How dangerous is the end of quantitative easing (QE)? Some argue that central bank liquidity is strongly correlated with asset prices, so tapering (QT) will inevitably cause a sharp reverse. Such a simple analysis forgets that share prices are determined by a wide variety of factors with, for example, the discount rate and earnings stream standing alongside QE.
What has been the impact of QE on government bond yields? The honest answer is that according to some academic studies the impact varies from “a little” to “a lot” but central estimates are that the pace of tapering currently envisaged in the United States will add about 0.5 percent onto bond yields, i.e., serious but not extreme. In addition, factors other than QE have driven interest rates to their current low levels.
In fact, QE coincided with a noticeable deceleration in productivity growth as well as weaker inflation plus less volatility in both growth and inflation across most major economies. This helps explain why the term “premium” (the excess yield that investors require to commit to holding a long-term bond instead of a series of shorter-term bonds) has been historically low, as well as explaining why we have witnessed low inflation expectations embedded into markets.
Turning from the discount rate effect on share prices, we also need to consider the outlook for corporate profits. The peak of the earnings cycle has probably been seen. That is very different to saying a profits recession lies ahead. Share prices are supported by a broadening of cash flows across sectors and countries as the global recovery develops.
Has too much good news been priced into equities, opening the way for an autumn correction? Quite likely but while our House View has taken some risk off the table we remain overweight global risk assets.
To take a more extreme view, we would need to see more extreme triggers – such as a serious slowdown in China under the weight of its debt burden or a revival of political risks in Europe. There are imbalances to monitor, such as various household or emerging market debts, but these would need an aggressive monetary tightening to trigger any major concerns we would have about them. In turn that would require serious signs that central banks are well behind the curve in relation to controlling inflation.
All in all, QE has clearly affected cross-border capital flows – after all about 20 percent of global government bonds still have negative yields – but a range of other factors have supported equity markets. A correction is easy to see but a market crash requires more than just QT.
– Contact us at [email protected]