Fulcrum Research

WhatwillhappentomarketswhenQEends?
GavynDavies
29th May 2013

Last weeks market reaction to Fed Chairman Bernankes suggestion that the FOMC might begin to taper back QE within a few meetings represented a trial run for what might happen when central bankers really do remove the punch bowl at some point in the future. The largest reaction came in the most leveraged markets (notably the Nikkei, which fell by 6.5 per cent), but there were simultaneous acrossthe-board declines in global bonds and equities. When the Fed ended QE1 and QE2, there were declines in the S&P 500 index of 15 per cent and 23 per cent respectively. These events, however, proved to be only minor fluctuations in the great bull market, which quickly resumed when the central banks announced new asset purchases. Many analysts1 believe that QE has caused a major bubble to appear in asset prices, the full extent of which will be unveiled only when the central banks start to shrink their balance sheets. Others reply that the rise in both bond and equity prices has been justified by economic fundamentals. This is probably the most important debate in the financial markets today, with enormous ramifications for both policy makers and investors. Bubbles are notoriously difficult to identify in real time, and it is wise not to be too dogmatic about this. The immediate response of the major asset markets will depend on the exact economic circumstances at the time, the existing state of market expectations and extent of leverage in each of the major asset classes. However, we would like to comment on three major questions in the bubble debate in US markets, since the answers to these fundamental questions are likely to frame the global market response over a lengthy time period after QE ends. First, is there a bubble in government bond markets? Clearly, government bond yields are substantially below their historic averages, but that does not necessarily mean that they are in a bubble, which would be true only if yields have dropped much

For example, Gillian Tett argues in the FT (http://on.ft.com/18rJWKG) that the reach for yield has artificially inflated all asset prices, with

the consequence that there could be a bout of violent instability if a shock, such as the end of QE, hits the system. Paul Krugman

(http://nyti.ms/11JOBsq) and Antonio Fatas (http://bit.ly/13Ts6ze) reply that extremely low real yields are a natural consequence of the
excess of global savings over capital investment, and of similarly low short term interest rates, so neither bonds nor equities are in a bubble.

further than would be implied by economic fundamentals, especially by the decline in expected short term interest rates. A large part of the decline in yields can indeed be explained by the prolonged period of near-zero short rates which is now built into the bond market. But not all of it can be. Ben Bernanke recently pointed out that long bond yields have actually fallen by more than can be explained by the drop in expected short rates (see the first chart). Almost 2 percentage points of the decline in US bond yields stems from the so-called term premium in long term interest rates, which is the unexplained residual in the long yield after taking account of the expected path for short rates. A negative term premium is extremely unusual, implying that the market is willing to lend to the government on long term debt for a lower rate of return than they expect to receive from rolling over shorter term loans for the same length of time. Since the latter strategy is more liquid, a negative term premium would not generally be expected to arise, and it might be a mark of a bubble. The Fed Chairman does not think so, arguing that the negative term premium is an understandable consequence of fundamental factors, including the safe haven demand for bonds, the attraction of bonds as a hedge against riskier assets, and the demand for bonds from foreign central banks. Several of these factors can be seen as being ultimately linked to the excess of global savings over investment, which has been associated with the recession and the central bank policy response. But, even if you do not choose to view this as a bubble, and to some extent this is a matter of semantics, the drop in yields has clearly brought forward bond returns from the future into the present, implying that forwardlooking bond returns will be abnormally low. Second, what is the case for arguing that there is a bubble in equity markets? It is clear that the reach for yield has started to have a profound effect on sectoral behaviour within global equities, as argued in this earlier topical commentary2. But, at least until recently, there has been relatively little sign that equities had become overvalued, because the equity risk premium had widened substantially (see the second chart). Essentially, as the bond yield has dropped into unprecedented territory, the earnings yield on equities has remained roughly constant, implying that equity prices have been underpinned by the growth of corporate earnings. An alternative way of looking at this is to argue that the equity risk premium, proxied in the graph by the gap between the earnings yield and the bond yield, has increased almost in lock-step with the decline in bond yields. As investors have sought the safe haven of bonds, they have simultaneously demanded a higher risk premium for holding equities, and that risk premium might offer some protection to share prices if the bond yield starts to rise. There has been some decline in the risk premium recently, but much of the cushion still seems to be intact. The main worry about equities, therefore, is that corporate earnings cannot maintain their high share of nominal GDP indefinitely, but that is another matter entirely. Third, what does all this imply for future returns? Central bankers have typically been unwilling to talk much about this question, but it seems clear that their actions on interest rates and QE have brought forward returns from the future, even if they have not
2

Gavyn Davies (2013), Equity markets join the global reach for yield, 5 May 2013 - http://on.ft.com/ZzJuEk

caused a bubble in bonds or equities. The outgoing Bank of England Governor Sir Mervyn King, showing increasing candour as retirement approaches, admitted as much in his final BoE press conference recently: The reason for concern in the future is that we know that at some point real interest rates have to get back to a healthier and more normal level You would expect to see some consequences for asset prices, possibly falls in asset prices. It will be important that people have had time to get to a point where their degree of indebtedness is not such that they find themselves in deep financial trouble when asset prices fall. Sir Mervyn is saying here that it has been a deliberate strategy of the central banks to drive yields down, and therefore bring asset returns forward from the future, in order to help with the process of private sector deleveraging. Whether or not they have created bubbles in the strict sense of the term, the unavoidable consequence of central bank action since 2009 is that they have reduced the returns to be expected in the future. However, that process has not yet advanced anywhere near as far in equities as it has in government bonds and credit. That fact is likely to go a long way towards framing the eventual long term response to the end of QE. In summary, bonds seem much more vulnerable to a very lengthy period of sub-par returns than equities appear to be. 29th May 2013

Disclaimer Source: This article is based partly on material which appeared in an article by Gavyn Davies published in the Financial Times on May 26th 2013. This material is for your information only and is not intended to be used by anyone other than you. It is directed at professional clients and eligible counterparties only and is not intended for retail clients. The information contained herein should not be regarded as an offer to sell or as a solicitation of an offer to buy any financial products, including an interest in a fund, or an official confirmation of any transaction. Any such offer or solicitation will be made to qualified investors only by means of an offering memorandum and related subscription agreement. The material is intended only to facilitate your discussions with Fulcrum Asset Management as to the opportunities available to our clients. The given material is subject to change and, although based upon information which we consider reliable, it is not guaranteed as to accuracy or completeness and it should not be relied upon as such. The material is not intended to be used as a general guide to investing, or as a source of any specific investment recommendations, and makes no implied or express recommendations concerning the manner in which any clients account should or would be handled, as appropriate investment strategies depend upon clients investment objectives. Past performance is not a guide to future performance. Future returns are not guaranteed and a loss of principal may occur. Fulcrum Asset Management LLP does not represent that the contents of this commentary are complete or accurate and they should not be relied upon as such. All information in or attached to this commentary is subject to change without notice. Fulcrum Asset Management LLP is authorised and regulated by the Financial Conduct Authority of the United Kingdom (No: 230683) and incorporated as a Limited Liability Partnership in England and Wales (No: OC306401) with its registered office at 6 Chesterfield Gardens, London, W1J 5BQ. Fulcrum Asset Management LP is a wholly owned subsidiary of Fulcrum Asset Management LLP incorporated in the State of Delaware, operating from 767 Third Avenue, 39th Floor, New York, NY 10017.