The end of Quantitative Easing

Last month, we tried to quantify the size of monthly liquidity injected by various central banks into the market. We also opined that such liquidity was the main source of demand for equities, and arguably the last remaining pillar of support for this aging bull market.

By way of update, The European Central Bank (ECB) has now decided to end its Quantitative Easing (QE) program by next December. In the US, the Fed has signalled that further tightening is on the way. In any event, its balance sheet reduction program is set to accelerate, and is expected to end some time in 2019 or early in 2020.

Without getting immersed in details, the bottom line is that between now and the end of 2019, a significant amount of liquidity will be taken from the market. In other words, there will be much less money to invest. For corporates, it means less liquidity and a lesser ability to buy back shares.

This will mark a fundamental change to the favourable supply/demand dynamics that have so far fuelled the bull market. In other words, demand will drop as a result of lesser liquidity, whereas suply shrinkage will subside.

At the time of writing, markets have yet to react in a negative way to this news. Obviously, equities are still riding the wave of strong ecomomic growth and corporate earnings, but this can only go so far. At some point, the market will realize that an aggregate PE ratio of 25 times is not sustainable. If you combine reduced liquidity with excessive valuation multiples, emerging markets troubles and the looming trade war, there is hardly any reason for optimism.

Not all equities are equal

To better assess future outcomes, one has to measure how differenrt equity indices have so far performed. One of the worst performing this year has been the Dow Jones Utilities Index. As of June this date, the Index is 15% off its high for the year. In Canada, utility and pipeline stocks have fared even worse, with losses ranging between 15% and 25%. Real Estate Investment Trust losses have ranged between 10% and 25% depending on the sector. In both countries, we can attribute this poor performance to one main reason: higher interest rates.

Another poor performer has been the consumer staples sector. At the time of writing, the Global Consumer Staples Index is 10% off its peek, reached earlier in the year. In the US, some consumer sector blue chips currently offer attractive yields of 3.5% or higher.

The point is that when the bull market ends (if it hasn't already), losses will not be the same across the board. We expect high fliers in the technology and industrial sectors to be hit much harder than utilities and consumer stocks. So one way to be better positioned for the next setback is to add exposure to defensive and interest senstitive stocks that have recently performed the worst, and reduce exposure to technology and growth stocks that have performed the best.

What about high interest ratesÉ

The question on your mind is probably now: if interest rates are going up, then obviously interest senstitive stocks will get less attractive. Is it not too early to overweight such sectors? The answer is possibly yes (who knows), however:

First, markets move in anticipation. So much of the bad news about interest rates has already been priced in. Savvy investors did not wait for rates to go up to start selling interest senstitive stocks. They initiated their sell off before the tightening process started, in anticipation. We are not saying that the sell off has stopped (clearly not) but much of it has already taken place.

Second, as interest sensitive sectors sell off, valuation multiples improve: we are talking about sound companies with good business franchises and predictable cash flows. Thus the danger of a free fall in prices is contained. On the other hand, the risk of a free fall is much higher in the case of technology and other high growth companies that have fuelled the bull market in its late stages.

Third, even though interest senstitive stocks react negatively to higher rates in the short-term , they do perform acceptably in the long-term. Remember that higher interest rates are the result of strong economic growth, and the inflation that normally comes with it. In that respect, companies in the utilities, pipelines and consumer sectors have business models that are naturally hedged against inflation.

For example, the long term take-or-pay contracts on which pipelines companies rely are indexed to inflation. So are the long-term rental contracts of all REITS. As for utilities companies, their regulator-approved pricing model is based on a certain guaranteed return on capital that is also naturally indexed to inflation. Finally, when it comes to consumer staples companies, their competitive edge and business franchise allows them to pass on pricing increases to their clients. In summary, now that all such sectors have taken a first hit in reaction to higher rates, they are not a bad place to be in for the long-term.

How much to put in each sector and how do you rebalance your portfolio in response to changing market dynamics? Those are two questions we will take up in our next update.

June 14, 2018