Is Quantitative Easing the Silver Bullet to Economic Recovery? (Giulotto)

 
By Joseph Giulitto, Trust Company of America

Some rise by sin and some by virtue fall.
– Shakespeare

I saw this quote recently while researching another topic. I found it to be appropriate to capture the challenge that professional money managers have in finding investments appropriate for the current domestic economic and geopolitical environment. The rules (that apply to what makes an investment good or bad) that have been established over the previous 40 years of investing are no longer relevant, and those investments that typically would struggle during a massive global recession have been successful in achieving a rising valuation. The Fed’s actions of late have certainly created buoyancy in a rather questionable market. But to what end? Are we slated now for yet another round of quantitative easing? QE3 to the rescue…

The Fed’s Answer to Recovery

Trying to find the right blend of investments during any normal market cycle can be trying. Throw into the equation the Fed’s involvement with quantitative easing, colloquially known as “QE,” and suddenly everything you may have thought you knew is no longer relevant. To add to the confusion, there are few historical references on which to base our future decisions – creating a recipe for complexity. The standard variables that an advisor may use to determine investment quality or the technical analysis that has worked over the previous decades may not apply in the same manner as before.

The term quantitative easing, as defined by Investopedia, describes a form of monetary policy used by central banks to increase the supply of money in an economy when the bank interest rate, discount rate, and/or interbank interest rate are either at, or close to, zero.

Quantitative easing is a phrase that has been added to the vocabulary of nearly every human in the developed world. Over the last four years, actions by the national banks across the globe have taken steps to stave off massive economic downturns by finding ways to inject liquidity into their respective economies. Historically, where government spends- a bubble develops. Only to be further followed by the eventual collapse of the bubble and the wake that is created.

The now infamous quantitative easing is the Fed’s answer to providing a potential recovery to the markets and economy. In past years, the Fed’s “go to philosophy” was to simply cut or raise interest rates to either cool or ignite the economy. While arguments exist in support of this methodology the question might be: why not stick with what works? Well, to answer my own question- because it wasn’t working.

When the Fed lowered rates to near zero it became a game of “what next.” What fiscal silver bullet existed that the Fed could use to create an up swell in the overall sentiment of the American and global investor? While the idea of QE seemed a fresh perspective on our shores for solving the financial crisis one didn’t need to look back too far to find an eerily similar event.

Japan: A QE Case Study

Japan is the only economy in the modern age to have tried a nationwide stimulus of QE for a significant period. The Bank of Japan lowered its rate aggressively with no effect on the economy. Once at zero the Bank of Japan (BOJ) instituted the first set of QE and ran the process for the following five years. Some economists would say that it appeared that the BOJ continued to have a hand in the economy by injecting liquidity from time to time even up to the current day. Like a defunct junkie, the economy of Japan is attempting to wean itself from the BOJ and its liquidity injections. Is this what the future holds for not only the US, but all economies that have participated in the game of QE (read – Euro zone)?

With today’s active methodology of QE the RIA would have to ask what this means to the current day investor. If we have this one example of the impact of QE on Japan’s monetary policy as our historical reference, we would ask what the impacts of QE were and how do we use this knowledge to our advantage? Looking at Japan as our case study, we find that the period that the BOJ was active in its QE philosophy corresponded to the largest expansion of Japan post WWII. In my readings many economists would not credit the QE with this expansion. I believe we would be remiss to think one did not impact the other.

QE and the Investor

With that said- should an investor throw caution to the wind and build an all equity exposure portfolio and let it ride? Hold on before you push that trade button. There is always another side to the market. What happened in the past will certainly happen again. Let us not forget to refer to our history lessons. Japan experienced significant volatility within the bond markets during the advent of QE. A bond bubble was created that had a significant impact on the economy of Japan. So much – that it nearly thrust them into another bought of stagnation, and ultimately a depression. This bond correction forced more action from the BOJ. This proverbial teeter totter of activity by the Japanese Fed has still yet to fully play out.

The consideration in this history lesson is asking the question how should one (country) use the power of QE? While most agree that QE is an effective measure to help stabilize short term liquidity issues, QE will never serve to provide the replacement for the truly hard decisions that need to be made by government to create a healthy and productive capitalist system.

We know that QE works, at least for a short term fix. The question is how long is this fix going to be used? We also know that from a historical precedent there are pitfalls, specifically in the bond market.

With the recent commentary coming out of the Fed identifying several downside risks. Is it time to reevaluate your current position?

Or to quote Shakespeare once again:

A fool thinks himself to be wise, but a wise man knows himself to be a fool.