Are Global Markets Addicted to QE?
Years on from the biggest economic crash since the Great Depression things are starting to look better in equity markets. The Magellan Financial Group flagship Global Fund has returned a staggering 48.7 percent for the 12 months to December 2013 and the Platinum Asset Management International Fund gained 47.2 percent over the same period.
Things are once again looking good for sharemarket investors. Or are they?
“Quantitative Easing”(QE) describes the process by which central banks in the US and UK have been keeping interest rates depressed since the GFC, allowing corporations to rebuild their balance sheets and make debt servicing easier. However it also enabled corporations in these markets to buy back huge swathes of their stock, inflating share prices. A recent article by Zerohedge.com estimates half a trillion dollars was spent on share buybacks in the US so far in 2014. Share repurchasing has created a semblance of good economic performance while disguising how firms have gorged themselves on cheap debt (albeit to recapitalise balance sheets decimated by the GFC.)
Low interest rates and the quest for better yields on invested assets have pushed investors into riskier asset classes as seen in the stellar growth in hedge funds, commodity ETF’s and private equity investments. According to Lipper, alternative fund net flows were up 40.71 percent in 2013 on the previous year. While studies show that these investments are less correlated to ordinary stocks, they have their own unique risks which are little if at all understood by most investors. An April 2013 study by CME group discussed how standard measures of investment portfolio risk such as Sharpe ratios can mask risk components of alternative investments. In times of crisis asset classes become more closely correlated and any anticipated diversification benefit evaporates. One of the major learnings from the Global Financial Crisis was that “tail risk” events, those that are deemed highly unlikely or random, are more common than we might think.
QE has created a benign business environment in developed nations. However at the same time it has had spillover effects in others such as large investment flows into emerging markets economies as investors seek higher yields. It is estimated that US$4 trillion of funds has moved into emerging markets since 2009. In late 2013, news that the US Federal Reserve was to begin easing back the QE program led to large currency falls in India, Indonesia and Thailand as investors ran for the exit. In Australia, the news sent the dollar to a three-month low of US88.2 cents.
The Fed has chosen to continue its program of QE for now, while indicating that it will be looking to taper it back in the near future. However it remains to be seen just how orderly financial markets will adjust. The QE program means low debt payments for corporations and mortgage-holders and ready access to investment capital for emerging nations looking to develop infrastructure, roads and hospitals. Tapering QE will lead to rising bond yields in the US and investment flows back into developed markets.
QE tapering is coming sooner than later. Whether investors, corporations and governments are ready for it is another matter.
Further Reading:
http://www.zerohedge.com/news/2014-09-23/blackstone-slams-broken-bond-market-despite-record-bond-issuance-driven-stock-buybac
http://www.cmegroup.com/education/files/PM146_Education_Kaminski_article.pdf
http://www.fool.com.au/2014/01/16/magellan-returns-48-7-warns-of-global-financial-risks/
