are in complete agreement with Ms Sun. They look at this slowdown as increasing the prospect for more government stimulus; despite the fact that past government stimulus has created massive bad loans like the World development in Tianjin.

One of the main problems for investors and business people is asymmetry of information. Basically some of the players have more information than others and much of the information is simply not available. So investors and employers rely on signalling. Employers hire employees who signal their competence by more education. Investors invest in companies which signal good future perspectives and higher possibilities of success.

The problem with the recent spate of free money is that it has turned signalling on its head. Whenever Ben Bernanke, Mario Draghi, or the People’s Bank of China announces that they have come up with another weird idea for pumping more money into the economy, it should signal that they are worried about the growth prospects for the economy. A prudent investor might deduce that the economic situation is rather dire and it might be a good time to avoid risk.

But that is not what is happening. Instead of avoiding risk at each announcement, investors are piling into it. Since there is no cost to buying assets that don’t really have a return other than what the greater fool will pay for them, assets like gold or Chinese real estate, the demand for them continues to rise.

Markets are beginning to react to nothing else. There is a strong correlation between the size of the Fed’s balance sheet and the S&P 500. There is an even stronger correlation between the exchange rate of the dollar/euro and the size of the Fed’s balance sheet relative to that of the ECB. The euro rises as the US in effect prints more money and falls as Europe does.

The problem with this uncoordinated global economics experiment is that there are many unintended effects. They have caused a great deal of suffering by lowering returns for those on fixed incomes. They have forced pension funds into ever more risky investments like junk and emerging market bonds. They have exacerbated pension issues that could impact municipalities. Dealing with the financial crisis has saddled the ECB (European Central Bank) and the Federal Reserve with vast piles of potentially impaired collateral. Then there are high oil prices and of course bubbles. But the largest issue is the way that it has warped investors’ perceptions.

In the meantime Ms Sun, China economists, and western investors speculate on when the next stimulus package is going to come. They should rather worry about the real economic consequences the distortions have had on disastrous developments in places like Tianjin, because at some point the flow of free money will have to stop.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages. Mr Gamble can be contacted at [email protected] or [email protected])


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