- European pension funds say QE has worked, but with unintended consequences
- Overall, QE has destabilised pension funds
- Japan offers a worrying precedent as doubts about the future effectiveness of unorthodox monetary policy grow
- The West seems ill prepared to face a new downturn
After averting a 1929-style global depression in the wake of the Lehman collapse in 2008, central banks in key economies have faced the Herculean task of unwinding their crisis-era emergency measures, involving zero-bound interest rates and large-scale asset purchases.
Ten years on, advanced economies have continued to operate below their natural speed limits. Quantitative easing (QE) has reached the point of diminishing returns, while denting the credibility of its principal architects.
In June 2017, former US Federal Reserve Chair Janet Yellen mused that quantitative tightening in terms of the Fed’s balance sheet normalisation would be like “watching paint dry”. Yet, while the paint was still drying, the Fed was back at panic stations in January 2019, after the stock markets’ cardiac arrest in late 2018 was blamed on the Fed’s rising rates and shrinking balance sheet. The Fed duly performed a sharp u-turn barely a month after the chairman, Jerome Powell, had proclaimed that quantitative tightening “was on autopilot”.
The Fed’s rate-hiking cycle has now been reversed, as recessionary red flags flutter in the global economy. The European Central Bank (ECB) has followed suit. A new era of QE beckons.
It is time, therefore, to perform a stock-take on the effect QE has had on pension plans so far and how their asset allocation approaches are likely to change as QE evolves into its next round. This has been done by the 2019 annual Amundi-CREATE survey ‘Quantitative easing: the end of the road for pension investors?’.
Involving 153 pension plans and 38 pension consultants across Europe, the survey found that, as a crisis-era measure, QE has worked. But its unintended side effects have undermined its overall effectiveness.
On the plus side, it stabilised financial markets that had been roiled by the severe 2008 credit crisis. It delivered good returns on riskier financial assets. It eased financing by governments, companies and households, as liquidity dried up. It gave governments time to tackle the deep-seated causes of the crisis. Above all, it kick-started growth in the global economy caught in a vicious spiral.
On the minus side, it allowed global debt to rise inexorably and sow the seeds of the next crisis. It disconnected asset prices from their intrinsic value. It allowed financial imbalances to build up as markets have hit fresh highs with convictionless trades. It gave governments an excuse to backslide on essential growth-friendly supply-side reforms. It overinflated pension liabilities via zero-bound interest rates.
Overall, QE has destabilised the finances of pension plans (figure 1).
The numbers in the figure are all the more worrying against the backdrop of the longest bull market in history. The main culprit is falling interest rates. They mean lower cashflows, as plans typically rely on bonds to fund regular pay-outs to their retirees. To cover the resulting shortfall, they have had to invest even more. Falling rates also inflate the present value of future liabilities, as measured under prevailing pension regulation.
Pension plans are thus relying on two avenues to improve their funding levels – fresh one-off cash injections from their sponsors, and an approach to investing that favours equities, illiquid assets and emerging market assets. We will return to these points in our second article in January 2020.
Case study: a Swedish pension plan
QE has worked as a crisis measure. It has not restored growth to its long-term trend, nor has it arrested the steady accumulation of unsustainable debt or improved personal income for the masses – the things that occurred in previous periods of expansion. If anything, via asset price inflation, QE has accentuated the income inequalities in our societies and fuelled the rise of populism.
QE could be driving large economies on both sides of the Atlantic into a deflationary zero-interest funk of the sort experienced by Japan since the 1990s. The global economy is exposed to various macro risks that could easily tip it into another recession. They include the trade war between America and China, a disorderly Brexit withdrawal, high debts in many economies, the incomplete institutional architecture of the euro-zone, and structural policy inertia.
Fiscal policy in the key economies has been slow to respond because their public debt burden is unsustainably high, leaving little leeway to implement the required supply-side reforms and big infrastructure projects.
Thus, the end-game of QE may well be the adoption of modern monetary theory – a fashionable heterodox doctrine based on the view that traditional macroeconomic frameworks are no longer fit for purpose in this decade. It argues that QE has failed to provide the boost that economies need.
So it advocates huge rises in public spending, alongside job guarantees and minimum basic incomes. Such policies have been tried in the past in Latin American countries. After the initial jobs boost, triple-digit inflation and massive devaluations have been the principal outcomes.
