Let’s forget for ten minutes the upcoming Q3 reports (supportive for stocks), US policy risks (probably the biggest medium-term risk for stock markets), hurricane-related diversions and North Korean rumblings - and turn to a pretty fundamental issue, most likely the biggest one in contemporary capital markets: Central bank interventions in and manipulation of capital markets.
The Bank of Japan has been leading the field all the time. In terms of size (BoJ’s balance sheet is now close to the size of Japan’s national GDP), in terms of the dependency of government financing on its central bank (BoJ market share in government bond market now stands at ~ 45%; annual BoJ buying of government bonds is twice the annual tax revenue and equals the annual public budget - terminating bond buying would trigger an immediate crash in Japan) and in terms of variety of assets the BoJ is buying (government bonds, REITs - and stocks).
It’s the latter which is of particular interest for stock investors. There had been an interesting article in Bloomberg highlighting the distortions the BoJ is creating in the Japanese ETF market as the BoJ accounts for 75% of the total ETF market (see the attached article at the end of the snippet).
In Euroland, investors are wondering when the ECB is going to start crossing this frontier and step into equities - as a means to circumvent the "unwelcome" scarcity of government bonds and ownership limitations. Will this be the main policy tool of last resort in a next crisis/crash?
It is tempting for stock investors to look forward to a new price-pushing co-investor, but they should think twice about what they really wish for in the long run.
Let´s broaden Bloomberg’s analysis a bit. Some basic lessons can be learned (see chart 1):
- Central bank purchases of stocks push markets upwards. The BoJ certainly contributed heavily to the massive rally in Japan.
- However, it’s not a silver bullet for the long run. The Topix peaked in August 2015 and is still some 4% below the level back then. In this period, the net asset value of BoJ ETFs has risen by close to Yen 11 trillion or > US$ 100 bn (based on Bloomberg data). In the year to date, the Japanese market has underperformed the US and Euroland - and is only flat in euro terms. Despite massive central bank support, stocks remain a two-way street.
Chart 1: Bank of Japan net asset value of Japanese stock market ETF vs. Topix
Over time the BoJ has become increasingly important. Its share of the Japanese stock market has risen from 0% in late 2010 to now 5% (see chart 2). This has been funded from thin air, i.e.by simply printing money. The interesting point is that the incremental gains of one percentage point in ownership are realised in an increasingly shorter time period. It took 4 1/2 years to reach 2%, but only 2 1/4 years to add another 3 percentage points (to the current 5%). This reflects two patterns: the declining positive impact of BoJ buying on stock prices and the increase in buying volumes by the central bank.
Investors should not be fooled. This is serious and creates massive long-term problems:
- At some companies, the BoJ seems to have already reached a visible double-digit stake (e.g. at Fast Retailing). Is the BoJ going to control private companies?
- What is going to happen when the BoJ tries to exit the stock market again? Can a stock market crash and/or recession be avoided?
- What happens if the BoJ is not able to exit due to economic cooling/declining stock prices and the resulting public outcry. If one extrapolates the recent gains in ownership to the future - and does not assume another decay of the positive impact on stocks or any further increase of volumes - it will take only 13 years and the BoJ owns one quarter of the Japanese stock market. Ultimately, the BoJ is nationalising the stock market and thus eroding one fundamental pillar of a market-based economy (bear in mind it already "owns" the government bond market).
Chart 2: Share of Bank of Japan ownership in Japanese stock market
Source: Bloomberg, BHL Research
Looking at the slow motion attempts of the key central banks to withdraw their interventions, their back and forth even in better economic times after they have dived so deeply into capital markets in bad times, gives sufficient clues about the difficulties central banks are facing. As a starter, look at the recent ECB press conference. It may become pretty asymmetric: a tiny retreat in an upswing, followed by much bigger additional involvement in future downswings.
Central banks like the BoJ want to "help" markets but they risk destroying them. In my view, this is the great paradox of modern central banking.
In the longer run, this is the biggest Damocles sword hanging over markets.