Be ready when QE makes way for QT
Market distortions created by quantitative easing could prove fertile grounds for investors when central banks switch to quantitative tightening
• Quantitative easing (QE) by central banks has pumped huge amounts of liquidity into the financial markets over the past decade.
• Although QE staved off a depression it has added distortions to the capital markets.
• Quantitative tightening will have a different impact on different equity market sectors.
• Stockpickers could benefit from the new environment.
Quantitative easing (QE) has been a monetary experiment carried out by central banks across the world, unprecedented in its scale and its duration. Even honest central bankers would have to say it is uncertain what the results of this experiment will be. But, as Andrew Milligan, head of global strategy at Aberdeen Standard Investments argues, it has been successful in staving off the threat of depression after the global financial crisis (GFC) of 2007-08 which has been the worst global financial crisis since the 1973 oil price hike and the 1929 Wall Street crash.
So proponents of QE would argue that its use was well justified in ensuring that the global economy did not suffer a crash. But there is no doubt that QE has led to distortions in capital markets on the back of the $1.5trn (€1.3trn) a year invested into financial assets by central banks.
Global equity markets have experienced a boom as a result of QE-induced low interest rates. But now, as central banks led by the US Federal Reserve, are reaching the end of the need for QE, the introduction of quantitative tightening (QT) could have important implications.
Vincent Reinhart, chief economist at Standish Mellon, argues that when a central bank intervenes in markets at a time of crisis it is a big player. A crisis, by definition, is a withdrawal of capital from trading with risk-averse markets. The central bank is essentially leaning against an open door.
As markets improve and capital returns there is more incipient trading and arbitrage across markets, so central bank QE activities have less effect. Presumably, central banks will not start unwinding QE until they are confident that markets have healed completely and therefore the unwind should have even less effect.
Central bank officials have announced QT well in advance, they will be slow in enacting incremental amounts, and will respond to economic and financial conditions as necessary, Reinhart argues. They are hoping that, unlike 2013, the impact of tapering of QE and implementation of QT will be inconsequential.
Eoin Maher, equities analyst at Unigestion, asks whether investors should be comfortable counting on continued low interest rates for investment security – especially at a time when the Fed has embarked upon a series of rate increases and other central banks are entering tightening mode too.
The Fed, says John Bilton, a strategist at JP Morgan Asset Management, will probably undertake some form of balance sheet reduction during the autumn of 2017. It is likely to start at a rate of $10bn a month before slowly rising to $50bn per month.
The economic environment is the best it has ever been since the GFC, says Adrien Pichoud, chief economist at SYZ Asset Management. There has never been a period when the US, Europe, Japan and emerging markets all experienced synchronised growth.
As Pichoud points out, if growth is positive, then it is logical for central banks to ask whether the unorthodox and extreme measure of QE is still warranted. “No one is advocating tightening to cool down growth, but so much was done when the risks of deflation and a recession were seen to be high that it is now time to withdraw some of that stimulus,” he says.
Pichoud argues that the key for central banks in making policy here is inflation. All the large institutions have an explicit inflation targeting objective, although the Fed also has an employment target. Pichoud sees the actions of the European Central Bank (ECB) were not aimed at increasing growth or reducing unemployment; they were specifically aimed at fulfilling the ECB’s mandate of achieving an inflation target of about 2%. Indeed, a side effect of QE has been a misallocation of capital. As Maher argues, the wealth effect and trickledown economics concept has not led to a recovery in economic growth. Rather, it has led to the inflation of risk assets.
While the other central banks would like to follow the Fed in normalising interest rates, Pichoud sees the room for manoeuvre as limited since none of the central banks, including the Fed, are achieving their inflation targets. Their approach to reversing QE and moving to quantitative tightening (QT) looks set to be gradual. It should not, therefore, trigger a large structural change in market behaviour, although it may be a cause of some volatility.
Milligan concurs. QE has certainly had a dramatic effect on the term structure of interest rates, and therefore the discount rate for equities has changed. This is partly the result of low short-term interest rates and partly due to QE. Therefore, there is an impact on equity valuations. But he argues that equity valuations are discounting future cashflows and what we have seen over the past few years is a decent rise coming from improvements in margins, productivity and growth. Companies have benefitted rather than households.
“There has been a whole series of factors enabling increases in corporate profitability in the US, Europe and Japan. That aspect should not be forgotten,” says Milligan. The question is whether that will change in the future. Possibly, says Milligan, but not necessarily because of a reversal of QE, as there is a series of other factors that will drive corporate profitability.
Several factors will affect the impact of QE. Milligan says financials will outperform if the yield curve steepens by 50bp. The relationship between performance of banking stocks and changes in the yield curve is clear.
If QT is undertaken slowly and cautiously, with investors retaining confidence that economic activity is being supported and central banks are not trying to cool down economic growth, cyclicals will outperform. If the yield curve does steepen, then bond proxy stocks bought for their dividend yields might generate less demand.
But there are a couple of other important sectors that are unaffected by QE and QT. The technology sector looks increasing like it is undergoing a structural change in a winner-takes-all environment. Does QE have anything to that? A quarter of the S&P 500 and of Asian markets are technology (less so in Europe). Raw materials, energy and commodities account for 20% of the UK and a large percentage of emerging markets. The performance of those sectors is more dependent on the China growth and demand story than QE.
So financials and cyclicals will be supported by a moderate degree of QE tapering over the next couple of years. However, a large portion of the equity markets is little affected by QE.
Bilton argues that while QE and QT are referred to as “extraordinary monetary policy”, people have to get rid of the “extra”. The ability for the Fed to influence the back of the yield curves through QE and QT, as well as the front through setting interest rates, is not a piece of its toolkit that it is willingly going to give up. Using the balance sheet has become a normal mechanism for policy implementation by balance sheets.
If interest rates do remain low for several more years it is likely to be as a result of a lack of vigour in the economy, which would likely cause earnings growth to be sluggish anyway, negating the argument for high valuations, argues Maher. He adds that if the cost of money has been artificially suppressed by QE for such an extended period of time, it is logical to expect distortions in the pricing of equity fundamentals. Two companies in the same industry with potentially different balance-sheet metrics could end up being valued similarly.
Such discrepancies makes life more difficult for stock pickers. But if history is any guide, if interest rates continue to steadily normalise, and if QE has peaked, there could be a multi-year period of mean reversion ahead. That should provide a rich environment for active stock pickers.