November 18, 2021

👀 Updated Outlook | MBMG Investment Advisory 08th November 2021

👀 Updated Outlook | MBMG Investment Advisory 08th November 2021

  • While we have to be careful to separate background noise from the symphony of markets, the changes indicated by the Fed during its meeting on 02-03 November would be, if enacted, the most dramatic significant change in investment markets for quite some time.
  • The Federal Reserve announced that it intends to begin pulling back on its bond purchases, a process known as tapering. This news is hardly a surprise as it comes at a time when inflation has risen beyond their expectations and for longer then their officials estimated earlier in this year. The situation is tricky as the labor market still remains weaker than before the Covid-19 pandemic and inflation-adjusted wages also remain lower with limited signs of a broad based catch-up.

By 2008, asset markets (both capital such as stocks & physical such as property) had been driven to all time highs by record levels of private debt creation that were proving impossible to sustain.

In fact, they had begun adversely feeding back to the systems that had created them, the banking and financial systems, in a way that threatened the ongoing viability of many major and minor institutions worldwide (when asked ‘How closer were we really to meltdown?’, former Treasury Secretary Tim Geithner once answered me ‘We were melting!’)

It’s well known that governments ‘bailed out’ the banking and financial sectors in 2008. It’s less well understood that they also took on the role of those sectors going forwards and having at their disposal the almost limitless resources of sovereign governments with their own currency issuance, they were able to underwrite record levels of credit creation, without the same capital constraints that the financial sector had encountered but also, without a Fed branch on every street corner, they had no evident conduit to feed those directly to businesses or consumers but rather only to the financial sector which they had underwritten.

These experiments were meant to be temporary but after 13 years of this ever-expanding experiment, it is clear that underwriting asset price stimuli obviously supports asset prices but doesn’t feed back into the main economy. Asset holders benefit but most people lose out and this causes serious division and understandable resentment. The election of Donald Trump in 2016 was the misguided human, or at least American, equivalent of the Capuchin monkey experiment- www.youtube.com/watch?v=meiU6TxysCgEven policymakers have become aware that there is a limit to how far they can push their experiments at ‘playing God’ with the financial resources of each country.

The US Fed initially implemented the first round of so-called Quantitative Easing policies (‘QE1’) as an emergency measure in November 2008.

These ceased in June 2010, 19 months and $2.1 trillion later. 

However, just 2 months later the Fed backtracked and extended the original programme. This extension became known as ‘QE2’ and had the more limited aim of purchasing around $30 billion of assets each month to simply maintain rather than further increase the Fed’s expanded Fed balance sheet for a period by replacing maturing securities.

By September 2012 that this was no longer, from policymakers’ perspectives, sufficient and the Fed expanded the scale of the programme and removed any target end date.

Less than 3 months later, the Fed more than doubled the rate of asset purchases (to $85 billion per month). This programme became known, at least within MBMG, as QE Infinity.

The sheer scale of such an open-ended programme became a cause for concern and throughout 2013, pressure increased on Ben Bernanke, the Fed Chair at the time, to announce an exit, after having announced that interest rates would remain at or close to zero at least until the end of 2015. His first attempt to ‘sell’ an end to QE to financial markets in June 2013 resulted in a stock market pullback of almost 5% in 3 days, forcing Bernanke to walk back his plans. By September he withdrew the planned exit by December, replaced it instead with a gradual plan to reduce or taper monthly purchases.

By October 2014, the asset purchase programme finally paused, with the Fed’s balance sheet having swollen from around $800 billion before the Q-Experiment to around $4.5 trillion. Despite volatility, especially in equity indices, capital markets responded in a reasonably positive way initially. The S&P 500 returned 29.6% in 2013 and 11.4% in 2014, breaking the 2,000 barrier for the first time just before the end of the asset purchase programmed.

However, the first half of 2015 saw equities struggle to make progress and in late August major indices fell around 10%. Although this fall was short-lived, it was repeated in the first quarter of 2016, as the Fed gradually tried to raise interest rates to ‘neutral’ levels above 2%. Stock markets fell back below March 2014 levels.

