Are we about to see a collapse in global share and commodity prices as QE2 draws to a close?
That’s the pressing question asked by the highly regarded Richard Koo, who is chief economist at the Nomura Research Institute, in his latest research note.
Koo argues that when US Fed Reserve boss Ben Bernanke announced his $US600 billion bond-buying program, dubbed QE2, his deliberate strategy was to push asset prices higher.
It works as follows. When the US central bank buys up long-term US government bonds, bond prices start rising, while yields fall. As a result, private investors start rebalancing their portfolios, using their funds to buy different assets, which pushes up the price of these different assets.
Bernanke’s hope was that rising asset prices would buoy private sector sentiment, which would prompt households and businesses to spend more, which would boost the economy.
Now, Bernanke announced that the Fed would buy $US600 billion in long-term bonds between November 2010 and June 2011, which was roughly equal to all the debt issued by the US Treasury in that period. According to Koo, these purchases by the US central bank meant that “in aggregate, private-sector financial institutions would be unable to increase their purchases of US Treasury securities, because all of the growth in Treasury issuance would be absorbed by the Fed”.
At the same time, US businesses and households were still rushing to repair their balance sheets that had been damaged following the financial crisis. As a result, private investors were unable to increase their overall purchases of private sector debt.
According to Koo, this left US institutions, such as banks and insurance companies, with few investment options. After all, the Fed was buying all the new government debt that was being issued, while the private sector was simply not borrowing. Little wonder that money poured into stocks and commodities.
Koo points out that real estate could have been another destination for this money, but investors stayed clear of that sector because it had just gone through a bubble, and values remained extremely uncertain. As a result, investors were left with two remaining options: stocks and commodities. “That, in my opinion, is why both markets have surged since the announcement of QE2”, Koo says.
But, he warns, the real problems are yet to come.
After all, the fair value of an asset is supposed to be worked out using a discounted cash flow approach — which involves looking at the future cash flows that the asset will generate, and then discounting them by an appropriate interest rate.
Can the prices artificially boosted by QE2 be justified by the more sober DCF analysis? And can the surge in commodity prices since QE2 be justified in terms of real demand?
Koo argues that there’s nothing to worry about if investors have concluded that share prices at their current level can be justified by DCF analysis. But, he adds, this requires strong growth in the economy, and in corporate profits.
“In other words, current share prices can be justified using the yardstick of DCF analysis if both GDP and corporate profits are expected to increase at a robust pace going forward. The same is true of commodity prices.”
But, Koo argues, a major problem arises if people decide that current share prices cannot be justified, because of factors such as persistent high levels of unemployment, falling housing prices and sluggish money supply growth.
“That would suggest that share prices and commodity prices are in a QE2-driven bubble and that now may be an opportunity to sell assets that have been lifted higher by QE2.”
Given that the US central bank already has interest rates at zero, which leaves no room for further rate cuts, and that the US and the UK are heading towards tighter fiscal policy, which will have a negative impact on the economy, Koo notes that there’s little prospect that DCF values will be boosted through policy measures.
Koo argues that the entire QE2 approach was inherently risky, and that the resultant rise in asset prices it caused “represented a potential bubble — or at least a liquidity-driven event — from the start.”
The big question now, he says, is whether the real economy is able to keep pace with the surge in asset prices that QE2 has fostered. “If it cannot, higher asset prices will be considered a bubble and will collapse at some point.”
According to Koo, this could leave the US economy in far worse shape than if QE2 had never been implemented. “If stock and commodity prices are in fact in a bubble and if those bubbles were to collapse, the balance sheets of the financial institutions and hedge funds making investments with the expectation of higher asset prices could suffer heavy damage, exacerbating the balance sheet recession in the broader economy.”
In this light, Koo says, Bernanke’s QE2 policy represented a major gamble. “It was a gamble in the sense that the Fed tried to raise share prices with QE2. If the wealth effect resulting from those higher prices led to improvements in the economy, the higher asset prices would ultimately be supported by higher real demand, thereby demonstrating that prices were not in a bubble.”
But, Koo points out, this is putting the cart before the horse, because “it is ordinarily a stronger real economy that leads to higher asset prices, and not the other way around”.
Markets may be able to sustain these higher levels, he says, if investors were to turn a blind eye to DCF values.
But, he warns, “with market participants paying close attention to DCF values, any delay in the economic recovery will naturally bring about a correction in market prices”. And this will cause the entire QE2 effect to disappear.
*This article first appeared on Business Spectator.