MARKET RECKONING IS COMING AFTER A DECADE OF QE / THE FINANCIAL TIMES MARKETS INSIGHT

Market reckoning is coming after a decade of QE

The divergence between asset prices and incomes has historically generated problems

Michael Mackenzie



The stellar ride asset prices have enjoyed since the demise of Lehman Brothers dominates the financial system. And the prospect of a reversal is rightfully worrying.

Years of ultra low, and in some cases negative, interest rates, alongside massive quantitative easing programmes, have been a grand experiment in monetary policy. Low rates have compelled investors to seek higher returns from riskier assets such as equities, junk bonds and, until early this year, local currency emerging market debt.

Another feature of bond yields stuck at low levels is that they enhance the value of companies’ future cash flows and, in doing so, help share prices. This explains in part the appeal of owning fast-growing tech companies that generate vast cash flows, such as Apple and Amazon, that in recent weeks have reached $1tn valuations.

When they embarked on QE the aim of central banks was to create a wealth effect in the form of rising equity and home prices that, in turn, would bolster the broad economy. In QE’s early days, fear of an inflationary surge was strongly felt among some investors. Gold bugs can only look back wistfully on 2011, when the spectre of QE unleashing inflation drove the precious metal to the dizzy heights of $1,900 an ounce.

The fact that an inflation scare didn’t materalise is why the 10-year Treasury note yield sits well shy of its April 2010 peak of 4 per cent, and its inability to sustain a rise above 3 per cent continues to support US stocks and junk bonds.

Rather than generate a surge in inflation, a data point helps illustrate that it has been the boom in asset prices that has defined the decade for financial markets since the crisis.

Russ Mould, investment director at AJ Bell, notes that US household net worth has risen beyond $100tn and is nearly 50 per cent higher than its prior cyclical peak a decade ago. In contrast, the Census Bureau shows that the median real US household income today has only just returned to the levels of 2007.

The divergence has been fuelled by the boom in asset prices and, as Mr Mould reminds us, in both 2000 and 2007 markets and the economy faced a dramatic reckoning after gains in household net worth outpaced net income for several years.

A crucial difference between today and prior periods of elevated asset prices is pointed out by Dhaval Joshi at BCA Research, who notes that 1990 was largely focused on Japan, in 2000 tech and telecoms led the way while 2007 reflected the US mortgage and credit boom.

This time the rise in asset prices has been far broader and with the Federal Reserve leading central banks’ retreat from QE, the cracks we are seeing across parts of emerging markets and the faltering performance of non-US equities raises concern that this is the start of a broader reckoning.

As US overnight interest rates have risen to 2 per cent and the Fed’s balance sheet is shrinking, the mood music for global markets has shifted since the most recent peak for FTSE All World equity index in January. Exclude the US from this measure of global developed and emerging large and mid-sized companies, and it has fallen some 13 per cent from its early year high. In sharp contrast the US equity market hit a new all-time high just weeks ago, reflecting the hefty bump corporate earnings have enjoyed from the Trump administration’s tax cuts.

With the latest US inflation data on Thursday arriving a touch below expectations, the prospect of the 10-year Treasury yield rising back over 3 per cent has dimmed for now. But how long a buoyant economy and signs of inflationary pressures can square with a 10-year yield below 3 per cent is a key question for markets. Should the US labour market remain buoyant, fuelling faster wage gains, the ingredients for an inflation scare are in place.

Indeed, Lael Brainard, a member of the Federal Reserve’s board of governors, this week indicated there was scope for the central bank to raise short-term rates above the current estimate of the longer-run rate, which is just shy of 3 per cent.

All of which presents a huge policy challenge to the Fed as tax cuts fuel concern in some quarters of an economy that will soon overheat. For highflying US asset prices, the principal danger is that a sharp rise in long-term bond yields, via an inflation scare, would very much leave Wall Street looking like Icarus.

The silver lining for investors is that in such a scenario the best thing to buy will be a 10-year bond that would then offer a far more attractive yield.