In an effort to stimulate spending in the economy, the major developed market central banks – the Federal Reserve, ECB, BoJ and Bank of England – have employed a variety of tools including holding interest rates close to zero, providing guidance over future policy, liquidity injections and most talked about of all, large scale quantitative easing (QE).
These actions have been designed to drive down the value of cash relative to other asset prices such as bonds, equities or real estate. Easier financial conditions and higher asset prices should in turn encourage spending and borrowing and invigorate economic growth.
In recent weeks, attention has turned to what the world will look like when QE ends, as discussion that the Fed will moderate (or “taper”) its monthly QE purchases has rattled markets. Bond yields (prices) have risen (fallen) sharply around the world and the US dollar has strengthened. Equity markets, which had re-rated on the back of easy monetary policy, have also declined lately.
Correction or re-rating?
Are we then witnessing a temporary correction or the start of a re-rating of US dollar cash, a period characterised by falling asset prices in US dollar terms as monetary stimulus is gradually tapered then withdrawn?
While the short-term move might be a bit overdone, in our view financial markets will need to adjust over the coming 12-24 months to higher bond yields as QE purchases are scaled back and attention turns to Fed interest rate hikes. If this view is correct, markets will be subject to bouts of volatility and bond yields on a rising trend.
But it is important to remember that the Fed will only reduce policy accommodation if economic conditions are robust, an environment supportive of corporate revenues. Moreover, the Fed is likely to proceed with caution – it does not want to destabilise financial markets and the threshold to counter inflation risk is far higher than that placed on supporting growth.
Therefore, we believe that relative valuations and the policy environment should remain supportive of equities outperforming cash and most fixed income markets over the medium-term.
Decisions to be made
However, the volatility of recent weeks is a shot across the bows for how markets will react to signs that QE purchases are coming to an end. The return to more conventional monetary policies will be a major challenge for markets over the coming 12-36 months, in our view.
The good news is that the market has started to consider this challenge and recent weakness is improving valuations and throwing up opportunities across markets, although developed market government bonds remain on the expensive side (just a bit less so).
We intend to talk more about some of these opportunities when we have implemented new positions.
