Curmi & Partners

Not-So-Beautiful Normalisation

Article by Matthias Busuttil

Not-So-Beautiful Normalisation

Ten years is a long enough time for individuals to become habituated with the state of the environment that surrounds them, even if such state would be classified as “abnormal” or “unusual” over a longer time frame or in the context of historical standards.

Much like a living organism, financial markets also display traits of adapting to shifting market dynamics. Indeed the last ten years have experienced extraordinary conditions, compared to what is deemed to be a “normal” environment, to the extent that a new paradigm has developed.

As debt levels soared in 2008 and deflationary risks posed a significant threat of economic depression, an unprecedented level of stimulus was required to boost demand and restore inflation. Given the limited scope and ability to extend fiscal stimulus, central banks have launched money-injecting programmes and lowered interest rates in an attempt to soften financing conditions and spawn demand for investment expenditure.

This has worked, to an extent, in increasing the demand for loans and restoring confidence with the second-round effects of boosting employment and consumer demand. But it has also brought about a number of undesired effects, the cost of which are difficult to quantify and which are playing up now that central banks are in the process of unwinding the stimulus.

Side Effects

The effect of increasing money supply and lowering interest rates, in the absence of a complimentary fiscal push, has resulted in the creation of a financing provision that is in excess of what the real economy can absorb in terms of employment and productivity. Consequentially, the excess capital has flowed into financial markets which, in combination with lower interest rates and bond yields, fuelled an appreciation in asset valuations.

The high debt levels were offset by the increase in asset values. This provided the opportunity for all types of borrowers not only to refinance their debt at cheaper terms, but also to increase their indebtedness further. In fact we have seen an increase in share buybacks in the US and in Europe, where corporates borrow capital to buy back shares thus increasing their capital leverage, as well as a record number of bond issues rated BBB, i.e. just above sub-investment grade status.

The boost in risk-taking is also seen across investors and savers who have moved towards riskier assets in order to maintain their targeted levels of return as interest rates moved lower, thus sustaining higher asset valuations further.

Withdrawal symptoms

As these side effects fester, the process of reversing monetary conditions becomes more delicate. Volatility in financial markets and asset valuations has been recognised by central banks as a potential risk in reversing monetary policy which can dent investor confidence. This volatility has materialised over the course of 2018 mainly due to the following factors:

 The first is the uncertainty around corporate earnings expectations and whether earnings growth will more than offset the impact of rising interest rates and inflation. This puts in question the sustainability of elevated asset valuations in a normalising monetary environment.

Secondly, the potential revision in asset valuations due to monetary tightening depends not just on the underlying economy but more directly on the pace and the flexibility with which monetary authorities will tighten monetary policy and their judgment of the current state of the economy.

Lastly, the move towards a higher interest rate environment has increased concerns about the ability of corporates to service rising finance costs or to refinance their higher debt levels at viable terms.

The dramatic sell-off in financial markets towards the end of 2018 has made these symptoms become more apparent and uncovered some truths about the challenges that economies face in their journey of normalisation.

In fact, the sell-off reflects not just the risks related to political uncertainty but also a lack of conviction in the ability of the economy to cruise ahead without the continued support by the monetary authorities.

Risk of Slowdown or Recession?

In a situation where the global economy, excluding the political drama, is fundamentally sound, expectations are still anchored on positive growth for the next few years.

However, the process of draining out the excess liquidity to a level that is in balance with the economic capacity requires an adjustment in the pace of growth of the economy, in other words a slowdown. This is more pertinent for the US economy, where the growth has been above economic potential and unemployment below long-run target levels.

Policy makers need to weigh the costs of retaining stimulus, while at the same time safeguarding confidence in the economy. Decelerating too fast poses high risks that the economy can spiral into a recession, especially when both central banks and governments have little or no ammunition left to counter the blow.

At this stage, erring towards maintaining stimulus at the cost of running the economy above potential growth seems to be the most sensible option.


The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.