A fiery debate
rages among investors over the question of central bank stimulus. The
question is whether the stock market needs stimulus in order to advance, and is
stimulus only creating a bubble which will burst at some point and lead to
depression?
Regardless of the
philosophical rectitude of central bank intervention, there can be no denying its
efficacy. The most fundamental truth of the
financial market is that “liquidity, liquidity, liquidity” is the market’s
lifeblood. Financial stimulus contains the
seeds of recovery and will cure any bear market in equities, as I’ll attempt to
prove in this commentary. The truth of
this assertion can be found in the very wisdom of King Solomon, who in the book
of Ecclesiastes wrote that “money answers all things.” Stocks will always, without exception,
respond positively to stimulus – provide there are no countervailing obstacles
in the way [e.g. tax increases, margin requirements].
Critics of
stimulus often point to Japan as an example of how quantitative easing (QE)
supposedly failed. Seventeen years ago the Bank of
Japan (BOJ) led all other central banks by more than a decade with its
zero-interest-rate policy, when its benchmark rate was lowered to zero for the
first time during March 1999. As Dr. Ed Yardeni recently observed:
“The BOJ lagged
behind the ECB by nearly 20 months, introducing its negative-interest-rate
policy (NIRP) on January 29 of this year. The
central bank was early with QE when it expanded its reserves balance starting
during November 2001 through January 2006. That was
just a warm-up act for the dramatic expansion of these reserves that started in
early 2011, and then went vertical since late 2012.”
While Japan’s
economic troubles remain, is it fair to assume that the BOJ’s attempts at
stimulus were an abysmal failure? Let’s
examine the evidence.
Following is a
long-term graph of Japan’s Nikkei stock index.
Japan’s attempts at QE started in late 2001 and ended in 2006. Given the downside momentum that had been
established in the Nikkei heading into 2001 – 11 years worth to be exact – it
took some time before the first effects of the stimulus registered in the stock
market. By 2003, however, the Nikkei was
on the up-and-up. Japan’s central bank
let their foot off the QE accelerator between 2006 and 2001, though, and this
explains why the rally didn’t continue further.
The 2008 credit crisis only added to the Nikkei’s woes.
Then starting in
2011, the BOJ once again commenced QE at an even more furious pace than
before. This led to a much quicker
improvement in the Nikkei, which zoomed to its highest level in over a
decade. Undoubtedly, Japan’s second
attempt at QE would have been far more successful had not the government
implemented an ill-advised tax increase.
This foolish measure heavily undermined the positive impact of QE and
put the brakes on the Nikkei rally. It
also put Japan’s economy back into recession for a time.
A
lingering problem for the European Union countries since 2008 has been the
negative impact of years of misguided austerity policies. European Central Bank (ECB) President Mario
Draghi famously pledged years ago the ECB would do “whatever it takes” to
reverse the deflationary undercurrents plaguing the euro zone. But until this year the ECB failed to live up
to that promise. Late last year Europe’s
central bank finally got serious and lowered deposit rates while extending its
80-billion-euro monthly asset purchase program.
Positive
results of the bank’s efforts to date haven’t yet been seen, though there are
preliminary indications that many European bourses are establishing
intermediate-term bottoms. Much depends
on the ECB’s commitment to QE in the year ahead. By keeping the proverbial pedal to the floor
for an extended length of time, the ECB may yet succeed in reversing the
continent’s financial malaise. However,
if the bank makes the mistake Japan made by easing up on QE prematurely, the
euro zone can expect to see a resumption of the economic malaise.
By far the biggest
success story of QE has been the U.S.
The Fed’s unprecedented stimulus measures in the wake of the 2008 credit
crash galvanized an historic rally in the stock market which brought recovery
to the major indices in record time. Since
the U.S. essentially has a financial economy, any sustained recovery in
financial asset prices must of necessity lift the economy sooner or
later. Thus the improvement in many sectors
of the economy since 2009 can be attributed, at least in part, to QE.
The evidence to
date strongly suggests that stimulus played an integral role in fueling the
mighty asset price recovery that began over seven years ago. The Federal
Reserve’s interventionary QE program was successful beyond anyone’s wildest
guess when measured by the result of the equity and real estate markets. And while
many are quick to condemn QE as having been a failure at resuscitating the
economy, the data would argue otherwise.
