Massive central bank intervention, in the form of quantitative easing (QE) and ultra-low interest rates, was employed as an emergency defibrillator for the financial system, designed literally to shock it back to life again. That was in the depths of the Global Financial Crisis which began nearly a decade-and-a-half ago. In the event of established last-resort organisations, such as the International Monetary Fund, being overwhelmed by the incipient systemic melt-down in financial markets and the risk of subsequent economic mid-winter, what were seen as revolutionary strategies were only ever envisaged as being temporary. History has proved that to be far from the case: helped by deflationary pressures and low nominal levels of inflation, often below the main central banks’ targets of 2%, ultra-low interest rates have proved enduring, frequently at a negative real rate after adjusting for what little inflation there has been. As for QE, in Europe the ECB has had an active programme of bond purchasing continuously since 2015; less of a defibrillator, QE is more like monetary methadone administered regularly to the economic patient seemingly incapable of functioning without it. However, as national debt levels remain historically high but simultaneously post-Covid economic recovery is rapidly becoming fact rather than mere hope, the narrative is turning to the time when the principal central banks begin dialling down the stimulus. Investors know it is going to happen; policy makers know it too. Nevertheless, there exists almost a state of bluff between the two as to when and how.
Markets as much as central bankers are at fault
Complicating the picture, investors themselves have become complicit in the need for stimulus. QE works by the central bank purchasing bonds in the open market, then holding them on its balance sheet; if demand for bonds is greater than supply, prices rise and yields fall. As yields decline (and subsequent bond issues are priced off prevailing yields) not only do the bonds become more expensive, but nominal incomes fall too. Cash hungry investors, particularly pension funds and life companies with significant and immediate cash requirements, go seeking income at a more reasonable price elsewhere: other asset classes including equities (dividends) and property (rents) become more attractive and valuable, pushing up those prices also. Thanks to the artificial stimulus of central bank liquidity, markets are forced to, and propped up at, higher levels than would be natural. When markets have an inkling that the stimulus is to be wound down, the risk is that everyone heads for the emergency exits simultaneously. Known as Taper Tantrums, the most notable was in 2013 when Federal Reserve Chairman Ben Bernanke, helped by one of his hawkish board members, Jerome Powell (the current Chairman), notified his intentions to the markets to begin winding down the liquidity injections; through tautological ‘forward guidance’ his aim was to help stabilise markets rather than spring a shock on them by reducing purchases without telling them. The effect was precisely the opposite. Bond markets swiftly reacted with falling prices, the effect rapidly being mirrored in equity markets. The Fed was forced quickly to steady the ship.
QE: financial backstop or strategic economic lever?
One of the consequences of the Fed’s 2013 reaction (and much the same was seen here in the UK in the aftermath of the Brexit vote in June 2016 when the Bank of England panicked and made an unwarranted interest rate cut backed up with QE) is that investors have come to see QE as a financial backstop rather than a strategic economic lever. There is a growing sense that whenever they get in to trouble, as seen at the end of 2018 when US equity indices fell sharply, markets will be bailed out by the authorities in order to prevent the knock-on impact on confidence caused by falling share prices and rising bond yields (which have a real effect by pushing up debt financing costs). Indeed, last March, when the Fed put in place the last piece of its Covid-recovery QE jigsaw by announcing that its massive bond purchasing would extend to the upper echelons of the High Yield sector (once-upon-a-time officially known as ’Junk’), the prevailing attitude was that the Fed had essentially created a virtually riskless market.
Monetary tightening: a logical linear progression
Central bankers are now openly talking of the possibility of tapering QE; Canada is already practising it. It is no news that, without panicking, investors are anxious about the prospects of higher interest rates should ‘hot’ economies begin to suffer enduring above-target inflation. But when considering what might happen (rather than when), there is a logical sequence to be followed. Both QE and low interest rates are ‘loose’ policies; they complement each other. Raising interest rates, a tightening policy, intuitively cannot happen while QE is still in operation; the stimulus effect of QE would cancel out the braking effect of a higher interest rate. Logically, the process is linear.
It will be a great feat if central bankers are able to pull off the trick of weaning markets off the liquidity drug without requiring an almost immediate return to rehab. Different from the Global Financial Crisis, following which most governments were either missing in action or actively pursuing austerity measures, what also remains to be seen is whether the funding of new and immensely loose fiscal policies being employed by most Western administrations is capable of being sustained through economic growth and taxation, or whether national treasuries will remain reliant on egregious spending coming through higher borrowings propped up by central bank QE, in which case we are no further forward.
These are complex issues literally without precedent. We have no pat answer; there is no roadmap; nobody has been presented with such circumstances before but as ever on the Merlin Portfolios, we exercise our judgment and reserve the right to change our minds when or if the facts change.
The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the individuals mentioned at the time of writing are not necessarily those of Jupiter as a whole and may be subject to change. This is particularly true during periods of rapidly changing market circumstances.
Fund specific risks
The NURS Key Investor Information Document, Supplementary Information Document and Scheme Particulars are available from Jupiter on request. The Jupiter Merlin Conservative Portfolio can invest more than 35% of its value in securities issued or guaranteed by an EEA state. The Jupiter Merlin Income, Jupiter Merlin Balanced and Jupiter Merlin Conservative Portfolios’ expenses are charged to capital, which can reduce the potential for capital growth.