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Full monetisation is now the rule rather than the exception

Stefano Quadrio Curzio

In last year’s review, I observed that even before the COVID-19 outbreak hit western economies, central banks had embarked on a course of full debt monetisation, by buying bonds issued by their respective governments.

The level of debts and deficits was so high that the slightest effort by central banks to return to a more neutral cost of capital and balance sheet would have resulted in a fall in asset values. This was attempted by the Fed in autumn 2018 and quickly reversed. We learnt through that experience that the Fed, as the monetary authority of the world’s reserve currency, will draw the line at equity market corrections of 10–20% before stepping in through a range of market-supporting operations.

The economic shutdowns across the western economies imposed by governments in the wake of the virus outbreak have cemented this policy of full monetisation as the rule rather than the exception. Across Europe and the US, central banks have monetised over 100% of the exploding debts of their respective governments. This policy, once embarked on, cannot be stopped as the debt that is generated would have to be defaulted on, being largely unproductive debt.

As the private sector was not called upon to fund the government deficits but was instead provided with extra liquidity to avoid calamitous debt defaults through furlough and business loan/holiday schemes, it was left free to chase asset values to very high levels in a year that saw the biggest disconnect in decades between economic results and equity prices. As a result, 2020 ended with the highest level of private sector net worth to GDP in history.

“Flexibility, an ability to react to policy decisions, and the freedom to move capital across sectors, geographies, and time frames have become crucial assets.”

Stefano Quadrio Curzio, Adviser to L1 Board

As we enter 2021, financial stability issues should become more topical again. The policy of central banks funding any level of deficit while keeping to their arbitrary inflation targets will, of course, continue. However, should financial instabilities arise again in this environment, their actions will have to take on a more radical bend. Though it is impossible to guess at the moment what such actions may be in response, at the time of writing, in early 2021, investors are embracing risk with a high level of confidence, as shown by the number of loss-making IPOs, the volume of SPACs being quoted, use of leverage, and high levels of retail participation in the stock market.

In many sectors of the equity and bond markets, there is no longer any connection between valuation and underlying economic reality. Much of this is explained by great optimism about an economic boom, taking the view that this is not the worst recession for 300 years but an economic shock poised for rapid recovery, fuelled by government stimulus packages and high levels of household savings that will supposedly materialise post COVID-19. A lot is fuelled by the biggest government spending programme ever witnessed in modern history.

As a result of all the above factors, we face an extremely uncertain and unstable environment. Flexibility, an ability to react to policy decisions as they become manifest, and freedom to move one’s capital across sectors, geographies, and time frames have become crucial assets. None can be taken for granted any longer, but L1’s shareholders’ heritage gives us a good starting point as we address these challenges.