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The asset classes most at risk of a QE-led bubble

02 June 2014

The unwinding of the biggest financial experiment in modern history is gaining momentum, but experts say this offers little to cheer about.

By Daniel Lanyon,

Reporter, FE Trustnet

Since 2008, the Federal Reserve and the Bank of England have been buying financial assets – mostly Treasuries, gilts and corporate debt – in a bid to shore up the economy from contraction.

The gradual removal of quantitative easing by the Fed since the beginning of the year has generally been regarded as a return to the norm, spelling the end of six years of financial crisis.

However Eric Chaney, head of research at AXA Investment Management and chief economist at the AXA Group, believes that QE could still have a number of unintended consequences for investors.

He is not convinced that it has worked in the way it was supposed to and says that anyone who is celebrating its withdrawal is being naive.

“Monetary policy is supposed to work by stimulating demand and raising output, but if ‘low-flation’ has structural causes, such as the shape of the wage distribution curve rather than a lack of aggregate demand, then the risk is that liquidity injections may inflate asset prices instead of real demand,” he said.

“Three possible candidates for bubbles are high yield bonds in the US, peripheral bonds in the eurozone and housing in the UK.”

High yield US corporate debt is up more than 88 per cent over a five-year period, while rallying eurozone debt has seen funds such as Threadneedle European High Yield Bond perform strongly in recent years.

Performance of fund vs index since Sep 2008

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Source: FE Analytics

UK house prices, particularly in London and the South East, have also had a stellar run of late. Recent reports suggest that valuations in the capital rose by 4.2 per cent in April 2014 – the fastest monthly rate since records began.

“The other risk, particularly in highly intermediated regions like the eurozone, is that flooding banks with liquidity may delay restructuring, allowing zombie companies to be kept alive by zombie banks and resulting in stagnation and deflation,” Chaney added.

Stephen Jen, managing partner at SLJ Macro Partner, believes that QE's distortion of financial markets could have a severe effect on asset classes such as US equities further down the line.

He thinks the third and most recent bout of quantitative easing – QE3 – has been particularly harmful.

“The benefits of QE3 in particular will likely not be justified by their costs and I question the use of a very blunt tool to address problems that I believe are actually structural,” he said.

“The costs of QE3 should become visible as the Fed starts to normalise its stance. QE3 has created significant distortions in financial markets, including another escalation of emerging markets turmoil.”


“The fact that US policies since 2008 have been focused almost exclusively on demand stimulus through monetary operations in contrast to much of the rest of the world, which has undertaken important supply-side reforms, will put the US in a disadvantageous position in the coming years,” he said.

Performance of indices over 5yrs

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Source: FE Analytics

Following relatively poor returns throughout the 1990s and 2000s, the S&P 500 has been the standout stock market since the financial crisis. FE data shows it is up 116.67 per cent over five years, significantly outperforming the FTSE 100 and MSCI AC World indices.

Vincent Reinhart, chief US economist at Morgan Stanley, believes the Fed will retain its $4.5trn balance sheet of debt for the foreseeable future, as selling down it assets would be politically unattractive.

He thinks the possibility of further monetary easing is very possible, even though optimists point to the "normalisation" of policy.

“It will be an enduring part of our future and they will be under increasing pressure to do more,” Reinhart said.

“Were economic conditions to worsen, the Fed would be expected to step up and could decide to expand its range of policy instruments.”

ALT_TAG This view is shared by FE Alpha Manager Steve Russell (pictured), manager of the Ruffer Investment Company, who believes that central banks’ obsession with avoiding deflation will result in further monetary easing and eventually a high inflationary environment.

“The pressure is still there for more growth, which is very difficult to come by. Central banks are so desperate for growth they don’t mind if inflation is a by-product, and I think that’s dangerous,” he said.

“I don’t think there will be any more QE for now as it seems out of fashion. However, I think there will be a continued tolerance for real interest rates to be lower for longer, as well as higher inflation.”

Russell has major positions in inflation-linked bonds and gold as a result. He believes that dividend-paying stocks are at most risk of a bubble in the coming years, as they are attracting so much interest from yield-hungry investors.

Yielding stocks have had a strong run themselves of late, with the FTSE 350 Higher Yield index significantly outperforming the FTSE 350 Lower Yield index over a three-year period.


Performance of indices over 3yrs

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Source: FE Analytics

Jen agrees that such a laissez-faire attitude to inflation is dangerous.

“Much of the fears regarding deflation are exaggerated. Fighting any kind of deflation at all costs is in itself a dangerous policy,” he added.

All of the experts agree that the lack of clarity surrounding exit strategies is a particular cause for concern.

“Communicating clearly on how exit strategies will check risks should be at the core of forward guidance. At present, we are a long way from this,” said Chaney.

Reinhart added: “We are not yet getting adequate rate guidance and communication has been inconsistent with the Fed’s Open Market Committee history.”

“It is possible that we will suddenly get harmony within the committee, but it’s not likely. Janet Yellen will seek a compromise which is likely to mean that when action comes, it will be more forceful.”
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