Question: when is strong global economic growth likely to cause investors a serious headache?
Answer: when financial markets have become so reliant on prolonged quantitative easing (QE) by central banks that to remove it would cause a horrible shock.
In other words, the risk that investors are not focused on at the moment is of monetary tightening to fend off the threat of inflation.
That was the ironic warning delivered by Garry Evans, global head of equity strategy within HSBC’s global research department, in Hong Kong last week.
“In my view, the liquidity injection by central banks has been the major reason behind the relatively good performance of equities in the last four or five years, and the first signs of that being withdrawn would be taken as a negative,” Evans noted.
In fact the MSCI World Index has risen 20.7% over the past three years and 32% over the past four. It comes after a period of quantitative easing from central banks worldwide to pump liquidity into the global economy.
Just last year in September, for example, the Bank of Japan expanded its asset purchasing programme by ¥10 trillion ($111 billion), while in July the Bank of England added £50 billion ($79 billion) to support the UK economy.
Further, last month the US Federal Reserve indicated that it would continue purchasing US Treasuries to the tune of $85 billion a month.
But should there be any surprising uptick in economic growth, the likelihood is that the Fed would withdraw its QE programme to ease potential inflation, Evans noted.
Fed officials are estimating GDP growth of 2.5-3% for the US in 2013, upgraded from a forecast of 2.2-2.8% in June.
“It’s one of the clearest rules of the equity markets that the first tightening move by central banks in a cycle normally causes equities to correct relatively sharply,” Evans added.
He cited 1994 as an example, when the Fed incrementally raised interest rates from 2.5% to 6% over a year. The S&P 500 dropped 4.6% in the six months after the Fed first acted.
“Given how big this QE has been, the effect could be bigger than usual,” said Evans. “I don’t think [monetary tightening is] likely at all, but it’s probably a risk that people have not focused on and if it doesn’t happen this year, it will happen at some point.”
Certainly monetary tightening is not seen as likely in the near term, with the markets still so reliant on the provision of liquidity from central banks.
“I think it’s very difficult to see self-sustaining domestic demand without the ongoing easing of liquidity,” says Neill Nuttall, CIO of global multi-asset group at JP Morgan Asset Management.
Given fiscal constraints in the US and Europe, he argues that liquidity from monetary easing will be a continued requirement. The chief threat to such support would be inflationary concerns.
“Any hint of inflation or inflation expectations becoming embedded would begin to raise the question of whether central banks can continue to provide that liquidity,” Nuttall adds.
“I am not forecasting inflation. I think [there are still] global output gaps, excess labour supply, and excess productivity capacity, so we don’t see inflation picking up. But given the monetary accommodation of the last five years, if it does take hold, it will be one of the biggest threats to markets.”