Co-ordinated global policy moves placed the onus for credit creation on policymakers outside the US (especially the European Central Bank, Bank of Japan, People’s Bank of China & the Bank of England. This triggered more positive sentiment, especially for risk assets in the later part of 2016, through 2017 and into 2018.

Just as US policymakers had sought to escape the task of continuously driving asset prices ever higher by feeding them with liquidity, these policymakers in turn pulled back, leading to a fall of 20% in global equities at the end of 2018.

Initially the Fed eased monetary conditions from around mid-2019 by lowering effective interest rates but when it became clear that supporting asset prices required additional liquidity, the Fed once again began expanding its balance sheet (using a different technique, not strictly QE) from September 2019 onwards.

As 2020 dawned, the Fed’s assets amounted to $4.2 trillion, the Fed Funds Rate was back down to 1.6% and the S&P500 stood at around 3,200 (equivalent to capitalization of around $27 trillion).

By November 2021, the Fed’s assets have more than doubled to over $8.5 trillion, the effective interest rate remains below 0.1% & the S&P500 stands around 3,750 (equivalent to capitalization of $39 trillion).

The Fed currently adds $120 billion ($60 billion each of treasuries and asset backed securities, mainly mortgages already issued by banks) to its balance sheet each month. From next month, it intends to buy $15 billion less each month and to stop purchases altogether mid-2022 (by which time its balance sheet should amount to $9 trillion) although it reserves the right to change these plans (pretty much any way it likes) according to changing conditions.

The Fed is even less clear about interest rate hikes, with conflicting opinions from its committee members about when to raise interest rates and by how much.

Taken together, the following factors may explain why the initial response to the Fed announcement has been relatively calm, with 2 days of positive reaction from risk markets, presumably comforted by the relatively gentle pace and tone of the Fed announcements, with more caveats and more room for manoeuvres (i.e. U-turns) than actual policy details:

  • The sheer scale of balance sheet expansion (the best part of $4.5 trillion in 22 months already and projected to be approaching $5 trillion by the end of 30 months) dwarfs the $3.5 trillion spread over 5 years from September 2008-2013.
  • Indications are that certain parts of the financial system have unprecedented extremes of surplus liquidity (the big US banks are in various ways continue to discourage deposits), which has yet to be absorbed.
  • The Fed have given themselves far more ‘wiggle room’ than previously.

However, the attempts to taper and to ‘neutralise’ interest rates in 2013, led to consequences that were still primary drivers of financial markets until they were overtaken by the pandemic. While 2021 might not be a carbon copy of 2103, there are perhaps aspects of market conditions following the previous taper that we should consider on the following slide.

Policymakers have indicated that the intend to remove the biggest single factor driving asset prices (especially risk assets such as equities, private equity, corporate debt, property).

There is clearly also some appetite among policymakers for raising interest rates.

When they have done so in the past, they’ve had to swallow their pride and backtrack.

There was however a honeymoon period in 2015-7, thanks largely to the exceptional credit impulse from China, Japan and the EU before, in 2019, the Fed had to cut rates and start expanding its balance sheet again.

There is nothing to indicate that these policies likely to be any more successful this time than previously.

The yield curve suggests that the bond market expects short term rate hikes to be unsustainable and expects rates to fall back again.

It’s hard to see risk asset valuations remaining indefinitely elevated but they may move higher for some time (or not), making exposure to assets such as equities, private equity, corporate debt, property even riskier at this time).

Higher rates will hurt short term bonds but unintended curve flattening may support the longer end.

The Fed may well ultimately be forced to backtrack again this time, leading to considerable volatility across asset classes.

If foreign policymakers do ‘step up’ again as they did last time, they are better prepared to ensure that any stimulus is more contained within domestic economies, so more specific geographical risk asset allocation might be necessary.

There’s no guarantee policymakers will be able to achieve the same kind of support of capital markets that they achieved previously.

Cash is now preferable to short term bills. While long term bonds may still be attractive, expect increased price volatility so positions should be built and maintained more cautiously.


Disclaimer: The above information has not been independently verified. This investment brief is given for information only and does not represent an investment proposal, recommendation or advice to invest in the shares or business of the subject company. Additional information shall be made available to interested parties subject to the execution of the requisite confidentiality undertakings. The financial information, actual and/or forecast, provide herein is based on management representation.


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