Central bank policy isn’t enough to improve the current lacklustre growth environment and is more likely to harm markets over the long term than anything else, according to Heartwood’s David Absolon.
The investment director says central bankers are becoming more “flummoxed” in terms of how to deal with the current economic environment and, as such, it’s prudent to question whether unconventional monetary policy is exacerbating problems rather than fixing them.
Ultra-loose monetary policy was first implemented as an emergency measure following 2008’s financial crisis.
However, given the low-growth and low-inflation environment we still find ourselves in, a number of central banks across the world have continued to reduce interest rates to historically low levels and use quantitative easing in a bid to bolster their economies.
This in turn has come alongside the scrabble for yield, with bond sitting at ultra-low yields and equities trading on markedly high valuations.
Performance of index vs sector in 2016
Source: FE Analytics
Absolon argues that there are several ways such policies can in fact damage future returns across markets by discouraging investors and leading to a lack of pricing power across companies.
“Actual inflation and inflation expectations remain low and are falling in some economies such as Japan. Ultra-low interest rates appear to discourage investment, leading to a ‘hoarding’ effect among consumers and companies. Cheap money is all well and good, but there has to be demand for it,” he said.
“Aggressive quantitative easing diminishes future returns across asset markets and leads to a likely long term misallocation of capital.”
“‘Zombie’ companies - those that might otherwise not survive were it not for ultra-low interest rates - were once talked about only in Japan but there are worries that this may be a more general phenomenon across developed economies, exacerbating oversupply and general lack of pricing power.”
The investment director adds that QE serves as a headwind for developed economies with ageing populations in particular, given that it depresses interest rates over the long term which then has a knock-on effect on pension funds.
He also points out that negative interest rates will have a detrimental impact on banks and their ability to raise short-term deposits, which could then lead to a tightening of financial conditions.
“Currency volatility is being encouraged, but not always in a way reflecting a central bank’s specific objectives,” Absolon continued.
Performance of currencies vs sterling in 2016
Source: FE Analytics
“This has most clearly been seen in Japan where negative interest rates have not had their desired effect. The yen has strengthened 15 per cent on a trade-weighted basis since January and this has hurt large-cap exporters, contributing to weaker economic activity.”
“In the eurozone too, the currency has been relatively stable on a trade-weighted basis and now European Central Bank policymakers are more focused on generating credit growth rather than boosting external demand.”
Rory McPherson, head of investment strategy at Psigma, argues that high equity and bond valuations combined with low economic growth begs the question as to whether investors should buy into traditional assets at all.
Given that there are fewer attractive value plays available to investors, he warns that future returns will be higher-risk as the safety net of buying into cheap assets in the first place is no longer there.
“Phrases such as ‘we’re in a low return world’ and ‘borrowing from tomorrow to pay for today’ get hackneyed around far too often in the various outlooks currently doing the rounds,” he said.
“Both statements are factually accurate, but tremendously unhelpful from the perspective of an investor looking to make money. They do however cut straight to the nub of my ‘why should I bother?’ question.”
McPherson points out that current growth levels are due to productivity slowdown, increased levels of debt and ageing populations in developed economies.
While he says that government spending will help, it is unlikely to do enough to encourage stable long-term growth.
“Valuations within conventional fixed income are eye-watering (yields at multi-hundred-year lows or near enough). Within equities, they are just plain old ‘expensive’. Unless you’d scooped down too much strong Belgian lager, it’s hard to argue they are ‘reassuringly’ so,” he continued.
“Equity valuations are of course greatly skewed by the US market which accounts for circa 60 per cent of the global stock market. It trades on over 17 times next year’s earnings and has endured five consecutive quarters of negative earnings growth. Hence you can forgive us for not wanting to hang too much weight on the ever bullish earnings’ growth numbers for next year (circa 13 per cent).”
As such, the team at Psigma struggles to see traditional assets providing investors with much of a positive return at all as we head through the year.
The head of investment strategy describes bonds and equities as becoming “exhausted” to the point where they simply won’t be able to perform to the same degree they have been able to historically.
“Our decisions and calls reflect a lot of analysis but perhaps the cleanest and easiest way to distil our thoughts on traditional assets is simply to say that trees don’t grow to the sky,” McPherson said.
“A traditional ‘60/40’ mix (with 60 being the percentage in equities) has yielded a return of nearly 8.5 per cent a year for the last 35 years against a backdrop of a 2.6 per cent inflation rate.”
“That translates to an increase in capital value of over 17 times before inflation and almost 7.5 times in real terms: this can’t go on forever.”
In terms of portfolio positioning, Absolon agrees that investors should look beyond traditional assets when repositioning their portfolios, but believes they should still hold equities and bonds.
“Investors are caught between an environment littered with macro uncertainties and one in which asset prices continue to benefit from the slosh of central bank-induced liquidity,” he explained.
“We believe the most prudent strategy is to stay close to neutral in equities, have a bias towards shorter-dated bonds, and to look to other asset classes for alternative sources of returns.”
“At the same time, we are holding ample liquidity to take advantage of further periods of volatility as they inevitably occur.”