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Neil Woodford

Unintended consequences

26 February 2015

Quantitative easing benefits those of us with wealth rather than economic fundamentals, argues fund manager Neil Woodford.

One of the many topics for discussion by the World Economic Forum in recent years has been deepening income inequality. Indeed, it was identified as the most significant trend of 2015 by the forum’s experts. It is therefore ironic that, as the world’s policymaking elite met in Davos last month, the European Central Bank (ECB) introduced a policy that exacerbates inequality, with Germany finally conceding that the eurozone’s problems were significant enough to warrant a programme of quantitative easing (QE).

QE is money printing hidden behind a very poor disguise. Central banks create money electronically, and with it they buy assets, primarily sovereign bonds. The intention thereafter is that the institutional investors that have sold their sovereign bonds will reinvest in assets a little further up the risk spectrum. This forces the next seller to do the same and so on. Ultimately, the stated purpose of QE is to inflate the price of risk assets in the hope that, in so doing, the benefits of higher asset prices in the financial world will trickle down through the economy to provide a boost to activity in the real world.

Unfortunately, we have plentiful evidence from the last six years to confirm that the trickle down simply does not work. The fruits of the policy are consumed in the financial world but the wider economy fails to benefit. On its own, QE does nothing to improve economic fundamentals.

percentage share

Data provided by Woodford Investment Management

Wealth effect

What it does do is redistribute wealth. It makes the asset rich richer but the asset poor see no benefit and continue to be more exposed to the economy’s structural problems, such as high and rising youth unemployment, a lack of real wage growth and persistently high debt levels. Hence, we have wealth and income inequality in the western world rising to levels with which policymakers are clearly uncomfortable. Indeed, this undesirable and unintended consequence of QE in the US was one of the primary reasons that the Federal Reserve abandoned it last year.

The ECB’s decision to embark on a QE programme later this year followed months of speculation and eventually arrived against a backdrop of a weak and deteriorating economy. The eurozone already has negative inflation rates and the policy may have been introduced too late to avoid a more prolonged bout of deflation in the region than the brief period of falling prices that we saw in 2009.

Regardless of the fundamentals, however, global stock markets have enthusiastically greeted the prospect of QE in Europe. It has become a knee-jerk reaction for risk assets to rally in anticipation of the next liquidity injection – the policy is, after all, designed to lift asset prices and it has succeeded in doing so in the past.

Brimming value

However, as we are all regularly reminded, past performance is not necessarily a guide to the future and there is good reason to believe that risk assets may ultimately behave differently this time. Firstly, we must consider valuation. When equities were cheap, QE fuelled a re-rating. That story has now played out, however, and stock markets now generally look much more fully valued. From here, it is much more difficult for markets to move materially higher. Indeed, in an environment where earnings are vulnerable to downgrades, global stock market indices are pregnant with risk.

Secondly, there is the Greek situation which, at the time of writing, remains unresolved and uncertain. Even if negotiations do conclude successfully, it is difficult to see how a compromise can provide a permanent solution to Greece’s problems and keep the Germans happy at the same time. Europe’s troubles are not just confined to Greece, although the current stand-off does epitomise the region’s broader issues. In other words, the eurozone crisis will rumble on with the potential to upset financial markets at any time.

So there are good reasons, in my view, to question the market’s knee-jerk positive reaction to more QE. That’s not to say stock markets won’t continue to move higher – they might; but, if they do, it is likely to be through a further re-rating rather than earnings growth. In turn, this simply brings with it the ultimate risk of an even more significant correction when fundamentals eventually and inevitably reassert themselves.

‘Remain focused’

From a strategy perspective, therefore, the introduction of QE from the ECB does not change the way my portfolios are invested. I remain focused on identifying attractively valued businesses that I believe are capable of delivering long-term returns in spite of all the headwinds. Fortunately, although stock market indices now look vulnerable more broadly, inequality exists in stock markets as well as economies. There remain some profoundly attractive investment opportunities and, by focusing my portfolios towards these, I continue to feel very confident about the prospect of delivering long-term positive returns.

Neil Woodford is the founder of Woodford Investment Management and is manager of the St. James’s Place UK High Income fund.

This article first appeared on www.woodfordfunds.com.

The opinions expressed are those of Neil Woodford and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers or St. James's Place Wealth Management.

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