Mr Bernanke’s position in perspective

In early 2002, then Fed Chairman Greenspan delivered a robust ‘Humphrey Hawkins’ address that was hugely supportive of equities by promising rapid economic growth for the economy but, in so doing he essentially sacrificed the bond markets. As it turned out, the economy was already weakening at that time (Greenspan had simply been wrong in his assessment of conditions) but the subsequent weakness in bond prices (rise in yields) caused by the comments can only have undermined the real sectors, with the result that by 2003, deflation fears had returned to the global economy.

When Mr Greenspan, and Mr Bernanke, who was then in effect his understudy, realised what had happened, their response to the deflations scare in early 2003 was to use direct money market operations to control the short end of the curve, the promise of long periods of low rates to tether the middle of the curve, and talk of low long term inflation expectations to hold down long term rates.

There are at least two schools of thought as to why the Fed has launched a new ‘extraordinary measures’ monetary campaign now. First, there is the view that the Fed want to achieve a rise in inflation (despite the fact that he also announced a 2% inflation target at the same time) that erodes the real value of the nation’s private and public sector debt burdens over time, albeit at the expense of savers, and that holding bond yields down as inflation rises (so real yields are negative) is part of delivering recovery.

A second view is that Mr Bernanke wants to force other major economies into easing and that Fed rhetoric and action may usher in competitive QE in Europe, Japan and China, at least because further QE in the US should be expected to be bad for the dollar and to avoid relative currency appreciation against the dollar, other regions would need to follow Mr Bernanke’s lead.

At one level, progressive easing strategies that are global in nature are clearly required to ensure adequate systemic liquidity, but on the other hand such initiatives can create competitive devaluation cycles, which can be viewed as dangerous and ultimately self-defeating. In addition, history shows that periods of monetary instability or global inflation (were that to result) do not generate good asset market returns.

Perhaps more worryingly, in terms of risks to markets and economies, if there were to be competitive QE cycles in western developed debtor economies, it may be that Emerging Markets quickly establish capital controls, which would serve to create yet more instability.

As a backcloth to the central bank policy initiatives, it is clear that most policymakers are distinctly nervous if not pessimistic, particularly outside the core of Europe. The gossip is that in private meetings, many describe the Euro project as doomed and most expect a global recession of some form – possibly quite severe – before too long. The IMF’s forecasts have been consistent with this notion and although it is fashionable to dismiss these people as being inaccurate historically, it is notable that their forecasting errors have usually been on the too optimistic side (for political reasons). If they still have this bias, then we can assume that in reality they are really quite pessimistic at present, and we are seeing policy easing, albeit gradual in Asia and Australia and we have the FRB and even the BoE joining in. However reluctantly and unquantifiable, the ECB has been dragged in this direction.

Of course, the Central Banks may be wrong. Mr Draghi may have saved the world and global production trends may be picking up on a sustained basis. If this is so, the facts will have changed and we should expect Central Banks to change their policies.

It is for this reason that we believe that the current valuation/liquidity inspired rally in risk asset markets faces two quite opposing threats. Either the world economy is in a much worse state than the consensus realises (i.e. the Central Banks are right but the Investment Bank economics departments are wrong) with the result that earnings forecasts will need to be savagely reduced. Alternatively, the Central Banks are wrong and QE3 will not need to occur. If the latter is true, we can expect pressure on bond yields and then markets will quickly lose their valuation support.

Against this backcloth, we anticipate that long term equity investors should be focused on stocks supported by strong balance sheets, robust free cash flows and priced to offer high and rising dividend flows.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla