The recent increase of liquidity into global markets through Quantitative Easing (QE) has helped to swell a number of investment sectors and create dangerous market valuations which will pose a serious risk to investors when QE is finally tapered, says Duncan Lawrie Private Bank.
With the US announcing plans to cut back its QE programme and recent figures in the UK indicating a stronger economy with less need for further QE stimulus, investors who went in search of high yield returns in recent years to combat the low rates payable in cash, may now see their investment plummet as liquidity in some markets dries up and the high yield bubble bursts.
James Humphreys, investment manager at Duncan Lawrie Private Bank, says: “There can be no question that a big change in monetary policy, like the withdrawal of QE will have huge implications for global markets, not least because all the money sloshing around has had a significant impact on some sectors which would otherwise have remained somewhat lacklustre.
“The continued pouring of liquidity into the markets has swollen certain investment sectors and has created dangerous market valuations which are posing a serious risk to retail investors. Investors looking for better yields than they would get on cash have been attracted to investments such as highly leveraged investment trusts and a number of illiquid asset classes that will all come tumbling down when the economic cycle turns.
“Evidence of the potential threat facing UK investors can be seen in the US where all signs point to QE starting to be tapered. One example in particular is the US corporate high yield market, which is made up of the bonds issued by sub-investment grade corporations – otherwise known as ‘junk’ bonds. The amount of liquidity poured into the economy has meant that this market has benefitted from much greater demand than it would have had otherwise and in effect it is keeping certain corporations alive that would have faltered.
“The corporations in this sector have essentially been able to issue bonds at historically low interest rates and this has enabled them to refinance themselves on very attractive terms. Meanwhile, more troubled companies in this sector with maturing loans have been able to roll their debt forward using the bond market and buy time before facing difficult repayment decisions.
“The result has been a rise in the number of ‘Zombie’ businesses in the US with few growth prospects and dying business models that are being kept alive by easy credit conditions.
“Ultimately this means that investment capital is not finding its way to viable small and medium sized businesses with good growth prospects. The ‘zombie’ companies that are enjoying all the investment capital at the moment are the ones which, on a longer term basis, are less likely to provide returns and when the QE is finally tapered, will be sure to experience a steep drop in value.
“The global QE environment has ultimately forced UK retail investors to play with fire as low returns on cash and high quality fixed interest securities force them to naively take more risk with their capital in the search for a reasonable income. However, many retail investors are taking on risk that they simply cannot afford or do not understand and not only will they suffer, but so will the long term economic prosperity of the UK.
“With UK interest rates anchored at their current low levels, there is precious little sign of the hunt for yield ending soon and valuations on some higher yielding assets are becoming completely detached from reality. However as liquidity dries up short-term opportunism in the market will come crashing down to earth with a bump and is likely to leave many investors out in the cold.”