Investing in a world without QE

Investing in a world without QE

Tue 14 Dec 2021

It may be difficult to remember, but in the midst of the global financial crisis and long after, QE wasn’t really trusted by markets. For the next five to seven years, almost until 2015, most money managers did not trust the bull market and remained underweight risk. They paid with underperformance and the rise of passives. Then, we began to wonder what could ever stop the Quantitative Easing juggernaut. The answer was always simple: inflation.  

Last week saw US inflation hit a 40-year record of 6.8%. The fine print says that the bulk of the price rises focuses on energy prices and cars/trucks. And also, that it is supply, not demand-driven, which means it would respond very differently to interest rate hikes. However, once a number like that hits the headlines, details are forgotten and things happen quickly.

Source: Bureau of Labor Statistics, Mazars calculations

It is difficult to find a participant in today’s market who remembers what this kind of price pressure even feels like. Last time inflation was running this hot, the Cold War was raging, personal computers had not been invented, ‘Chariots of Fire’ was named the best movie of the year and Ben Cross was the hottest name in acting. Meanwhile, an unlikely Hollywood actor named Ronald Reagan had freshly occupied the White House. Interestingly enough, however, the present incumbent in the Oval Office, Joe Biden, was already a 10-year Senator from Delaware. His memory of how inflation brought down his party’s President, Jimmy Carter, should be vivid, as he sees his own approval ratings slide for the same reason.  

Source: Realclear Politics, Bureau of Labor Statistics, Gallup

In the last twelve years, monetary accommodation ballooned and central bank assets for the US and the EU rose nearly eight times. All they achieved was a meagre 1.5% inflation. Policy leaders fretted about deflation and tortured their intellects about how to normalise the yield curve again and turn money lending into a profitable operation once more. They talked rates up; they tried to stoke inflation expectations but to no avail. The yield curve remained flat as a pancake. It took a global pandemic and the biggest post-war supply chain shock to see inflation.

Inflation might not necessarily always be a monetary problem. It is, however, always and everywhere a political one.

Since 2008, the US central bank has exercised a dominating amount of control over the prices of all assets across the risk spectrum. It was not just its ability to throw trillions into financial markets at the push of a button. It was the threat that this posed to short-sellers. No one wanted to be caught with short positions at any time when the US central bank would decide to start printing. So, they were long.  

The Fed’s freedom to print money at will, in all probability, shall be soon tested. And with it, the cornerstone of the last twelve year’s financial paradigm.

For one, with inflation that high and wage pressures exacerbating and eating into corporate margins, the Fed’s compulsion to raise interest rates, i.e. make money more expensive, is growing. QE, which in essence makes money cheaper, can’t really exist in a rate hike cycle. Next year will feature a more hawkish Fed, so these sorts of decisions will be made easier.

To be sure, raising interest rates and stopping QE has more of a psychological effect than a real one. Inflation, not rates influence consumer behaviour. Rates are a signal that ‘we are doing something about it’. The signal is politically expedient and might serve the purposes of policy makers across all branches of government, especially during a mid-term election year for the US. But raising the cost of money in the US by a fraction does very little to speed up the production and transferring of goods from Asia. Demand driving orders is not the result of credit-induced exuberance but rather panic, as wholesalers and retailers are running short on everything as a new Covid-19 variant becomes dominant. So, in all probability, no matter what the Fed does, this bout of supply-side inflation will remain firmly outside its control.

What does this mean for investors?

In the coming investment committee, we will fully assess the rise of risks against valuations and market momentum. The Fed’s ability and willingness to suppress any sort of equity and bond market risk in the last twelve years is, at the very least, compromised by surging inflation. However, we don’t believe there’s sufficient reason to panic.

For one, there’s still plenty of money in the system. Since September 2019, the Fed’s balance sheet went from $3.7tr (already considered a huge balance sheet), to $8.6tn. A 130% rise in two years, which added another $4.9tn to the global financial system. More than $10tn have been added by the four major central banks (US, EU, China and Japan). For investors, that huge liquidity pool constitutes the most potent financial safety net in history. It will take years for that money to be fully integrated into the financial system. Fiscal stimulus in the US and China ensure more money for the real economy. So does the almost $2tn in Private Equity dry powder.

Source: Fed, ECB, BoJ, PBOC

And, overall, money will remain cheap. Raising interest rates 1% or so, sends the message but does not make money materially more expensive. If central banks really believed that this sort of inflation could be fought with higher rates, then we would already be experiencing a 7% interest rate. With global Debt-to-GDP skyrocketing to 356% over the past two years, government debt-to-GDP over 110% for many developed markets, and fiscal easing on the way, materially raising the cost of capital is simply not an option.

Source: Futures

But what about QE?

We have to accept that QE’s use was also, mostly, psychological. Short term market operations might still be used to bail markets out of trouble. But with inflation running that high, adding trillions of long-term money into the system within the space of months at first whiff of market distress, is probably out of the question, even if it’s just for politics.

Should investors be worried?

Equity investors should get used to more volatility, and may well experience an equity re-rating and lower valuations in the next few months. This is more so for funds heavily exposed in tech, where valuations have risen disproportionately to the rest of the market. Focusing on fundamentals and being selective about managers will go a long way into preserving wealth.

Bond investors will have a more difficult time. High liquidity gives hope to traders that they might still find someone to take their holdings out of their hands at an even higher price. But the bulk of fixed income investors, who tend to hold the asset to maturity, is in trouble. Either they will lose a steady stream of money in real terms over the next few years, or they will experience a sharp correction in prices. Real returns (yield minus inflation) are deep into negative territory. Assuming 3% average inflation over the next five years, an investor in the five-year US Treasury note yielding 1.27% would experience an assured loss of 1.75% per annum, or 8.5% of their overall investment. Because no market can operate under an assured loss assumption, the probability for a sharp price correction (so that annual yields may rise) is climbing fast. Central banks will still remain a big buyer of debt, but adding no new money into the system would allow yields to drift upwards. We are already deeply underweight bonds and considering ways to mitigate the impact of a possible re-rating event on those that we do hold.

Why the case for remaining invested still stands

The end of QE and the end of the current paradigm, however, is not a disaster. The money already printed is not going anywhere and it can continue to fuel markets for a long time.And QE’s withdrawal will be handled with care. Inflation may be catastrophic in an election year, but so is a market rout, with US households having a record 41% of their total assets in equities.

Source: Federal Reserve

 It may even prove a blessing in disguise, as it could return long-gone sanity to investment markets. To be sure, a post-QE and post-rerating world, is a different, more volatile, world. Volatility may be uncomfortable, but it is also the mother of opportunity. Investors will see traditional strategies, like the 60/40 equity/bond portfolio, working again. Overall, this should reduce risks, or at the very least, make them more manageable. Shorting markets may, on occasion, pay off as a strategy. Shorting capitalism over the longer term, never does.  And while we expect a tantrum, or more than one, we believe financial markets will outgrow QE, much like humans do: by learning, sometimes the hard way, that even if things occasionally go south, is not the end of the world.