Mario Draghi and his colleagues at the European Central Bank (ECB) have arrived comparatively late to the quantitative easing (QE) party.
The Bank of England and the US Federal Reserve both began their respective programmes shortly after the financial crash of 2008. Meanwhile, Japanese prime minister Shinzo Abe expanded the country’s bond-buying programme in November 2014.
However, the ECB has been determined to make a grand entrance, with a commitment to more than ¤1trn (£716bn) of total stimulus, buying up roughly ¤60bn worth of bonds each month until September 2016. That’s 60 per cent of gross eurozone supply and almost double the share of Treasury bonds purchased by the Federal Reserve.
Broadly, QE appears to be working. The ECB forecasts 1.5 per cent inflation this year, with it rising to 1.9 per cent in 2016 – just shy of its 2 per cent target.
David Ennett, head of high yield at Standard Life Investments, attributes QE’s success to the steeliness of the ECB’s commitment and the scale of the stimulus. “The big QE programme did surprise the market in terms of its size and scope,” he says. “When [Mr] Draghi has come out and banged the table on credibility, the market responds very favourably to that.”
But John Bilton, head of multi-asset strategy at JPMorgan Asset Management, says the ECB’s forecasts should be taken with a pinch of salt. “We are optimistic on the outlook for the eurozone, but given the ECB’s inflation forecasts in the past few years have significantly overshot reality, it may take some time for the market to fully accept [Mr] Draghi’s projections.”
Market signals do give reasonable cause for optimism, with flows of ¤400m into inflation-linked, exchange-traded funds in the first quarter suggesting increasing inflation expectations and a cheaper euro boosting net exports.
“I’d agree that you have to take these projections with a pinch of salt,” Mr Ennett says. “But it’s more about the direction of travel than the absolute level. It’s important that [Mr] Draghi has been able to change the mindset from deflation to low but positive inflation.”
If optimistic forecasts prove well-founded, this could expose many investors to considerable unanticipated risk.
With eurozone sovereign debt flirting with the zero lower bound, all-time lows of 0.085 per cent yield on 10-year bunds and record-breaking negative yields on Swiss debt, even cautious investors have been forced into riskier assets.
Tom Becket, chief investment officer at Psigma Investment Management, notes blue-chip corporate bonds have not been much cheaper, with BMW and Nestlé both issuing hundreds of millions of euros worth of bonds with a coupon of less than 1 per cent in the past few months.
Research conducted by Markit and UBS shows that half of BB-rated bonds are now trading at a yield of 2 per cent or less. “Investors have been forced out of cash and driven along the risk curve, and are now often investing indiscriminately in assets that are perceived to be lower risk and provide an income,” Mr Becket argues.
“There is the [not small] possibility of major losses in certain assets that investors mistakenly believe are low risk.”
Mr Becket notes QE is making low-risk investors’ hunt for uncorrelated assets in Europe increasingly challenging, prompting cautious fund managers to look away from sovereign debt and expand their positions in long-term equities, high-yield fixed income, cash and precious metals.
But Mr Ennett does not think that diversification necessarily means longer-duration, higher-risk positions. He notes: “This is not how we position our portfolio. We find the best value in a diversified portfolio of well-capitalised companies in the core of Europe, particularly those in export-linked industries.”
Any extra risk investors have been prompted to take on may be compounded by liquidity problems once rates pick up.
“Liquidity will inevitably be squeezed as bonds are removed from the market,” says Steven Bell, co-manager of the F&C Macro Global Bond fund. “There have already been problems in Dutch treasury bills and there are worries about German ‘Schatz’ [two-year government bonds] when futures roll. But [worsening liquidity] is a small price to pay for reviving the European economy.”
Mr Ennett agrees: “An uncontained sell-off is not our base case.”
While Mr Draghi may have been a late arrival to the QE party, he now seems to be its life and soul. But as some strategists are now warning, risk-ready investors may be in for a punishing hangover in 2016 if early signs of success are a signal of bigger rate rises further down the line.
Raphael Hogarth is a PPE student at Oxford University
