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Should investors fear the end of the QE party?

01 October 2014

Markets are closely watching the withdrawal of quantitative easing by the Fed, but Henry Hunt, Thomas Miller’s head of portfolio management, says this is no reason for fear.

By Henry Hunt,

Head of Portfolio Management, Thomas Miller

Last year was a ‘banner’ year for global equities. This year has been more mixed but the United States of America has been scaling new highs.

ALT_TAG US equity prices have now tripled since the low in March 2009 and this has raised some worries that the markets are in ‘bubble’ territory, pumped up by central bank policies, in particular quantitative easing (QE).

Adding its voice to the market bears, the Bank of International Settlements (BIS) - one of the few to predict the 2007 crisis - has recently issued a stern warning that markets are detached from economic reality and that low interest rates may have pushed investors to take on too much risk and leverage in their search for yield.

Performance of indices over 5yrs

ALT_TAG

Source: FE Analytics

Bubbles occur when market prices become substantially separated from underlying fundamentals, in particular the growth outlook for corporate profits.

As central banks pull back from QE, should investors be fearful and raise cash weightings? To help answer this question, and avoid the big equity market drawdowns in the future, investors should focus on three main market drivers: macroeconomic indicators, valuations and investor positioning.

None of these market drivers today suggest to us that global equities are in a bubble yet.

Leading indicators do not warn of an impending downturn in the global economy nor a recession in corporate profits, valuation indicators are only moderately expensive on our models and finally widespread investor bullishness is absent.

There is still a lot of caution around and relatively high cash levels are being reported.

Capitalist economies are amazingly resilient. The financial crisis and global recession took place just over five years ago and the US and UK economies have gradually been returning to a more normal state.

Over the next few quarters it is reasonable to expect US economic growth of 3 to 4 per cent at an annualised rate and UK growth of 2 3 per cent. Worries about a secular stagnation seem overblown.

QE programmes are coming to an end in both countries and interest rates are likely to rise modestly in 2015.

The main reason is that US banks in particular are in a healthier position and want to expand their businesses again after years of regulatory pressure to shrink their balance sheets.

Demands on the banks for more capital relative to assets and for more liquid assets had hindered lending growth and caused economies to stagnate. QE programmes were needed to offset the contraction in the banking systems.

In other words, without QE, economic conditions in the last five years would have been much worse.

In the eurozone, by contrast, for various reasons (in part ideological in part legal) there has been no QE and economic growth has continued to stagnate.

Credit growth remains very weak and regulatory ‘stress tests’ this year are unlikely to encourage more risk-taking by the banks.

Unemployment is exceptionally high and there is a growing risk of deflation or falling consumer prices.

These trends have resulted in a collapse in German bond yields to Japanese levels, with the 10-year yield below 1 per cent.

A QE programme on the scale seen in the US and UK is urgently needed in order to improve economic growth prospects.

If and when the European Central Bank (ECB) launch their own QE, eurozone equities will rally and German government yields are likely to rise once again and put upward pressure on global government bond yields.

Against this background, the US stock market should continue to rise over the next few years.

Setbacks of 5 to 10 per cent will occur and, indeed, are probably likely as the Fed turns more hawkish; but a major collapse is improbable until their economy falls back into recession.

Currently the economy is nowhere near a recession and furthermore, the Fed does not need to trigger a recession as inflation remains low. The Fed could even re-start QE, if necessary.

Over the next 12 months, US corporate profits should grow by 5 to 10 per cent and equity total returns are likely to be of the same order.

Non-US investors may also benefit from a stronger US dollar; the dollar is currently relatively cheap and likely to benefit from widening interest rate differentials between the US and most other countries.

Non-US developed equity markets have underperformed and are on generally cheaper valuations.

The US market usually leads the cycle but when the global economy picks up more widely other markets may start to outperform.

UK corporate earnings have suffered partly as a result of the strength of sterling and that country’s equity market may benefit from a lower pound in the next 12 months. Companies with US dollar earnings should do well.

Further monetary stimulus by the ECB and Bank of Japan would be a signal to buy those markets, especially the small and mid caps.

Higher eurozone equities would also lend further support to the UK and US equity markets.

In a world of low nominal and negative real (inflation adjusted) interest rates, global equities while volatile are still likely to be amongst the most rewarding investments in the next few years.

Investors should not fear the end of the QE party. It should represent a return to economic normality in the UK and US. In the eurozone, the party may be about to get going.


Henry Hunt (pictured at the top of the article) is head of portfolio management at Thomas Miller Investment. The views expressed are his own.

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