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Rooting around in the underbrush of quarterly stock performance in search of wisdom can be frustrating. It often yields little significant insight because sometimes nothing much changes. For instance, May and June have been one of those periods where we witnessed a lot of activity but no meaningful action.
In fact on Monday, July 1, the Dow Jones Industrial Average closed at 14,975 which was almost identical to where it closed on Friday, May 3 — 14,974.
All in all, since the beginning of the year, the main consideration for investors has revolved around which financial asset class would benefit the most from the next tidal wave of liquidity created by the world’s central banks: Primarily the Federal Reserve and the European Central Bank.
But behind the scenes, the markets worried about some time in the future when interest rates might return to a period of normality, with inflation advancing at about 2 percent and bank deposits paying 5 percent. Yet since the onset of the financial crisis, we have become accustomed to thinking of these conditions as a bizarre historical anachronism instead of the normal state of affairs.
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| Investors have begun to think about the consequences of an end to QE. |
However, recently there have been indications that conditions could be changing. The wake-up call went by the rather innocuous moniker of tapering. This means that if the Federal Reserve thinks that economic conditions are improving, they will start to buy fewer government bonds.
Investors Know QE Will End … Someday
You might think that this isn’t a surprise. After all, if things are getting better, shouldn’t we expect things to start to go back to normal?
As it turns out, this was indeed a big shock to financial markets, and they pulled back sharply. That’s because the financial world has become completely hooked on the Fed’s generosity. Thus, any indication that Mr. Bernanke might be less generous at some point in the future causes a lot of angst.
When they saw what they had done, Fed officials tried to get the cat back in the bag by throwing around a lot of caveats such as “if this … , then maybe … , but not yet.” And even though the markets have regained their footing, investors are no longer ignoring the fact that QE will at some point have to come to an end, and have begun to think about the consequences.
The Fed has no doubt spooked itself with the market’s reaction to a rather mild statement of the obvious. Thus even if the Fed begins to taper interest rates, they are likely to remain below their ‘natural’ level for a long time to come. Bernanke has always been very clear that the exit from QE will be straightforward.
What he appears not to have fully factored into his calculation is how dependent the markets have become on the Fed’s easy money policies. Given that part of the policy of QE is to ensure that asset prices are held up in the hope of encouraging economic activity, it is very unlikely that the Fed has any appetite for significant falls in asset markets.
However, the Fed has shown the markets that they know where the exit is, and this is likely to lead to a period of increasing volatility. It is unfortunate that investors have to think about what are experimental-economic concepts in order to position their portfolios successfully. The fact is that nobody really knows what will happen as we walk this line, but the risks are significant and genuine.
Against this backdrop of higher volatility, with markets more sensitive than ever to the utterances of central bankers, we are in a world where good economic news might be taken very negatively, as it almost certainly brings forward the end of QE. With the market likely to be skittish, it is time to go back to the basics of investing. This means sticking with a balanced approach both within and across asset classes.
The cat will likely stay in the bag for a bit longer, but it’s starting to squirm.
Best wishes,
Bill
Bill Hall is the editor of the Safe Money Report. He is a Certified Public Accountant (CPA), Chartered Financial Analyst (CFA) and Certified Financial Planner (CFP). Besides his editorial duties with Weiss Research, Bill is the managing director of Plimsoll Mark Capital, a firm that provides financial, tax and investment advice to wealthy families all over the world.