MARKETS WEIGH EXCESS LIQUIDITY AGAINST WEAK ECONOMIC ACTIVITY / THE FINANCIAL TIMES COMMENT ANALYSIS

Markets weigh excess liquidity against weak economic activity
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September 23, 2012 5:27 pm
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by Gavyn Davies

It is often claimed by economists that the central banks have run out ammunition to boost economic activity, but they certainly have not lost the ability to have an impact asset prices. Since the latest round of quantitative easing was signalled back in June (see this blog), global equity prices have risen by 14.5 per cent, and commodity prices are up by 15.4 per cent, despite the fact that economic activity data have shown no improvement whatever over this period.



Clearly, these impressive moves in asset prices have been triggered by a sharp decline in the disaster premia that were priced into markets only three months ago. Mario Draghi and Ben Bernanke have, in a sense, purchased global put options on risk assets, and have offered them without charge to the investing community.



By doing the market’s hedging for it, the central bankers have certainly had an impact. Confidence, while not fully restored, is much improved, which is exactly what was intended. But there is no sign yet from hard data that the downward slide in global GDP growth has been reversed. Until that happens, the market rally will remain on insecure foundations.



It is instructive to take a long view of the behaviour of asset prices since the financial crash reached its nadir in the second quarter of 2009:

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A quick glance at the graph suggests that equities, bonds and commodities have all been in bull market trends ever since the successive rounds of quantitative easing started. However, a closer inspection reveals that this is not in fact the case. Only bonds have been in a continuous uptrend. The behaviour of global equities and commodities can more meaningfully be split into two separate phases.



From the start of the recovery to the end of April 2011, both equities and commodities recorded extremely strong bull markets, with both asset classes rising by some 90 per cent.



Since then, however, the bull market in risk assets has fizzled out. In the second phase (shaded blue), equities have been volatile around a broadly flat trend, and commodities have actually fallen by 16 per cent from the peak, despite their recent rally. Quantitative easing has not been powerful enough, at least up to now, to restore the 2009-11 bull market.



What explains the distinct change in the behaviour of risk assets after April, 2011? Many different factors have been at work over that period, including the worsening of the eurozone crisis, and the marked economic slowdown in China. In fact, if we inspect the performance of equities in the major regions since then, we see that eurozone and Chinese equities have sharply underperformed the global average, which confirms that shocks in these two regions have been important.



However, the over-arching factor has surely been that the growth rate of global GDP has slowed from a significantly above-trend rate in the first couple of years of the recovery to a rate that has been well below trend in the past 18 months. Around that time, markets realised that the output gaps, or the amount of economic slack, in the global economy was not going to disappear in a smooth and predictable manner in the years ahead. Fiscal policy was tightened, and unemployment stopped falling in many countries. From then on, although bouts of quantitative easing have been capable of generating sharp bursts of strong rises in risk assets, they have not been able to generate a sustained bull market.



This is important, since the recent rises in risk assets have gone far ahead of the levels that seem to be justified by recent data on economic activity. For example, the rise in US equities (as a typical example) has gone much further than the composite ISM indicator of business activity would seem to support:

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And the the rise in global commodity prices seems to have become even more stretched than equities, relative to US economic activity, which may be one reason why commodity prices have struggled in recent days:
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The obvious interpretation is that investors have been willing to place a great deal of weight on the announcements of the central banks, and are acting in advance of a pick-up in activity that they expect to follow the monetary easing. They are basing their behaviour on past episodes of quantitative easing, all of which have seen large increases in risk asset prices (of the order of 10-30 per cent in US equities, for example) in the 6 months following the key policy announcements:

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This is encouraging, because if a similar pattern is replicated this time, it suggests that the full impact of QE has probably not been fully priced by the time of the formal Fed or ECB announcements; there may well be more to come. (See this chartpack for a full set of charts covering previous Fed announcements since 2009.)



There is however one major caveat to this. Although previous rounds of QE coincided with strong bursts of performance from risk assets, they also coincided with the start of upturns in global economic data:
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It is hard to be sure whether these upturns were directly caused by the success of the monetary easing, in which case the rise in risk asset prices was ultimately reflecting stronger economic activity, or whether the observed pattern is just a coincidence. It is possible, for example, that past Fed announcements of QE were triggered by abnormally weak patches of economic data, in which case the subsequent “recoveries” in activity might have been unconnected with QE. If so, the markets might have been responding to the improved data, not simply to the central bank’s asset purchases.




Goldman Sachs has estimated this weekend that QE3 might eventually result in $1,200bn-$2,000bn of additional asset purchases by the Fed. The upper end of this range is larger than QE1 and much larger than QE2 or Operation Twist. On past performance, risk assets have not yet fully reflected this new programme and should rise further. But we will need to see an improvement in economic activity quite soon if these bullish scenarios are to come to fruition.




In fact, if the healthy and prolonged bull market of 2009-11 is to resume, we will probably need to see global GDP growth returning sustainably to an above-trend rate. Although growth in the eurozone and China will probably recover in 2013, that still seems to be a very tall order.