Back in 2009, the Bank of England (BoE) announced its first-ever round of a rather unconventional policy tool called QE. To put this move into context, this extreme response to stimulate the economy was not ever taught or even discussed in detail in my Economics lectures at university in the early noughties, and its use and effectiveness was still being debated by central banks around the globe following its implementation by the Bank of Japan.
The dual economic impact of QE
QE entailed purchasing government assets from the pension funds, high-street banks, insurance companies and non-financial firms with the aim of stimulating and injecting liquidity back into the economy. This historic action had a dual impact on the economy.
First, as prices on these bonds rose due to increased demand, yields were pushed lower, effectively lowering the cost of borrowing. This, in turn, encouraged additional consumption and investment for individuals and firms alike. Second, it encouraged those selling the assets to central banks to use the money to either buy other risk assets with a higher yield (like company shares and bonds), partake in additional spending, or lending out this money to corporates and individuals hence contributing to the overall money supply.
In 2011, due to the emerging Eurozone sovereign debt crisis and growing concerns of a double-dip recession, the BoE returned to the market, flexed their muscles and carried out another round of QE. Finally, in 2016, driven by fears of a post-Brexit recession, the BoE again intervened by announcing an interest rate cut and a further expansion of its balance sheet—yet more QE.
Active managers stand to benefit from the return to normalised monetary policy
Now, clearly QE has many benefits and succeeded in its key objectives. However, one of the frequently discussed side effects is its impact on risk assets. By purchasing bonds and driving down yields, investors are forced further up the risk spectrum as more and more assets generate negative real yields. This in turn drives up the prices of a multitude of assets, increasing the correlation between asset classes and also within asset classes. From an equities perspective, the outcome is a fairly indiscriminate rise in stock prices and a distortion of asset prices.
However, the landscape in the UK is changing. At the back end of 2017, for the first time in a decade, the central bank increased the base rate. This was followed by a further rate rise at the start of August and additional rate rises are expected next year. As the BoE returns to a normalised monetary policy and begins to set the scene for unwinding QE, conventional wisdom dictates that this will play into the hands of active managers as correlations across and within asset classes begin to break down and asset prices become more acutely related to fundamentals.
Time to look beyond Brexit
The UK equity market shares many of the characteristics investors look for: cheapness relative to history and peers, best-in-class income stream and solid earnings growth. But it remains an unloved asset class. Investors appear to overlook the fact that over 70% of the revenues generated by FTSE 100 companies are derived from outside of the UK, global growth remains strong, and that a weaker sterling is a positive for UK exporters. Instead, they remain transfixed on the clouds overshadowing a Brexit deal. Uncertainty will remain for the foreseeable future, with media reports causing daily changes in sentiment, which is why I believe it is as important as ever to manage risk and focus on long-term fundamentals. As dispersion, rather than correlation, becomes the new normal, it is likely to be accompanied by new challenges, but it should also present fresh opportunities. When the correlation breaks lower, asset allocators will have to reassess risk levels, diversification strategies and for equities, there is likely to be a sharper focus on fundamentals. By conducting sound, bottom-up, factually based analysis, active managers should be able to distinguish themselves from their passive counterparts. And so, as a wise old investor once said, if you want a date with returns, you need to ask risk for a dance. Whether this narrative plays out or not? Only time will tell.
Blake Crawford is the portfolio manager of the JPM UK Dynamic Fund. Find out more >
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