Opinion – Helio Beltrão: Europe in snooker

In 1989, the biggest financial bubble of all time burst: the stock market and Japanese real estate. After a decade of monetary stimulus, property prices have soared into the stratosphere. The Imperial Gardens in downtown Tokyo (only 1 km²) were worth more than all the real estate in California combined. The Japanese stock market’s Nikkei index has never recovered and is still 30% below its 1989 peak.

The boom was devastating for Japanese savings and the economy.

I remember only one investor who navigated the bubble well, when he identified a Japanese airline with negative equity, that is, the accounting indicated more debt than assets. But the company owned a property in central Tokyo whose market value was many times its book value. The investor bought the company, sold the property, paid off the debts and pocketed a hefty sum.

Frightened by the devastating scenario, the Bank of Japan conceived unconventional instruments, which were copied by other central banks after the 2008 crisis and intensified with the pandemic. The little-noticed novelty is that this worldwide experiment in currency sleight of hand is running out due to the offspring that has given birth: inflation.

The return of positive real interest rates to combat rampant inflation could compromise financial and economic stability. Alternatively, if central banks get their hands on it and allow inflation to continue rising, a crushing recession seems inevitable. If you run, the bug catches, if you stay, inflation eats.

The artillery of central banks in the last 15 years has incorporated the following new weapons of mass injection: 1) Zirp (zero interest policy, inaugurated by Japan in 1999), 2) QE (control of the amount of money, since 2000) and, more recently, 3) long-term interest rates, the yield curve control (2016). These are policies to inject new money into banks and the economy, with the alleged aim of fighting low inflation.

However, the market understands that the unofficial purposes of the main central banks have been to a) support stock prices, b) mitigate (or try to extinguish) the so-called economic cycle, c) create money for the respective governments. In fact, whenever there was a crisis in the banks or the stock market, the weapons were detonated. And central banks have been monetizing public deficits, proving to be independent only on paper.

With the injections to fight the pandemic, there was a very rare synchronization of the economic cycle in the world. Inflation is now rising simultaneously in almost all countries, even Japan. Almost all central banks have already started or announced interest rate hikes, such as Brazil, the United Kingdom, Canada, Australia and the United States.

The notable exception is the European Central Bank, which has fought inflation with nothing but empty rhetoric. Last year, it abandoned the historic inflation target of “below 2%” and adopted an inflation target of “close to 2%” (may fluctuate above for a long period). The ECB’s new “dovish” attitude by Christine Lagarde pushed inflation to over 5%.

In Europe, wages are “pregnant” from this consumer inflation, which, in turn, is “pregnant” from wholesale inflation, which has been running above 20%.

ECB snooker is real. The start of the interest rate hike could raise the cost of borrowing for the Italian and Greek governments too much (and drive down fixed-income bond prices), creating a situation similar to the existential crisis of the euro ten years ago. But if the ECB continues to finance deficits in Italy and Greece and charge zero interest rates, the price-wage-price inflationary spiral will kick in.

Something’s gotta give. The prudent investor has changed his portfolio from the “risk on” kit to the “risk off”.