Until a few weeks ago the latter seemed to have triumphed, as markets climbed sharply in anticipation of radical action from the Federal Reserve and the ECB. The news was even better than anticipated; Bernanke made a pioneering pledge to tie QE3 directly to employment data, the ECB showed a credible route to rescue repentant peripheral bond markets, and the Bank of Japan further extended its own QE programmes.
Risk asset view
But, as so often with central bank initiatives (especially in Europe), the travelling can be better than the arriving.
In this case, hawkish talk on bank bailouts from Germany, Finland and the Netherlands undermined the shock and awe of Draghi’s ingeniously designed bond-buying programme, while worsening economic data in Japan and Germany has again put investors on ‘earnings watch.’ Despite such setbacks, this was a strong quarter for risk assets, with their bias toward corporate bonds, global equity income stocks and blue-chip thematic cash flows.
Bouts of market weakness within a longer-term upward trend suggest a slow but gradual victory for the world’s central bankers and their QE programmes. Despite the political fragility of Europe and the pain of deleveraging across the western world, we have managed to avoid deflation while seeing the price of risk assets climb and their volatility fall. Indeed, since Barak Obama was elected in January 2009 the total return from the S&P500 has been above 70% while equity volatility has fallen by almost three quarters – not bad for a purportedly business-unfriendly president.
So, this should be a war that central banks can win – theoretically they have unlimited liquidity at their disposal, and are often cheered on by politicians for whom QE can seem more attractive than years of further austerity. But with interest rates at or close to zero in all major markets, policy is increasingly ‘unconventional,’ and untested.
In short, markets have warmed to QE, or “large scale asset purchases” as Bernanke refers to his bond and mortgage acquisitions. He summarised his thinking on their impact in a key speech at Jackson Hole last month, where he said large scale asset purchases “appear to have boosted stock prices… this effect is potentially important because stock values affect both consumption and investment decisions”.
Similar sentiments have been echoed by the Bank of England and other central bankers.
Ride the equity wave
With friends like these, shouldn’t the global investor just sit back, ride out the occasional setbacks in equity and risk assets, and enjoy a state-sponsored rise in equity markets?
Yes, in theory central bankers hold all the cards, but the enemy is still redoubtable. We are attempting to escape from the largest mountain of public and private debt ever accumulated by the developed world, with public debt higher even than that seen at the end of World War I or II.
Equity markets face other challenges: politicians staring at empty coffers in their own treasuries will be sorely tempted to tax record levels of corporate cash flow. The attack has been led by France’s Socialist government with €20bn of taxes on business and the wealthy, while keeping public spending at an eye-watering 56% of GDP.
In the US, dividend taxes will be a key battle ground; if Congress lets the current law expire, today’s 15% tax rate on qualified dividends reverts to ordinary income tax rates, currently around 35%.
In reality a change will likely be part of a more comprehensive tax bill that addresses the taxation of US corporations’ overseas earnings.
So the battle to dominate financial markets continues, with investors torn between a debt-induced era of slower growth and lower profits, and the market’s adrenalin rush as liquidity and QE purchases gush from world’s central banks as they reflate assets and repress interest rates.
To date, investors have backed both sides in this war by pouring money into bond funds hoping they will rally if growth is weak and as central banks buy bonds through QE, ultimately encouraging corporate spreads to narrow. Company treasurers have been quick to react by massively increasing issuance (often opportunistically) at today’s super low yields – September was the second busiest month in the history of the euro bond markets.
Consequently, many investment-grade companies have secured their financing requirements for several quarters in advance which is extremely positive for long-term corporate stability and supports the investment case for companies’ debt and equity alike.
Asset calls
We continue to favour global equity income and cash-flow-rich theme stocks as a better hedge. The durability of their dividend payments remains key, of course, in the face of weak global growth (and, for UK investors, rising sterling), and this interestingly focuses our portfolios away from traditional yield sectors such as banks and telecoms.
Instead, we are attracted by the long-term pricing power available in the life insurance and reinsurance sectors, the intellectual property and patented technology in key industrial stocks and restructuring initiatives specifically designed to support cash flows or dividends (e.g. Pfizer, Wal-Mart and Home Depot).
Global diversification is needed to avoid aggressive regulation or dividend taxes in any one market. In all of this we are well aware that we are not alone in recommending global yield stocks as the core of our portfolios, but this investment war has, I feel, several years left to run…
“The strongest of all warriors are these two – time and patience.”
– Leo Tolstoy, War and Peace
