The effectiveness of monetary policy in the current environment is debateable, and this debate is live even within the Fed. Ben Bernanke, its president, claims that the measures taken to date are responsible for the recovery in economic activity and improvement in employment.
Contrarian argument against QE
His colleague at the Dallas Fed, Richard Fisher, doubts that this additional monetary easing will persuade firms to increase capital spending and hiring owing to their concerns over the long-term outlook.
His view is that: “Democrats and Republicans alike have encumbered our nation with debt, sold our children down the river and sorely failed our nation. Sober up. For unless you do so, all the monetary policy accommodation the Federal Reserve can muster will be for naught.”
Bill White, a respected economist from the OECD, goes further and highlights the unintended consequences of ultra-easy monetary policy: weakening growth over time, reducing the health of financial institutions, threatening the functioning of financial markets and the independence of central banks, as well as the undesirable social impacts of favouring debtors over creditors.
Despite this, we see little chance of a change in policy and this strengthens the argument for holding some gold and gold mining companies in portfolios.
Nor is the impact on equity markets clear. Indeed, stock markets have sold off in the aftermath of the latest moves by the Fed.
However, this was after rallying strongly in anticipation of action by both the US and European central banks.
We see inflation trending lower in 2013, but we continue to expect problems to arise in the future. At some point the huge amount of monetary stimulus and the lack of investment in new capacity will trigger a rise in prices.
This is likely to occur at a time when unemployment remains high and overall indebtedness in the UK, US, Europe and Japan is excessive. This will mean that central banks are likely to be slow to raise rates.
The fact that a dose of unanticipated inflation would be convenient for highly indebted sovereigns makes it more likely that policy tightening is gradual.
Asset allocation calls
We continue to be cautious on government fixed income securities that are offering yields below historic, current and expected future levels of inflation. They offer an appropriate hedge against another deflationary scare for more defensive portfolios but in general we prefer inflation-protected bonds. These can perform well if inflation picks up but central banks keep interest rates low, a scenario we see as likely at some point.
Central bank actions to keep government bond yields low have also brought down yields on corporate and emerging market debt, in some cases to historic lows. The strength of balance sheets within the corporate sector means that we see room for investment-grade corporates to enhance portfolio yields. Overall we see better value in equities than bonds, with the yield on equities in many markets exceeding their government bond equivalents.
For equities, earnings expectations for this year have been revised down while prices have risen, meaning valuations are less attractive in absolute terms. We see upside to equity markets in our baseline scenario.
We continue to favour developed markets over the emerging world. We note, however, that emerging markets have lagged for two years, which means relative valuations have improved. In addition, our cautious view on China has become more mainstream. This creates scope for the new administration, due in October, to surprise us on the upside.
In conclusion, the European Central Bank has reduced the odds of a catastrophic collapse of the euro. Still, the crisis is far from over. The US Federal Reserve has also upped the ante with open-ended intervention in the mortgage market. This has boosted confidence in the short term, but the warnings are getting louder on the negative long-term consequences of its actions.
We see upside to equities and other risk assets in our baseline scenario. However, over the next year we will need to see the real progress in the US towards a sustainable tax and spending policy and further moves towards a federal Europe. This agenda will ensure volatility.
The story this year has once again been “don’t fight the Fed” or indeed the European Central Bank. Still, when a Fed insider tells you
they are out of bullets, it is right not to be complacent. We continue to balance equity risk with holdings of inflation-protected bonds, gold and selected hedge funds. We hold some cash in order to profit from periods of market stress.