But after about
six years of easy money, the Fed brought its QE program to a close in late
2014. After that the stock market as
measured by the NYSE Composite Index (NYA), the broadest measure of U.S.
equities, entered a prolonged sideways trend, which can largely be attributed
to the loss of QE. The loss of billions
of dollars per month of liquidity for stocks was gone and with it the sustained
forward momentum that fueled the market’s surge from 2009 to 2014.
Keeping the U.S.
market buoyant since then has been a combination of factors. Continued low interest rates coupled with
huge inflows of cash from foreigners seeking a safe haven from the global
crisis have been a huge benefit for equities.
The lack of competition from commodities and other assets has also
helped. This influx of foreign “hot”
money has amounted to a de facto stimulus for stocks, so in essence the market
is still receiving stimulus from afar.
Stocks
need stimulus in order to advance in the absence of a strong economy. When the economy is strong investors need no
prodding to put their excess earnings into equities with hopes of greater
profits. A strong economy also breeds
confidence in the present and optimism about the future; it serves as a kind of
natural stimulus for the stock market.
Ironically,
central bank stimulus can also serve as a deterrent for small investors since
they interpret the need for stimulus as confirmation that the economy is weak
and needs assistance. Thus the public
sometimes lack the incentive to take risks when QE is in full swing. It’s the professional investor who is
sophisticated enough to read between the lines and buy stocks in a weak
economy, provided there is stimulus.
This is the great paradox of a stimulus-driven bull market: only the few
participate, yet it eventually benefits the many as the wealth generated from
higher stock prices permeates the broad economy.
The
great unknown factor concerning QE is the outer limit of its success. Just how successful can QE be in stimulating
the economy? A satisfactory answer to
this question hasn’t yet been supplied.
Just when it looked like the financial market rebound from the 2009 low
was ready to explode into a full-fledged runaway bull, the Fed took its foot
off the accelerator. Eventually the
generous liquidity the Fed was supplying ground to a halt and the stock market
responded accordingly as its forward momentum slowed exceedingly.
Central
bankers, it seems, have an inveterate fear of inflation. Most of today’s voting Fed members came of
age during the runaway inflation of the 1970s.
The memories of that harrowing experience continue to haunt them, and
its influence is reflected in their policies.
The prevailing belief is that too much QE equates to too much
inflation. This is a fallacy. The U.S. and global economies have been so
significantly altered by demographic, social and political shifts in the last
two decades that inflation won’t be a major concern for many years to
come.
The
Fed could have doubled its asset purchases between 2009 and 2014 without
creating any appreciable increase in inflation.
Instead it decided to stop QE before inflation even registered, which
was tantamount to pushing a stalled vehicle up a hill only to stop pushing
before the summit is reached. It would
have been exciting to see just how successful QE could have been had the Fed
decided to gun for prosperity. Instead,
the Fed chickened out and ruined its best chance at delineating once and for
all the outer limits of central bank stimulus.
The
other objection to a full-throttle QE initiative is the widespread fear of
creating another asset bubble similar to the real estate bubble that popped in
2006 and led to the credit crisis.
History and human nature testify that a catastrophic crash of the
magnitude of the ’08 credit storm takes at least one entire generation (i.e.
circa 20 years) to dissipate. In other
words, it takes the advent of an entirely new generation who didn’t experience
the crisis to repeat its mistakes. At
present there is a complete absence of risk-taking behavior among the
generation that experienced 2008. That
deep-seated fear of risk won’t disappear anytime soon. Thus the “bubble that broke the world” isn’t
going to happen again for a long, long time.
The
simple answer to the question, “Can stocks survive without stimulus?” is an emphatic
“No!” Stocks always need fresh
injections of liquidity to gain ground and surge ahead. Whether the stimulus takes the form of QE,
fiscal policy or surplus savings is a moot point. But stimulus in all its many forms must be
present to propel equity prices ever higher.
And rising stock prices in a financial economy like the U.S. always
creates a wealth effect. Thus in the
final analysis, stimulus is to everyone’s benefit.
