Keep a close eye on the fat, drunk, drugged elephant

We do not know how the economy and markets will cope with the removal of quantitative easing and what the aftershocks might be, writes Kate Rogers

Higher levels of inflation could be damaging for charity investors, writes Kate Rogers
Higher levels of inflation could be damaging for charity investors, writes Kate Rogers

Investment managers are accomplished at looking to the future and appearing confident about what might be around the corner. We use sometimes complicated, sometimes simple models to tell us the likely direction of markets - if interest rates are up, bond prices go down, if corporate earnings are better, equity markets are better, and so on.

But with every confident forecast there are always unknowns, and at the moment the metaphorical elephant in the room is quantitative easing. Central banks in the UK, US, Europe and Japan have all used quantitative easing to try to stimulate the economy. This is done by buying financial assets, such as government bonds, from banks and other institutions, thereby supporting prices and lowering yields. Low yields act as a stimulus by encouraging spending and investment in higher-yielding assets (such as equities) and penalising those holding cash. An almost unfathomable amount of money has been pumped into markets in this manner over the past five years. In the UK alone, the Bank of England's quantitative easing programme has totalled £375bn.

In the aftermath of the financial crisis, it was vital that central banks took steps to prevent a banking meltdown. Quantitative easing achieved this aim and has undoubtedly also supported asset prices. Despite this initial success, it is worth remembering that this is nothing short of the biggest policy experiment that we have seen in our lifetimes. We do not know how the economy and markets will cope with the removal of this stimulus and what the aftershocks might be.

As is the City's custom, there have been numerous analogies. The US analyst Peter Boockvar likens the effect of quantitative easing to beer goggles: for those unfamiliar with the term, the Urban Dictionary defines it as the phenomenon by which one's consumption of alcohol makes alluring a person whom one would usually find unattractive. Or, as the president of the Dallas Federal Reserve wrote: "Things often look better when one is under the influence of free-flowing liquidity."

Another oft-used analogy is that quantitative easing is akin to putting the economy on a highly addictive painkiller: hence tapering - the removal of this stimulus - is like weaning the economy off this drug. But this suggests that the addiction can be cured and the drug removed from the system: I fear it is not that simple.

Perhaps a better analogy might be that suggested by Richard Jeffrey, chief investment officer of the financial management firm Cazenove Capital: he likens quantitative easing to feeding someone with an abnormally high carbohydrate diet. The person might have more energy, but will build up significant amounts of fat - partly visible, but also around vital internal organs. Once the diet has ended, the person might appear to have shed some weight, but the fat in the body remains dangerous and, in the wrong circumstances, can have severe consequences.

These analogies are by no means perfect, but they emphasise the challenge that the policymakers face and the uncertain landscape for investors. The main threat is higher levels of inflation, which could be damaging for charity investors. It is inflation that erodes the ability of a charity to maintain its charitable impact over the long term and threatens the real value of the endowments or foundations. The drunken elephant in the room needs to be watched, not ignored.

Kate Rogers is client director at Schroders

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