Markets’ animal spirits need taming; QE froth is great for asset prices, less so for the real world

October 25, 2013 11:51 am

Markets’ animal spirits need taming before a hard fall

By Michael Mackenzie in New York

QE froth is great for asset prices, less so for the real world

History may not repeat itself but will it rhyme with a messy denouement for risky assets? In the final quarter of 1999, a surfeit of central bank liquidity thanks to concerns over Y2K pumped up the technology bubble before the bottom fell out of the market the following year. Fast forward to 2014 and there is no getting away from massive central bank stimulus propelling asset prices and allowing investors to downplay fundamental factors.This week provided a vivid illustration of poor economic news being cheered as investors pushed the S&P 500 to a record peak. The rationale behind bad news representing a bonus for the market is the bet that the moderating pace of US job creation means the Federal Reserve is in no position to start withdrawing its hefty stimulus.

In a very short time, investors have become confident that any tapering of the Fed’s $85bn in monthly bond purchases is a story for next spring and not this year.

When the Fed announced open-ended QE last December due to concerns over elevated unemployment, the US created more than 200,000 jobs per month during the final quarter of 2012. For the three months ending September, the pace has dropped to 140,000 new jobs, clearly a macro challenge for initiating any taper.

It illustrates how money printing has been great for asset prices and less so for the broader economy as the S&P 500 has climbed nearly 30 per cent since it bottomed last November.

Michael Hartnett’s team at Bank of America Merrill Lynch estimated this week thatglobal central banks have boosted liquidity by roughly $9tn since equities bottomed in 2009. In that time, they say global market capitalisation has risen $35tn while the global economy has expanded only $14tn.

“We believe the longer it takes for liquidity to feed through to economic growth, the greater the risk is that liquidity could cause excess valuations in financial assets,” wrote Mr Hartnett.

Already we are seeing debt in private equity leveraged buyouts equal 5.3 times earnings before interest, taxes, depreciation and amortisation, just shy of 2007’s figure of 6 times ebitda.

Then there is the surge in issuance of payment-in-kind toggle notes, which provide a company with the option to pay lenders with more debt rather than cash in times of squeezed finances.

So far this year volume has reached $9.2bn, surpassing 2012’s tally of $6.7bn and making 2013 the best year for Pik notes since 2008, when $13.4bn were sold.

The blanket of security being embraced by investors is the view that QE is extending the next corporate default cycle beyond its usual run of six years.

Instead of late 2014 marking a starting point for credit stress, the thinking is that vulnerable companies can rely on cheap funding to keep them alive until late 2016 or early 2017.

For policy makers, the froth in markets warrants close scrutiny as they wrestle with the major problem of QE – it’s been great for equities, loans and home prices, less so for the real world.

Jim Sarni, managing principal at Payden & Rygel, says: “Intuitively, the Fed know they need to get out of QE but they’re not ready. The end of QE will not happen until there is a wider recognition that QE is distorting asset prices.”

One thing is certain. Should markets keep rising, with Treasury, mortgage and corporate bond yields returning towards their lows of this spring, the central bank runs the risk of repeating previous policy errors.

Richard Gilhooly, strategist at TD Securities, warns: “Stepping aside until March of next year, or later, is a certain recipe for overvalued asset markets that will cause more problems when they adjust to economic reality at some point down the road.”

He adds: “They have an opportunity to take the element of surprise and do a token taper and get away from this perfectly telegraphed profile for rates that did damage in 2006 and in the bubble of 1999.”

History has shown the markets’ animal spirits need taming before a hard fall. Next week, the Fed’s policy meeting represents an opportunity to remind investors that they are being too complacent in thinking there is no imminent taper.