QE: Farewell or Au Revoir?

The US policy of Quantitative Easing (“QE”) is due to end later this year. Growing uncertainty about the evolution of monetary policy as the economy strengthens is likely to contribute to increased market volatility. Should QE be bade “Farewell” with the economy strengthening, this will mean a less accommodative monetary policy with negative consequences for markets; should it end with the economy weakening, it is more likely that this will prove to be merely “Au Revoir” for QE as it remains the only policy tool available to stimulate a weak US economy. In either case, a period of increased market volatility is likely, and portfolios should therefore remain light in US equities.

The Federal Reserve (“the Fed”) expect to complete their QE programme by 31 October 2014, after 6 years and a $3 trillion increase in the Fed’s balance sheet. The original rationale for introducing QE was to extend the scope of monetary policy after interest rates had fallen to near zero. One of its anticipated advantages was to raise the demand for, and thus the price of, securities in the financial markets. This had the benefit of increasing general economic confidence, as well as reducing the cost of capital for companies who would then be better able to boost capital spending. Forcing liquidity into the financial markets was therefore expected to boost the real economy.

Since February 2009, QE has created a substantial bull market in most financial assets: in Dollar terms, US equities have risen by almost 200%, and global equities by 150%; in addition, yields on all types of bonds have declined to historic lows during this time. The QE programme has taken US financial markets to high levels of valuation, as this injection of liquidity into the financial system has sought to find a home.

Looking back at market movements in recent years, the stock market moved steadily upwards during each phase of QE, but tended to be much more volatile when QE was not the Fed’s declared policy (in mid-2010 and from mid-2011 to mid-2012) .  Alongside lower bond yields, equity markets have become much more expensive during the phase of QE. QE has been a supportive factor for the US stock market, and we have noted previously that most of the rise in global equity markets in recent years is accounted for by rising valuations rather than rising earnings.

The effect on the real economy is less clear. Bank lending to US companies has risen, but little of that lending has been spent on capital investment. Instead, additional lending has funded large share buyback programmes and merger and acquisition activity by US companies. Both of these activities boost demand for shares in the stock market but do little for growth prospects in the real economy.

QE1 was very effective in stabilising the market for a number of credit instruments and economic growth rose from -4% to +3% while it was in operation. Since then growth has remained between 1.5% and 3% despite QE2 and the far larger programme of QE3, which have both been conducted in the face of muted economic growth. This level of growth has been disappointing when compared with a normal level of growth of 3% or more since the 1980s, and typically much faster rates of growth when recovering from recessions.

It is interesting to note that both QE2 and QE3 were initiated at about the same time as economic growth began to slow. This indicates that (i) the Federal Reserve has a low tolerance for a weaker economy, and (ii) with interest rates already at zero, if they fear a weaker economy, their only response has been a new and larger QE programme. It is likely that markets would interpret any re-introduction of QE as a major failure for the Fed.

The recent decision to bring QE to an end by October 2014 was based on the Fed’s forecast that growth will rebound to 3% from the second quarter and stay there for the next few years. However, the US economy has only managed a 3% year on year growth rate in three quarters since 2008, so this would require a substantially healthier economic performance than has been seen for some time. It is quite feasible that the economy will weaken again once QE has come to a halt, in which case the Fed may feel obliged to restore a QE programme since there are no other obvious policy options. This would be seen as very negative by markets as it would highlight the US economy’s lack of ability to grow without extraordinary policy action.

The introduction of QE was a new experiment in monetary policy when introduced, with no one really understanding how and whether it would work and the size of the programmes that would be necessary. Equally, ending QE (and at some point, reversing QE) will also be experimental, and the effects on markets and the economy are unknown. The experience of Japan early this century, and the two short-lived attempts to end QE in the US in the last few years, has been that markets react negatively to an early withdrawal of liquidity, and that this damages confidence and sentiment in the wider economy. The Fed is hoping that economic recovery is (i) more firmly established than the current GDP data imply, and (ii) able to withstand the negative effects of less demand for market securities from QE. The current trajectory of unemployment suggests that the US economy is indeed self-sustaining and, to date, QE has been wound down without adverse consequences. However, if the withdrawal of QE does stall the recovery then it will be very difficult to kick-start the economy again, since the Fed will be left with few policy options other than renewed and magnified QE.

Throughout 2014, we have been expecting (i) more muted returns from markets than we saw in 2013, on account of this change in policy by the Fed, and (ii) greater volatility in market prices as QE was tapered and then eliminated.   Market returns have certainly been more muted so far in 2014 but they have adapted to the tapering of QE without a rise in volatility. However, the looming prospects of tightening monetary policy and rising interest rates, though positive for the Dollar, are likely to cause problems for US equities, and we remain light in US equities across our portfolios.