Out with the new and in with the old?

As rock-bottom interest rates draw to a close and US short-term real yields return to positive territory, Dr Niall O’Connor of Brooks Macdonald, looks at what the end of quantitative easing means for investors.

From easing to squeezing

The US Federal Reserve is unwinding its quantitative easing programme: as the Federal Funds rate has increased, the
3-month US Treasury yield has also crept upward. For the first time in a decade, cash is now generating a positive inflation-adjusted return, as shown by the green area on the chart below.

Source: Bloomberg, October 2018. Past performance is not a reliable indicator of future results.

 

Quantitative easing forced investors out of ‘risk-free’ assets and into risky assets. The yields on ‘risk-free’ assets (US government bonds) were pushed so low, that they dropped below the rate of inflation in 2008. During the decade of negative real returns from cash (the red section of the chart), investors were forced further along the risk spectrum in order to avoid losing money. This meant that they had to look at assets with a higher yield (i.e. higher than inflation), which usually required a longer duration and/or lower credit quality. Strong demand for these higher yielding, lower quality assets rippled through financial markets, meaning that companies have been able to borrow at very cheap rates even when issuing low-quality debt. The description ‘higher yielding’ is also a bit of a misnomer, as yields are still at historically low levels; the increase in risk taken by investors is disproportionately greater than the increase in potential return that they stand to receive.

In the equity market, quantitative easing meant that two strategies have performed particularly well over the past few years: growth and momentum. Growth stocks are those whose current earnings may not be high, but which have significant potential for high earnings in the future – you are effectively paying now for future potential, and taking on the risk that that potential may not be realised. When yields are low, the discount rate used to bring your future price back to its present value is also lower, which means that growth in the future has a higher present value today. As shown in the chart below, value stocks underperformed growth stocks until September 2018, where the trend appears to have begun to change.  Momentum looks at the rate of equity market price changes, and in the fast-rising markets of the past few years, momentum-based strategies have performed well.

Source: Bloomberg, October 2018. Past performance is not a reliable indicator of future results.

 

Quantitative tightening implies that the trends perpetuated during quantitative easing are likely to reverse, and the areas of the market that performed well in the ‘new normal’ of low yields since the financial crisis, are unlikely  to continue to do so as yields continue to rise. Taking the example of growth strategies versus value, if yields rise, then the discount rate used is also higher, which makes the present value of future growth opportunities lower, and is negative for growth stocks. By contrast, value strategies, which rely on current yields rather than future growth, are likely to benefit from this shift.

The US budget deficit

The increase in the US budget deficit is also putting upward pressure on US Treasury yields. Despite the growth and strength of the US economy, the country’s budget deficit has been increasing as a result of the current President’s policies on tax cuts and spending. Ordinarily, when an economy is healthy, a country will aim to shrink its budget deficit in order to stop the economy overheating and to provide room to manoeuvre when the economy next runs into difficulties – effectively, fixing the roof while the sun is still shining. The reverse has been taking place in the US.

The chart below plots the US unemployment rate against the country’s budget deficit, going back to 1948. The clear trend is that the lower the unemployment rate, the smaller the budget deficit (or the larger the budget surplus, as has occasionally happened). The current position (circled in red) shows that for the unemployment rate of roughly 4%, the budget deficit is larger than it has ever been. The change over one year (shown by the yellow arrow and previous year’s position, circled in yellow), is significant.

Source: Brooks Macdonald

 

We believe that the trend of rising yields shown in the first chart is set to continue, unless the US hits a recession or suffers a significant slowdown in growth. In this scenario, the Federal Reserve would halt its programme of rate increases and the pace of quantitative tightening would slow. In a recession, however, the size of the US budget deficit leaves limited room for fiscal stimulus, should the economy and the labour market start to flag. Although the near-term outlook for the US is likely to continue to be characterised by economic growth, the incongruity of the labour market figures and the budget deficit have created a vulnerability.

 

What next for investors?

Equities:

While the outperformance of growth and momentum strategies has been a boon for many investors, it has probably made it harder to distinguish between funds which have performed well because the managers have added value (alpha), and funds which have simply benefited from rising markets and being invested in growth and momentum styles (beta). Performance numbers alone will not tell the whole story. When the stylistic shift from growth to value occurs, the distinction between alpha and beta will become clearer. As Warren Buffet famously said, “it’s only when the tide goes out that you discover who’s been swimming naked”. Knowing why funds have performed the way that they have will become increasingly important in terms of making sure you are appropriately positioned for the future.

Bonds:

If a positive yield is once again available on cash, then why would an investor take additional risk in order to generate a small return above inflation? It is likely that an increase in rates at the short end of the yield curve will precipitate an increase across longer dated maturities. For those companies that took advantage of low rates on offer during quantitative easing, it may be harder to refinance their debt at attractive levels, and investors may be less sanguine about holding riskier assets with low yields, once higher yields start to trickle through.

The Defensive Capital Fund:

While changes in markets present opportunities, these opportunities come with risk attached. We have chosen to take a number of defensive positions in the Fund in order to protect against volatility and rising yields that we think is likely to materialise over the next few months. For example, we have increased our cash allocation to its highest ever level, and have bought a put option on the FTSE100 index to protect against downside losses.

As we look ahead to the new year, we believe that the ‘new normal’ of quantitative easing will retreat further into the distance, and we will continue to monitor and adjust our DCF positioning to adapt to rising yields.


Issued by Brooks Macdonald

Important information

This document is intended for professional advisers only and should not be relied upon by any persons who do not have professional experience in matters relating to investments. Past performance is not a reliable indicator of future results. The value of your investments and the income from them may go down as well as up and neither is guaranteed. Investors could get back less than they invested. Brooks Macdonald is a trading name of Brooks Macdonald Group plc used by various companies in the Brooks Macdonald group of companies. Brooks Macdonald Group plc is registered in England No 4402058. Registered office: 72 Welbeck Street, London  W1G 0AY. 

Brooks Macdonald Asset Management Limited is authorised and regulated by the Financial Conduct Authority. Registered in England No 3417519. Registered office: 72 Welbeck Street, London  W1G 0AY.

More information about the Brooks Macdonald Group can be found at www.brooksmacdonald.com.