By way of background, the Bank of England holds £375 billion of gilts. The US Federal Reserve has been buying $85 billion of US bonds each month giving a holding at the end of 2013 of some $3.7 trillion. The Fed is now reducing its monthly purchases by $10 billion to $75 billion of US bonds a month from January 2014 in a process known as “tapering”. This is still significant monetary easing in the USA but it marks a turning point. Over time we can expect the monetary easing to stop completely and eventually reverse through reductions in the gilt and bond holdings and increases in interest rates.
There are a number of consequential effects that can be expected, some of which are likely to impact your business:
- Interest rates on government debt will rise as these have been driven down by QE. This may have an impact on company borrowing costs and if so, will reduce company profitability. At the start of the Financial Crisis interest rates fell rapidly, with UK bank base rates moving from 5% in late 2008 to 0.5% in early 2009. There is a good chance that once rates start to rise the increases will come quickly.
- Pension liabilities will fall as they are calculated by reference to long-term interest rates. The interesting question will be what happens to assets held by pension schemes. To the extent the investment is in government bonds, prices are likely to fall leading to lower asset values. Investments in equities could rise as the economy recovers but this will be offset by higher interest costs. The other factor affecting equity prices is the multiple of earnings on which they trade – this is the big uncertainty. It could rise due to greater confidence or it might fall as the returns on “safer” investments increase.
- Some “zombie” businesses which have delayed failure due to low interest rates and over generous tolerance by banks will fail. Others may experience a sufficient improvement in their trading performance that they come off the critical list. A key differentiator here is likely to be the cash conversion cycle. Those that quickly convert purchases into sales receipts may do well if they are able to grow their business to offset the increasing interest costs; those that have a long cash conversion cycle could become insolvent as trading volumes improve.
- Bank lending is likely to remain subdued as a result of the higher capital requirements imposed by Central Bankers, who may even develop the nerve to introduce contra-cyclical capital requirnents, squeezing the supply of credit further.
- Currency exchange rates will change with consequential impacts on import and exports. The effects will not be uniform but there are likely to be unpleasant consequences for emerging market economies such as India which require structural reform. Predictions in the area of exchange rates are fraught with difficulty – the US dollar often moves in a counter intuitive ways as investors value it’s “reserve current” status in times if turmoil. The economies of Brazil, India, Turkey, South Africa & Indonesia are seen as being particularly exposed due to their high current account deficits (reliance on imports) and all suffered in May 2013 when the Fed first mentioned tapering.
- It is also helpful to think about what the effects of QE have been and whether these will reverse as QE is withdrawn. Initially QE was expected to lead to price inflation, this has certainly not happened in terms of consumer prices but we might have had deflation without it. More likely the asset price inflation that we have seen in the investment markets (stocks and bonds) does seem to have been driven by QE. The likely impacts of unwinding QE on asset prices have been covered above.
All businesses need to think through the impacts on their company directly and the second & third level effects on customers, suppliers, employees and other stakeholders. Having a plan which deals with the uncertainties will be important.
This was written by Steve Sampson, a Commercial FD with over 25 years’ experience in business and first published at http://goo.gl/WQpuAr.
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