23 March 2015

IPE Views: The impact of European QE on asset allocation

Quantitative easing (QE) in the euro-zone has begun and is already having some noticeable effects. Bond yields in Germany were already negative, but elsewhere it is noteworthy that recent issues of Irish sovereign debt have also been taken up at negative yields. The normal rules of investment seem to have been suspended as investors seek to scramble for euro-zone government bonds in the hope they will be able to sell them on to the European Central Bank (ECB) at even higher prices.

The extra demand for bonds from euro-zone investors can also be expected to increase demand for other types of assets, including corporate bonds. With extra demand comes higher prices and lower yields. If bonds and Gilts are not a significant part of a pension scheme’s portfolio, interest rate and inflation hedging should continue to be considered, in order to mitigate the impact of interest rates staying lower for longer. Whilst yields are at historical lows, it does not necessarily follow that they will revert to some ‘mean’ that is significantly higher. They are equally as likely to stay low and may even go lower if further bouts of QE bring more demand into the bond markets.

Equities are highly priced, and some markets, like the UK, are touching all-time highs. But again, QE is likely to inflate the price of all assets as the relative valuation of equities should follow bond prices higher, as those equities may begin to look good value in the face of low or even negative yields elsewhere. Since many equity markets are dominated by global stocks, it is hard to see whether any single region will benefit.

Euro-zone investors may switch their focus onto euro-zone equities first, which may lead to those stocks performing well relative to other areas, although there is a risk recent falls in the value of the euro may continue. Hence, some globally diversified equity exposure would seem reasonable– as the effect of QE may be to continue to erode the value of the euro compared with other currencies.

Pension funds should equally look outside equities for returns. Whilst diversifying sources of returns has been common for many investors, at a time of low absolute prospective returns, many investors should find some room for absolute return strategies in their portfolios. Asset classes that return a steady low positive return over the next decade may suddenly begin to look quite exciting if the alternative is lower-risk, negative-yielding bonds.

Investors need to assimilate the impact of QE quickly to position their portfolios for the economic circumstances ahead. Hedging interest rates and inflation rates still looks wise, together with diversifying sources of returns. Whilst bond and equity markets are at historically high levels, other sources of returns, and specifically absolute return strategies, should be used in any diversified portfolio.

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