What to do as quantitative easing becomes quantitative tightening

Here’s a little something I want you keep in mind as you read the rest of this column. Seventy years ago a single Bic Cristal pen cost the equivalent of one week’s wages for the average secretary. Today you can buy a pack of 20 for a tenner. That works out to about 0.03% of the weekly earnings of a secretary.

The result of this stunning fall in price — or rise in productivity — is that Bic sells 7.4 billion writing instruments and other stationery products every year. Brilliant, isn’t it?

Hang on to that for a few minutes while we move on to something rather more miserable: the state of mind of the people in charge of managing the ridiculously large portfolios of assets held by central banks. They are responsible for $5.5trn worth of wealth.

But, according to a new poll reported in the Financial Times last week, they strongly suspect that as the very loose monetary policy of the last decade is reversed and interest rates are allowed to rise, there is a chance they might lose rather a lot of it. This makes them very nervous. As it should. After all, they surely know best what is likely to happen to markets next.

I have often bored you about the September 2011 quarterly report from the Bank of England that predicted that, while quantitative easing (QE) would work on the economy in various ways, the one to which it attached “particular importance” was the “portfolio balance channel”. This was code for “bubble creation channel” or more simply, a very sharp rise in asset prices.

The purchase of assets under QE, said the Bank at the time, would push up both the price of the assets bought (mostly bonds) but also the prices of other assets.

“When the central bank purchases assets, the money holdings of the sellers are increased,” it said. “Unless money is a perfect substitute for the assets sold, the sellers may attempt to rebalance their portfolios by buying other assets that are better substitutes. This shifts the excess money balances to the sellers of those assets who may, in turn, attempt to rebalance their portfolios by buying further assets — and so on.”

Think of the money poured into the markets by QE as a mountain of hot potatoes being chucked from one asset manager to another and you get the picture. Potatoes in, prices up.

The US Fed has also made no secret of the fact that one of the main points of QE was to shove up bond, house and stock prices and make everyone feel better. The then chairman Ben Bernanke wrote as much in an article in the Wall Street Journal in November 2010.

The good news is that this bit of the plan worked. In a paper out a few weeks ago (staff working paper No 720) bank analysts suggested that without QE house prices in the UK would have been 22% lower by 2014 than they actually were. Equity prices would have been 25% lower.

You could argue, as some still do, that this has nothing much to do with QE. Equities were exceptionally cheap back in 2009 so their rise could simply be a function of that. Cheap things tend to rise in price over time. However, look at a chart of the moves in the S&P 500 index alongside a QE timeline and you might not be so sure. It rose into the first two bouts of QE and fell as each ended. It rose into QE3 (the biggest and longest of the lot) and when that ended in 2014, went precisely nowhere for two years (it started to rise again in 2016 as company earnings picked up).

Asset prices will fall – but don’t cash out

You will see the problem. If QE really has caused much of the rise in asset prices over the past decade, surely the lack of it and then its reversal will cause those same asset prices to fall? The authors of Paper 720 certainly seem to think so. “When policy is tightened you might expect broadly offsetting effects in the opposite direction,” they say.

So does James Ferguson of research firm Macrostrategy Partners. This isn’t happening yet in the UK, he says, but in the US, QE is now fast turning to quantitative tightening (QT). Set to accelerate throughout 2018, it is something that should be seen as the “overriding” dynamic for markets and the reason why the bull market in the US really is on the way out. Potatoes out, prices down.

This might be making you nervous – and it probably should be. Unless the Fed suddenly reverses policy again (halting QT or restarting QE) now doesn’t feel like the best time to pour new money into markets.

However, it isn’t time to cash out. QE and QT will come and go but for the long-term answer to your finances look to the latest Barclays Equity Gilt Study. In it you will see that being connected to the long-term prosperity of the private sector (as exemplified by the secretaries and the pens) is a must.

Over the past 118 years UK equities have returned on average 5.1% a year in real terms. Long-dated gilts have returned 1.3% and cash has delivered a fairly pathetic 0.7%. In the US those numbers, over 87 years, are similar: 6.7%, 2.6% and 0.4%. Being significantly out of equities isn’t ever going to feel good for very long.

With that in mind, as long as you aren’t overinvested in the US; have good exposure to the UK domestic sector (it has underperformed, is relatively cheap and isn’t at immediate threat from QT); and have attempted to create a bias to value, you need do nothing in particular new.

You will be wondering why, if I have no dramatic advice, I have spent 1,000 words telling you all this. It is so that you are ready. Most people don’t read Bank of England reports nor do they think much about QE any more. They might be surprised — panicked even — to find themselves significantly, albeit temporarily, poorer at some point in the not too distant future. You won’t be surprised. And that I think, will help.