Beyond Quantitative Easing

Commentary from Mark Phillips, analyst at Sanlam

Beyond Quantitative Easing
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At the FOMC meeting on 18 September 2013, Fed Chairman Ben Bernanke indicated job market conditions were still weak and expressed concern that talks of tapering had already initiated tightening in the financial markets. Tapering remains on the cards, but will likely follow later in the year if the data confirms the Federal Reserve’s basic outlook for growth and the labour market.

It seems that in a short space of time, the world has developed an obsession with quantitative easing (QE). We seem to have forgotten that this extraordinary measure was called for by extraordinary times. QE was never meant to persist – and there are many good reasons why it shouldn’t.

When Ben Bernanke, Chairman of the US Federal Reserve, noted in July that they might consider tapering off QE if there was sufficient evidence of an economic recovery, the market panicked. It certainly seems that market direction has become increasingly rooted in sentiment rather than fundamentals.

Under QE, the US Fed committed to buying bonds (to the value of USD 85 billion each month), thereby increasing money supply and keeping interest rates artificially low.  Theoretically, banks would then lend on this new found largesse to companies that would expand their operations, stimulating demand and kick-starting the economy.  And to some degree this has worked, as evidenced by the Fed considering removing stimulus from the economy (but only five years later).

Increasingly though, we are becoming concerned about the side effects of QE. In short, as QE continues, money increasingly seems to find outlets into the economy other than those originally intended. QE was premised on the idea that people would continue spending money at the same rate and in the same way, rather than changing their spending patterns by hoarding cash or repaying debt.

The trickle-through effect of money from the financial sector to the real economy would theoretically provide a powerful kick-start to the economy, bringing it out of recession and ensuring its return to a healthy growth rate.

However, QE does not seem to be benefiting the man on the street. Rather, it seems to be increasingly inflating asset prices the longer it continues. By keeping interest rates artificially low, QE makes riskier higher-yield assets, like junk bonds or the stock market, more attractive. Price signals and market functioning are therefore being distorted by these unusual policy measures, and resource misallocation has become a real concern. In addition, emerging markets experienced inflows from the carry trade, as investors fled the dollar in search of higher yielding assets elsewhere.

But these portfolio flows are now playing havoc with emerging market currencies as these flows begin to unwind, both due to the anticipated end of QE and growing security concerns over Syria.

How the economic future of the world will play out depends on some key uncertainties, two of which are the effect of policy response and strength of economic recovery. To date, the economic recovery has come in stops and starts, and not been convincing. And while the world may survive policy failure in light of a strong economic recovery scenario, policy failure in a low-growth world would see the disastrous escalation of the economic crisis. 

Our base case scenario remains one of modest returns in light of a slow but hesitant economic recovery, given the current fundamentals. Popularly dubbed the ‘muddle through scenario’ and tug-of-war between multi-speed growth globally, this scenario would see more modest returns than the headier days of the equity bull market.  Challenging, but survivable to most investors, provided that they face up to the new reality early and adjust their expectations accordingly.

However, we believe policy response has the potential to either derail or cement the current tentative economic recovery. When and how quantitative easing is withdrawn is an absolutely key decision. If QE is withdrawn too early, faith in the ability of central banks to control monetary policy effectively may falter, and it may be impossible to reintroduce it successfully later.

On the other hand, in light of an economic recovery, no matter how hesitant, there is no reason to continue QE. Somehow though, the world seems to have lost sight of the fact that QE was a necessary but extraordinary measure in a specific time and place. In a healthy economic environment, it will simply inflate asset prices further and lead to more pain down the road.

With so much noise in the market, it is absolutely essential to focus on the basics and not get swept up in the emotion. We believe our robust culture of debate helps us to maintain a sober outlook. Moreover, amid the uncertainty, it is always prudent to remember that with volatility comes opportunity. By challenging our colleagues we challenge ourselves, and in doing so we believe we continue to make prudent long-term portfolio construction choices. 

At SMMI we are prepared to say a fond farewell to QE when the time is right. However, it is also important to remember that after the Federal Reserve’s asset purchases are wound down, the forward guidance should ensure that monetary policy remains accommodative and supportive of an economic recovery. Ben Bernanke's term as chairman of the Federal Reserve comes to end in February 2014.

Speculation remains on the changing of the guard at one of the most influential institutions in the world.  Larry Summers’ withdrawal probably opens the way for Janet Yellen, who seems to be in the Ben Bernanke mould. She is dovish and there are no signs as of yet that she would balk at ramping up QE if needed.

Ultimately the world would do well to remember QE is just a tool in the central banker’s toolkit.

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