Duncan Lawrie Online ▼

Posted on: 15 April 2015

The amount of liquidity in the global financial system continues to grow, thanks to massive quantitative easing (QE) programmes in both the Eurozone and Japan.

Extraordinary monetary policy measures have been in force in a number of countries across the world since 2008, after global central banks were forced into co-ordinated action to limit the possibility of the financial system falling to pieces. At varying times since then, five major central banks have printed money via QE programmes - ostensibly to boost demand via cheap money within their respective economies.

The US may have curtailed its QE programme, but with neither the Japanese nor Eurozone economies yet out of the woods, it would be surprising if QE did not continue in some form or another around the world in the near term.

So, what impact has QE had so far?

Almost without fail, currencies have been impacted by QE, with significant US dollar, euro, yen, krona and sterling weakness during periods of easing. We have argued before that currency weakness was likely an intended result of QE (despite protestations to the contrary), and the Eurozone's recent foray into QE appears no different.

It has also contributed to lower levels of volatility across asset classes, as well as significant inflows into equity markets - as bond yields have trended lower, investors seeking higher rates have been forced into more volatile assets, including equities. This, in turn, can contribute to equity prices becoming detached from their fundamental valuations, as these investors may value the equity market based on its income yield rather than its earnings.

What do we mean by this? In the long term, the price change of equity markets should reflect the change in the earnings of the underlying companies. However, in the short term, equity prices can deviate some distance from the underlying earnings, due to many factors - including QE.

Should we be concerned? QE has helped equity markets perform well since the financial crisis, even in the face of poor economic and earnings data. As outlined above, QE is likely to continue until economic growth in the Eurozone and Japan becomes more self-sustaining, suggesting that there should be some support for equity markets for now. Valuations have also been supported by low and steady inflation, which is also likely to remain the case for a while longer. If earnings grow more quickly, then equity valuations may improve and better reflect fundamentals.

The European Central Bank - led by Mario Draghi - has successfully brought about a 28% fall in the value of the euro versus the US dollar over the past 12-months. This should help make the Eurozone more competitive in global trade, but may also be a headwind to US growth. It is unclear whether Europe can take up the slack if the US begins to slow more sharply, but both regions remain very important for the UK market: approximately 27% of UK large cap earnings come from the rest of Europe, versus 24% from the US[1].

While macroeconomic factors appear to be broadly supportive of equities, the divergence among central banks with respect to monetary policy and the resulting impact on both currencies and equities is likely to cause volatility throughout 2015. Q1 saw the biggest intraday moves in the USD/EUR since the single currency was first introduced, and as we approach the Fed's expected interest rate rise, more volatility is likely. This causes us to remain cautious, and maintain a well-diversified position across asset classes and geographies.

To read more news from The Commentary April 2015 edition please click here

[1] JP Morgan, Guide to the Markets Q1 2015.

All data has been compiled by Duncan Lawrie from sources believed to be reliable. Full details of sources are available on request.

The comments and figures in this document are generally applicable but you should always take specific advice  to suit your individual circumstances before taking any action. Errors and omissions excepted.

The value of investments and income generated may fall as well as rise, and investors may not get back the  amount invested. Past performance is not a reliable indicator of future results.