In order to provide liquidity in the financial markets in the wake of the 2008 global financial crisis and subsequent meltdowns, major central banks around the world adopted dramatic programs of quantitative easing: Purchasing government securities and lowering interest rates with the goal of reversing the downturn in gross domestic product growth.
Now some six-plus years later, the U.S. Federal Reserve has ended its QE program and begun, albeit slightly and slowly, the process of raising interest rates. While economists and market observers may debate the effectiveness and magnitude of the Fed’s QE programs, there is little doubt that capital markets have been generally favorable and investors have been rewarded for risk taking during this period.
We are now, however, faced with an unknown: After an historic financial meltdown and an equally historic application of monetary stimulus, will the risk/reward scenario continue for investors, or was QE just a temporary inflation of capital markets?
As of this point in 2016, investors have been battered and bruised by a constant series of volatile swings and it is important to assess the longer-term implications of the end of QE for financial markets. In order to do so, there are several factors to be considered.
QE’s effectiveness is through adding a large amount of cash into the system. If this created favorable capital market momentum and there is no new cash, where will the forward momentum come from? Will central banks introduce new measures to encourage lending and spending, two areas that have not rebounded to the extent expected?
QE has been a global phenomenon with central bank policies diverging only recently with the cessation of the U.S.’s version. Given these policies are designed to stimulate and only end when economic improvement is viewed as sufficient, a cessation of global QE may signal a fundamentally sound economic environment that would allow markets to advance, and decline, more naturally.
Markets respond not only to factors such as economic conditions or fundamentals, but also to market psychology and buying/selling behavior. Acts of terrorism, the conditions in the Middle East, and a divisive presidential campaign can, certainly in the shorter term, be every bit as impactful in terms of investor sentiment than the pace of GDP growth or data regarding unemployment or the price of oil. Clearly, QE has had an added effect of providing a backdrop of psychological support with expressions such as that from the head of the European Central Bank, Mario Draghi, who famously said they would do “whatever it takes.”
A key and difficult to predict variable is the rate of inflation. Historically, high rates of inflation have given rise to economic uncertainty making corporate planning difficult. Generally, rapidly increasing and higher levels of inflation have led to diminished returns from equity markets. The very low levels of inflation currently creates competing influences as little demand driven pricing power indicates a slow growth environment, yet very little concern for a potential overheating that could create greater uncertainty. Much like the story of "Goldilocks and the Three Bears," inflation should not be too hot or too cold so that markets can comfortably dine on a bowl of porridge that is just right.
As these variables are assessed observers will have varied views and opinions, yet there is no doubt that the global economy is entering uncharted seas with the potential for a continued sell-off in equity markets, a return to a more bullish environment, or simply a volatile course to longer term lower returns across most capital market options.
In periods of uncertainty, those overseeing or managing portfolios should be aware of key elements that are likely to influence their investments and understand their own level of sensitivity to changes in these factors.
- The effect of higher interest rates: All else equal, consumers would see their discretionary income erode as they address higher debt repayments. Savers including pensioners would benefit as they receive greater interest income. Higher rates are likely a positive for pension plans, as liabilities would be valued using a higher discount rate assumption than is currently used, resulting in lower pension plan maintenance costs. The speed and magnitude of rate increases is an unknown and will play an important role in terms of impact for each investor.
- Whither Inflation? As previously stated, inflation has remained low in much of the world. Anemic global growth is one factor, along with the declining velocity of money, as corporations and consumers accumulate cash rather than make investments in infrastructure or purchase goods and services respectively, helping to keep inflation from rising. However, inflation can increase quickly from unforeseen events such as adverse supply shocks, or by jumps in new demand. If inflation spikes quickly, central banks may be forced to implement policies that would be designed to curb economic growth.
- What is your tolerance for risk? Can you or your governing body tolerate a major market decline? Investors should always remember that the value of a portfolio is a snapshot in time and not a guaranteed level of future worth. It cannot necessarily be liquidated at the same market value quickly and the portfolio value can change dramatically should a crisis arise. It may be prudent for any investment professional, trustee, fiduciary, or agent involved to have a plan of action or an approach to managing such events. This can remove part of the emotional decision-making that can arise when global conditions turn negative.
Although most investors have enjoyed the fruits of favorable equity markets during the last several years, with the most noticeable exception of the last nine months, this has occurred while economic conditions have continued to be weak at best. It is important now that investors review their strategies with the following considerations in mind:
Equity strategies: Given that there are concerns of a continued equity markets sell-off, are there equity strategies to possibly mitigate the risk? Are dividend strategies or other factor-tilting solutions a better risk-adjusted approach for the portfolio? But this last question presupposes that such approaches outperform equities in general and that some could help cushion losses in a decline? Should one pare back exposure to equities? And if so, what is the appropriate trigger for reinvestment?
Fixed-Income Strategies: Many strategies have been positioned with an expectation of slow, but generally rising interest rates. While this may be beneficial if this forecast is accurate over the long term, in the nearer term it can significantly limit returns. Carefully considering “core plus” and credit driven strategies may help. In addition, in areas such as mortgages, while still aligned with fixed income in general, this can help mitigate some of the impact of rising rates.
Absolute return strategies: Are there other investment solutions available that may not necessarily track the indices at the same pace to the upside, but provide attractive capital preservation features in a downturn? This pertains not only to equity investment but also to fixed-income solutions. An attractive possible solution includes the growing number of choices within the category of multi-asset class strategies that seek to limit losses while generating returns through directional and non-directional allocations.
Alternative investments: In the pursuit of higher returns or for reasons of diversification, many investors have focused on alternative investments. However, alternative investments have also enjoyed strong cash inflows, especially in private equity. Have they become overvalued, or is there still fair upside potential in the alternative space? Hedge funds have struggled against traditional equity markets in the post financial crisis bull period and, in many cases, have not fared well during the most recent decline. There may be a cyclical shift away from hedge funds, as fees for certain strategies may be too high relative to the performance provided, but there are still opportunities available in this space.
In addition to these specific considerations, investors are encouraged to review their overall asset mix. This can be vital in assessing whether the total portfolio is assuming risks that are unlikely to be rewarded in the future. In times such as these, stress testing and related analysis can be a valuable tool to best understand how investments will react under differing conditions. The relative calm and securities appreciation encouraged by global QE appears to have ended. The recent volatility could represent the beginning of a rapid change in trend especially as other QE programs may cease in the future. It is therefore imperative investors be vigilant in understanding their financial risks and how these risks should be addressed in order to provide a more effective portfolio that serves its fundamental purposes and constituencies.
Joe Cerullo is a senior consultant at Segal Rogerscasey.
