Letting go of Daddy's hand

By Buttonwood

THE ending of QE3, the third phase of the Federal Reserve's quantitative easing programme, was hardly a big surprise. For the markets, the more alarming news in yesterday's Fed statement was the relative hawkishness about the timing of the first interest rate increase. In the middle of the October market tumoil, expectations for the first rate rise had pushed out to 2016; next year looks more likely, for the moment. The dollar perked up on the news but equity investors reacted calmly; the S&P 500 fell by just three points.

Nevertheless, we may have reached a turning point. Six years of asset purchases have stopped, for now. The titans of the free markets will have to let go of Daddy's hand and pedal on their own for a bit. (It is a nice irony that QE has tended to be championed by those on the Krugmanite left but it has delivered huge profits to many on the right, who fondly claim that their wealth is the result of their own success, and not any official intervention.)

Will this be the moment that the markets collapse? My old, and much-respected, colleague John Authers worries in the FT that

The dollar is rising, now that investors expect US rates to start rising, and this puts pressure on US exporters, while pressing down on inflation. Stocks look overvalued and bubbly, just as the bond market is signalling concern about an economic slowdown.

His concerns are well-founded. But I wonder whether we have yet reached the moment of truth. First, the Fed has prepared the markets well, tapering its asset purchases over a long period. There is no suggestion that the Fed will offload the bonds it has bought; indeed it seems clear that central banks will have much large balance sheets than they did before the crisis. Second, the Fed is not the only game in town. The ECB may yet expand its balance sheet (indeed last week's cover story argued that it should do so ASAP) and the Bank of Japan is still being supportive. Third, many people in the markets probably suspect, when push comes to shove, that the Fed will pull back from actually increasing rates. It was noticeable, earlier this month, that the market plunge was halted when a Fed governor suggested that QE should continue after all.

I am reminded of the days when we were part of a nanny share; the other toddler would often fail to eat the healthy meal provided. The parents, worried about his growth, would offer chocolate to ensure he ate some calories. The lesson was quickly learned; refuse the broccoli and chocolate will be the reward. Similarly, those in the markets know that, if a sell-off seems sufficiently severe, the central banks will change tack. It has happened many times in the past, going all the way back to 1987.

Why have risk markets done so well for so long, in the face of sluggish economic growth? Clearly, a push factor has been at work; with cash yielding zero, investors have been forced to take more risk. But there has also been a pull factor; profits have been remarkably strong, despite the weak economy. A share price is the discounted value of a company's future cashflows; when the discount rate fell, the present value of those cashflows rose. In a slow growth economy, expectations of those future cashflows should have fallen as well, but buoyant profits mean they have not.

This is all down to higher margins; for the S&P 500 companies, earnings per share have risen more than 50% since the crisis but sales per share have hardly budged. If capitalism worked properly, margins ought to fall because of an investment spree; if returns are high, more capital should be invested until the resulting competition brings returns down again. But this hasn't happened, perhaps because the growth outlook is poor or perhaps because companies prefer to use their cash to buy back shares. The high profit share is the corollary, of course, of the very sluggish growth in real incomes in recent years; capital has gained at the expense of labour. Some believe this shift is permanent because of globalisation and technological change; so far, they have not been proved wrong.

One potential cause of a sell-off in markets, therefore, is evidence that the profit share is slipping. For the US, this could be the result of a stronger dollar (although this is not wholly negative). Globably, it could happen as voters rebel against their squeezed incomes and insist on policies that tax business, or restrict global trade; witness the rise of the populist right in Europe. Or it could happen if the global economy slows more sharply than expected, perhaps because of China; or indeed if China's overinvestment causes it to flood global markets with cheap goods.

The other potential cause of a sell-off in markets is through a central bank mistake. Some think the liquidity created by QE will eventually leak into higher inflation, but there is no sign of this as yet. More likely is a decline into deflation which would lead to financial distress as debts become more difficult to repay.

If that does show signs of happening, then we may indeed get to see QE4 rolled out. Daddy might have let go of the market's hand for the moment but he's still close by.