How to invest in a post-QE world? According to John Stopford, Head of Multi-Asset Income at Investec Asset Management, investors may be concerned about how different asset classes are going to react when the effects of the quantitative tightening begin to be felt. “Ten years ago, the global financial crisis hit, and the central banks responded by flooding the system with liquidity. Markets have been a rush ever since. Investor did not have to think too hard about what they owned. All asset classes have gone up. But what would happen when quantitative easing begins to turn and unwind? Is there a risk that bonds and equities will sell-off together? The answer is probably yes,” explained Stopford.  

“Most of us got used to an investment world where movements in the US equity market were negative correlated to movements in US bond market. This has been the norm for the last 20 years or so. But, from 1984 to 1998, the correlation between the S&P 500 Index and the US 10 Year Future was positive. During that period, bonds and equities went up and down together. Investors need to understand that if there is a common driver that pushes both bonds and equities in the same direction, then both will tend to have a positive correlation behavior. In this decade, the common driver has been the monetary stimulus, that essentially pushed all the assets up. Investors need now to be more selective and look for mispriced assets rather than assuming that owing big pockets of beta is going to win the day”, he continued.     

In developed markets bonds there are some areas that are starting to look more attractive and are more likely to offer at least some protection if equities sell-off. “Essentially, it is about valuation and finding government bond markets with reasonable yields in real and nominal terms. We are beginning to find some value in government bond markets in US, Australia, New Zealand and Canada, where central banks have begun to tighten or already have tighter interest rates. The Fed’s tightening is being felt mostly elsewhere rather than in the US, which is dangerous because it allows the Fed to fall into a false sense of security and continue to ratchet monetary policy tighter”.

The Fed usually tightens until something breaks

In the past, the Federal Reserve has typically tightened interest rates until they reach a point in which they have tightened too much. This point is usually when the yield curve gets inverted. “The Fed looks at the US economy, which is booming, they look at US inflation, that is in line with target inflation, they look at unemployment, that at 3,9% is well below the sustainable rate of unemployment and they decide to go tightening. Meanwhile, the pressure is happening outside the US, for example in Turkey and Argentina. Emerging markets are beginning to feel the pressure of the liquidity tightening, but as long it is not yet impacting in the US, there is nothing that will stop the Fed from carrying on,” he stated.

Over the next year, investors should not be worried about a recession. Typically the latest stages of an economic expansion in a bull market are very rewarding. By the second half of 2020 though, the market outlook may get more complicated.

“Now, the Fed is tightening interest rates and they may be the cause of a bear market. But other central banks have just started tapering their quantitative easing programs. They are tightening liquidity, but they are not rising rates yet. They are not giving themselves ammunition to fight the next battle. In the typical recession, central banks cut rates by 4% to 5%. What are central banks going to do now? The one-month deposit rate in Europe is still negative and the European Central Bank is talking about raising rates after the summer of 2019. If a recession may hit in 2020, how high will be European rates by then? Meanwhile Japan is still pursuing quantitative easing but tapering a bit. There is a big question mark about what policy makers are going to do. In the past, they came out with creative ways of adding liquidity, but there will be less ammunition to fight the next crisis”.  

Regarding credit vulnerability and the rising uncertainty in the markets, Stopford believes that the risk premiums are compressed at this point in the cycle, but this is something that it is beginning to change. “The yield premium offered by the US High Yield in terms of spreads, a compensation for credit uncertainty, and the equity volatility measure of VIX have typically moved together. But due to the higher level of uncertainty, it seems that they may decouple a bit. Equity volatility is going to remain suppressed for much longer and credit spreads will start to increase as the market is beginning to worry more and more about future defaults.  

A challenging environment makes selectivity crucial

The US dollar remains the world reserve currency, even if there are some currencies like the renminbi, the euro or the sterling pound that are candidates to become reserve currencies, but they all have some flaws. “The dollar remains the principal world currency. Trade is still around 80% denominated in dollars. It is not surprising that the US remains the most liquid capital market and it is the place where borrowers go if they want to borrow. The quantitative easing has facilitated an explosion in debt outside the US denominated in dollars. The problem is that dollar funding conditions are now tightening, and lot of that monies are just stock in the US because that is where the economic growth is and where the returns are. Borrowers finance themselves through global trade. When the global economy is expanding, borrowers that are earning dollar revenues can service their debt tend to have excess of dollars at that point and diversify their investments, generating reserves and putting downward pressure on the dollar. On the contrary, when global trade goes into recession, there is a shortage of dollar revenues, dollars are used to fund borrowings and the price of the dollar goes up. By now, global trade is under pressure, with new protective policies and tariffs.”

On the other hand, the Japanese yen is easily the cheapest developed market currency in the world. “Japan has been running an aggressive quantitative program for some time. Japan is essentially a capital exporter. The Japanese have excess of savings and they tend to send those excess savings to other markets to earn a return. When they hit a crisis, they stop sending their capital abroad, therefore, the yen tends to have very good defensive characteristics. If equity markets collapse, Japanese investors temporarily become more cautious and the yen will tend to go up. We need to think more cleverly about how to diversify investors exposure in the current environment”, he concluded.