How QE is changing the way investors behave

QE has led to risk being mis-priced. But for how much longer?

How QE is changing the way investors behave

For the last month or two, markets have been reacting to Mario Draghi’s somewhat expected announcement of Quantitative Easing (QE) in Europe. Whilst it’s too soon to judge how effective it has been in achieving its ultimate goals, one thing is certain: QE is changing the investment landscape.

At first glance, this doesn’t seem like a very striking observation: when QE was initially launched, many predicted this. In fact, it’s what QE was designed to do – that is, restore confidence and change economic behaviour. A frail banking system is a threat to both citizens and businesses and leads to everyone battening down the hatches. Yet whilst the lift in business confidence and equity price levels was expected, the long game is very uncertain. We’ve never in history seen such a significant and prolonged monetary stimulus. We are in uncharted waters and our saviours are out of lifeboats!

At the start of QE in the UK and US some schools of thought voiced fears of the expanded money supply triggering runaway inflation. Those of a Keynesian ilk suggested QE was not only helpful but urgent and necessary to restore confidence. It’s clear that in the case of the UK and the US, QE did prevent a lengthy recession if not a depression. In the case of Europe, I would argue that QE is very late but most necessary; and the austerity that has been applied so far has been harmful.

So how does all this affect investor behaviour? The answer is a fundamental shift in the return characteristics of certain asset classes. In particular I refer to government bonds, corporate bonds and hedge funds. We’re living in an era of financial repression. This is when interest rates for savers are kept below the level of inflation to allow banks to provide cheap capital to businesses and individuals. It also reduces the cost of the government’s own debt.

Financial repression

Financial repression makes it much harder to generate income from a set stock of capital. It changes all the assumptions used when making investment and savings projections. QE floods the system with liquidity. That liquidity drives down the (forward looking) return on all assets (by driving up the price). That means one thing: retirement income falls short of expectations. At the same time, medical science and biotech are finding ways to make us live longer.

The investor community is responding to this tension by drifting further up the risk curve. In order to provide the expected levels of return for clients, professional investors are forced to produce that return or find oblivion. That generates a dangerous form of short-termism where a large professional class of investors chase the same assets because everyone else is chasing them: not to do so risks making them lose out on the run. But everyone knows the run is QE driven and by definition temporary. It creates the conditions for an overreach and a severe correction. We’ve seen this in both equities and corporate bonds of late.

This shift in focus leads the investor community to make purely tactical investment decisions based on second guessing policy makers and other market participants rather than on economic fundamentals. This paradigm shift created many new risks in the system.

QE habit

It was widely understood from the start that QE by itself could only act as a temporary relief to the economic difficulties we are suffering from. It could not be a long term solution. It was designed to give policy makers some breathing space to implement necessary structural economic reforms. But this risks being superseded by a sense that QE is the ‘new normal’: it is something investors are becoming reliant on in ever increasing doses to achieve their returns.

But if people are concerned about how QE is affecting the markets in worrying ways, they are also alarmed at what might happen if the engine comes juddering to a halt. What if QE is suddenly withdrawn from a dependant market? We saw what happened when the Fed first tried to start ‘tapering off’ QE in the US. This scenario is known as the ‘sudden stop’: the most likely outcome would be an aggressive re-pricing of equities, as the current QE induced boom comes tumbling down. Equities are normally high risk high return assets but the current fragility of the system is raising that risk while reducing the potential return.

Risk mispriced

Those in the know are uneasy with this new reality. The plain, unvarnished reality is that low-risk assets are no longer low-risk, while high-risk assets pose a greater risk than ever.

Savings rates need to be higher but middle class incomes have stagnated for decades. There are no easy solutions to this. In my opinion, retail investors would be well advised to focus on their capacity for loss, and to keep their investment time horizons firmly in mind.

There’s never been a more important time to have an open and honest relationship with a trusted financial adviser.

 

Learn more

If you’d like to learn more, read: European QE: why it can’t work

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Categories: Viewpoint
Tags: Risk

About Author

Mike Abbott

Mike Abbott is Head of Sable Wealth, which offers financial planning, mortgage, tax and investment advice to London-based clients who have an international aspect to their situation.