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Turning the QT tap. Gently does it!

QT TAP

Who would have thought it? ‘The value of investments may go down as well as up’!

If nothing else, 2018 served up a reality check. The eerily benign volatility environment we enjoyed over a sustained period came to an abrupt end last year. Just twelve months ago the buzz words exciting investors were ‘synchronised growth’. In 2019, after 90% of asset classes delivered negative returns over last calendar year and the best performing asset class was cash, one of those words has changed. The new, less appealing phrase is ‘synchronised slowdown’. So what’s leading to this and what is the market fearing?

Valuation, liquidity or sentiment?

Anyone that has attended one of our’s adviser CPD events will recognise the diagram below. It’s a handy way to think of the interplay between factors setting prices in investment markets, and to answer that question, what is the market fearing, one of these three points is a good place to start… Liquidity.

No party goes on forever

Central banks around the globe accumulated $15 trillion of debt taking policy action to counter the global financial crisis. Nearly all asset classes, except for cash, have been beneficiaries of falling interest rates, the result of generous helpings of liquidity. However, no party goes on forever and this one has definitely peaked. The US is already well into QT (Quantitative Tightening) mode which is simply the opposite of QE (Quantitative Easing). Rather than reinvesting the proceeds of maturing bond holdings into the market, the central banker lets them mature, removes money from the financial system and shrinks their own balance sheet.

While no other central bank apart from the Fed has begun to unwind (Bank of Japan continues to buy) the diagram below indicates how the path ahead is going to differ greatly from the path we have been on.

Bearing in mind only the Federal Reserve was in unwind mode in 2018 the implications of these numbers are compelling. The G3 (US, Europe & Japan) central bank balance sheets shrunk by $92bn in the first nine months of 2018. In the same period of 2017 they had increased by $1.7trn. So while the absolute reduction in 2018 was not huge, coupled with the much slower pace of buying elsewhere, it has created a liquidity withdrawal of $1.8trn, to all intents and purposes, money vanishing from markets. That rate of reduction is only going to quicken, since the European Central Bank concluded its bond buying programme, in December 2018.

The great QE experiment

QE was a major experiment and no one at its beginning could say they could confidently call the outcome. As it turns out, from a returns perspective, the outcome has been a very positive one. The lowering of interest rates prolonged the bond bull market beyond the 30 year mark. It has been equally supportive to riskier asset classes such as equities. One of the only asset classes to really struggle has been cash due to negative real returns after inflation. But that was the whole idea, to get people out of cash, into the shops or into investment at risk.

Gently does it!

As the QE party comes to an end, the role of central bankers has never been more important. Intuitively you would assume anything which benefited from QE will be negatively affected by QT. The key will be the pace of change. All the trillions of liquidity injected into the market is not going to disappear overnight. There is plenty of liquidity to support global markets and there will be for some time to come.

…just because someone tells you they are going to punch you in the face, it doesn’t mean it will hurt any less!

There is no doubt, the Fed and other central banks have a difficult job on their hands. For certain, QT is going to alter the return profile of different asset classes from fixed interest to equities moving forward. So long as central bankers are skilful in their approach it won’t mean Armageddon. They will use ‘forward guidance’ to lead the market in the direction they need to follow. However, just because someone tells you they are going to punch you in the face, it doesn’t mean it will hurt any less! Forward guidance alone will not be enough. They must also be nimble, dynamic and reactive as necessary. We have already seen Jerome Powell Chairman of the US Federal Reserve provide an example of this. He altered his tone on interest rates in response to market overreaction. And QT isn’t a nuclear button which once pressed cannot be cancelled. Central bankers keep their hands on the wheel and are tasked with navigating markets safely through the journey.

The value of investments may go down as well as up

As we found out last year, ‘the value of investments may go down as well as up’ and for clients investing over the long term, in the right Risk Grade portfolio, that will not be a surprise. But after many years of easy money, it is worth checking risk tolerance, against historic volatility and the max 12 month gain and loss analysis. PIM provide this for all our solutions and it has just been updated for the 20 year data to the end of 2018. While, as we have seen, the short-term dynamics in markets have changed decisively, the long run risk/reward relationships have changed little, a point to help lift investor sentiment, even as the liquidity tap is being turned ever tighter.



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