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Is everything now a bubble and if QE turns off, will it burst?

26 January 2019

The addiction to abnormal monetary policy is proving troublesome for policy makers, says David Jane, manager of Miton’s multi asset fund range,

Many years ago we described QE as battlefield medicine, quite necessary at the time but with real danger of addiction if not exited early. Ten years after its introduction, attempts to exit QE are proving more problematic for the US than policy makers may have expected.

Despite a strong economic backdrop, Fed Chairman Powell’s attempts to tighten policy rates and Europe’s exit of QE appear to have stumbled against the barrier of rapid stock market falls and declining economic expectations. The message from markets seems clear, without free money the ‘everything bubble’ bursts. Powell’s more dovish comments have been assumed to imply further weakness in asset prices will be met with looser monetary conditions and, therefore, the party can continue.

Consequently, it’s reasonable to argue that the ‘everything bubble’ narrative is real. Market’s consistently negative response to any reduction of abnormal monetary policy supports that thesis, and what is harder to know is how and when it ends. It appears policy makers would like to end the QE era but feel they can’t move in any way that is destabilising to financial markets. Following Powell’s comments, expectations of US interest rate rises are now dramatically scaled back. The assumption is that if conditions deteriorate further, a new round of QE will be initiated.

Markets and economies now appear addicted to abnormal monetary policy and the consequences of any concerted attempt to exit appear too troubling for policy makers. So, perhaps we can confidently assert that the ‘Powell Put’ is firmly in place. We would not be so certain. As ever, reality is a lot more nuanced than such simple narratives.

Markets could simply be attempting to read into recent events meaning that suits their existing prejudices. Those in the everything bubble camp can see it as above, but those on the other side can see the changes in interest rate expectations as reflecting a lower inflation outlook, on the back of a falling oil price, and the market moves as a healthy correction reflecting lower profits growth in 2019 than 2018, against a slower economic backdrop.

Our view sits a little in both camps. We have to be alert to the possibility that markets are so artificially inflated by years of free money that a reckoning is long overdue, and that recent moves are the start of something much more serious. At the same time, we are alive to the more likely prospect that we’ve seen another short-term setback to bring valuations back into attractive ranges. We are avoiding investments where the valuation is dependent on a high degree of optimism, either about the economy or an individual company’s prospects. We are also avoiding companies with high levels of debt, as these are always the first to get into difficulty if the economy slows or lenders become more discerning. Our corporate bond portfolios remain very short dated, complemented by some much longer dated government bonds and gold to act as downside hedges. On the positive side, there remain plenty of good quality businesses on attractive valuations, often with relatively low levels of dependency on the economy. Many parts of the market are now discounting very negative scenarios, with a lot of bad news already priced in to large parts of both the equity and bond markets.

 

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