The purpose of QE3 was to stimulate economic growth and corporate earnings, which is what the markets expect. Sadly both will be disappointed
Edmund Burke, the eighteenth century politician and philosopher, wisely pointed out, “You can never plan the future by the past.” Sadly that is just what markets often do. In the United States the past has taught money managers “not fight the Fed’’. In other words, when the Federal Reserve acts, either through raising or lowering interest rates, you should invest accordingly. So it is not surprising that the US and other markets around the world have rallied over the summer in expectation of additional monetary easing. The idea is that earnings and profits of listed companies everywhere will rise as more money flows into the world’s economies. These expectations are based on a historical precedent, but there are six reasons why this time it may be a poor guide to the future.
The first reason has to do with the policy of quantitative easing. The chairman of the US Federal Reserve (Fed) insists that the so-called QE is just the same as past policies in that it lowers interest rates. But the policy is in fact quite novel in its form and much different in its extent. Interest rates have never been suppressed for this amount of time. There are many different opinions as to the consequences, but one thing is sure. They will not be what people expect. All policies are based on what turn out to be false assumptions. In something as complex as the global economy, there is a massive amount of misinformation. The combination inevitably will lead to unintended consequences.
The second reason why the present QE won’t work concerns the means used to do it. In the past, the US central bank bought government bonds, US Treasuries, and mortgage-backed bonds. This time it limited itself to the purchase of only mortgage-backed securities (MBS). While the politicians in Washington are happy to borrow an unlimited amount of money, people buying homes in America are more circumspect. Since the crash of the housing market, the banks have been much more careful who they lent money to. With fewer loans, the banks could get by less staff. So the number of MBS being created is limited to just $1.5 billion per week or $6 billion per month. The Fed wants to buy six times that amount and has to buy in the secondary market. This has raised the value of the bonds and increased profits for the banks and the holders, but it does not necessarily create more money.
The third reason concerns the assumption that by lowering interest rates the Federal Reserve forces investors into riskier assets like equities or commodities. This is simply not true. For example in Europe riskier assets like Spanish or Italian bonds are paying interest rates over 5%, but money is flowing into safer German bonds, which have a negative real rate. The collapse of 2008 has not been forgotten. Companies, savers and retirees, would rather be sure to have their capital returned than increase the return on their capital. Besides, the choice to increase risk may be subject to legal limits for institutions like pension funds and insurance companies.
The fourth reason applies to a basic assumption of monetary policy. The assumption is that if you lower interest rates, consumers will borrow and spend more. Usually this has been true, but not now. US consumers have actually been deleveraging. Their credit card debt is 22% below its 2008 peak. Also mortgage debt is also falling. Net repayments have been increasing and the increase has been accelerating since 2009. Meanwhile pensioners without high yielding fixed income investments spend less.
The fifth reason pertains to Europe and China going into recession. To solve its debt problems Europe opted for austerity, which has resulted in a slowdown. China has been printing money for three years, but growth rate has been constantly slowing. While the US is not heavily dependent on exports, it is still part of the global market.
The sixth reason bears upon corporate earnings. Cheap money is supposed to translate into better corporate earnings. The question is whether there is any correlation? Actually there is very little. Corporate earnings had already hit bottom and had started to improve before QE1. They had the largest growth by the second quarter of 2009 and the rate of growth has declined ever since, despite QE2. Although QE2 probably didn’t do much for corporate earnings, at least it looked good. When the program was started in August 2010, the ratio of negative to positive earnings guidance was about 1 to 1. Now it is over 3 to 1.
The purpose of QE3 was to stimulate economic growth and corporate earnings, which is what the markets expect. Sadly both will be disappointed.
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(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages. Mr Gamble can be contacted at [email protected] or [email protected].)
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