Quantitative Easing

Quantitative easing and macro factors keys to investment success

PUBLISHED : Monday, 31 December, 2012, 12:00am
UPDATED : Monday, 31 December, 2012, 4:58am

The American comedian Will Rogers provided sage advice about investing: "Don't gamble. Take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it."

The key to that phrase, "buy some good stock", implies a somewhat outdated style of investing: to buy stocks and bonds of issuers with strong fundamentals. Many a fund manager swears by such a "bottom-up" approach, by which they buy firms with high quality earnings, governance and growth, on the expectation this will eventually be expressed in a rising share price.

The problem is macro factors dominate today's markets. Most particularly, the global regime of zero interest rates, often delivered on the back of quantitative easing, colours most markets and affects the valuation and performance of all firms, both good and bad.

Look, for example, at the case of corporate earnings, or what is typically the key driver of a firm's share price.

In a period of low growth, profit margins and cash flow improve perversely. Initially, companies cut costs to improve profitability. As revenues are stagnant, companies have no need to invest in expanding capacity or working capital, thereby releasing cash. Reduction in depreciation charges and the ability to use cash flow to cut debt lowers interest costs, as do sharp decreases in interest rates.

Cost cutting, productivity improvements and restructuring don't last forever. In the long run, increases in profitability require revenue growth. But lower growth translates into lower demand, which slows revenue increases. Lower demand and overcapacity in many industries have cut corporate pricing power, lowering profits.

A striking feature of recent corporate history has been low and poor quality revenue growth. Earnings have increased more than revenues. Specific factors have driven revenue growth for individual companies or sectors.

The build-up of cash on corporate balance sheets is frequently cited as a sign of corporate health. Since 2008 in the United States, companies have been net lenders rather than borrowers and now hold about US$1 trillion in cash. Japanese companies hold liquid assets of US$2.8 trillion. European companies also hold large cash balances. Mark Carney, the newly appointed Bank of England governor, referred to the US$300 billion of cash held by companies in his native Canada as "dead money".

The high cash balances reflect uncertainty about future financing conditions and the inability to rely on banks for lending. But it primarily reflects a lack of investment opportunities.

Cash surpluses have helped stock prices and returns. Many companies have returned capital through stock buybacks and higher or special dividends. In the US, fear of tax changes has also been a factor. But investors are now faced with the problem of where to deploy the cash.

Other companies have used surplus cash to buy competitors. Given the mixed results of such mergers (HP's many acquisitions come to mind), it is unclear that this will benefit anyone other than shareholders of the acquired companies and investment bankers.

Equity valuations increasingly also reflect changes in the market environment.

Changing demographics also affect stocks. Investors approaching retirement may switch to more defensive assets and seek steady incomes, favouring bonds and cash. Low and declining returns over time have also undermined demand for equities, which is evident in outflows from equity funds into other assets.

Central banks' zero-interest-rate policies affect markets in other ways. For example, investors have become desperate for yield. They have converged on income securities such as dividend stocks and bonds, creating a growing concern that a fresh asset bubble (particularly in high-yield bonds) is under way.

With few policy options to stimulate economies and markets, central banks seem set to stay on a path of continuous quantitative easing - printing money to buy stocks, bonds and other assets.

Many people dispute the effectiveness of quantitative easing to boost economies, especially given the inflationary threat of such money-printing schemes. But no one disputes that quantitative easing is a dominant force in markets.

This generally works out to be a bad deal for investors, as it drives down yield on investments, often below the rate of inflation. It also means people now have to be central-bank policy experts to precisely navigate their chosen sphere of investment.

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money