Quantitative easing (QE) and its ramifications have not been among the top financial headlines in recent months, aside from the occasional news report about monthly meetings held by the European Central Bank and the Bank of England – institutions that are still buying bonds with newly created money. I can detect you yawning already, because this is pretty dry stuff. But bear with me, for the QE story is far from reaching its final chapter. There remain some interesting plot lines to explore, with potentially far-reaching consequences for savers, investors and property owners.
Let’s first remind ourselves what QE was designed to achieve and where we are today, a little more than eight years after it was launched by the US Federal Reserve and then other central banks to help avert a global depression following the financial crisis.
In theory QE should work something like this. A central bank creates money to buy bonds from financial institutions, which reduces interest rates, leading business and people to borrow more, so they in turn spend more and create jobs to boost the economy.
Since the financial crisis erupted, nearly $13 trillion has been created by central banks to buy government and corporate bonds. Like me, you may struggle to understand what that figure means in the real world (bearing in mind that this new money wasn’t actually printed, it was created electronically). It is the number 13 followed by 12 zeros. In real terms it represents about 70 per cent of annual US economic output.
QE continues to be implemented globally to the tune of around $200 billion a month. In the UK, the BoE started a fresh round of bond-buying soon after the EU referendum, amounting to £60 billion in government bonds and £10 billion in corporate bonds. The BoE programme has a further 12 months to run.
Since the financial crisis, $13 trillion of money has been created.
In the Eurozone the ECB has extended its bond-buying program until December at least, but is reducing its monthly purchases from €80 billion to €60 billion from April. So far it has bought €1.5 trillion (£1.3 trillion).
Meanwhile, the Bank of Japan has an open-ended commitment to buy Japanese government bonds (JGBs). This is part of the government’s strategy to end decades of disinflation and low domestic consumption. The BoJ’s task in this respect is to ensure that yields on 10-year Japanese government bonds don’t rise much above 0 per cent. Briefly, the QE idea in Japan is that a zero or negative return from JGBs encourages savers and investors to look elsewhere for returns and boost economic growth in the process. The BoJ’s recent annual expenditure on JGBs amounts to ¥80 trillion (£570 billion).
These are mind-boggling sums of money that have turned conventional investment thinking on its head. Tried and tested concepts such as value-based investing have been supplanted by momentum, which has been primarily upward. Indeed, barring a few hiccups, since it was first introduced QE has provided owners of bonds, equities and property with a regular free lunch.
In its simplest terms QE has, on the surface, succeeded in boosting economies around the world, although not by as much as had been hoped. Lending is up: in the UK consumers are more indebted than ever before according to BoE figures, but the collective ability to service debt is underpinned only by zero-bound interest rates. To some extent that is also true for homeowners taking on a mortgage. But rocketing property prices come at a social and economic cost: affordability, as measured by the average house price-to-earnings ratio reading of 5.81, is at its most stretched since August 2007, according to Halifax. In cities in the south of the country, the affordability ratio is higher than 10 according to Lloyds Bank, with Oxford recording the highest reading of 10.7, closely followed by London and Winchester at 10.5.
QE has helped finance directors to engineer a false sense of corporate health.
Price growth is beginning to cool, but affordability is not likely to get any easier: although there has been some wage growth over the past year, it is unlikely to match the rise in inflation. Growth in the retail price index is widely expected to exceed 4 per cent in 2017 and 2018.
In the UK and globally, demands for wage increases to exceed or at least match inflation will be fiercely resisted by governments and companies. The need for governments to service rising debt and persistent deficits will mean public sector employees will continue to see real cuts in living standards as inflation-led wage demands are pushed back.
The corporate borrowing binge fuelled by QE and low interest rates – one of the central aims of QE – has had unintended consequences. Money raised on the bond markets has not generally been ploughed back into business and productivity growth. In his March Budget, Chancellor Philip Hammond acknowledged that UK productivity growth is some 17 per cent behind the G8 countries’ average and lags Germany by some 35 per cent.
Rather than help businesses to grow, QE has helped finance directors to engineer a false sense of corporate health via share buybacks (which flatter price/earnings ratios) and a stream of unsustainable equity dividends to satisfy the demands of investors clamouring for the yield they once received from the bond markets.
Peter Spiller, manager of Money Observer Rated Fund Capital Gearing, explains how that is being played out in the US. ‘Productivity has disappointed since the financial crisis, dropping from around 1.5 per cent to 0.5 per cent a year,’ he says. ‘This is in part due to low levels of capital investment, which has been low relative to history in most areas of industry, and in part because share buybacks and dividends combined make up more than 100 per cent of corporate profits.’
Savers have been the biggest cohort of losers from QE. Inflation will continue to rise this year and next, while interest rates stay rooted to the floor. This is the concept of ‘financial repression’ really starting to show its teeth. In the first five or so years after the financial crisis, savers were insulated from low interest rates by low inflation, which is no longer the case.
While most investors have been rejoicing at the QE-inspired returns they have made over the past eight years, the question remains: what will the post-QE landscape look like (when that time comes)? For the immediate future, a careful watching brief is advised, as it seems equity investors are suffering from a Trump-inspired dose of exuberance.
‘Markets and the economy are most likely enjoying a sugar high that will not last a year,’ says former US Treasury secretary Larry Summers on his blog (larrysummers.com). In a reference to the new Trump administration, Summers also highlights a more sinister reason to treat signals from the stock market with caution. ‘New governments with authoritarian tendencies have historically brought about bull markets even before they led to disaster. Governments with much stronger authoritarian tendencies than anything plausible in the US, like those of Hitler or Mussolini, nonetheless saw strong markets in their early years.’
According to Thesis Asset Management’s Michael Lally, investor complacency means some of the classic indicators of a market about to correct are now visible, such as a ‘broad acceptance among the participants that, although prices might be looking a little stretched, not to worry because the momentum is strong, the economic backdrop is supportive and the alternatives are even more expensive or unpalatable.’
SPECTRE OF DEFAULTS
As yields on government bonds creep up, we should bear in mind that over the next few years the US, and the rest of the world, will need to deal with levels of debt ‘that cannot be serviced at normal interest rates’, says Spiller at CG. Indeed, in the bond markets Lally thinks there is a ‘spectre of defaults’ from financially less disciplined sovereigns and banks, particularly in Europe.
Spiller believes the only politically viable reaction to excessive debt levels is the maintenance of interest rates below normal levels and, crucially, below the rate of inflation. There is a precedence for this form of financial repression after the Second World War, which persisted for more than three decades. ‘Short real interest rates were negative for more than half the time between 1945 and 1980,’ Spiller points out.
He adds: ‘Any other approach to working down excessive debt almost certainly causes widespread defaults and probably depression, which rules it out as a viable policy choice in a democratic political system.’
Low interest rates and high inflation will be the only way to get out of the QE debt heap
So, in the long run it seems that low interest rates and high inflation, which is what we most feared when QE was first introduced, will be the only way for the world to dig itself out of the QE debt heap.
When inflation does start to accelerate, all asset classes will be under pressure from rising nominal interest rates, with few exceptions. However, says Spiller, ‘inflation-linked bonds would enjoy capital gains as real interest rates are first pushed to negative levels before eventually rising. The attraction of a significant weighting to inflation-linked bonds within a diversified portfolio remains undiminished.’
I think this is where I will be investing a large chunk of the cash that’s in my own portfolio, looking for a deserving home. They say there’s no such thing as a free lunch – and the $13 trillion QE bill is overdue.
The author was editor of Money Observer from 1998 to 2015.