Context from the June 2014 investor letter:
“The BIS (Bank of International Settlements), which is the central bank to central banks, caused a flutter with the commentary in its recent annual report (published on 29 June 2014). They essentially warn that central bank policies of easy money have increased the risk of a financial crisis, and suggest that central banks should pre-emptively tighten policy to moderate this risk. At their first public appearances after the report was published, both Janet Yellen (US Fed Chairman) and Mario Draghi (ECB Chairman) took the opportunity to assuage investors that they were not inclined to heed the advice. To avoid making this letter too lengthy we have included the highlights from the BIS annual report as an appendix in a separate document for those of you who are interested.”
Note that the following is NOT a summary of the contents of the BIS Annual Report. We have selectively highlighted content that pertains to weak economic fundamentals, easy monetary policy of central banks, high valuations of risk assets, and high level of complacency among investors.
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“Through its impact on risk-taking behaviour, monetary accommodation had an impact on asset prices and quantities that went beyond its effects on major sovereign bond markets. Credit spreads tightened even in economies mired in recession and for borrowers with non-negligible default risk. Global investors absorbed exceptionally large volumes of newly issued corporate debt, especially that of lower-rated borrowers. And, as the search for yield expanded to equity markets, the link between fundamentals and prices weakened amid historically subdued volatility and low risk premia.”
“Term and risk premia can only be compressed up to a point, and in recent years they have already reached or approached historical lows. The risk is that, over time, monetary policy loses traction while its side effects proliferate. These side effects are well known (see previous Annual Reports).
Policy may help postpone balance sheet adjustments, by encouraging the evergreening of bad debts, for instance. It may actually damage the profitability and financial strength of institutions, by compressing interest margins. It may favour the wrong forms of risk-taking. And it can generate unwelcome spillovers to other economies, particularly when financial cycles are out of synch.
Tellingly, growth has disappointed even as financial markets have roared: the transmission chain seems to be badly impaired. The failure to boost investment despite extremely accommodative financial conditions is a case in point.”
“In contrast to what is often argued, central banks need to pay special attention to the risks of exiting too late and too gradually. This reflects the economic considerations just outlined: the balance of benefits and costs deteriorates as exceptionally accommodative conditions stay in place. And political economy concerns also play a key role. As past experience indicates, huge financial and political economy pressures will be pushing to delay and stretch out the exit.”
“The current weakness of aggregate demand may suggest the need for further monetary stimulus or for easing the pace of fiscal consolidation. However, these policies are likely to be either ineffective in current circumstances or unsustainable: taking a long-term perspective, they may simply succeed in bringing forward spending from the future rather than increasing its overall amount over the long run, while leading to a further rise in public and private debt. Instead, the only way to boost demand in a sustainable manner is to raise the production capacity of the economy by removing barriers to productive investment and the reallocation of resources. This is even more important in the face of declining productivity growth.”
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