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Quantitative Easing Invades

by Community Manager

‎02-27-2014 01:13 PM

Purple loosestrife.jpgBy Wasif Latif,
Vice President, Equity Investments

 

My eldest son recently asked me to help him prep for a science test on invasive species. A species is designated as invasive when it is not native to the ecosystem to which it is introduced and is harmful to native biodiversity. 

 

Take the purple loosestrife (Lythrum salicaria), pictured at right. Native to Europe, this invasive plant grows rapidly in most environments. Its expansion in North American wetlands has shaken the region’s ecology. As it forms dense colonies, the purple loosestrife crowds out native wetland plants that are staples and shelters for wildlife. At first, the purple loosestrife looks appealing, even beautiful, but conservationists have had to resort to extreme measures, even introducing nonnative insects, to check its spread.  

Why am I giving you a biology lesson? Because I think the world of finance has been exposed to an invasive species of its own, and it’s important to know what we’re dealing with.

 

It's called quantitative easing. It first showed up in Japan when the Bank of Japan used QE to tackle a deflationary spiral. The bank eventually halted its use, but the economic damage from its QE experiment lingers. Japan continues to struggle with even more debt than the original real estate bubble created. 

In 2008, with leadership from the U.S. Federal Reserve, the central bankers of the developed world introduced QE to the global financial system to circumvent a debt-induced crisis. QE was initially applauded because it helped our ailing economy. But like the purple loosestrife, QE is beginning to distort our market ecosystem, primarily by altering the perception of risk and return.  

 

Today, the impact of QE is being felt in the form of greatly reduced cost of capital, which in turn promotes more risk-taking than under normal conditions. When more capital is available at a cheaper cost, investors tend to place it in riskier assets. Stocks have performed so well over the past three years in large part because investors perceive less risk in buying equities, thus lowering the "risk premium" in equities.

 

When it comes to comparing the relative values of stocks and bonds, the artificially lower risk premium on stocks perverts this relationship. In this way, QE is gradually skewing the natural balance of risk and return in the global financial system, leading to an increasingly distorted relationship between risk and valuation.

In my last blog post, I discussed QE and the Fed’s decision to taper it in December. Now that tapering has begun in earnest, the debate between the bulls and the bears may see some resolution. Perhaps it is only coincidental, but U.S. economic data have begun to soften. Corporate earnings beat expectations in the fourth quarter of 2013, but future earnings are being guided down. At the same time, equity volatility has clearly perked up and jolted some complacency out of the market.

 

As I’ve stated before, I believe tapering will not be met by a complementary surge in economic growth. In my opinion, as the quantitative easing species is extracted from the ecosystem, it will leave an environment of tepid economic growth. Moreover, I believe the taper will not herald the full recovery to normalcy that economists are expecting and the market currently seems to be pricing in.

 

U.S. stocks may perform moderately well this year, and it is possible that they will even post a positive return. However, they're unlikely to perform as well as non-U.S. stocks, especially European equities. In the long term, American equities are likely to underperform relative to European and emerging markets due to three factors:

 

  1. U.S. equity valuations are much higher than other developed and emerging markets, which historically diminishes relative long-term returns.
  2. Not only are U.S. equities more expensive, but they also carry overly ambitious future expectations as profit margins in the U.S. are near record highs.
  3. The Fed is reducing QE, not increasing it.


The QE drawdown is having two effects. Volatility and interest rates, which have been artificially suppressed in my opinion, are now creeping up, and neither is good for stocks (more on this below). Additionally, the American reduction of QE places it ahead of the European Central Bank and Bank of Japan in the rate cycle, meaning there's a greater chance of QE from the ECB this year, which would be very positive for European equities.

 

With U.S. markets becoming more volatile themselves, largely due to significantly weaker-than-expected ISM manufacturing index numbers and durable goods orders, some Fed watchers have floated the idea that Janet Yellen may taper the taper. Now that's a mind-bender. Instead of reducing the QE program at a rate of $10 billion per month, the Fed may opt to reduce it by a smaller amount in a move to calm markets.

 

Yellen’s testimony to Congress on Feb. 11 did not provide details on what’s ahead for the taper.  However, the market received the news with renewed jubilation as Yellen clearly indicated her intention to remain extremely accommodating on monetary policy. She basically said the economy is still not strong enough for the Fed to stop its extraordinary measures. To me, that says, “We will taper the taper or pump up QE if things get worse again.”

 

This statement more or less coincides with my view that the economy has not reached escape velocity from the dastardly grasp of deflation, nor has it returned to normal. It remains in the grip of an invasive species: Relaxatio quantitativa.

 

202359-0214

 

Copyright © 2014 USAA.

 

This material is provided for informational purposes only by USAA Asset Management Company (AMCO), a registered investment adviser. The material is not investment advice and is not a recommendation, an offer, or a solicitation of an offer, to buy or sell any security, strategy, or investment product. The views and opinions expressed in the material solely reflect the judgment of the individuals, but not necessarily those of AMCO, as of the date provided and are subject to change in the future.  All information and data presented herein has been obtained from sources believed to be reliable and is believed to be accurate as of the time presented, but AMCO does not guarantee its accuracy.  The information presented should not be regarded as a complete analysis of the subject discussed.  Any past results provided do not predict or indicate future performance, which may be negative. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of AMCO and USAA.

 

Investing in securities products involves risk, including possible loss of principal.

 

As interest rates rise, existing bond prices fall.

 

Foreign investing is subject to additional risks, such as currency fluctuations, market illiquidity, and political instability. Emerging market countries are most volatile. Emerging market countries are less diverse and mature than other countries and tend to be politically less stable.

 

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