With QE 4 around the corner, the stock market will rally

3D chrome Dollar symbolVivek Kaul

The post financial crisis world is a weird one—the world’s biggest economy doesn’t do well and the stock market rallies in another part of the world.
The gross domestic product(GDP) of United States grew by 0.2% for the period January to March 2015. This was an advance estimate released by the Bureau of Economic Analysis. The second estimate is scheduled to be released on May 29, later this month.
The BSE Sensex rose by 479.28 points or 1.77% to close at 27,490.59 points yesterday (May 4, 2015). A possible explanation lies in the fact that the bad economic growth number might force the Federal Reserve of United States, the American central bank, to go in for another round of money printing or quantitative easing (QE), as the economists like to call it.
As Albert Edwards of Societe Generale writes in his latest research note: “The US economy is struggling and the Fed will ultimately re-engage the QE spigot.” The Federal Reserve has already carried out three rounds of money printing, with the last round better known as QE III ending in October 2014.  Until October 2014, the Federal Reserve had been printing money and pumping money into the financial system by buying government bonds and mortgaged backed securities.
The idea was to flood the financial system with money by buying bonds and drive down interest rates. At lower interest rates, people were more likely to borrow and spend money. This would help businesses and in turn, the overall economy. While this happened to some extent, what also happened was that institutional investors borrowed money at low interest rates and invested them in financial markets all over the world. This led to stock market rallies all over the world.
With the US GDP growing by just 0.2%, it is more than likely that the Federal Reserve will go back to its tried and tested strategy of printing money in the days to come. This round of money printing will be referred to as QE IV. What makes the situation more than likely is the fact that even a 0.2% economic growth is overstated. This is primarily because it includes a huge inventory build up. Inventory essentially refers to goods which are being produced but not being sold.
Inventories during the period January and March 2015 went up by $110.3 billion. They had risen by $80 billion during the period October to December 2014. An increase in inventory adds to the GDP. Nevertheless what it also means is that there will be production cuts in the months to come, which in turn will pull the GDP down.
Edwards of Societe Generale estimates that without this unprecedented rise in inventories, “GDP would rather have declined by some 2½%!”
Economists at Bloomberg estimate that: “inventory rise added 74 basis points to growth, which means that final sales (GDP ex-inventories) actually contracted (-0.5 percent).” One of the reasons for this rise in inventory is the strong dollar, which has led to imports flooding the United States.
Another reason put forward by American economists for the build up of inventory is the more than usual ‘snowy’ winter in large parts of the United States. Nevertheless as Edwards argues: “Sales are declining on a year on year basis, but we are assured this is due to the cold weather. But if it is not, and sales do not surge in coming months, then the economy is heading into recession as the inventory sales ratio has now reached levels that will necessitate savage cutbacks in production.”
What also does not help is a slowdown in consumer spending. During the period January and March 2015, consumer spending rose by 1.9%. It had grown by 4.4% in the period October to December 2014.
The next meeting of the Federal Open Market Committee (FOMC) of the Federal Reserve is scheduled on June 16-17, 2015. It had been suggested earlier that the FOMC will start raising the federal funds rate in June. The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank, on an overnight basis and acts as a sort of benchmark for short and medium term loans. Federal funds rate is currently in the range of 0-0.25% and is likely to continue staying in that range.
With the US economic growth collapsing during the first three months of the year, there is no way the FOMC will start raising the federal funds rate in June. What this also means is that money will continue to be available at low interest rates for institutional investors to borrow and invest in financial markets all over the world. The Sensex rising by around 480 points yesterday was an indication of the same.
Also, one of the things that I have learnt in the post financial crisis world is that central banks seem to have come around to the belief that the only economic weapon they have to get economic growth going again is to print money. Given this, QE IV might well be on the cards in the days to come. And this means foreign institutional investors will continue to invest money in Indian stocks.
All I can say as of now is stay tuned and watch this space. 

The column appeared on The Daily Reckoning on May 5, 2015.

