There is no doubt, the stock market has been on a tear over the past year as we can clearly see on this chart:
I was a frequent trader, particularly prior to and during the Great Crisis; my investment strategy in recent years has tended toward buying when others are selling I looked at the 2008 crisis as a buying opportunity, particularly for good quality preferred shares. Right now, I don't like the market; it is frothy and, in my opinion, is not based on any fundamentals that I understand. That said, apparently many investors would disagree with me and, in a hunt for return in this prolonged near-zero interest rate environment, desperation for yield reigns supreme.
What is most surprising is that one group of investors is increasingly turning to equities to boost the portfolios that they manage; central bank reserve managers.
Over the past ten years, total reserve holdings have risen by over 500 percent to approximately $11 trillion in 2013. Official bank reserves are expected to increase from 29 percent of OECD government debt in 2011 to 38 percent by 2016 if current trends hold. At this point, reserves amount to the equivalent of one-third of OECD bond markets.
A study by the IMF that polled 67 central banks around the world shows that over the past five years, reserve managers have had increasing difficulty with liquidity problems in their reserve portfolios with just over half of the 67 central banks expressing liquidity concerns. As a result, nearly three-quarters of the reserve managers were forced to change their asset allocation by:
1.) reducing the level of commercial bank deposits.
2.) reducing their exposure to unguaranteed bonds.
3.) reducing their holdings of long-term AAA bonds.
This rebalancing of assets and low returns on bond portfolios has resulted in 31.8 percent of reserve managers in advanced economies exposed to equity markets and one in seven of those surveyed are investing in equities, an investment that was considered completely unacceptable for central banks just a few short years ago. These managers are hoping that a rise in the value of their equity portfolios will offset a decline in the value of their bond portfolios as interest rates rise. Interestingly, of middle-income nation central banks, only 8.7 percent are investing in equities and among low-income nation central banks, none are investing in equities.
Let's look at an example. A relatively large purchaser of equities is the Bank of Japan, holder of the world's second largest reserves. On November 30, 2013, the BoJ held the following assets:
The Bank of Japan held ¥1.360 trillion ($13.33 billion) in stocks, ¥2.419 trillion ($23.7 billion) in index-linked ETFs and ¥139 billion ($1.36 billion) in real estate investment trusts out of total assets of ¥224.1 trillion ($2.197 trillion). At the end of 2009, the Bank of Japan held only stocks with a value of ¥1.335 trillion and no equity ETFs or REITs. Obviously, the Bank of Japan is like the rest of us; seeking yield. Back in April, the Bank announced that it will pump an additional $1.4 trillion into Japan's economy over the next two years through asset purchases. Over that period, it will be doubling its investments in equity exchange-traded funds.
Other central banks that invest in equities include the Swiss National Bank (SNB) which states the following on its website:
"The equity portfolios are made up of shares from medium-sized and large corporations in advanced economies. The SNB takes care to ensure that its equity management, too, has no impact on the markets. Furthermore, it does not regard itself as a strategic investor. Thus, equities are managed passively and according to a set of rules, and on the basis of a strategic benchmark comprising a combination of equity indices in various currencies."
Nowhere on its website, could I find the actual size of the SNB's equity portfolio although according to Bloomberg, in the first quarter of 2013, the SNB had about 15 percent of its assets held in passive funds that track equity indices. Other central banks with substantial equity investments include the Bank of Israel, the Czech National Bank and the Bank of Korea.
It is interesting to see that low returns on bonds have changed how even the most conservative central bank reserve managers invest. Low returns are forcing both individuals and central bank reserve managers to invest in riskier and more volatile asset classes. Even though central banks state that they are passively investing in equities, the message that is being sent to retail and wholesale investors can easily be misconstrued, leading to unintended upward pressure on equity prices, something that the world's stock markets may be experiencing right now.
It's all part of the signals that the world's central banks are sending to the so-called "free market".
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