Some unintended consequences of QE
Although the well-trailed announcement by the European Central Bank (ECB) of a quantitative easing (QE) programme has been greeted with enthusiasm we would caution that investors should be careful what they wish for. Planned purchases of €60 billion per month until September next year will soon absorb the sovereign bond issuance in the Eurozone which is put at around €400 billion. From this perspective, the strength of Eurozone bond markets noted above is less of a mystery. The demand-supply balance in the Bund market will be particularly acute as Germany intends to run a budget surplus this year, making investors less willing to sell their holdings as the Bundesbank/ ECB seeks to fulfil its QE quota. Note that the ECB can also buy limited quantities of supra-national IG bonds, although this only relieves the pressure on sovereigns at the margin.
The effect of QE on growth in the Eurozone remains an open debate and we see the principal transmission mechanism to the economy as being through the exchange rate (as discussed above). If the experience of the Eurozone mirrors that of the US, UK or Japan then much of the extra liquidity being created will find its way onto bank balance sheets rather than increased lending. This in turn will boost asset prices, but unlike the US and UK, the wealth effect in the Eurozone is likely to be relatively muted given the smaller capitalisation of the equity markets.
QE also means that the supply of investible government paper will be reduced, thus creating a problem for institutions such as pension funds and insurance companies who need a steady flow of risk-free (or low risk), high quality assets to match their liabilities. Consequently, many Eurozone pension and insurance funds are looking outside the region in a search for yield. The same process is already occurring in Japan led by the Government Pension Investment Fund (GPIF).
The consequences of this are likely to be significant for global bond markets as we expect to see spill-over effects as markets outside the Eurozone experience inflows from yield seeking investors fleeing QE. The spread between US Treasuries and Bunds, for example, remains wide by historical standards, indicating the incentive to shift funds remains high (chart 18). Note that capital flows from Europe to the US to exploit the carry between bond markets have been instrumental in weakening the Euro against the US dollar.
Consequently, ECB QE will be widely felt and differs from QE in the US and UK where, for most of these programmes the domestic government was running a substantial budget deficit which absorbed much of the central bank's purchases. On this analysis, bond yields globally are set to stay historically low. There is likely to be some upward pressure on the US yield curve as the Fed raises interest rates, but this will be primarily felt at the shorter/ medium end of the curve. As we move further out, upward pressure on yields is likely to be tempered by yield seeking investors from overseas.
The spillover effects need not be confined to sovereign bond markets, as we have seen elsewhere the search for yield will take investors into credit, equity and real estate markets. At a time when the prospects for corporate earnings growth in the US are becoming restricted (see above), companies offering stable dividends will remain attractive from a yield perspective.
The incentive to buyback shares will also remain strong and we expect to see a further shrinkage of the number of outstanding shares available on the US equity market. This trend has been in place for some time and, according to independent research house Strategas, the number of publically quoted companies in the US has shrunk from 8,800 in 1997 to around 5,000 by the end of 2013. The counterpart has been significant growth in the number of private equity companies. The end result is a corporate sector which is increasingly run for cash, is more heavily funded by debt and is less dependent on equity.
From this perspective, the latest fall in bond yields driven by the ECB QE programme, supplemented by a continuation of the Bank of Japan's buying, can be seen as another turn of the screw on financially repressed investors. Facing risk free yields of close to zero, or even negative in some cases, investors are once again being forced to accept more risk in the hunt for yield. This will also often involve sacrificing liquidity, particularly where the risk asset is credit or property.
Investor preference for "bond-like" equities will remain strong and companies will be increasingly run to return cash to investors. Company Chief Financial Officers will continue to look to replace expensive equity with cheap debt. However, whilst this reconfiguration of the financial system may meet investor needs, it may not be so good for the economy. There is a danger that in prioritising payments of dividends and interest coupons, capital expenditure will suffer.
In a recent analysis of the global equity market1, analysts at Citigroup found that the ratio of investment (both capex and R&D) to distributions through dividends and buy- backs has fallen significantly as companies have focussed on rewarding shareholders. The move was particularly marked in 2014 with global listed company investment declining 6% as much as in the financial crisis, whilst global dividends and buy-backs rose by 15%.
The decline in bond yields is not the only factor driving this: CEO incentive structures are skewed in this direction and shareholders have been badly burnt during previous periods of rapid capex expansion (e.g. the tech bubble at the turn of the century and more recently the commodity boom). Nonetheless, there has been a strong correlation between the down trend in capex to distributions and bond yields (chart 19).
This creates the risk of a new low growth equilibrium where QE actually inhibits economic growth by making the corporate sector less willing to invest as low interest rates drive investor preference for bond-like companies. The resulting low level of growth then reinforces low interest rates thus completing a negative loop. This rather perverse effect from QE may be one reason why investment has tended to disappoint despite the low level of interest rates created by asset purchases.
However, if it is not possible to find alternative sources of income there would have to
be a cut in the pay-outs from long term savings plans. In other words, pension and
insurance plans would have to cut their returns, so hitting the incomes of those in
retirement. The effects would take time to come through as long term assumptions
were brought down with each actuarial review. Nonetheless, the impact on
consumption would be significant and would hit some of the less well off members of
society. This suggests that the underlying problem is one of a lack of income growth
to fund both capex and dividends. In other words we may well have to accept that we
cannot have strong corporate capex in a world where companies are now playing a
role as alternative income providers.
An opportunity for government involvement?
Is there any way of avoiding such a stark choice between lack of investment and growth, or depriving pensioners of income? One route which might mitigate the problem and provide a path to both better growth and more attractive risk free yields would be for government to get more involved, either directly or by priming the private sector. Whilst many will baulk at an increase in public spending there are considerable unmet needs in infrastructure and healthcare which would lend themselves to long term financing.
Given the shortage of long duration risk free assets created by QE, we would expect
investors to snap up a well designed issue. The EU investment plan which intends to
leverage €21 billion of public money into €315 billion of private investment will be
worth watching in this respect. The plan is still small in relation to the €14 trillion EU
economy but the expenditure would support growth, add to productive potential and
help solve the shortage of assets.
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