The global financial markets and, in particular, the United States financial market has just completed its fifth year of a grand experiment. As we enter 2013, it is now part of the status quo, the norm and so we are now in the most dangerous phase of this experiment where circumstances associated with the experiment is taken for granted.
I am, of course, referring to the policy by central banks around the world to cut interest rates and in layman's terms "print money" in an attempt to first of all prop up failing economies and, secondly, stimulate economic growth.
Back in 2001, there was a similar mini experiment in the United States where faced with a looming recession the US Federal Reserve cut rates to record lows. The impact of holding rates so low for a number of years culminated in the financial crisis of 2007. Once again, as part of the resolution to that crisis, more aggressive policy action of a similar nature has been the prescription.
Many other central banks around the world have taken a queue from the US Fed and have also done similar. The result is that interest rates are at the lowest they have been in history.
So that you appreciate the point the Central Bank of T&T introduced a "repo rate" in 2002. This rate provides a reference point for interest rates in the local market. At the time of introduction, the rate was 5.25 per cent.
As the US Federal Reserve cut rates in their economy our Central Bank acted in a similar manner taking the repo rate down to five per cent in 2003-2004.
As rates in the US began to rise, we did likewise with the TT repo rate getting to as high as 8.75 per cent in 2008. Five years later the US Fed funds rate is at the zero bound and in T&T the repo rate has fallen to 2.75 per cent; a record low.
We are now at a stage where markets have grown accustomed to functioning in a low to zero interest rate environment, risk is being priced and measured consistently in such an environment and cautionary actions have turned into habits.
Unknown consequences
Just as nature acts in strange and unpredictable ways in extreme temperatures, so too can financial market when faced with the unusual circumstance of a zero interest rate environment.
Appreciate that the reason for the current policy is well intentioned. The objective is to engineer economic growth. Back in the Great Depression era of the 1930s, the US government embarked on a bold initiative known as "the new deal", which basically attempted to use fiscal measures in order to bring the economy out of depression.
In the current incarnation of a depression, the US found itself with limited fiscal space to maneouvre and also a lack of political will to take tough and timely decisions. It was therefore left to the monetary authorities to take on the mantle of economic saviour.
The rationale behind the zero interest rate policy followed by the successive rounds of quantitative easing is simple; encourage people to take more risk. The US Federal Reserve would buy financial assets from the market. That provided the market with cash, the expectation was that the cash would then be used to purchase more risky assets as the Fed was effectively "hoarding" the less risky assets in the market.
The purchase of more risky assets would increase the demand for such assets causing their price to rise. The ensuing wealth effect of higher asset valuations would result in a greater level of consumer spending which would, in turn, lead to more economic activity with a flow through into more jobs, which then results in more spending and the positive feedback loop ultimately being measured in terms of economic growth.
Sounds good on paper and in fact the US stock market, which is an example of a risky asset class has produced a return of more than 100 per cent since 2009 and last year the market as measured by the S&P 500 was up over 12 per cent. So while most people were running scared from the economic headlines those that took the time to understand what was taking place and sought proper advice should be counting relatively handsome gains.
Dividends
The same phenomenon was seen locally. As interest rates on savings and investments trended to zero, there was a shift into local stocks. For the past two years, the local stock market has been on a roll and the main driver coming from stocks with a high dividend payout.
The dividend yield is the relationship between the dividend per share and the stock price. The higher the dividend yield, the better the return. This yield on stocks is comparable to the yield on a fixed-income investment. As fixed-income yields trended to zero, the opportunity to earn higher yields on stocks provided an attractive proposition. The result was a rising stock market.
The example with stocks above clearly illustrates how the actions of central banks around the world would push investors into more risky assets. Another asset class to benefit is that of property and while it is too early to talk about a recovery in the US housing market,it is apparent that this market is or has already bottomed out.
While there is no doubt that stocks, commodities and other risky assets have gone up on account of Central Bank policy and action the economic activity resulting from these unprecedented actions have been between sluggish to underwhelming. As we move into 2013, two questions arise.
The gamble
The first is when will the end game arrive in terms of a return to a more normalised interest rate environment, and the second is whether the zero interest rate environment has become so ingrained and so much of a crutch to the economy that adjustments to this policy results in another crisis. Of course, there is the side element that the longer zero rates remain as the status quo, the more risk becomes mispriced and it becomes just a matter of time before someone, somewhere, does something stupid and another crisis ensues.
It is for this reason that I see 2013 as being a pivotal year, almost an inflection point. It is my view that during the year, the markets will begin to challenge the notion of fiscal sustainability as it relates to the policy of ever increasing budget deficits. That is going to create interest rate pressures.
Then, of course, there is the scenario where everything seems to be going well. Economic growth builds momentum, unemployment starts to tick down and inflation starts to tick up. In those circumstances, the Federal Reserve will be compelled to adopt a less accommodative stance. The financial markets will anticipate such moves and depending on how aggressively they attempt to preempt the actions of the Federal Reserve, there is ample room for more market dislocation.
The bottom line is simply this: remind yourself that we are in the middle of an experiment. Recognise that the policy action, while now very familiar, is still unprecedented. Understand that, in such circumstance, there is no rule book from which to seek guidance and so we will be very lucky to be able to exit this scenario without any missteps.
It means, therefore, that as investors, you need to remain vigilant and avoid being complacent. Yesterday's gains belong to yesterday. The objective now is to continue to manage risk effectively going forward.
The early bird catches the worm, but the second mouse gets the cheese. There is value in being active and there is also value in sometimes taking a pause. Seek out the necessary advice for there are always gains to be had but be careful.
In 2013, if you are cavalier in your investment approach you could well be playing with fire. Ian Narine is a broker registered with the Securities and Exchange Commission.
