Both the US Federal Reserve and the European Central Bank have surpassed market expectations with their latest policy announcements. In an extension to the Fed’s quantitative easing programme, chairman Ben Bernanke pledged to purchase $40bn of mortgage-backed bonds per month, continuing indefinitely until the outlook for the US job market improves. In focusing on mortgage-backed bonds, Bernanke is attempting to buy up poor loans from banks made to homeowners in better times. On top of this, he extended the promise to keep interest rates close to zero until at least mid-2015.
The open-ended nature of Bernanke’s commitment draws comparison with ECB President Draghi’s pledge earlier this month to keep government bond yields at a manageable level with unlimited purchases, provided governments ask for assistance.
Not surprisingly, markets have responded positively to both announcements. The possibility of a euro break-up has been pushed significantly into the future although not eliminated entirely. Note that Draghi’s plan did not include Greece, which will undoubtedly need yet another bailout. Some have suggested that Draghi has assumed Greece would exit at some stage and concentrated on erecting a firewall around the larger economies most at risk from contagion.
No one knows for sure what the long-term effects of QE might be but in the short term, the consequence is that stockmarkets are experiencing a “risk-on” rally. Defensive shares such as utilities tobacco and healthcare have fallen while cyclical shares typically commodities and gold have risen significantly.
Central banks are effectively forcing investors out of cash – which yields virtually zero – into more risky investments. To me, the irony of the situation is that as investors worry about inflation they buy commodities, which then causes inflation, directly affecting the very consumers these central banks are trying to help. Since June, the price of oil has risen 30 per cent. I am sure you have noticed that the price of a litre of petrol is up around 10p. So while QE might provide a sugar rush to the markets, I remain unconvinced of its benefits in the real economy.
The US economy seems to be improving but I think this latest round of QE confirms the desire to keep the present debt-laden system going rather than addressing the structural problems of too much debt. The danger seems clear that in doing so the Federal Reserve could be inflating another credit bubble.
Those looking for signs of problems should watch the US, German and UK government bond markets for warning signs. These markets will be particularly sensitive to long-term inflation worries and currency debasement. Ten-year gilts yields have risen from 1.75 per cent to 1.9 per cent over the last week or so but I think this is more a reflection of some short-term profit taking and some moves into Spanish and Italian debt. It is far too early to say that gilts have broken out of their recent trading range.
So, what should investors do? There is no simple answer but these announcements do highlight the need for greater vigilance in your own portfolios and the asset mix that you have. I still believe high-yielding shares offer excellent value against a background of continued low interest rates and therefore equity income funds are worthy of consideration. As I have mentioned before, the more economically sensitive exposure of Clive Beagles’ JO Hambro UK Equity Income dovetails nicely with Neil Woodford’s more defensively positioned Invesco Perpetual Income.
Gold is often cited as an area which should benefit from QE. Its price has risen by over $150 in the last few weeks but it could have much further to run. Two easy ways to gain exposure are via an Exchange Traded Fund or via a fund investing in gold mining shares such as BlackRock Gold & General.
Finally, I think it is worth remembering that notwithstanding the boost provided by central banks, markets are not without risk. Geopolitical risk in particular is ever-present – I wonder how long Israel will allow Iran to continue building its nuclear programme. Should the situation flare up, we would see the price of oil skyrocket – something the global economy does not need at present.
Mark Dampier is head of research at Hargreaves Lansdown