Imagine a birthday cake covered in candles. When you blow on them, you expect them to go out. But instead, they reignite and flicker even more brightly whenever there is a passing breeze. As the US Fed this month celebrates the thirteenth birthday of its quantitative easing (QE) programme – which has artificially kept alight the economy and financial markets – there is mounting concern that the fire may be starting to spread.
There are of course appropriate times to use monetary stimulus, such as after 9/11 or during the Global Financial Crisis. But even during relatively benign periods the Fed has demonstrated it is more than happy to stoke the economy. Every time there is a hint of volatility it responds with another round of QE. It just keeps stoking the fire.
There are, of course, deserving people who should be given a helping hand. But there are also very reasonably paid people receiving cheques in the mail for no obvious economic reason. Before the crisis, such profligacy was not given credence, but in recent years it has become expected, even mandatory, to satisfy markets.
The new US administration is providing fresh fiscal stimulus in its ambitious infrastructure plan. Under normal circumstances, investors would factor in that this would probably lead to higher corporate and other taxes, which would shrink profit margins and weigh on equity valuations. Companies may also raise prices to maintain profits, resulting in inflation. But, based on past form, how should we rationally expect the Fed to respond? Few would doubt that it would once more reach for its balance sheet to head off negative consequences, so equity markets barely take notice.
Equity investors accept volatility; they willingly accept it in exchange for returns. But QE has resulted in it remaining at or below average historical levels despite the real-world turmoil of the pandemic. It encourages a false sense security that the situation can continue forever and unrealistic expectations of what should be considered reasonable equity market volatility. It is unsustainable, so at some point it is going to end – and whenever it does, it is unlikely to end well.
Some argue, with rates at historic lows, it is a good idea to borrow money to support growth even if it means allowing the national debt to balloon. But how far can this logic be extended? Equity markets are at an all-time high, growth is expected to be around 6% and unemployment is so low that there are reports of labour market shortages.
The economy will inevitably slow later in the economic cycle. At that point, we may then find ourselves in a recessionary environment with levels of borrowing that make it difficult to apply much-needed stimulus. The Fed is not preparing itself for when it may actually be needed.
Historically, monetary expansions were balanced over time with contractions and borrowing self-corrected by repayment. But the reversals never seem to arrive – the Fed had barely started to unwind QE from the financial crisis before it added to it during the pandemic.
Source: St Louis Fed, Excess reserves of depository institutions, 2007-2020
Economic theory suggests that when countries print money to fulfil unfunded spending, the result is inflation. The Fed is letting inflation drift higher up, justifying its inaction on temporary factors and fear about the potential impact of Delta strain of Covid-19. Inflation is a sign of overstimulation and financial results suggest it may not even be effective.
During September we experienced the worst week for results in nine months and investors are becoming worried that companies will not hit their targets. Advocates of fundamental investing have been expecting this for a while.
Commentators have talked about the risks of QE for a decade. But as we have so far escaped severe consequences – if we put aside the excessive boom in property prices and resultant inequality – people have become comfortable. The markets expect the Fed to always step in and help them, but one day we may wake up to a significant correction.
The important question for investors is what they can do to minimise risk. I would suggest that you first examine your equity portfolio for allocations to sectors and securities with excessively high valuations. Second, identify areas with attractive fundamentals. In short, take your profits and redeploy them in sectors where there is a solid investment case regardless of QE.
We also need to acknowledge that there's an overreliance on US equities. Valuations are at an all-time high and it is questionable how much further they can run. Non-US equities have not kept up, largely because other central banks have not pursued QE as aggressively, so it makes sense to diversify internationally. There's a massive opportunity in China, especially in the retail sector. Investors simply cannot ignore its scale and the recent market correction may present a buying opportunity.
Likewise, there is a wide gap between the huge valuations of growth and value stocks. Tech sector growth stocks have done spectacularly well during the pandemic, but can this continue? By comparison, some high-dividend value stocks appear attractive and surely have more room to run. Likewise, financials are making record profits but stock prices have not gone up commensurately; they also tend to make more money from lending when rates go up.
Small cap valuations have also not increased as quickly as one would expect during a period of such strong economic growth. Travel and hospitality stocks have been on a wild ride, alternating between optimism that latent demand for holidays will spring into life to pessimism about new variants of Covid-19 destroying business. Low valuations must of course be coupled with strong fundamentals; there are plenty of reasons for a bad stock to lose favour.
As QE enters its troublesome teenage years, investors would do well to remember some old-fashioned lessons. Diversification is always your friend, and it is essential to understand the fundamentals of anything you invest in.
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