From Demo’s desk…
As global equity markets rallied after their steep decline in the spring, many market pundits pointed to the speed and magnitude of stimulus enacted by policymakers worldwide. Just how much have quantitative easing (QE) and other stimulus actions helped to push up asset prices? Quantitative Easing: A Primer
First, a quick explanation of QE. In order to support economies, policymakers can engage in fiscal or monetary policy. Fiscal policy refers to government spending and tax policies. Monetary policy is used by central banks to control the supply of money. Traditionally, this has involved changing the key interest rate: i.e., lower rates reduce the cost of capital and entice businesses and consumers to borrow more, increasing the money supply. However, as interest rates have approached near-zero levels, more unconventional approaches, like QE, have been required. With QE, the central bank purchases financial assets from financial institutions and issues credit to the banks’ reserves, thereby increasing the money supply. During the 2008/09 financial crisis, the U.S. Federal Reserve began its first foray into QE. The Bank of Canada had its first move into QE this past April.
How Does QE Affect Equity Markets?
When central banks purchase government bonds, yields are pushed down, reducing the return on relatively safer financial assets. As such, investors may look further along the risk curve, such as to equity markets, in search of greater returns. QE and other stimulus actions have also increased liquidity and the money supply, which may have flowed to equity markets. Stimulus actions may have also provided confidence to investors that central banks will continue to support economies through difficult times. Some market analysts contend that this has led to artificially-inflated asset prices. Over the longer-term however, the risks of QE can be mitigated if economies can outgrow the pace of the increase in the money supply as a result of the easing.
What Does it Mean for Your Portfolio?
In some ways, the actions taken by central banks have changed some of the historical assumptions about the financial markets. This may be why there are many differing opinions of what is yet to come. Is inflation imminent? Some argue that stimulus actions have put excess funds into economies, which is inflationary. If the world moves towards deglobalization and supply chains exit China, higher production costs will likely lead to higher prices. Many central banks also want moderate inflation. Inflation worries may explain the increasing interest in gold and cryptocurrencies.
Yet, when QE ended in the U.S. in 2014, many economists expected to see a substantial rise in inflation. This never happened and the stock market advanced in the years that followed. It remains unclear exactly what happens to equity markets upon the departure from low-interest rates and easy money from central bank policy. Eventually, economies will need to acclimate to a market environment with significant levels of public debt — the consequences of which are yet to be seen.
However, one reason for savvy investors to maintain confidence is that well-constructed portfolios use asset allocation and diversification, not just across different asset classes but also risk factors, to help mitigate risk. This involves balancing portfolio exposure to account for the ongoing uncertainty and the potential economic outcomes in the near term. Another reason? Being invested. Participation can be key to generating returns for the longer term. History has shown that even the worst periods of retrenchment have been followed by times of economic growth. This time is likely no different.