Why I'm Not Afraid of QE Ending

Markets dipped at the end of last week, in reaction to FOMC chairman Ben Bernanke's comments that quantitative easing might end earlier than consensus had assumed. Now is a good time then to lay out my view how the ending of QE will impact markets. 

Many are arguing that the equity market rally has been liquidity fuelled, and that its ending can only be bad for investors. As is often my want, I disagree on both points.

First, whilst central bank policies have certainly helped the rally, there is little evidence that they fully explain the current market level. Equity prices are generally in line with earnings expectations. Therefore, arguing that this is a liquidity bubble is tantamount to claiming that earnings themselves have been propped up by QE. I doubt that is true. I think QE has eased debt costs during a painful structural adjustment, and has averted a far worse outcome. But I find little evidence it has directly driven earnings (except perhaps in areas of the housing and real estate financing markets). Importantly, if QE had driven earnings, then surely the Fed would be able to claim its policies had achieved their goal?

Earnings, I think, have benefitted from ongoing global growth and shifting economic balances (such as labour losing so much of its negotiating power). And prices are consistent with earnings.

What about the impact of QE? Certainly it may bring some initial selling, as we saw last week. But such selling is likely to represent a buying opportunity. Why?

First, the Fed will surely learn from Japan and do too much before it does too little. So the economy will likely sustain as QE tapers out. The Fed only went hard into mortgage securities when the housing market was already turning, giving its policy a tailwind. It will surely use the same tactic with the process of winding up QE.

Second, much of the money I talk to is playing cautious. Either on the bench, near to it or still biased to the bear side. The single greatest reason I know for this resistance to engage on the bullish side is nervousness about if or how QE will end. Once the path is reasonably clear, and there has been a steam-venting price dip, I suspect a lot of cautious money will start to get involved. Why? Because the systemic/fiat currency fears will ease, and the economy will be in reasonable shape.

Not to say QE has really worked. It's main contribution is surely having prevented something worse. The Fed still looks to be wrong about the structural impact of the crisis - the US remains on a sub-par growth path with high long-term unemployment, despite sustained government spending (including on benefits).

But if we define reasonably fairly what the Fed's goals were, then it has done ok. Getting out does remain a challenge as recent government finance improvements are unlikely to sustain. But there is little reason to expect the patient to show addiction as the liquidity drug is removed. Longer term relapses are a far higher concern, at least to this analyst.