Inside investment: Through a glass, darkly

Andrew Capon
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The president of the Federal Reserve Bank of Dallas, Richard Fisher, has compared the effect of quantitative easing on investors to “beer goggles”.

Former chairman of the US Federal Reserve Alan Greenspan once boasted to Businessweek that he would always aim to conclude a sentence "in some obscure way which made it incomprehensible". He was prone to "mumble with great incoherence". And to the army of analysts who pored over Fed-speak with exegetical excitement, he warned: "If I seem unduly clear to you, you must have misunderstood what I said."

The times have changed. Until 1994 the Fed did not even immediately announce the deliberations of the interest-rate-setting Federal Open Markets Committee. Paul Volcker, Greenspan’s predecessor, would call in journalists over the weekend. Given the premium modern central bankers place on communication skills, it is perhaps no surprise that Janet Yellen got the top job at the Fed.

She has long since mastered the art of forward guidance. Yellen’s verbal dexterity will be vital. In many ways her challenge is as great as that faced by her predecessor, Ben Bernanke, during the financial crisis. She has to steer monetary policy towards normalization, beginning with the tapering and reversal of quantitative easing, while keeping a cap on long-term interest rates and without rattling markets. It is quite a balancing act.

The reaction to Yellen’s first news conference last month shows just how difficult her task is. But let’s suppose that over the next few months she somehow manages to combine the rhetorical precision of Cicero with the Delphic sophistry of Greenspan and markets behave. Which will be most vulnerable to a normalization of monetary policy foreshadowed by the end of asset purchases in the autumn?

Follow the money

Many seem convinced that QE has created a stock-market bubble. The S&P500 reached a record intraday high on March 21 and is now up 175% from its March 2009 nadir. That took five years. The 56% fall that preceded this bull market took just 15 months. It is not unreasonable to think that the rally was a rational response to the avoidance of Götterdämmerung for global capitalism that seemed likely in October 2008.

Other than the empirical evidence of rising prices, it is hard to find good theoretical reasons why QE should support equity markets. At the margin it might lower the discount rate investors use to value the present value of future company cashflows. There seems little evidence of that as valuations are broadly in line with history. Or, QE might directly boost corporate profits by lowering the cost of debt service. But, in reality, companies have used cheap borrowing to leverage their balance sheets.

The most likely mechanism by which QE could have boosted equity valuations is by encouraging more buying by investors shaken out of low-risk assets offering no yield. But that has not happened either. According to the US mutual fund trade body, the Investment Company Institute (ICI), the net assets held in equities fell from around $6.4 trillion at the end of 2007 to $5.9 trillion at the end of 2012. That net figure takes into account the stock market rally, so the flow is even more negative.

Over the same period the net assets of all bond funds rose from around $1.7 trillion to $3.4 trillion. Among US retail investors, equity investment has stagnated while bond flows have soared. A similar pattern has played out around the world. A recent report by Goldman Sachs suggests that since the stock market nadir in 2009, $1.2 trillion has flowed into global bond funds and only $132 billion into equities.

The EM dress rehearsal

Past flows might be a harbinger of future vulnerability. The recent performance of emerging market debt is instructive. After many years of record inflows, there was a sudden stop around the time of the "taper tantrum" last summer. According to Bank of America Merrill Lynch, positive emerging market debt flows at mid-year of $5.5 billion turned to outflows by the year-end of $13.2 billion. The JPM GBI-EM Global Diversified Index fell by 9% in 2013. Outflows and poor performance have continued in 2014.

The historical data from ICI and Goldman Sachs show that if QE did drive investors into riskier assets, it was in the form of credit and bond funds. That is still true in 2014. In spite of the continuing stock-market rally, Bank of America Merrill Lynch data show that flows into high yield and credit alone have comfortably exceeded total equity flows in the year to date.

The same firm’s latest fund manager survey shows that credit managers are worried more about "bubbles" in their markets than a Chinese slowdown or Fed tapering. The signs are all there: record deals; record issuance; record cov-lite issuance; yields on junk at record lows; increasing corporate leverage; and the return of leveraged products such as CLOs.

By the time the Fed gets to the end of tapering these bond investors will be faced with a new reality. The next step toward normalizing monetary policy would be a rise in the federal funds rate. The beer goggles are coming off. If Yellen can finesse this transition without market dislocation, it will be a remarkable achievement. The excesses in credit markets suggest it is also unlikely.