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Robin McDonald: QE has caused a huge distortion of asset prices

I think Nomura’s Bob Janjuah hit the nail on the head when he recently said: “The Fed and the ECB are directing and attempting to orchestrate the grossest misallocation and mispricing of capital in the history of mankind.” It’s working.

Gluskin Sheff chief economist and strategist David Rosenberg added his agreement when he said: “The Fed has completely altered the relationship between stocks and bonds by nurturing an environment of ever deeper negative real interest rates. The economy and earnings are weak and getting weaker but the interest rate used to discount the future earnings stream keeps getting more and more negative and that in turn raises future profit expectations.”

Today, many economic and market variables sit outside prior historical observations. That is to say that we operate in a world of extreme prices.

Consider, core long-dated government bond yields have hit their all-time lows in 2012 (US data going back to 1790). Typically, this would occur in the context of a fragile economy and a weak equity market. Indeed, the last time US 10-year bond yields were comparatively low, the dividend yield on the S&P 500 was a juicy 16 per cent!

Today, that same index yields 2 per cent and in total return terms is trading at an all-time high. Thanks, Ben Bernanke.

Of further intrigue is how the market has achieved this record high, namely being led by perceived defensive shares. While this is understandable in the context of an uncertain future, it is unusual nonetheless.

Our role as fund managers is to generate good risk-adjusted returns for our investors. The difficulty with the world that our central bankers have engineered is that evaluating ‘risk’ is becoming increasingly problematic.

For the avoidance of doubt, we continue to believe that risk is largely a function of the price you pay and therefore approach highly-priced ‘safety’ (government bonds, gold, certain defensive shares) with caution.

Having turned tactically bullish in Q4 of last year, we have captured this policy-induced “break-out” in the market fairly well. So how do we respond to QE3 or QE-infinity as it has been more accurately labelled?

In recent months, we have been rather vocal in asserting that a third round of money printing in the US was neither necessary nor desirable. Our contention has been that QE – and by extrapolation a weak US Dollar – is no longer helpful in generating sustainable economic growth. This view has not changed.

To capture our thoughts on its market impact, I will turn once again to Nomura’s Bob Janjuah.

He says: “I believe that the maximum upside is around 10 per cent to equity markets (from here) and, furthermore, capturing this 10 per cent will be one of the riskiest and most stressful phases of the market rally out of the 2008/09 lows. The scope for a complete reversal in sentiment and for gapping risk-off price action is very high, so being long risk over the rest of 2012 needs to be done with extreme caution.”

Tread carefully.

Robin McDonald is fund manager of Cazenove Multi-Manager Diversity range


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