Thursday, October 11, 2018

Central Banks and Equities - The New Monetary Policy

Updated July 2019

Given that the post-Great Recession economic expansion is one of the longest in history, one can be certain that the world's central banks will have to come up with an even more imaginative monetary policy than zero/negative interest rates and massive expansions of their balance sheets through the purchases of government bonds to stimulate the economy back to life.  If we look at the example of the Swiss National Bank (SNB), we may get an idea of how the world's central bankers will respond to the next economic contraction.

While the Swiss National Bank is not the first central bank that one thinks about when the topic of central banking is raised, is using some monetary policies that are rather unique in the world of central bankers.  While, like the rest of us, central banks are searching for yield on their foreign currency/exchange reserves which are used by central banks for one of seven reasons:

1.) to keep the value of their local currencies at or near acceptable exchange rates

2.) to keep the value of their local currencies lower than the United States dollar

3.) to maintain liquidity in case of an economic crisis

4.) to ensure that foreign investors have confidence in the bank's ability to protect their investments

5.) to fund certain sectors of their economy

6.) to ensure that a nation has the ability to meet its external obligations

...and, key to this posting:

7.) to improve returns on their reserves by investing in safe investments which historically have been gold and government debt

Let's take a closer look at the last item in the list, central banks investing in "safe investments".  Like the rest of us, central banks like to achieve a return on their "savings". 

According to the Official Monetary and Financial Institutions Forum or OMFIF, some central banks have "forayed into...equities, though most remain wary of proceeding too far in this direction".  On average, the global central banking system has a 1.5 percent allocation to equities.  OMFIF notes that the Swiss National Bank is an exception as you will see later in this posting.  As well, the Bank of Japan holds nearly $165 billion worth of equities although most of these are in exchanged traded funds (ETFs) rather than holdings of specific stocks and these ETF holdings make up just 3.6 percent of its total balance sheet, however, in January 2017, the BoJ owned 2.5 percent of the total market capitalization of the Tokyo Stock Exchange and nearly 58 percent of Japanese equity ETFs listed on the Tokyo exchange.

Now, let's look at the outlier, the Swiss National Bank.  According to its own website, the SNB owned the following assets as its foreign exchange reserves at the end of the second quarter of 2019:

Notice that 20 percent of the banks assets are in equities.  According to Trading Economics, at the end of the second quarter of 2019, the SNB had CHF 759 billion (US$766 billion) in assets, down from its all time high of CHF 772 billion (US$779 billion in April 2019 but well above levels seen prior to the Great Recession:

This means that the SNB held roughly $163.6 billion in equities at the end of Q2 2018.

Unlike the Bank of Japan, the SNB actually holds individual equities in its portfolio.  Thanks to the NASDAQ, we can see at least some of the equities were held on June 30, 2018 thanks to the filing of form 13-F or the Institutional Holdings Information that is filed with the Securities and Exchange Commission.  Here are the position statistics for the quarter:

Here is the sector weighting:

Here are the top holdings where the SNB's position has increased (2181 equities in total):

Here are the top holdings where the SNB's position has decreased (71 equities in total):

Here are the new positions (109 equities in total):

Here is the SNB's equity investing philosophy:

"The SNB is a purely financial investor. By replicating individual markets in their entirety, thereby diversifying its placements as broadly as possible, it pursues as neutral and passive an investment approach as possible. In a few cases, the SNB does not apply the principle of full market coverage. For example, it does not invest in equities of mid-cap andlarge-cap banks and bank-like institutions, to avoid possible conflicts ofinterest. In addition, it does not purchase shares of companies that seriously violate fundamental human rights, systematically cause severe environmental damage or are involved in the production of internationally condemned weapons."

As you can see, the Swiss National Bank has taken a rather unique position among the world's central banks, using its financial heft to invest rather heavily in equities.  While its relatively small size makes reduces its overall influence on the world's stock markets, the same cannot be said for the world's most influential central banks, most particularly the Federal Reserve.  Here is a table outlining the Fed's current reserves which are held in the System Open Market Account (SOMA):

Currently, the Federal Reserve is prohibited from owning equities, however, given the massive change in the Fed's operations (i.e. the unprecedented expansion of its balance sheet) during and after the Great Recession and the nearly $4 trillion in assets that it holds, should another significant economic crisis take hold of the global economy, all bets are off since it would be rather easy for Congress to pass legislation allowing the Federal Reserve to intervene in the stock market, potentially creating yet another reason why investors should be very cautious about investing in the current market that is only marginally connected to any kind of fundamental valuation and that could be further distorted by Federal Reserve intervention.

Let's close with this last rather sobering quote from the OMFIF report:

"Central banks’ accommodative monetary policies have ‘won time’ for these institutions as well as for politicians. This may delay the reckoning; it will not prevent it.

1 comment:

  1. The problem with equities is that it's tantamount to owning bonds as far as monetary policy is concerned. When the Fed buys bonds, the interest rate declines and money flows into the stock market. The same people who own bonds also own stocks, so if you invest in one, it's pretty much the same as investing in the other insofar as the money supply is concerned. Those investors are sitting on piles of cash that they got from selling bonds. And they will also be sitting on piles of cash that they got from selling equities.

    What the Fed needs to do is find an asset class that is owned by a completely different group of investors. My suggestion is commercial real estate. Buy office buildings, apartments, retail space, etc. Those assets produce income like a bond, but if you buy real estate, you are putting money into the hands of a very illiquid group of investors, and they will turn it over immediately, paying overdue bills, repairing deferred maintenance, etc... much faster than a bank that is already sitting on a big pile of cash that it doesn't know what to do with. The idea is to increase the velocity of money.

    Of course, real estate is a much riskier and more complex asset to invest in than bonds. But much of the risk can be eliminated by appropriate enabling laws that are applicable only to the Fed. And much of the complexity can be eliminated by contracting with private asset managers to manage the properties. The Fed won't need financing because it's buying with newly printed money.

    The Fed can pick and choose its sellers to avoid enriching the wealthy. It can buy depressed real estate from pension funds, insurance companies, banks, nonprofits, and other widely owned institutions. When the market recovers, it can sell them back to the private sector before inflation sets in.

    Another class of real estate the Fed should consider is vacant land. It produces no income, but it is a lot easier to manage.