Markets continue to follow the money

This month (4 April) marks the second anniversary of Japan launching its own version of Quantitative Easing (QE). When the scheme was first announced by Bank of Japan Governor Haruhiko Kuroda, the idea was to let QE run for two years and then stop. That deadline now looks to have been quietly dropped, especially as Kuroda actually sanctioned an increase in the scale and scope of the QE programme last November.

With clients' portfolios in mind, there are five potential lessons here.

• Once a central bank starts a QE scheme, it can be very hard to wean yourself off it.
• If the global economy really was on a firm road to recovery, central banks would surely be looking to ease back on the monetary medicine or even tighten.
• Central banks remain in the box seat when it comes to where markets are going.
• Currencies are being used as a policy tool and clients may need to protect themselves.
• Deflation is seen as the enemy but there is one area where inflation can be clearly seen, namely asset prices, as stock and markets grind higher (and other areas such as art and horseflesh also attract strong interest).

For the moment, the tide of central bank liquidity is lifting most boats and the markets that are running fastest are generally the ones where monetary policy is at its loosest – Japan and the Eurozone. Note these are total return figures, in local currency.

QE is helping to fuel equity market performance in Japan and the Eurozone

Source: Thomson Reuters Datastream. Covers period 1 January to 1 April 2015. Results in local currency (dollars for MSCI indices and FTSE All World)

If an adviser believes Japanese or European equity exposure are suitable for a client's overall strategy, target return, time horizon and appetite for risk, there is no shortage of active and passive funds which target these markets. Examples are provided for Japan below and this spring's wage round – or shuntō – must be followed closely. If workers prise hearty increases from their employers maybe Kuroda and Prime Minister Shinzō Abe can argue QE is working, as it stokes inflation and gets money circulating again, to the potential further benefit of the Nikkei 225.

The best performing Japanese large cap funds over the last five years

Source: Morningstar, for Japan Large Cap Equity category. Clean funds only. Where more than one class of fund features only the best performer is listed.

Best performing Japanese investment companies over the last five years

Source: Morningstar, The Association of Investment Companies, for the Japan and Japanese Smaller Companies categories * Share price. ** Includes performance fee

Best performing Japanese ETFs over the last five years

Source: Morningstar, for the Japan Large Cap Equity and Japan Small/Mid-Cap Equity categories Where more than one class of fund features only the best performer is listed.

On and on and on

Japan may have begun with good intentions, outlining a two-year QE programme but it now seems  Tokyo is committed to the programme for a lot longer than that.

This mirrors what happened in the US and UK. America launched its programme in November 2008 with a $600 billion mandate and ended up expanding it three or four times to around $2.4 trillion, a sum the Federal Reserve shows no signs of sterilising. The UK took its initial £175 billion outlay to £375 billion and, like the US, appears to have no plans to withdraw that stimulus.

The US Federal Reserve and the Bank of England have at least stopped adding to their QE schemes but they are in no rush to tighten interest rates. Market expectations for the first hike in the headline cost of borrowing have been pushed back to late this year or beyond. This suggests the foundations of the recovery may not be as sound as we would like – global indebtedness continues to rise, after all – and central banks are still apparently more concerned about a downturn than an inflationary overshoot to the upside. Sweden joined the QE party in the first quarter and over 20 central banks have already cut interest rates in 2015.

The prospect of money staying cheaper for longer leaves clients with a dilemma when it comes to gleaning a decent return on their hard-earned savings. Cash is being forced up the risk curve – toward lower-grade bonds and equities. Since Japan's QE launch in April 2013, the Nikkei 225 benchmark has surged 52% to 19,207.

Rich man, poor man

Some policymakers are keen to try and create a wealth effect by forcing stocks higher and are equally keen to force their currencies down, to help fuel exports and inflation – Japan's Prime Minister qualifies on both counts and the Eurozone's Mario Draghi probably does as well. The charts below shows how the dollar, the globe's reserve currency, has risen remorselessly against both, even allowing for its pause for breath this spring.

The dollar has risen sharply against both the euro and the yen over the past year

Source: Thomson Reuters Datstream

There has to be a risk such beggar-thy-neighbour approaches can only go so far – it is impossible for everyone to have a weak currency at the same time. In the meantime, clients might like to considering protecting themselves by taking any exposures via funds, active or passive, which hedge out currency movements. This will cost a few extra basis points but it may be worth it as the contrast between the table below and the one above is clear. This one shows the first-quarter's returns from the major markets in sterling terms, rather than local currency. Both the overall results and pecking order are quite different.

European stocks look less impressive in sterling terms in 2015

Source: Thomson Reuters Datastream. Covers period 1 January to 1 April 2015. Results in sterling.

Central banks are fretting about deflation but they are at least helping to boost asset prices.  Headline consumer and retail price inflation may be subdued and central banks cannot afford to let deflation become entrenched, as it increases the globe's huge debts in real terms. The authorities are likely to keep printing to stave off this danger even if loose monetary policy is promoting inflation in one area: asset prices. This can be seen in equities, bonds and property as well as art and horseflesh and there remains the danger an extended period of QE leads to bubbles, overvaluation and eventually an accident.

Hubble, bubble

It is possible to argue there is a correlation between central bank asset buying programmes and stock markets. The three charts below look at the assets of the Bank of Japan, US Federal Reserve and Bank of England. Stocks have found it harder – though not impossible - to make ground in Britain and America once the QE taps have been turned off.

Bank of Japan's asset-purchase programme looks to be helping Japanese stocks...

Source: St. Louis Fed – FRED, Thomson Reuters Datastream, AJ Bell Research NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

...while US and UK equities are making slower progress...

Source: St. Louis Fed – FRED, Thomson Reuters Datastream, AJ Bell Research NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

...in the absence of central bank liquidity

Source: St. Louis Fed – FRED, Thomson Reuters Datastream, AJ Bell Research
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

The last word

QE could keep the market pot boiling for some time, or at least until valuations become so stretched that even booking a small real-terms loss on cash looks like a better trade than buying stocks or bonds.

Spotting a “bubble” is the devil's work and they only tend to become apparent with the benefit of hindsight, although they do tend to follow the similar patterns, according to Charles P. Kindleberger and his seminal tome Manias, Panics and Crashes.

Supporters argue QE has already boosted growth and fuelled a recovery in the UK and US. But we will only know if it really works in the long run once stimulus is sterilised. Japan has been here before. It tried QE and a zero-interest rate policy (ZIRP) between 2001 and 2006. The Nikkei 225 rallied by 140% to a peak of 18,262 but rolled over once the programme was halted. The economy also stalled, hampered by the outbreak of the Great Financial Crisis in 2007.

The Nikkei 225 rolled over once the Bank of Japan's 2001-06 QE scheme ended

Source: Thomson Reuters Datastream, AJ Bell Research NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Russ Mould, AJ Bell Investment Director