Unprecedented Times in the Market: Quantitative Easing and its Impact

 

April 2014 Update

Spring Greetings! Waking up to birds chirping, and baseball season has begun – what could be better? Well, the Rockies could be, but that is neither here nor there.

Unprecedented Times: Quantitative Easing

In our last update, we talked about whether or not the stock market was getting too expensive and if we thought it was due for a correction.  Our conclusion for various reasons, many having to do with The Fed and Quantitative Easing (QE), was that the stock market is likely to cool off a bit in the coming years, and in fact it did that in the first quarter of 2014. The Dow was down about 1% and the S&P 500 was up about 1%. 

The question as we look forward to the rest of 2014 continues: How will the unprecedented QE and its cessation, affect the economy and the stock market going forward? We have talked about this in previous updates, but as a quick review, the so called “QE3” was a program by which the Fed would create money and use that money to purchase $85 billion worth of Treasuries & mortgage bonds each month.  The bonds purchased by the Fed are bought from banks in an effort to increase liquid reserves at the banks.  This increased liquidity should in theory lead to the banks loaning out more money to their customers, which in turn should stimulate the economy. And a stimulated economy usually means a good stock market.

Whether or not QE3 has worked is the subject of much debate.  The idea behind QE sounds like it could work, but most the data seems to show that QE has not done very much to get the banks loaning at a faster rate.  At the same time, when you look at the improvement in the economy and the gains of the stock market last year, you would have to conclude that QE must have done some good.  A lot of this may just be psychological.  Investors & business owners see that the Fed is doing all they can to get the economy going and they become more optimistic.

Most economists seem to think that stopping the QE purchases is a good idea, as the economy has improved and the unemployment rate has been going lower.  They are also concerned that too much QE could result in high inflation.  This is a valid concern and many analysts have been expecting and predicting that the increased money supply due to QE would lead to high inflation, ever since the Fed first mentioned the idea of QE back in 2008.  And, indeed, the money supply in the US has gone up dramatically since QE began, but inflation has not.  That would seem to be counter-intuitive, as you would expect inflation to pick up when the money supply goes up.  However, another factor that seems to be offsetting the increase in money supply is the decrease in the money “velocity”.  The velocity of money measures the number of times the average dollar is spent to buy goods & services over the year.  Below is a chart from the St Louis Fed, which shows their calculation of money velocity over the years:

As you can see, the velocity of money in the US has declined significantly since the economic downturn in 2008, in spite of the Fed’s QE programs (which also began in 2008).  In our view, this is partially due to the change in spending habits of the average American and partially due to the tighter loan policies of the banks.  But it is also a reflection of the higher capital requirements of the banks and the more stringent banking regulations.  The capital requirements have been gradually increased over the past few years and the banks are being required to implement stricter leverage ratios and liquidity requirements over the next few years.  This is probably very good, as it should mean that the banks are better equipped to handle the next economic downturn.  However, it also means that we have to go through an adjustment period where the banks are not loaning as much as they could, and in turn our economy is not doing as well as it could.

Whether QE worked or didn’t or whether they should taper or not, the actions of the Fed are unprecedented and we are about to find out what happens when they reverse those actions.  In January, the Fed began to “taper” their QE purchases by reducing the amount by $10b per month.  If they stay with that schedule, then the QE purchases would end in August 2014.

We really have no good historical examples of how the removal of that QE will play out.  For those analysts that feel that the QE purchases did “nothing”, then the eliminations of those purchases should have no effect.  In our view, the QE purchases did have a strong psychological effect on investors and business owners.  So going forward, the removal of QE purchases will likely make sentiment a bit more fragile.  At the same time, the Fed has indicated that they are monitoring the economic data very closely and stand ready to be more accommodative if needed.  Most likely that will mean that if the economy shows signs of slowing, then they will reinstate their QE purchasing, for better or worse.

As always, please call us with any questions you may have and/or future update topics you would like to see.