Central banks’ quantitative easing (QE) measures have done very little but create asset price bubbles across global financial markets, according to star manager Neil Woodford, who says investors need to concentrate on equities to protect their savings now more than ever. 
In order to regenerate their economies after the global financial crisis, central banks such as the US Federal Reserve and the Bank of England embarked on emergency and audacious monetary policies such as ultra-low interest rates and QE – a form of money printing which involves buying sovereign debt.
Six years on from the crisis, though, and interest rates have remained unchanged while QE is still very much raging in areas such as Europe and Japan.
While Woodford says the huge amounts of liquidity have helped drive the strong rally in risk assets since the markets bottomed out and pushed certain financial indices to their all-time highs, he warns that the measures have done very little to improve the underling economy.
Performance of sectors and indices since March 2009
Source: FE Analytics
“QE is a controversial policy for a number of reasons but, in my view, one of its biggest drawbacks is that it can be held primarily responsible for creating a dangerous mirage of normality, because it has driven a wedge between financial asset prices and the anaemic economy underneath them,” Woodford (pictured) said.
“From the outset, the objective of QE was to inflate financial asset prices in the hope and expectation that the rise in value of those financial assets would ultimately precipitate a trickle-down effect in the real economy.”
“That was the theory – in reality, we’ve had the first piece in the form of higher asset prices but we haven’t seen the follow-through. Some economists have argued that without QE, deflationary forces would have been more intense and growth outcomes may have been even worse.”
He added: “It’s difficult to argue against this suggestion but, in my opinion, QE has not delivered what the architects of the policy hoped it would deliver, namely, a real economic transformation. It has inflated asset prices, though, and therein lies my concern.”
As a result of the added stimulus and other factors indices such as the S&P 500 and the FTSE 100 have reached their record highs while, up until recently, yields on US, UK, German and Japanese government bonds were at record lows.
While some may see this as reason to be cheerful, the manager – who launched his £6.2bn CF Woodford Equity Income fund a year ago following his high profile departure from Invesco Perpetual – says it is imperative to understand that these are not normal times.
In fact, Woodford says investors need to be very careful when building their portfolios.
“Without an improvement in underlying economic fundamentals, if you keep driving asset prices up, in the end you create a financial asset price bubble,” he warned.
“We know from relatively recent history that asset bubbles burst in an unpredictable and unpleasant way with real economic effects that can be very damaging and long-lasting. This is why I worry about QE – the ultimate consequences of the policy could be the complete opposite of what it was originally designed to deliver.”
“Such an outcome could still be years away, however, and in the meantime, QE is likely to continue as a policy. Investors, therefore, need to remain vigilant and acutely conscious of inflated valuations.”
Woodford, who has more than tripled the gains of his average peer since the turn of the millennium, took the decision to launch his own fund management company in 2013 following 26 years at Invesco Perpetual.
Performance of manager versus peer group composite since Jan 2000
Source: FE Analytics
As the graph below shows, the CF Woodford Equity Income fund has got off to a flying start since its launch in June last year.
According to FE Analytics, it has been the IA UK Equity Income sector’s best performing portfolio over that time with returns of 19.34 per cent, beating the FTSE All Share by close to 15 percentage points in the process.
It has also generated the highest amount of alpha relative to its benchmark as well as having the best information ratio and risk-adjusted returns in the sector over that time.
Performance of fund versus sector and index since launch
Source: FE Analytics
While Woodford is clearly cautious in his outlook, he fully expects his fund to continue to perform well over the long term.
The main reason for that, according to manager, is because high quality equities will continue to be the best asset class in terms of returns and downside protection for the foreseeable future.
“Equity markets remain one of the few areas where undervalued assets can still be found,” Woodford said.
“There are large areas of over-valuation as well, so it’s very important to be selective, but there are enough attractive opportunities out there to build a diversified portfolio. Amongst smaller companies, we continue to find early-stage businesses which have tremendous long-term capital appreciation potential.”
“And, within the large-cap investment universe, some dependable sources of dividend yield and dividend growth are also undervalued, sometimes profoundly so.”
For example, the star manager says the likes of BAE Systems, Legal & General and Imperial Tobacco are very undervalued despite the fact that have delivered market beating returns over recent years given their dividend yields of more than 4.5 per cent.
Performance of stocks versus index over 2yrs
Source: FE Analytics
“When you consider that equities are real assets, capable of delivering long-term income growth and that bonds are nominal assets offering no growth, this situation looks anomalous. In my view, it is indicative of both the over-valuation of bond markets currently and the under-valuation of select high-quality, dependable growth stocks,” he said.
Woodford’s argument is supported by his fellow FE Alpha Manager ‘hall of famer’ Jan Luthman, who heads up the top-performing Liontrust Macro Equity Income fund.
Luthman recently told FE Trustnet that while QE is creating huge bubbles in financial markets which will inevitably burst at some stage, there is no point giving up on equities yet given that there is still a huge amount of liquidity which is likely to move out of bonds into higher risk assets.
“The overall message is that we are positive on equities,” Luthman said.
“At some stage, it will all end in tears but because of the liquidity from central banks the bull market could run for some time and hit some quite significant heights. If you want to be gloomy you could well see a 1987 or even a 1929 happening again as though things are different this time, the main driver – human greed – is still there.”
“However, at the end of the day there is a lot of liquidity out there and it is looking for a home. Even Greece, yes it could be apocalyptic, but it could fuel the bubble even more as it could prompt further QE from the ECB.”
“The main point is, where else do you go? I don’t think investors are ignoring the dangers of the world but they are just being swept along by a tidal wave of liquidity. The blunt answer is, there ain’t any other game in town.”
