Investors should beware a QE-fuelled bubble in rallying developed equity markets such as Japan and Europe, according to Ashmore’s Jan Dehn, who instead believes emerging markets offer better potential for longer term returns.
Quantitative easing [QE] is widely seen as the dominant force in lifting the surging equity markets of Japan and Europe [ex UK] of late, with these two previously precarious economies receiving monetary support from their respective central banks in the past six months who have been buying up debt and compressing bond yields.
According to FE Analytics, the Topix and MSCI Europe ex UK index have rallied over this period with the average funds in the IA Japan and IA Europe ex UK sectors also making strong gains over this period as the graph below shows.
Performance of indices and sectors over six months
Source: FE Analytics
Funds such as Lindsell Train Japanese Equity Hedged and GLG Japan Core Alpha have rocketed up more than 25 per cent while top performing Europe funds such as Artemis European Opportunities and Argonaut European Enhanced Income have surged about the same in six months.
Performance of funds over six months
Source: FE Analytics
In contrast, the US market – the dominant equity market for several years has started to splutter in 2015 less than six months after it wound up its own QE programme.
Dehn, who is head of research at Ashmore, warns that a divergence between equity prices and real world economic activity while providing short term returns is built on flimsy ground set to cave in.
“By fuelling bubbles, QE policies are contributing dramatically to widening the gap between financial asset prices and the real economy. It is also causing myopia and increasing volatility.” These are not merely side effects of QE. By directly undermining confidence they undermine the recovery itself,” he said.
“Ironically, in a global market place where the vast majority of asset prices have been inflated by QE the widespread perception that EM is ‘risky’ actually makes EM investments considerably safer.”
“Japan and Europe are openly engaged in exchange-rate intervention using QE. Indeed, the ECB launched QE just as the European business cycle began to turn up, which shows the policy was undertaken to weaken the euro. American businesses have already been hurt as have currencies in Eastern Europe.”
Emerging markets have also been having a strong run of late with the index up around 20 per cent over the past year and the average fund in the IA Global Emerging Markets sector up 16.58 per cent.
Performance of sector and index over 1yr
Source: FE Analytics
Some emerging market funds such as the Templeton Emerging Markets Smaller Companies are even close to doubling the index over this period with returns over 25 per cent.
Performance of fund, sector and index over 1yr
Source: FE Analytics
Despite the good run Dehn says investors retain a sceptical tone for emerging markets due to a track record of sell-offs mostly seen in the ‘taper-tantrum’ of 2013. However, he says in a world where QE is holding up the markets such as Japan and Europe, emerging markets offer better long term opportunity.
“The cautious sentiment towards helps keep valuations for emerging markets assets attractive – indeed, since QE has disproportionately gone into developed markets, almost every single emerging markets stock and bond market is today significantly cheaper compared to developed markets than prior to QE.”
“[It] also forces errant governments to fix their errors quickly, because they never get the benefit of the doubt, and this helps to keep issuers healthy. But we believe the greatest advantage of an emerging markets investment today is simply that it offers a key assurance that you are not investing in a QE-inflated bubble.”
Dehn adds the there is a huge risk associated with QE as it has in fact putting of any actual recovery in the real economy off any while offering the potential for stellar returns, also huge losses.
“Somewhere along the way, greatly aided by modern finance theory, investors lost track of what it means to make individual investments. Investing became a game of aggregation, of spreads, of indices and of the dynamics of the herd itself.”
The divorce of price dynamics and underlying risks is extremely dangerous. Without an anchor in the real world, asset prices are free to go anywhere.”
“Not only are central bankers finding it difficult to tighten policies in the face of ever lower realisations of trend growth rates, but in providing the ‘band aid’ of QE central bankers in the heavily indebted countries are actually further inflating already dangerous bubbles and making their eventual deflation that much more painful.”