As widely expected, The Federal Reserve (Fed) announced this week that it will begin inching away from its audacious post-crisis monetary experiment in October. With the European Central Bank (ECB) and even the Bank of England (BOE) also sounding progressively less lenient, we explore some of the things that we think investors should be thinking about with regard to quantitative tightening.
What it is and isn’t
Perhaps the most important (and unprofitable) misconception about quantitative easing is that it has been tantamount to money printing. For much of the period immediately following the 2008 announcement by the Fed, hyperinflation was the concern, resulting from too much money chasing too few goods. However, this misunderstood the way that money tends to be created in the modern economy. The dominant money printer in one sense is us, consumers and businesses. When we demand credit, and banks are willing to provide it, money is created. For much of this recovery, scarred by the horrors of 2008/09, both sides have been reluctant to demand/provide such credit. This is starting to change. Bank sector balance sheets are now more or less compliant with a more rigorous regulatory environment. Meanwhile, private sector confidence, and therefore appetite for credit, is increasingly buoyant. The approach of a more normal monetary backdrop is therefore to be welcomed.
Did it work?
There are always going to be difficulties in isolating the effects of quantitative easing. The absence of a counterfactual – a past where the central banks stood aside and let the chaos play out – leaves us guessing. Various studies have pointed at the effect of asset purchases as being an intuitive net positive for the economic recovery. This was surely the case at a time when central banks had run out of the more conventional monetary ammunition of lowering interest rates and were faced with an economy still in freefall.
The experience of the Great Depression, where shrinking money supply is now seen by many of its students as an important agent of the prolonged economic hardship, is perhaps instructive. In some sense, the global economy of 2008 was fortunate to have central bankers in the hot seats who had learned from the mistakes of their predecessors.
Who loses from the withdrawal?
The first and most important point to make here is that is thanks to careful communication, the approaching contraction of the Fed’s balance sheet is widely expected. The pace is also set to be very moderate, being mostly managed via gradually retiring maturing assets. The effect on bond markets is therefore likely to be pretty benign. For our part, we expect some upward pressure on term premia (the extra compensation often demanded by those lending to the government for a period of several years rather than a series of shorter term instruments), just as the central bank purchases of the last few years have surely helped to suppress this risk premium.
We do not expect the balance sheet to return to its pre-crisis size either – the fact that the economy has long since surpassed its 2007/08 peak is part of the story that requires the Fed to maintain a proportionally larger balance sheet, to meet demand for currency. On top of this, the Federal Open Market Committee (FOMC) has actually indicated a preference for maintaining a larger balance sheet anyway, citing associated benefits such as improving financial stability and the potential for more reliable transmission of monetary policy.
The job of achieving decent (even positive) real returns is set to get tougher for investors in high quality bonds. In the absence of the safe haven bid that has proven such a support of late, and amidst signs both of a bottoming in inflation data and a marginally more functional congressional backdrop, we would expect yield curves to rise and steepen towards the end of the year and beyond anyway. This effect is likely to be moderately exacerbated by the central bank’s contribution, as they slowly but surely relax their direct grip on the US bond market. The fact that other developed world central banks around the world are feeling similarly less lenient should have similar effects elsewhere.
For multi-asset investors, the advice remains the same. Equities are still expected to outperform Treasuries in such a scenario – something that we are already well positioned for within client portfolios. Historically the equity sectors that have tended to do well in this backdrop are the more cyclical areas of the market such as Industrials and Financials. For the former, a reviving backdrop for investment around the developed world amidst buoyant business confidence suggests that the sector has decent earnings prospects. For the banks and wider financials, higher interest rates will be very helpful for profitability, while that backdrop for private sector confidence and capital expenditure should speak well of the prospects for further loan growth. All we need now is a more appropriate price for that capital.