Monetary policy is starving the fund management industry of what it needs

06 Jan, 2014

The year just ended was a good one for equities. Even IPOs were up. Fund managers pursuing equity strategies rose with the markets. But the difficulties encountered by short sellers in 2013 and the strategies that performed less well last year - fixed income , macro and managed futures - are a reminder of just how hard it is to invest rationally in a marketplace driven almost entirely driven by quantitative easing (QE).

Predictably, investors are pouring money into equity long/short and event-driven strategies. In the short term they are probably right. Asset price inflation in the equity markets is precisely what we should expect from incontinent monetary policies and a lack of leadership which saw even the government of the United States reduced to farce. The Zimbabwe stock exchange used to find the same when it had an equally complaisant central bank and a tragi-comic government.

The only important question on investing this past 12 months was how to hedge a portfolio against the onset of "tapering" without damaging short term performance too much. After all, nothing fundamental changed in 2013.  Banks, especially in Europe, are still teetering on the brink of insolvency. Corporations are still loaded with cash, because they cannot find sensible investments when the price of every asset is inflated. Much of their cash finds its way back to the central banks.

This has had the virtue of preventing the surplus liquidity fuelling a surge in retail prices, though they have certainly drifted higher over the three years since quantitative easing was introduced. This reflected the QE-driven boom in commodity prices - which generated the almighty hangover from which firms and funds active in those markets are still suffering – and the absence of any productivity gains, thanks to the deliberate postponement by monetary policymakers of any need for firms to cut losses by selling assets and shedding staff.

In fact, those QE enthusiasts which blame inflation on the poor productivity performance of the supply side are missing the point entirely: there was no restructuring on the supply side because the whole point of QE and near-zero interest rates was to prevent that happening. As it happens, the potentially inflationary impact of the cryogenic approach to the real economy has been offset by the contradictory official policy of forcing banks to shrink their assets. Without it, QE would have fuelled an inflationary expansion of credit.

But a combination of quantitative easing and quantitative credit controls is an unstable blend of policies. Factory gate prices are now signalling deflation, not inflation, which is exactly what you would expect when real incomes are stagnant, asset prices are inflated, and industrial and commercial companies (and private equity firms, for that matter) are finding it hard to borrow even in those rare instances where an asset is under-valued as well as under-performing. It is hard to see how any of this will change when the cost of borrowing goes up, which is all it can now do.

Rising interest rates might well cause devastation in the bond markets, where years of ultra-low interest rates have ended in a hunt for yield that makes it seem as if the excesses of 2002-2007 did not happen. Predictably enough, high yield and leveraged loan strategies had a strong 2013, though neither did as well as Distressed. Non-traditional bond funds are attracting plenty of investors eager to travel down the credit curve. It is a textbook demonstration of mal-investment driven by unwillingness to wean markets off excess liquidity.

Reversing QE could have a similarly catastrophic effect in the equity markets. Already, inflated central bank balance sheets - the Federal Reserve balance sheet is up by $3 trillion on 2007, the ECB balance sheet by €1 trillion, and the Bank of England by more than £300 billion - hang over the equity markets like Swords of Damocles. As soon as the central banks stop buying and start selling, prices are likely to crash, as they did last summer when even the idea was aired.

Given the return in 2013 to the mix of momentum investing and hunt for yield to which many sober analysts have attributed the great financial crisis that began in 2007-08, it is not surprising that a number of veteran fund managers have given up trying to make sense of what is happening, and returned money to investors. But an even more worrying trend is this: the immense difficulties now encountered by fund management start-ups. In any industry, innovation depends on outsiders, not insiders. Increasingly, investors are supporting insiders only.

The extraordinary monetary policies of the last six years have prevented the restructuring of real economies and suppressed commercial innovation. They have had exactly the same effects in the financial economy. Of course, policymakers have since 2008 made financial innovation synonymous with destruction. Ironically, this has not prevented investment bankers using discredited techniques to devise risky products for income-starved investors entering a fifth consecutive year in which the benchmark dollar interest rate has sat at 25 basis points. But it has prevented genuine entrepreneurs identifying under-performing assets, and finding the money to buy them.

Dominic Hobson

QEinflationcentral banks