Quantitative Easing: The Dawn of a New Age ?
Every story begins with a new chapter and on June 19, 2013 began one such story. This was the story of an impending economic collapse— that of the emerging markets (EM). The press conference the then Fed Chairman, Ben Bernanke held that day will forever be etched in our memories for it caused ripples, albeit financial, across the world.
However, what were ripples in the west became tsunamis in the east. Foreign investors who had invested in emerging economies were the first ones to panic. Expecting an approaching truck in the form of higher borrowing costs, they fled. Markets plummeted, currencies took a beating, obituaries poured in and central banks bolted.
Is it possible for the Fed to phase out QE without causing economic instability, both in the United States and its trading partners? As the past testifies, absolutely not. In cognizance of this, is the Fed’s decision to taper bond purchases a good one? Undoubtedly yes.
To understand the future implications of the deconstruction of QE requires a solid macroeconomic understanding of the events which immediately followed Bernanke’s announcement.
It is no secret that most emerging economies, accounting for more than half of the world’s GDP in PPP terms, have massive Current Account Deficits (CAD). The foreseeable future of these deficits took a turn for the worse when the currencies of these EM’s took giant beating. The Indian Rupee fell about 15% and the Brazilian Real, about 20%. However they weren’t the only ones that plunged. The Indonesian Rupiah, the Malaysian Ringgit and the Turkish Lira fared badly too. In light of value erosion of their currencies, the CAD for emerging economies, given their large imports, was exacerbated even further. Furthermore, aware of the fact these emerging economies will have to pay more to borrow money in the future, foreign investors who had buoyed these economies till now retreated to the west. Then to arrest this free fall of currency values and to combat already high inflation, intervened the central banks of Turkey and India, raising not only repo rates but also likelihood of stagflation.
However, the tumultuous environment wasn’t confined to emerging economies only. Western capital markets, reacting to a fear of liquidity crunch, fell too. It was rather ironical that a measure, announced to acknowledge the improving health of the American economy, culminated in the Dow falling 200-points. Bond prices reacted sharply as well, their fall sending yields higher. As expected, the dollar appreciated.
Now that almost a year has elapsed since these events, let me present my prognosis of what the future holds for us.
I am of the belief that the capital markets of a country are in most cases, an accurate reflection of the health of its economy. This is so for they reflect investor sentiment— a consolidation of future expectations investors have of the world economy.
The MSCI emerging markets index has mostly stabilized, the Dow is all already breached its all time high, the FTSE which reacted sharply to the announcement of tapering has recovered too and the HSI and Nikkei 225 are faring rather well as well. In light of this, the future expectations investors have of the world economy look rather rosy.
Moreover there is ample reason to believe that these capital markets have already factored in the long-term effects of Fed’s actions. This conjecture backed by Eugene Fama’s Efficient Market Hypothesis which simply argues that the prices today are an accurate representation of the expectations of tomorrow. Therefore given that the plans of Fed have been in the news for almost a year now, there is ample reason to conclude that the tapering of bond purchases will cause lesser instability in the future.
However, unsubstantiated claims hold little water.
Emerging markets, despite reacting sharply to Bernanke’s announcement, await a second economic ascent. In light of China’s slowing growth, astronomical domestic debts, diminishing work-force and a mighty property bubble, I expect future investors to relocate their investments to other countries such as India, Indonesia, South Korea and Latin America. This is so because given their favorable demographic dividends and in S. Korea’s case, revolutionary technology, these countries can become competitive manufacturing economies. Moreover, in light of their falling currencies, they can achieve an edge in exports— a palliative for their current state of CAD. This seems even more promising in the wake of the observation that the sharp fall in the valuation for Emerging Markets corrected a few bubbles which might have started forming in these economies.
In light of these observations, most emerging markets leaving deeply troubled ones like Brazil and Argentina present attractive buying opportunities for they are at the moment, severely undervalued.
Coming to Europe, markets, after a temporary hurdle in June 2013, are all set to embrace their all time highs. Moreover, the economic condition of the EU, owing to ECB’s active intervention, is steadily regaining its health. Britain, thanks to its rising employment and earnings, is set to grow at 2.6% this year— a statistic which was revised positively in February 2014.
Abenomics, to an extent, seems to have cured Japan of its sluggishness. Nikkei, a little down from its all time high, is still quite high. As of 16 February, 2014, it is boasting of a 35.97% 3-year change. Moreover, with the improving health of the world economy and its attractively valued currency, the future of the export-intensive Japan, I believe looks promising. The yield of the Japanese Government’s 10-Year bonds is rather low— reflecting a large demand for it, in turn insinuating a rosy future.
Latin America however seems to be suffering. Economists believe that Brazil is in the midst of a recession— more precisely, a stagflation. Argentina, with its yawning CAD and meagre foreign reserves doesn’t look very good either. The Mexican 10Y bond yields too are at an all time high. I am of the view that the fortunes of Latin America have long been susceptible to the whims of the world economy but soon, if their governments fails to act upon their worsening economic condition, this will cease to be the case and they will start languishing in their own misfortune.
Having described an accurate picture of the world economy almost a year after the announcement of QE, there is ample reason to conclude that the overall macroeconomic outlook for the world looks encouraging.
In light of all these observations, even though the Fed’s announcement on June19, 2013 did cause ‘ripples’ in the west and ‘tsunamis’ in the east, the volatility in the global financial system seems to have decreased significantly. In hindsight, it seems as if global instability caused by the Fed’s announcement was temporary. As in Indian student studying in the United States, my fees too has more or less stabilized, after increasing at a moment, by almost 20%! Jokes apart, if one is to analyze the situation of the world economy today, one will observe that investors have favorable expectations from the future— the future without QE.
Taking all this into consideration, has the announcement of QE tapering caused instability in the global financial system? Yes. Will actual QE tapering cause further instability in the same system? As not only this essay but also the markets of today testify, certainly not.
The market reaction to Bernanke’s announcement on June 19, 2013 and the recovery which followed is evident in the following charts which also show the volatility as being negatively correlated to the market drop-
MSCI Emerging Market Index:
III. DowJones Industrial Average:
IV. Hang Seng:
VI. Nikkei 300:
VII: Japan 10Y Bond Yields:
VIII. Mexican 10Y Bond Yields:
Bloomberg Markets, The Economist, Financial Times, Economic Times, CNN Money, TIME Magazine
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