Equity markets were revelling in the sanguine tone of global central bankers as the Federal Reserve and European Central Bank committed, yet again, to inject billions of dollars into their economies.
Year to date returns on the Standard and Poor 500 Index climbed to almost 18 per cent on the news, the Morgan Stanley All Country Index and Stoxx Europe 600 Index close to 16 per cent, adding to the flurry of green that dominated global equity markets. For those of us trying to separate the facts from the noise, exactly how does the recent commitment translate into such a significant run up in equity prices?
QE3, as it is commonly dubbed, is largely targeting price stability and maximum employment. The dual policy mandate of the Federal Reserve is essentially aiming to keep money extremely loose by lowering borrowing cost and improving broader financial conditions. Increasing the size of the monetary base should translate into increased spending on consumer goods and capital expenditures greasing the wheel for further economic activity. Notwithstanding, the plan appears sound in theory but requires the conditionality of lending on the part of financial institutions. But haven’t we travelled this road before?
Following the Jackson Hole meeting in November 2008, the Fed introduced QE1, embarking into uncharted territory to increase the money supply. As policymakers successfully increased the size of the monetary base, it failed to consider that banks and other financial institutions were still recovering from the fear that brought them to their knees at the heart of the credit crisis. Being dealt a crippling blow, the crisis forged a tightening in lending standards and hunkering down on cash, failing to impact the much needed increase in the velocity of money.
Admittedly, there are some very positive indicators the economy is showing signs of strength. Private sector payrolls increased for 30 consecutive months, recouping more than half the 8.1 million jobs lost during the crisis. With historically low rates, lenders appear more willing to lend driving motor vehicle sales up more than 50 per cent from the lows during the recession. On the housing front there is much to be celebrated. Housing now appears to be showing signs of stabilisation with home sales rising the most in a year with a strong decrease in inventory of unsold homes. Housing starts, although far from pre-crisis levels, are now running at 750K annualized from 500K during the crisis. Consequently, home prices are now at the highest in more than two years. In a domestically demand driven economy, housing remains one of the most important sectors for the overall health of the US economy.
Despite the positive sentiments and a strong market reaction to recent monetary policy actions, the global economy still faces some very significant headwinds.
The European debt crisis and recession seem to have taken on fresh debate as Chancellor Merkel and President Hollande disagree on the timetable for oversight of Europe’s banking system. As the two heads continue their public spat, the Germans are showing increasing concern over Spain’s indecision to seek the much needed aid to shore up their banking system. Although the tail risk of an imminent Greek exit from the eurozone has admittedly receded, the movement of capital from peripheral countries continues to plague the region. Any further delay could weaken financial institutions leading to systemic failure within the region’s banking system. As painful as the thought may be for stronger core euro countries, there is increasing support within academia for mutualisation of past debt, adopting a common depositor’s insurance and consolidation of a banking framework to prevent further flight.
With much of the recent movement in equity markets attributed to policymakers’ actions, the issue of sustainability comes into question. Adding the persistent uncertainty of the fiscal cliff and general elections in the US, businesses have become paralysed, stemming all investment in capital expenditure and instituting a hold on hiring. As China and Germany confirm the deepening slowdown in their respective economies, the fundamental picture for top line growth looks very different versus the rise in equity prices supported by monetary actions.
As we have seen several times during and post the crisis, global central banks have intervened and cushioned disappointing economic news with a slew of unconventional policies. The market’s recent response to an unlimited commitment of taxpayers’ dollars appears very much in favour of the move. With the failure of QE1 and QE2 to provide any sustainable real growth in demand, investors must now wait with bated breath on whether central bankers have finally gotten it right, or face the consequences of a synthetically supported equity market.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.