Have we seen the final curtain? Last week, U.S. policymakers ended the much-debated and controversial era of open-ended Quantitative Easing (QE); the once $85 billion of monthly asset purchases is now a thing of the past. Whereas the Fed balance sheet will stay large for years to come, in excess of about $4.5 trillion today, Ms. Yellen and her team are committed (or daring) to allow economic outcomes, instead of liquidity injections, to set the direction for capital markets.
For the purpose of our discussion, it does not matter if the economy is on the right path or not, but more so that Ms. Yellen may be in the midst of preparing for undesired future outcomes. The recent pickup in economic activity should be proof of US resilience, and yet global output stands on fragile ground. The oft-cited decoupling of our domestic economy from adverse or even deflationary effects experienced in other parts of the world may prove to be elusive. The Fed needs to be prepared to reinitiate an accommodative stance, which is now an option.
QE was not a recent “invention,” nor the result of the Global Financial Crisis of 2008/2009. The Japanese adopted this particular approach in 2001, in response to the late-‘90s asset-bust in real estate and stocks. While most market observers point to the vast differences between the land of the rising sun and the U.S., the story is rather similar. Paired with a consistent zero-interest-rate framework, Japanese QE has been an “on and off” policy for nearly 15 years, even though it has ultimately proven to be ineffective in addressing deflation, and has potentially even eroded the long-term stability of the domestic financial system.
In the U.S., it is now for investors to endure a time of transition, likely marked by uncertainty: the “handover” from a liquidity-driven to a “real” economy. This evolution is a daring concept, especially considering a large-sized capital market as a result of asset-price inflation. As soon as volatility or deflationary domino effects “grip” investors again, the Fed will be very tempted to effectively act as the buyer of “last resort,” once more providing liquidity to the system. All in all, not a bad deal, as the original “Greenspan put” has morphed from Bernanke to Ms. Yellen, and yet it remains an unsustainable long-term measure should the real economy not come through.
In early assessment, financial-repression policies have been effective tools for stabilizing financial markets and, to a degree, supporting economic growth, mainly based on the created wealth effect. From a socioeconomic perspective, however, this form of monetary policy can be viewed as highly unpopular, since, effectively, risk is deferred and wealth is redistributed from savers to debtors. Central banks implementing financial-repression-led policies, directly and indirectly, will hinder free price formation in capital markets, largely as a result of “artificially” lowered interest rates and compressed volatility. Investors will be tempted (or required, as they are today) to seek riskier portfolio choices with the objective to maximize the return of investable capital, likely departing from an allocation of “safe,” interest-bearing assets.
Personally, I do not think we have seen the end of central bank activism. First, accommodative measures seem to have become a rotating mechanism on a global scale. When the Fed announced the end of QE last week, the Bank of Japan stepped in to announce their increased stimulus, and Europe will likely be next. Second, investors and, to some extent, the general public, have been spared of truly deflationary outcomes. Just as a piece of candy can bring a comforting sugar rush to a tired child, immediate benefits will soon turn sour. For the good of long-term economic and fiscal health, the U.S. economy needs to continue on its upward trajectory. Asset allocators, on the other side, are best positioned to embrace a potentially more volatile investment environment, with stock selection and a global-macro focus as key considerations for portfolio construction.
Matthias Paul Kuhlmey is a Partner and Head of Global Investment Solutions (GIS) at HighTower Advisors. He serves as wealth manager to High Net Worth and Ultra-High Net Worth Individuals, Family Offices, and Institutions.