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The Turning Tide

6th August 2014

By Neil Woodford

“You only find out who is swimming naked when the tide goes out.” – Warren Buffett, Letter to Berkshire Hathaway Shareholders, February 2002

The last five years have been great for financial assets. UK equities have enjoyed a prolonged bull run, as have equities more generally across the developed world. It isn’t just equities that have risen however; returns across practically any asset class you care to look at have had a terrific run – bonds, real estate, gold, fine art. It has been an unusually broad-based bull market.

Why? It’s a direct result of the unprecedented monetary policy that has been in place since the financial crisis, in my view. Quantitative Easing (QE) was explicitly designed to raise asset prices and, in this, it has succeeded. The policy has helped divert the course of the economies that have pursued it away from what may have become a full-blown depression towards something somewhat less severe. This has, by no means, been a benign economic environment, but not as bad as it could have been.

It is easy to argue that we could have been worse off without QE, but are we any better off? Policymakers had hoped that by increasing asset prices, they could engineer some sort of “trickle-down” effect, whereby increased wealth would lead to increased spending, the creation of jobs, and rising business investment, and that a virtuous cycle would ensue. This hasn’t happened, primarily because the assets that have increased in value are not broadly held by all members of the economy.

The asset-rich have got richer, but the asset-poor have not. An unintended consequence of QE, therefore, has been for the distribution of wealth in the UK to become even more unbalanced.

Policymakers have rightly started to become more concerned about this redistributive side effect of QE, not to mention the risk of inflating asset price bubbles to an increasingly dangerous extent. This explains why we haven’t seen further QE from the Bank of England since the end of 2012, and the US Federal Reserve is now tapering its own QE programme. I expect the Fed to have completely withdrawn its extraordinary liquidity support by the end of this year.

The big question is, what will happen to financial markets without the support of QE? How will markets cope without the drug to which they have become addicted? I don’t know the answer, only time will tell, but I suspect that the gap that has opened up between valuations and fundamentals will start to close.

Over the last five years, the rising tide of QE has lifted all boats. It has been an unusually indiscriminate rally with the individual strengths and operational performance of companies largely being ignored. With the tide now turning, I would expect the market to become more discriminate with fundamentals playing a much more significant role in determining the performance of individual stocks. In other words, over the next five years, I expect to see a stock picker’s market – an environment which ought to favour a fundamental investment approach and a cautious investment strategy.

The views expressed in this article are those of the author at the date of publication and not necessarily those of Woodford Investment Management LLP. The contents of this article are not intended as investment advice and will not be updated after publication.

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