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Central bankers in unknown territory as they prepare to shrink balance sheets: Warnes

Lewis Jackson  |  04 Feb 2022Text size  Decrease  Increase  |  
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As central banks around the world begin the historic task of weaning markets off years of stimulatory asset purchases, there’s an elephant in the room, according to Peter Warnes, head of equity research at Morningstar: they may not know how.

Despite more than a decade hoovering up assets of all varieties, most central banks are “apprentices” when it comes to the reverse, says Warnes. The one and only attempt at what is known as quantitative tightening was by the US Federal Reserve in 2017. It was stopped after two years due to bond market turbulence and an economic slowdown. No other central bank has yet attempted QT.

How policymakers go about reducing the US$31 trillion in assets held by central banks around the world is a major unknown for markets this year, claims Warnes, speaking at the Morningstar Investment Conference on Thursday.

“Raising and cutting interest rates is basically fairly easy. That’s been done for centuries. Quantitative easing was unconventional and hardly ever used before. The first time was post global financial crisis,” he says.

“Because they haven’t had the experience, you’ve basically got apprentices at work. There’s no master apprentice at the central banks at the moment as to how you can wind back these unbelievably bloated balance sheets.”

Uncertainty about the pace and extent of monetary policy tightening has already trigged major share market selloffs around the world this year. Interest-rate sensitive tech stocks have declined sharply, with the Nasdaq Composite down 12% year-to-date.

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Warnes saw little reason for confidence in the most recent comments from Fed Chairman Jerome Powell.

Speaking at a press conference last Wednesday, Powell said the Fed’s governing committee would discuss issues of “timing, pace, or other details of shrinking the balance sheet” at upcoming meetings.

“For goodness sake, you’ve been buying bloody bonds for 2 to 3 years, and have a US$9 trillion balance sheet. And you haven’t thought about it?” said Warnes.

“It’s the same situation here. We’ve got $650 billion on the RBA balance sheet, trebled since the pandemic. They stopped purchases in February. Then what are they going to do?”

The Fed has signalled balance sheet reduction could begin by mid-year. At its board meeting on Tuesday, the Reserve Bank ended its quantitative easing program. Governor Philip Lowe said the question of balance sheet reduction will be discussed in May.

Some central bank officials have claimed that QT will be a minor event, in part because its main impact is to signal central banks intend to raise rates. In other words, a gradual reduction in assets may have limited impact beyond the broad signal it sends to markets.

Rate hikes this year are all but certain in the US, already underway in the UK and possible in Australia. In remarks on Wednesday, Reserve Bank Governor Philip Lowe called rate rises this year “plausible”

What we do know is worrying

Warnes' list of 'reasons to worry' in 2022 was on full display for attendees, discussing record high valuations, slowing economic growth and recession warning signs flashing out of bond markets.

Australia’s economy is currently running hot, but most forecasters expect gross domestic product (GDP) to more than halve in 2023, a negative sign for earnings and share prices, he says.

“We’re far from boomtime conditions and markets need to understand that profits and cash flows cannot continue to grow at a rate significantly in excess of GDP growth for a significant period of time,” he says.

Recession signals are visible in government debt markets, says Warnes, where yields curves are flattening as the returns on short and long-term debt narrow. This process has historically been a precursor to recessions.

“Bond markets are not really embracing longer term economic growth that’s off the charts,” he says.

“The two-to-ten-year yield has inverted six times over the last sixty to seventy years. Each time it has been followed by an economic recession.”

Those warning lights are flashing as rising interest rates threaten to clobber equity markets grown fat on multiple expansion as opposed to earnings growth, says Warnes.

He pointed to data showing 80% of the market gains in the S&P 500 over the past year was due to expanding price to earnings multiples, compared to 20% for earnings and earnings growth.

Multiple expansion refers to investors paying more for the same quantity of earnings, often because of lower interest rates. As rates rise, future cash flows become less valuable, squeezing valuations.

“The platform for valuations is unstable and fairly weak,” he says.

“Dip a toe in the Ganges”

Warnes suggests investors put off by sky-high valuations in the US consider modest positions in China or India, where shares are trading at more affordable multiples.
“Look at that Indian market as an emerging market. Again, softly softly. Not too much money, but I’d dip the toe in the Ganges,” he says.

Warnes also admitted to having “nibbled” at Alibaba but warned investors to watch their exposure given the unpredictable nature of regulatory risk in China.

China’s CSI 300, which tracks the top 300 stocks on the Shanghai and Shenzhen stock exchanges is in bear territory, having fallen 20% from its peak in February 2021.

Alibaba is down 60% from highs notched in November 2020. Shares closed Thursday at a 34% discount to fair value.

“Press the button”

Cash is unloved in a world where deposit accounts barely outpace inflation, but Warnes recommends investors maintain a liquid buffer to give themselves optionality for when opportunities appear.

Find companies that satisfy the demand for necessities, with strong management and dominant market positions, he says. Build a list of suitable options and wait for them to drift into undervalued territory.

“Cash gives you the option to take advantage of opportunities as they present, he says.
“Especially if you’ve got your list of stocks you really want to own. They come down and you instantaneously press the button. You have your preferred list, you know how much you want to spend, you hit the buy button. You can’t do that if you need to sell something before you act.

Cash occupies around 10% to 15% of his portfolio, down from highs of 25%.

is a reporter and data journalist with Morningstar. Tweet him @lewjackk or get in touch via email

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