George Lagarias, chief economist at Mazars, delivers his popular commentary, this week focusing on Quantitative Easing(QE) and the markets reaction to risk
Global markets awoke from twelve years of a QE-induced haze to realise that the world is full of danger and risk. Meanwhile, many an active manager have changed professions and those that remain barely remember a time without the Fed’s safety net. Last week it was inflation and the Russian guessing game in Europe. The week before, it was weak earnings from Facebook. Volatility since the beginning of the year remains elevated, as the QE filter is now removed from financial markets. Investors are facing a trendless market, rife with risk, but also opportunity.
QE was never supposed to directly drive markets higher. Its primary function was to mitigate the downside, so that, naturally, mostly upside remained. In its absence, downside risks become more potent.
The primary focus of investors right now is the possibility of runaway inflation. Ukraine is closely linked to it, as the crisis is fuelling energy prices, exacerbating inflation pressures. Markets seem to be worried a lot more about inflation than central banks, which have decided to take a more measured approach in fighting higher prices. Market-implied rates are significantly above the Fed’s median rate estimate for both 2022 and 2023, suggesting a belief that the US rate-setting body is already significantly behind the curve.
Which brings us back to the original issue. Risk management, which can only begin when investors are comfortable with risk. But markets have forgotten how to deal with risk. For the past few years many fund managers found themselves under pressure from outflows due to competing passive funds. A lot of the less entrenched operators had to take on increased risk, in full knowledge that the Fed would provide a much better and cheaper blanket risk hedge than they ever could. This world turned on its head, when inflation numbers shot up and wage growth followed.
We feel that the market is not in a transitional phase, but rather at a crossroads.
On the right, a road returning to investing as we once knew it: de-correlation, higher volatility, a world where opportunity and risk co-existed. Active asset managers will probably be rewarded and economic growth, albeit volatile, will be higher.
On the left, incredibly this is still a QE-driven world. A generation of consumers will turn into a generation of caretakers, as the world battles environmental change. Most shorter-term inflation pressures will eventually subside and what remains will be modest growth, secular stagnation-level prices, plus “Green” and “China Transition” inflation. In this world, QE has only taken a hiatus, to return as investors remain sceptical about assuming risks.
Which way we will go, is really a coin-toss. The central banks’ lack of real conviction about inflation, evidenced by their paced approach to hiking rates, suggests that either they are slow to realise that the world has changed, or that they want to cover some downside risks without compromising their central strategy.
Our take is that the world tends to move forward not backward. Both of these scenarios describe a world either before 2020 or one before 2008. In reality, there’s a third path, towards a new world emerging after the pandemic. A world at the cusp of the New Green Economy and more technological revolutions wrought by Blockchain, quantum computing and possibly a new form of energy that would make redundant the internal combustion engine. A path where nations realise that globalisation can’t be scaled back and that this interconnected world needs new economic and political theories if the transition to the next phase of the nation-state is not to become dystopia. In this world, central planning is subordinated to the bottom-up forces of the economy, and the picture that emerges will not be one driven by policy but the one of the most prevailing winds. Companies understand this and focus on positioning for the next decade. Some prepare their “metaverse” and “Blockchain” strategies. Some focus on evolving hybrid work and a new way of managing. Meanwhile, supply chains are being repaired without -or even in spite of- national strategies, showcasing exactly how potent the power of businesses and innovation is to drive the economy. New theories will describe how the new world can evolve from the chaos of the old and how policy makers can restore civic supremacy.
The first two paths are easier to see, courtesy of hindsight and history. The third, and more likely, is lost in the mist. But, in our humble view, this is also the more likely one. We might not have an exact road map for it, but then again, when has there ever been one where the future (and not the past) is concerned? As asset managers, charged with preserving wealth for our clients, we need only ask ourselves not what paradigm of the past is more applicable but rather what vision of the future is more likely.