Mohamed El-Erian: Enter the sci-fi world of central bank action

In some science fiction movies, humans enter a distorted zone and undergo changes that affect them both in that strange world and in the more traditional one. Well, behavioural change is what happened to the traditional capital structure during its sojourn in the realm of zero-bound interest rates. And the acquired anomalies may be materially tested as interest rates gradually normalise, particularly if global economic growth disappoints again.
In the traditional characterisation of the capital structure, the risk-return mix ranged from secured fixed income obligations (low risk, low return potential), to unsecured bonds, hybrid securities and, of course, equities (high risk, high return potential).

Moreover, the further the two segments were from one another in the capital structure, the lower the correlations between them.
For securities at opposite ends of the capital structure, such as high quality government bonds and equities, the correlations were negative, thus providing for inbuilt risk mitigation for well-diversified asset allocations.
For quite a while, capital structures behaved accordingly. However, things changed in the aftermath of the 2008 global financial crisis as governments and central banks interfered more in the functioning of financial markets.
By choosing where in the capital structure to intervene directly and what to influence, the official sector altered the risk-return characteristics.
In addition, by forcing interest rates to artificially low levels and keeping them there, they changed the distribution of expected returns for individual securities, as well as the risk mitigation characteristics of diversified portfolios.
Initially, the overall impact was generally investor-friendly as prices of many financial assets were pushed higher. The bad news related to what followed.
As a simple illustration, consider the 5-year US Treasury note issued at the end of March. A low coupon and relatively modest yield curve roll-down meant the most investors could reasonably expect at issuance was a total return of 2.7 per cent over the subsequent two-year period.
If, however, five-year rates were to go up by 70 basis points, which in fact they did over the next three months, the bond was already 3.25 per cent under water (as of the June 25 close), altering the risk/return outlook.
Such initially asymmetrical return distributions were amplified as investors ventured further out on the yield curve and took on greater credit and liquidity risks. For example, Apple’s 30-year bond issued at the end of April came at a yield of 3.88 per cent. With the subsequent repricing of both interest rate and credit risk, the bond was down 12 per cent at quarter end.
The explanation for this asymmetrical distribution was simple: the closer interest rates and credit spreads got to the zero-bound, the smaller the upside and the greater the downside. This dynamic was exaggerated when securities were artificially compressed by experimental central bank policy.
Under these circumstances, investors’ perception of the capital structure inverted. A low-yielding government bond with a price essentially capped at par offered limited returns and high price risk. In contrast, equities were seen as providing the potential for large price appreciation, and this lack of price cap compensated for the downside risk.
This zero-bound aberration led some analysts to characterise equities as “safer” than bonds. Some even claimed they were the “new risk-free asset”. And the impact on asset allocation models could be quite dramatic.
In pursuing the investment implications today, investors would be well advised to remember that the postulated “safety” of equities, whether in absolute or relative terms, is state-specific. Absent consistently higher multiples, it works only if corporate revenues and profits increase accordingly and, therefore, if economic growth does not disappoint.
This qualifier is an important one, especially in a world where US growth is still recovering, Europe is in recession, China is slowing and other emerging countries are struggling to navigate fluid global conditions. Also, with policy responses remaining narrow, the past few years of monetary policy experimentation may just have borrowed growth from the future rather than created conditions for incremental expansion.
In sum, the notion of the inverted capital structure is a construct of the abnormal zone near the zero bound. When central bank activity mattered a lot more than fundamental economic activity, perhaps this new logic was not such an anomaly. Now, though, investors are looking at a different outlook; and if economic activity disappoints, inverted capital structures could prove costly illusions.

Mohamed El-Erian is chief executive and co-chief investment officer of Pimco

Fonte: FT