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How Quantitative Easing Changed the Markets and How to Weather Them

via The Market Mogul : The rise of asset classes such as private debt, or low-carbon strategies, and the development of asset allocation tools like absolute return investing, among others, owe part of their success to the development of multi-asset funds, exchange-traded funds and smart beta funds, that delivered high returns net of cost, according to surveys of the earliest adopters.

However, it should be noticed that, as the Financial Times rightfully points out, central bank large-scale asset purchases, commonly known as quantitative easing (QE) policies induced as a response to the 2008 Great Recession, artificially inflated returns by distorting the real value of those assets, thus contributing to their successful ascent to the status of relatively safe sources of return.

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QE policies, together with new financial regulations have radically changed the face of the markets by dampening volatility but not overall liquidity and making markets generally more predictable, thereby reducing the need to rely on smaller players to rely on their biggest peers that were used to take more financial risk.

Now that central banks are starting the bond buyback programme (reversing the quantitative easing policies), it is imperative for asset managers to implement their products in order to weather the unavoidable wave of instability that is coming, as markets re-adjust to their natural structure.

Specifically, investors need a better protection in the risk-return trade-off of investing strategies. Financial models are not enough because they often fail to take into account sudden, non-quantitative factors that affect markets, socio-political and psychological in the first place. The role of human judgment has never been more crucial, despite the increasing importance of machine learning in the financial sector.

Zero Effects on Liquidity of Non-Targeted Assets

Other more evident legacies of QE programme are shifting risks related to both low volatility and liquidity. Not only is risk in many cases is mispriced, but the lower liquidity premium actually reduces priced frictions to trading through a liquidity channel that temporarily increases the bargaining power of sellers, but only in the market for targeted securities.

According to a Federal Reserve research paper, the resulting reduced liquidity premium has a positive effect on markets only as long as QE purchases are ongoing and expected to continue. In addition to this, the very same report does not find any improvement in actual liquidity as measured by the trade volume of the product under the buyback scheme, Treasury inflation protected securities (TIPS) in this case, despite their initial reduction in price.

For investors, the unaltered level of liquidity premium but for a restricted target of securities doesn’t translate in more risk-less opportunities, but just in less risk for a range of debt that may not be suitable for individuals willing to increase risk for higher potential returns.

The Demise of Pension Deficits

Another downside of QE policies is their harmful effect on pension deficits: a fast increase in liabilities, not matched by the rise of asset values.

According to a survey by the Chartered Institute for Personnel and Development, more than 16% of medium businesses had to cut the pension benefits for their staff, and had profits reduced due to an increase in pension costs caused by annuity costs highly increased by low bond yields.

This in turn has reduced the amount of funds available for investment and expansion of the business, thus offsetting in part the positive effect of QE.

The Last Effect of QE: a Situation Never Seen Before

However, now that the Fed is ready to unload $10bn worth of treasuries each month for a total of $4.5tn, the scope for market upsets is very high, not only because of the current level of US corporate debt is higher than ever, but also because of the current global macroeconomic situation.

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Low inflationary pressure, low levels of unemployment and stagnating real incomes are a direct result of the politics of economic stimulus generated by central banks. However, such phenomena have never before coexisted: they always have been inversely related and put into question many of the economic theories that until now had enjoyed the highest level of consensus.

As the Bank of England Governor Mark Carney says, globalisation is to blame for the current relationship between inflation and domestic wages because of the oversupply of labour coming from emerging market economies. However, while the data suggests that this phenomenon holds at the global level, the question of migration of workers will remain unsolved because in most developed nations it is politically impossible to change immigration policies.

Will QE Always Be the Right Answer?

In the current political climate, there are more questions than answers about the possible outcomes of the gradual end of the quantitative easing era. Surely, money managers and investors should be ready to test themselves and their assets against worst-case scenarios but if the global economy is still too young to walk alone without support, central banks will be urged to intervene again.

This time, the next big question will be the feasibility of another cycle of QE policies in the long term, taking into account the effects on businesses, workers, and investors, who are perpetually locked in a world of stagnant wages, high pension deficits and few opportunities for high return investments.

A viable possibility is to use QE to finance education and the development of infrastructure, creating jobs, and providing social benefits in the long term by redistributing at least a part of the income lost to the people who have benefitted the least from the classic QE policies.

While this solution may sound too extreme to some, it may help central banks and governments altogether to contribute to the wellbeing of the whole society, and at the same time stand against the wave of populism that is currently spreading around the world.

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