Quantitative easing may well be pushing investors to hold more cash rather than risk assets, blunting its impact as monetary policy.
Known as the portfolio rebalancing channel, the thinking behind QE rests partly on the assumption that buying up government bonds will drive interest rates down and entice investors to tilt their holdings towards riskier investments like stocks. That in turn is supposed to goose investment and consumption.
Unfortunately, that assumption may be running afoul of, or fouling up, the way in which most investors construct their portfolios, according to Toby Nangle, head of multi-asset investments at London-based Threadneedle Investments.
He argues, convincingly, that by driving rates to rock-bottom levels, government debt can no longer properly play its role as ballast in an overall portfolio, steadying the ship and allowing investors to take on more risk than they otherwise would dare.
"Despite working in asset management for sixteen years, I have never met a major, sophisticated, institutional end-investor who did not believe (with a good degree of confidence) that on a five-year horizon stocks outperform bonds," Nangle writes in a note to clients. (here)
"This begs the questions of why give out bond mandates at all when clients could go all out on their favorite asset? The answer, of course, is that they care about the volatility of their overall portfolio returns."
In a normal market, government bonds and stocks are complementary assets; owning the former allows you to hold more of the latter for a given level of risk tolerance. That's because although both assets are quite volatile, when held together in a portfolio they actually produce less volatility.
Investors care about volatility - deeply. Suffering swings in value isn't just stomach-sickening, it can be ruinous, both for the careers of the asset managers involved and for the real needs of the owners of the capital.
And indeed, the data shows - and this is elementary portfolio construction - that mixing longer-dated government bonds with equities leads to less volatility than would be suffered if you held either asset in isolation.
Government bonds, therefore, are not just a hedge, but a hedge with a positive yield. That, in fact, is a principal reason for their popularity.
THE QE EFFECT
Now consider what happens when government bond-buying lowers the yields on those bonds to essentially nothing, or to a negative yield in inflation-adjusted terms. And also consider that under QE you as an investor are participating in a market dominated by one buyer - one whose motivation isn't profit but jobs and inflation and who might if it served its purposes at some point in the future become a massive seller.
"Most developed government bond markets now achieve little for my portfolio and I have sold them down to zero. I prize those markets that do offer the promise of offsetting equity volatility with a positive yield and use them to maintain chunky exposures to the most attractive equity markets," says Nangle.
So, what then to hold?
The problem is that most of the available assets other than government bonds which have a positive yield, such as corporate bonds, are much more highly correlated with equities. That means that they add risk and volatility to a portfolio.
That leaves cash, which has zero return but which doesn't have the capital loss downside of a bond. Sadly, if you hold more cash you need to cut your exposure to equities or again take on more risk. Either way, QE may be having the unintended effect of driving some to hold more cash.
So what are investors really doing?
A look at markets would seem to indicate that most are stepping up their risk, but the evidence isn't all one way. While money market holdings, in the U.S. at least, are down substantially from credit crisis peaks, they are still at historically high levels. And cash assets at commercial banks have skyrocketed, undoubtedly for complex reasons, but something which can be clearly read as showing household and corporate caution about the future.
As for QE, this all adds to the impression that its success as monetary policy is unproven.
For investors the bottom line is that the world has become a riskier place, and central bankers are forcing you to share the burden.
(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)