On Wednesday the US Federal Reserve (the “Fed”) indicated that their Quantitative Easing Programme (“QE”) (a programme where they buy Treasuries and mortgage backed securities) will be more conditional on economic circumstances in the US and is likely to be curtailed or tapered if conditions continue to improve. Specifically, QE will continue until the labour market has improved “substantially” or the unemployment rate dropped to about seven percent. The market subsequently had a small fit. During the two days following the announcement the S&P 500 sold off 3.85 percent and the 30-year Treasury bond also fell about 3.6 percent with yields ratcheting higher to 3.51percent. Liquidity sensitive assets such as gold and emerging markets were hit even more, down six percent and seven percent in two days, respectively. If you hadn’t noticed by now the market has been ultra-sensitive to media hype and buzz-words like “taper-tantrum”, “fiscal cliff” and “sequestration”, but don’t let them get in the way of your long-term investment plan.
To me the tantrum is a bit irrational. I understand that the expectations of future economic conditions and the Fed’s policy changes can affect liquidity conditions. As a result the market should anticipate less Fed intervention in the bond markets going forward and the Fed’s balance sheet should naturally and slowly stabilise if not shrink. As a consequence, bond yields may rise further. They were much too low in my opinion anyway and I’ve felt that way for some time (see: http://www.royalgazette.com/article/20111107/COLUMN05/711079924&source=RSS ). That said, does tapering destroy the economy and corporate profits? Has QE really affected the economy?
The overall economic impact from QE, outside of liquidity conditions and emotional perceptions, is likely to be limited and we have always felt this way. The bears, however, love to believe, and cite that, this market has been artificially enhanced and propped-up by the QE ‘sugar-high’ without even beginning to look at what has happened in the underlying economy since the first QE program was announced. In fact the whole concept that the Fed will begin backing away from easy money because the economy is getting better seems to me to be a positive thing. So let’s look at just three underlying aspects to see if a full blown tantrum based on QE changes at this stage is warranted or ever should be:
l When equity markets were hitting these levels in 2007, corporate profits in the US were about $1.3 trillion. Now they are nearly $1.8 trillion. QE didn’t magically create corporate profits.
l The monetary base has grown at a 25 percent annualised rate since the inception of QE yet M2 money supply has risen at a mid-single digits rate. Most of the money is sitting at the Fed as excess reserves. It isn’t flying around in the economy boosting things artificially.
l QE was almost certain to cause inflation say the Gold Bugs. But inflation expectations (based on five year forwards) never got above 2.5 percent and now are currently sitting way below the Fed’s desired rate of 2.5 percent at 1.75 percent.
I seriously question the actual impact QE has had on the economy therefore I don’t really feel its end is nearly as traumatic as the initial market reaction. To be honest I don’t really know how it truly affects the markets or the economy. But this is the point.
I feel macro-myopia continues to cloud perceptions of the general public. This incessant focus on the ‘big picture’ is obscuring some very attractive opportunities in select industries and securities which are being overlooked by a focus on those aspects investors cannot control anyway. No one really knows exactly how tapering will transpire. Nor can anyone definitely measure its direct effect on any asset class or the economy. A myriad of variables are involved. Therefore, why fret? We have already spent too much time worrying about the ‘fiscal cliff” and “sequestration” which turned out to be non-events anyway. The great investor Howard Marks says it best:
“One of the essential requirements for investment success and thus part of most great investors’ psychological equipment is the realisation that we don’t know what lies ahead in terms of the macro future. Few people if any know more than the consensus about what’s going to happen to the economy, interest rates and market aggregates. Thus, the investor’s time is better spent trying to gain a knowledge advantage regarding ‘the knowable’: industries, companies and securities. The more micro your focus, the greater the likelihood you can learn things others don’t.”
So focus on what you own and your asset allocation. Know what you own. Stick to your investment plan and process. Don’t have a tantrum and heed the words of Mr Buffett: “If Fed Chairman Alan Greenspan were to whisper to me what his monetary policy was going to be over the next two years, it wouldn't change one thing I do.”