On the QT

2009 saw the world embark on a giant economic experiment – that of Quantitative Easing (QE) in which Central Banks injected large amounts of money into their financial systems. Next month, the Federal Reserve announced this week, will see a new first for monetary policy – a policy of Quantitative Tightening (QT) in which money will be withdrawn from the financial system.
They have announced that this new policy will be phased in, starting at a rate of $10bn per month from October, rising each quarter to $50bn per month by October 2018. At the same time, they expect to raise interest rate four more times to 2% by the end of 2018.
The timing of this policy shift appears less related to current economic conditions and much more to two other factors. First is that Western Central Banks appear, as a group, to have decided that the very easy monetary policies need to be pulled back. In addition to the Federal Reserve, the Bank of England has also recently indicated its desire to increase interest rates and the ECB is has laid out plans to bring to an end its QE programme. This tightening seems to be globally co-ordinated. Secondly, the Federal Reserve appears to be publicly setting out its policy for the next year, in such a way that it would be embarrassing not to carry it through. This comes at exactly the time that there are many places on the Federal Reserve Board to be filled over the next twelve months by nominees of President Trump, including the key role of Chairman currently filled by Janet Yellen.
Over the period of QE, from October 2008 to October 2014, the Federal Reserve increased its balance sheet from about $750bn to $4.5 trillion through 3 separate programmes of purchases. Its peak purchase rate was $85bn per month.
The widely accepted effects of the QE policy were:
1. It helped to offset the effects of the Global Financial Crisis in 2008/9, and prevented a 1930s style Depression from setting in.
2. It has done little to foster a rapid economic recovery, instead US GDP growth has stabilised at a muted 2% pa rate, only a little higher than the increase in population, and inflation has struggled to exceed 2%. There is little evidence that the increased money supply has found its way into the real economy through physical investment.
3. The prices of financial have moved much higher, principally through higher valuations relative to the income streams they produce. This is evident in house prices, stock prices, bond prices and the prices of prestige assets such as artwork and vintage cars. The increased money supply has thus remained within the financial economy rather than the real economy.
4. The combination of lacklustre real economic growth, rapid growth in financial asset prices, and the skewed distribution of wealth in the US economy has meant that the very wealthiest in 2008 have become even more wealthy and inequality has risen very substantially with the richest 0.1% gaining much more than the richest 1%, who gained much more than the richest 10% who gained much more than the rest of the population.
The implications of QT are thus that what has been to be a key support for financial market prices will be reversed by falling valuations as money is withdrawn from the financial system. It may also be that in fact this has a limited impact on the real economy as the decline in wealth will affect only the very wealthiest in society who demonstrate a low correlation between changes in their wealth and changes in their spending patterns.
A deeper concern is that QT will affect valuations in both equity and bond markets at the same time. Most investors have not seen an environment in which both markets fall simultaneously and this has the potential for aggressive selling of leveraged positions in markets, which could take markets down to surprisingly low levels.

Saudi worries

Over the last eighteen months, Saudi Arabia’s foreign policy has become extremely assertive and has created major uncertainties for the oil market and the geopolitical situation in the Middle East. Both of these are of major significance for global financial markets.

In the second half of 2014, there was a major shift in Saudi policy with regard to the oil market. Stung by rapid growth in US oil output from shale oil deposits, which led to the US no longer being a net importer of oil, the Saudis refused to continue to act as the swing producer in the oil market in order to maintain an oil price above $100. They announced that they would continue to pump oil at full capacity in order to maintain their market share. With oil demand weak due to weak global growth, particularly in China, and supply plentiful, inventories have soared and the oil price has fallen to a level at which US shale oil is uneconomic. Prices below $60 will see exploration in the US shut down and development of existing discoveries discontinued, though this process has been slow due to US investors providing a lot of capital, both debt and equity, to US shale oil companies in the first half of 2015, believing that the oil price would bounce back towards $100.

For Saudi to maintain its share of the oil market, it was necessary for them to force the most marginal oil fields out of business – these were the US shale deposits, and Saudi continues to pursue this policy which will also maintain the US as a net oil importer. As a way of treating its historic key ally and protector, this was an aggressive decision by the Saudi government.

The financial market implications have been (i) major credit problems in the US high-yield bond market which had provided a lot of capital to the shale oil companies, (ii) massive cutbacks in planned capex spending by the major oil companies – should the oil price remain in the $30s almost all of them will have no sustainable earnings or dividends and (iii) the Saudi budget, which is based on the assumption of $100 oil has moved into an enormous deficit. In order to meet the gap of 15% of GDP in 2015, the Saudi government has drawn down from its sovereign wealth fund, which in turn has liquidated investments it held global financial markets. Other oil exporters have had to act in a similar fashion and some have dubbed this “Quantitative Tightening” as liquidity is withdrawn from financial markets in contrast to the “Quantitative Easing” employed by central banks in recent years, which has acted to support financial market prices.

Cynical political observers have long noted that when a government faces difficulties in its domestic economy, its politicians often discover an external enemy that needs to be confronted that also distracts the attention of its populace. It might be argued that the New Year’s Day decision of the Saudi government to execute Nimr Al-Nimr falls into this category.

Islam is divided into two key strands, Shia Muslims for whom Iran is the acknowledged leading force and Sunni Muslims for whom Saudi Arabia is the leading force, though Iran contains a minority of Sunnis and Saudi contains minority of Shias. This divide is at the very centre of unrest in the region as a whole. Nimr Al-Nimr was the leading Shia cleric in Saudi Arabia, and his execution for terrorist offences was interpreted as an attack on the Shia minority by the Iranians, which then led to an attack on the Saudi embassy in Tehran which led to the Saudis breaking off diplomatic relations with Iran. This heightens the tensions that already exist across the region. The situation is compounded by the number of different sides that exist in the region, where your enemy’s enemy may very well prove also to be another enemy to you rather than a potential ally.

This increasingly assertive Saudi government policy follows the appointment nine months ago of a new Crown Prince and Deputy Crown Prince, representing the appointed succession plan to the 80 year old King. Their more assertive policies are a break with Saudi tradition and may well indicate a new trend. Wars which lead to attacks on the major oil fields in the region have, on fairly recent history sent the world economy into recession very quickly.

Currently, most of the world’s powers have troops attacking someone in the Middle East region – the chances of a relatively minor event drawing in military forces of many countries is very real. Once again global geopolitics is centred on the region the oddity this time is that oil prices have fallen as tensions have risen.

A much less predictable Saudi regime is the last thing financial markets need when there are so many other factors causing uncertainty. For the investor, the best response is to build exposure to gold, which would perform well in the face of both the increased geopolitical uncertainty and greater uncertainties in financial markets.