There have been global meltdowns in the markets in the past, and there will undoubtedly be more in the future. When in the future is anybody’s guess, but there are some worrying signs that it could be a lot sooner than you might wish.
Over recent years we have seen quantitative easing in a number of advanced economies, including the US, Japan, Eurozone Europe and the UK. According to the Central Banks and Governments of those countries using quantitative easing, it is a useful monetary policy tool, leading to increased private sector spending and reduced inflation. But according to critics it is a way of penalizing savers and particularly pension funds, and overheating the economy. If those critics are right, and if we have not properly prepared for this, it could have detrimental consequences for our investment clients and our practices.
You are probably already aware of what quantitative easing is, but just in case you would like a refresher it is a way for Central Banks to increase the money supply, usually by buying long term gilts from commercial banks. Sometimes shares may also be purchased as a part of a quantitative easing strategy. The intention of the strategy is for the banks who receive this additional money to lend it out to local businesses, who will therefore expand and improve the economy.
According to the law of supply and demand, increased demand for a limited supply of anything should increase its price. When a Central Bank starts buying up gilts, and the Government is not at the same time increasing the supply of those gilts, this means the price of the gilts should rise. The rise in the price is more or less an inevitable consequence of the quantitative easing strategy.Almost by definition, therefore, we have an overheated bond market if you measure the market by capital value rather than yield.
If investors feel bonds are overvalued, they will tend to buy more shares. A secondary consequence of a prolonged quantitative easing strategy can therefore also be an overheated equities market.This leads to the wrong signals in the markets, and also to a certain degree an unnatural positive correlation between bond and equity prices. When this happens it can effect asset allocation strategies.
When investments are too highly valued you can, at some point, expect a correction. If bond and equity prices are both too high, the resulting correction could be quite significant. Central banks using quantitative easing have made it quite clear that they will reverse the policy by selling bonds back into the market when there are signs the economy has recovered. This means a correction in the bond market is extremely likely. The same goes for equities if the new money injected by the quantitative easing policy has resulted in an overheated shares market, unless in the meantime the intended effect on the economy has at least caused underlying values to catch up with equity prices. We don’t know when this may occur. It could be years from now or just days. But there are signs it is more likely to be earlier than later.
When the central banks of a number of major economies are all using quantitative easing to stimulate those economies this can hide many of the underlying economic problems. Those problems are often still there, but investors believe they no longer are. They haven’t been fixed, just camouflaged by the effects of quantitative easing. Again, this can result in inflated values on the stockmarkets, which in turn can result in significant corrections.
All of this suggests we may be due for quite a major correction in the US, Eurozone, Japan and UK markets. This will have a serious impact on any investment funds focussed on those markets, which could soon have our clients knocking on our doors asking why their pension and investment fund values have dropped so far. Advisers relying on income from money under management could be facing some very hard times as a direct consequence.
The only real questions are when, by how much, and what effect is this likely to have on your practice?