The banking crisis isn’t over, investors should be wary of currency depreciation in areas undergoing quantitative easing and printing money is not a ‘fix-all’ solution to improving the economy, argues Tilney Bestinvest’s Gareth Lewis. 
The chief investment officer (pictured) believes in adopting a top-down macro view when making investment decisions and, as such, is keeping a close eye on the impact of quantitative easing (QE) to both reap the benefits of monetary stimulus and soften the blow of any potential headwinds it could cause.
One way he is doing this with Tilney Bestinvest’s £9bn of assets is hedging against the euro while being overweight European equities.
Since European Central Bank (ECB) president Mario Draghi launched QE in March, the euro has plummeted against the dollar, dropping below parity for the first time since 2001.
Performance of euro vs dollar over 15 years
Source: FE Analytics
However, Lewis believes that if investors take the correct precautions, quantitative easing has made European equities far more appealing.
“To me, one of the main reasons why central banks are using QE is not because it boosts economic activity fundamentally. In my view, it’s to do with currency,” he said.
“So if you look at what QE does, it doesn’t actually drive yields down – it significantly weakens your currency and the central banks know this better than we do. “
“When the ECB announced QE at the beginning of this year, Draghi all through Q3 last year was quite critical of eurozone fiscal policy – it’s very unusual for a central banker to be that explicit in his criticism of the government’s policy.”
In September last year, Draghi stunned investors following a speech at the Jackson Hole Economic Policy Symposium by being much more critical than he had been in the past about strict fiscal austerity.
In a bold move to weaken the euro and prevent the eurozone from spiralling into deflation, the central bank president proposed a €1.1trn course of QE due to end in September 2016.
“In my view, he was probably forced into QE earlier than he wanted by the inflation rates and his main target was the euro,” Lewis explained. “He certainly achieved what he set out to do – the euro is very weak and collapsed after this.”
Performance of euro vs sterling over 1yr
Source: FE Analytics
“If you think of world economies as a table with not enough food to go around and everybody’s fighting for it, one of the ways you can make sure everyone has enough is to depreciate the currency – that’s the economy.”
He adds that not only is QE deployed to weaken currency, it is a way to inject money into economies while bypassing the banks.
The chief investment officer says that, while economies such as the US or the UK have either recovered or are now recuperating from the initial casualties of the banking sector in 2008, we are still in the throes of a banking crisis and this will affect central bank monetary policy.
“History tells us that loan loss provisioning within the eurozone remains inadequate and that capital remains scarce,” Lewis said.
“The European Central Bank’s asset quality review was a missed opportunity to stress this fact. The weak capital position of the banking system is forcing banks to rebuild their balance sheets through retained earnings, which is likely to keep credit conditions tight.”
To depict the importance of bank balance sheets and how easy it is for banks to become illiquid or insolvent, Lewis uses the analogy of an upside-down pyramid which is divided into three sections – the smallest section, keeping the pyramid balanced, consists of hybrid shares, preference shares and equity. The middle section is made up of senior secured debt, deposits, senior debt and subordinated debt.
The largest base section, which is balancing on top, is the loss-creating bank loans.
Diagram of bank balance sheet
Source: Tilney Bestinvest
“When you end up with a bank insolvency problem, the relationship between these goes out of kilter,” he explained.
“The failing of Northern Rock, for instance, was all to do with too many loans and not enough capital. When you end up with a big crisis like in the case of ’08 and the US housing market, the losses will simply wipe out the capital.”
Due to the delicate nature of banks’ balance sheets, Lewis says that injecting money into the economy via banks, which is what contributed towards the Japanese asset price bubble in the late 80s and early 90s, means that capital will simply become absorbed into the bottom of the ‘pyramid’ and build up the loss of the bank’s capital.
“All they want to do is build up the bottom of this pyramid. It acts as a sponge, so everything that is put into the banks isn’t passed on,” he said.
Lewis doesn’t doubt the usefulness of QE and says it is an efficient way to create readily available capital for the corporate sector. However, he warns that there is a danger of ‘too much of a good thing’ if it is not administered correctly, and turns to the US as an example.
‘QE1’ was launched in 2008 and ‘QE2’ in 2011 when the Federal Reserve started buying bank debt, mortgage-backed securities and treasury securities.
When ‘QE3’, an $85bn per month, open-ended bond-buying programme, was launched in 2012 by Bernanke, however, the US economy failed to reach inflation expectations according to many investors.
“If you think that QE is designed for only one reason and that’s to bypass the banks to protect from insolvency, in 2008 and 2009 it was quite clear that US banks were insolvent so we had QE1 and QE2,” Lewis said.
“The trouble is they carried on with QE3 and QE3 outlived its usefulness. The little joke made by Bernanke, the man who is single-handedly responsible for QE, said: ‘The problem with QE is that it works in practice but doesn’t work in theory’.”
“My view is that QE works, certainly in the early stages, to the extent that the global economy would be much weaker without it, particularly in the US and the UK. What we should expect QE to do, though, is stabilise an economic system when the banks aren’t helping.”
