Today in Frankfurt is overcast and rainy, which is a bit symbolic of the current economic environment in the European Union. The EU is plagued with slow/no economic growth, troubling unemployment, and generally weakened government balance sheets.
Frankfurt serves as the home of the European Central Bank, which sets monetary policy for those countries that are part of the EU. It is thus unsurprising that our speakers today focused on central bank policy; specifically, their impact upon economic growth in the past and looking forward.
I was particularly impressed with the remarks by Jurgen Stark, a German economist and former member of the Executive Board of the European Central Bank. The ECB provided support measures to member nations during the recent economic crisis, and continues support by means of a massive quantitative easing program, which injected funds into the money supply – similar to what the US Fed has done.
In that regard, Stark believes some success can be seen. In particular, the former “trouble” countries of Ireland, Portugal, and Spain are now witnessing positive GDP growth, falling unemployment, improved fiscal positions, and improved price competitiveness.
However, not everything is looking rosy. Greece is one example, having implemented no permanent reforms and “Grexit” from the EU still a possibility.
Stark made the compelling point that central bank intervention should only be viewed as buying time for policy adjustments, government and corporate balance sheet repair, and debt restructuring. Central bank intervention is a Band-Aid, not a permanent solution.
However, change has largely gone undone (with a few exceptions noted above). Market participants and governments have become too reliant upon central bank policy support. Also, there now appears to be a huge disconnect in many markets between fundamentals and prices – that is, assets are overpriced. The underpricing of risk sows the seeds of the next market bubble.
Another of today’s speakers was Martin Wolf, chief economic commentator at the Financial Times. He posited that the quantitative easing conducted by the Fed and ECB – new money pumped into the financial system – is here to stay and will never be redacted. If that is correct, what are the market consequences? Any rumor of a decline in quantitative easing has been met by falling market prices, further evidence that the markets are addicted to central bank policy and support.
So what is the prudent response? I believe that if we see asset price bubbles – overpriced assets – the correct action is the adoption of an insurance-like strategy that consists of setting aside a portion of current gains in order to offset or minimize the impact of future losses. In essence, take money off the table when assets are priced too high. Tilt portfolio allocations out of overpriced assets and towards underpriced assets. It doesn’t pay to take risk when the market is unlikely to reward an investor for taking on that risk.