Written By: William Bourne
William Bourne discusses the potential changes to quantitative easing that can soon be expected and the implications for asset allocation
Since the dislocations of 2008, the main policy setting for central banks has been to “print” money by providing plentiful liquidity to the banking system, colloquially known as QE. In the aftermath of the financial crisis, the authorities’ first priority was to prevent at all costs the implosion of the global financial system. Central banks genuinely believed that it was also the best way of achieving the growth the world needed: through the multiplier effect a dollar in the banking system meant several dollars in the real economy.
With hindsight we can see that they succeeded in the first of these objectives, but not in the second. The multiplier simply failed to operate because banks have been reluctant to lend, and corporates have not needed to borrow when marginal returns on new investment are low. Part of this phenomenon has been the unintended consequences of well-intentioned regulators, in particular Basel II and Basel III, who have made it increasingly expensive for banks to engage in their traditional activity of lending.
It is clear in 2016 that the policies of the last seven years of quantitative easing (QE) and fiscal virtue have run their course. The G7 GDP growth rate in 2015 was 1.8% and inflation 0.25%, not numbers that allow the West to grow or inflate its way out of its indebtedness. To make headway here a change in policy setting will be required, one which focuses as much on a higher level of inflation as growth. It will certainly involve putting money directly into the economy rather than via the banks, whether through fiscal or monetary actions.
Over the past 18 months, there are encouraging signs that central banks recognise this. The US has abstained from QE since 2013. In Japan the planned consumption tax rise was shelved in June 2016, and recently re-elected Prime Minister Abe shows every sign of turning to a more active fiscal policy. Even the former chancellor George Osborne had hinted at a change. There also seems to have been some agreement at the G20 meeting in February whereby the US dollar would be left to depreciate while the People’s Bank of China (PBoC) would actively reinflate its balance sheet. The US$ has certainly been weaker since then, while the jury is still out on the PBoC balance sheet.
What does this mean for markets? Over the last 25 years, shorting bonds has been a loser’s game. One commentator1 on the Japanese markets calls it “The Widowmaker” because so many investors have lost their shirts over the years by betting against Japanese Government Bonds. More recently, the same has been true of bonds globally, so that we now have long-dated UK index linked Gilts trading at real yields of -1.5% and many countries where nominal yields are negative.
These levels are by some way the lowest in recorded history, and are unjustifiable on long-term fundamental grounds. For example, it can only be right to buy a German 30-year bond on a nominal yield of 0.5% either because you wish to match a future cashflow, and are willing to pay the opportunity cost for the certainty, or because you are a trader and believe that a greater fool will take them off you at an even higher price in the future.
Term premia2 are at all-time lows for the US market, standing at -140bps on a 10-year bond. Translated, that means that investors are willing to shoulder this opportunity cost in return for the certainty of a 10-year bond. Term premia did not matter when bond yields were at 5%, because they were relatively unimportant compared to changes in inflation expectations or real yields. Today, however, with 10-year bond yields hovering around 0-1%, they are the key driver of bond price movements.
But change needs a catalyst, and however poor value bonds may be today, investors have always tended to look at the rear-view mirror. The major change in macro-economic policy on a global level outlined above will in my view be that catalyst. Prior to the Brexit vote, I had expected the UK to be a laggard, because of Osborne’s commitment to austerity and a fiscal surplus by 2020. Under a new chancellor, with the need to support the economy while the details of Brexit are negotiated, there are signs that the UK may instead be a leader.
Let me explore this in more detail. The Treasury has put in place a plan for over £400 billion of infrastructure spending over the next five years. We know that the Treasury has been keen to find funding for some of this from local authority pension funds. However, there is an identifiable mismatch between the green field infrastructure projects such as HS2 which the Treasury has in mind, which involve construction and commercial risks and the lower risk annuity-like cash flows which pension funds for the most part seek.
The solution ought to be simple: the government should either finance the construction phase itself, which it can do unprecedentedly cheaply using Gilts, or find a way to lay off the construction risk. Once the project is built, it can then be sold on to or refinanced by pension funds. When I put this to a Treasury minister at a pre-Brexit conference on infrastructure, his response in effect was that the “austerity” rules put in place by the Chancellor made it impossible.
Under a May government and with Brexit looming, that could and should all change. Either by taking the major construction risks on their own shoulders or by financing it with government-backed paper, and at the same time designing the financial structure of projects so that they are attractive to annuity-seekers, the Treasury can meet a number of objectives in one go. Its infrastructure programme will be funded, money will go into the real economy via the workforce building the projects, and pension funds will in time have access to secure inflation-linked annuity streams yielding more than Gilts to match their liabilities. And of course there is a stand-out precedent – President Roosevelt’s New Deal in response to the Great Depression in the 1930s.
Other countries will have different priorities, but the point is that QE version 2009-2015 is finished, and round the world future QE will look very different. When this happens, it will have the positive effect of normalising bond yields in due course, and possibly sooner than expected. Higher yields will result not so much from a fall in the government’s credit rating due to a higher level of debt. Rather it will be investors’ gradual appreciation that unlike in 2008 the indebtedness is now in public rather than private hands. It is always easier and more tempting for governments to try and inflate debt away, whereas the private sector tends either to work its way out or to default.
As historic examples of this, Britain in the 1970s was a case of publicly-owned debt leading to inflation, whereas Japan in the 1990s was privately-owned debt leading to deflation. Today, governments in one way or another have assumed much of the private debt which was exposed in the financial crisis, and we can expect inflation inch by inch to creep up on the world.
Those with their eyes in the rear-view mirror will ask questions. They may point to the undoubted regulatory pressures on pension funds to “de-risk” by investing in bonds almost regardless of their value, or ask what the catalyst will be for inflation, bearing in mind the surplus of labour and spare capacity in many industries. They are probably looking in the wrong direction: higher bond yields will come from higher inflation expectations, which in turn will be driven by the fact that western governments need it to deal with their debt. Sceptics may also turn to the argument that bond-market vigilantes will prevent governments assuming more debt. However, with the need to get bond yields higher now universally recognised, the vigilantes will find their weapons no longer have any effect.
A much looser fiscal policy or new kind of QE is not negative for equities, but there will be winners and losers. One particular highlight may be that the high quality dividend-paying defensive shares which pension funds have bought as substitutes for government bonds will underperform as funds switch back into bonds yielding more “normal” levels of income. Conversely, after a number of years of underperformance by value stocks, we can expect to see them gradually start to outperform.
In summary, pension funds of all colours should prepare themselves for the next major turn in the road, which will involve a different kind of QE and substantial implications for asset allocation generally, and LDI based strategies in particular.
1. Peter Tasker “The Widowmaker’s message: bring an end to austerity” www.petertasker.asia
2. The extra return required for investing in a 10-year bond rather than rolling over a 1-year bond 10 times