Investment Newsletter July 2017
Interes-tin anniversary
Mike Deverell Investment Manager
The 5th July 2017 saw an unusual milestone for the Bank of England.
and US rates also remained at near zero until very recently.
A decade earlier, the Bank had announced that interest rates would increase from 5.5% to 5.75% following their most recent Monetary Policy Committee (MPC) meeting. Incredibly, July 2007 was the last time the official UK base rate went up, meaning rates have just celebrated their 10th anniversary, traditionally symbolised by tin, of no increases. This means there are many relatively experienced financial services professionals who have never experienced a rate rise in their entire career!
Those low rates were designed to help the global economy recover from the near collapse of the financial system in 2008. Low rates are meant to work by stimulating borrowing and discouraging excess savings. However, even this was not enough stimulus and since then various central banks have also carried out vast amounts of quantitative easing (QE).
As we know, the following year saw the financial crisis and rates were reduced down to the then record of 0.5% in late 2008. Other central banks followed suit
A decade since the last rate rise and the Bank is now seriously considering putting rates back up. At the last meeting of the MPC four of the nine members voted to increase rates from the 0.25% level they have been since just after the EU referendum, back up to 0.5%.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter July 2017
How QE works
In itself this is not particularly significant. However, it coincided with hints from several other central banks that they might also begin to withdraw monetary stimulus. The European Central Bank (ECB) is likely to
slow down its quantitative easing programme in the relatively near future, whilst the US Federal Reserve may essentially start unwinding theirs.
To understand how this could affect the financial markets it is worth reminding ourselves how QE works.
cash elsewhere, often in corporate bonds or equities. This pushes up the price of those assets too.
QE involves a central bank electronically “printing� money which they then use to go out and buy government bonds on the open market. As there is a new buyer purchasing bonds in massive quantities, this pushes up the price of the bonds.
Chart 1 shows how the size of the balance sheet of three of the biggest central banks has changed over the past decade. The US Federal Reserve stopped carrying out quantitative easing in 2014 and so their balance sheet, in essence the total value of the bonds they hold, has held steady since then.
Because bonds pay a fixed level of interest in monetary terms, when the price increases the yield falls in percentage terms. This is meant to help reduce borrowing costs since typically mortgages and long term borrowing for companies are priced relative to long dated bond yields. This is an extension of how low interest rates are designed to stimulate the economy.
However, the Bank of Japan and the ECB have picked up where they have left off and both those central banks now hold more assets than the US Federal Reserve. This is quite incredible when you consider the respective size of their economies. Around $1.5 trillion US dollars of bonds have been bought by central banks in 2017 alone.
QE is also meant to stimulate the real economy in other ways. For example, if an investor has sold their bond to a central bank at an inflated price, they now have cash that they could go out and spend. However, this mechanism is quite limited in its effect on the economy since most investors simply reinvested this
Chart 1:
Source: Haver Analytics
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter July 2017
What happens when QE stops?
Given the amount of bonds purchased it’s no wonder that fixed interest markets have done so well, and that this has in turn helped fuel the stockmarket.
sheet will shrink and money will effectively be withdrawn from the system. This is essentially a reversal of QE.
Considering the vast amounts involved, it is natural to start asking, what happens when QE stops? What happens if it is unwound?
Chart 2 shows when the bonds held by the Fed will mature. There are over $120bn which mature this year and a further $420bn or so which mature next year. What happens if the Fed decides not to reinvest that $540bn over the next 18 months?
Unfortunately nobody can really answer that question! In essence it probably depends on the strength of the global economy at the time. If QE acts like a rate cut in many ways, then reversing QE can be thought of as similar to a rate rise. Whilst nobody is officially talking about reversing QE just yet, the Federal Reserve are considering stopping reinvestments. Even though the Fed stopped their QE programme in 2014 many of the bonds they bought have matured in the interim period. In order to keep their balance sheet at a steady level they have therefore reinvested the money from those maturities. This means that, even though the Fed’s QE stopped three years ago, they have carried on buying bonds to replace those that have matured.
Given that QE has been a fairly inefficient stimulant to the real economy, it may be that the direct effect on economic growth would be relatively low. However, the relationship between QE and asset markets has been much more direct. At the end of the day asset prices are influenced by how many people are buying and selling and what price they are willing to pay. If a large buyer withdraws from the market this may have a substantial effect on prices. Investors will therefore need to be watching such developments carefully and stand ready to act to protect their portfolios.
If they stop reinvesting as bonds mature but instead “cancel” the money they receive, then their balance
Chart 2:
Agency MBS
US Treasuries, FRNs, Linkers and Agency debt
Source: Bloomberg/Investment Management
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter July 2017
General Economic Overview The global economy continues to grow. That said, some recent economic data out of the US and the UK has been disappointing. In particular, high inflation in the UK caused by the fall in Sterling is starting to hit disposable incomes. Many central banks are considering tightening monetary policy whether through interest rate rises or changes to quantitative easing. However, global inflationary forces have waned somewhat with a fall in the oil price and delays in US President Trump’s spending and taxation plans. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets Our score is unchanged from last month as we continue to believe that many equity markets are fully or over-valued. In relative terms, our valuation indicators point to better value in markets like Asia including Japan.
-5
Fixed Interest The score is slightly lower than last month with the risk of higher interest rates. We generally prefer corporate bond to government bonds and are positioned towards bonds which have low sensitivity to interest rate movements. We hold some index linked gilts as a hedge against further falls in sterling.
-4
Commercial Property The current growth in the UK economy would indicate it unlikely we will see capital values increase, however rental yields remain ok. Brexit raises particular issues for the London office market and we are therefore avoiding this part of the market.
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
-4 -5
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest and equity, and hold only a small amount of property. This is balanced by additional holdings in defined returns, alternative equity and tactical cash.
A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for residential property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5% means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall.
These represent Equilibrium’s collective views. The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser. Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.