These could take us back to the inflationary 1970s which saw extreme volatility in financial markets and political upheavals. It is unwise to rule out ‘stagflation’, which has followed past periods of huge budget deficits funded by money printing; nor moral hazard, when policy makers do not take responsibility for their actions.
Before then, it is worth stressing that QE is at the point of diminishing returns in Japan (according to 75% of respondents), the euro-zone (64%), the USA (57%) and the UK (52%); as shown in the report.
As the Fed and the ECB reverse their quantitative tightening policies in the face of mounting recessionary worries, Japan provides a disturbing glimpse of the future. Since 1995, it has had nine rounds of QE without reigniting growth and inflation in the real economy.
There and elsewhere, QE has worsened income and wealth inequalities by putting a rocket under asset prices without pushing growth back to its trend line. It has not perceptibly tackled deep-seated structural problems such as ageing demographics, stagnant wages and slowing productivity. Governments have yet to address them, after their deficits hit record highs in the wake of the crisis. This may well have contributed, among others, to the rise of populism.
Initially meant as a temporary crisis-era measure, QE has acquired a life of its own, inflating the global pile of negative interest bonds to a record $17trn (€15trn) – a quarter of all fixed-income assets. Debt crises tend not to have a good ending, judging by past form.
Fears about ‘Japanification’
Japan first cut its interest rate to 0.5% back in 1995 and since then has had nine rounds of QE, including large-scale unprecedented purchases of equity ETFs lately, without rekindling growth and inflation. These have merely weakened the yen, boosted property and stock prices, and turned the Bank of Japan into one of the largest shareholders in Japanese companies. Mounting worries about what the future holds for both job and business security has restrained household and business spending.
Fears about the impending recession are now stalking the markets. But many pension plans are just as worried about the geographical spread of a deeper structural shift dubbed ‘Japanification’: ageing population, stagnant productivity, rising government deficits and extreme debt monetisation; all conspiring to drag down productive potential.
In other regions, while most of our respondents say that QE has reached the point of diminishing returns, a significant minority either remain unsure or say otherwise.
Yet, the backlash against QE is no less real. Many respondents contend that it has been a big factor in the recent rise of populism by favouring the rich via asset price inflation, while failing to spark inflation in the real economy owing to the rise of globalisation since the 1980s.
Globalisation has generated net gains worldwide but concealed the resulting inequalities in developed countries by claiming many semi-skilled jobs via offshoring as well as wage stagnation.
The process has also ensured that today’s sources of inflation are no longer confined to the domestic economy, as in the past. This has undermined the ability of central banks to control inflation – at least for now.
The future of QE
When asked about QE’s future, the most of our survey respondents say that it will be hard to unravel QE without huge market volatility – so deeply is it now entrenched in investors’ collective psyche after 10 years of ultra-loose money (figure 2).
A minority even anticipate that we may see a doubling down via the adoption of modern monetary theory. To them, QE 1.0 helped the rich via asset inflation. The recent rise of populism means that there will be QE 2.0 to help the poor via massive fiscal stimulus to be funded by central bank money printing.
This is especially evident with the ‘Green New Deal’ promised by the Democratic Party in the US and ‘People’s QE’ by the UK Labour Party.
The global inflation dragon is merely a sleeping giant, not a slain beast, if the history of such debt monetisation is any guide (see case study).
Despite a decade of QE, key economies in the West have not achieved escape velocity, the speed needed to break free from a gravitational deflationary force without further propulsion. With budget deficits now at record levels, their governments have been unable to address deep-seated problems in the real economy.
QE was not designed to tackle them head on but rather to give governments time to solve them via fiscal, education, training and innovation policies.
When it comes to the next recession, central banks will not only have a bloated balance sheet but also little latitude in lowering interest rates, if history is any guide. For example, the Fed has relied on policy rate cuts of about 5% points to reverse a normal recession in previous cycles.
Now, none of the advanced economies has anything resembling this degree of monetary ‘dry powder’. If anything, policy rates in Denmark, Sweden and Japan remain firmly mired in negative territory.
It remains unclear how the current debt mountain is likely to shrink in the foreseeable future.
Our next article will look at how pension plans are responding to developments that seemed unimaginable at the time of Janet Yellen’s confident assertion in 2017.
Pascal Blanqué is group chief investment officer at Amundi and Amin Rajan is CEO of CREATE-Research. Both are members of the 300 Club