Yellen does a Greenspan, talks about “irrational exuberance” in the stock market

yellen_janet_040512_8x10Vivek Kaul

Janet Yellen, the chairperson of the Federal Reserve of the United States, said yesterday: “equity market valuations at this point generally are quite high…There are potential dangers there.” This is the strongest statement that Yellen has made against the rapidly rising stock markets in the United States and other parts of the world.
In February earlier this year Yellen had said that the stock prices where “somewhat higher than their historical average levels.” In March, she had followed this up by saying that the stock market valuations were “on the high side”.
Central bank governors don’t say things just like that on the stock market, like the stock market analysts tend to do. When a central bank governor makes his view public on the stock market, the idea is to temper down the expectations of stock market investors in some way.
Take the case of a speech that Alan Greenspan, who was the Chairperson of the Federal Reserve between 1988 and 2006, gave on December 5, 1996. In this speech Greenspan said:
Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance[emphasis added] has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade.”
Greenspan was essentially saying that the stock market level might have run way ahead of the kind of earnings that were being generated by companies. And hence there was an “irrational exuberance”.
Greenspan recalls in his autobiography
The Age of Turbulence that at the end of the speech, he wondered whether people would understand what he was trying to get at. They sure did.
The Japanese stock market, which had opened by the time Greenspan finished his speech, reacted instantly. The Nikkei index dropped 3.2 percent. The Hang Seng in Hong Kong dropped 2.9 percent. The DAX in Germany went down four percent and so did the FTSE 100 in London.
The next day, when the stock markets in the United States opened for trading, the Dow Jones Industrial Average, America’s premier stock market index, was down 2.3 percent.
The NASDAQ Composite Index, where most of the technology companies listed, was down 1.8 percent at opening.
By the close of trading, NASDAQ Composite Index was down 0.9 percent and had recovered half of its losses. When the stock market opened for trading again on December 9, 1996, after the weekend, it was back trading at the levels it had been at before Greenspan made the “irrational exuberance” speech.
Various explanations have been offered over the years as to why the stock market investors chose to ignore what Greenspan had said and continued to stay invested in the dotcom bubble. One is that Greenspan did not immediately back his speech with the concrete action of raising interest rates. This argument is not totally correct because Greenspan did raise interest rates a couple of months later, although he did not do anything immediately. The second reason given is that by the time Greenspan raised the red flag, the market was already irrationally exuberant. It had already formed a mind of its own and was in no mood to listen. As the economist Ravi Batra writes in
Greenspan’s Fraud:The lure of free lunch is so powerful that it clouds our vision. For once Greenspan had offered words of wisdom, but in doing so he lost his audience. The master bartender wanted his customers to sober up. They wanted more: whiskey, champagne, rum, just bring it on.”
The stock market needed a little more than just one Greenspan speech to sober up. A series of interest rate hikes might just have done the trick. But this can only be said with the benefit of hindsight. Nobody likes to spoil a party that is on. Greenspan too was human, and he did not want to be a killjoy.
So what is it that we can learn when we compare Greenspan’s warning with those made by Yellen in the recent past. Yellen’s warnings on the stock market like that of Greenspan might also have come a little late in the day. But unlike Greenspan who just made one warning and then more or less kept quiet, till the dotcom bubble burst in 2000, Yellen has come up with a series of warnings. If she keeps saying the things she has been the investors will eventually take her seriously. The only question is when.
Further, just talking about stock market being overvalued won’t help. If Yellen has to rein in the stock market then the Federal Reserve also needs to start raising the interest rates. The trouble is that with the American gross domestic product(GDP) growing by just 0.2% between January and March 2015, Yellen and the Fed are not really in a position to start raising interest rates.
In fact, what makes the economic situation even more worse than it actually looks is the fact that even a 0.2% economic growth is overstated. This is primarily because it includes a huge inventory build up. Inventory essentially refers to goods which are being produced but not being sold.
Inventories during the period January and March 2015 went up by $110.3 billion. They had risen by $80 billion during the period October to December 2014. An increase in inventory adds to the GDP. Nevertheless what it also means is that there will be production cuts in the months to come, which in turn will pull the GDP down. Albert Edwards of Societe Generale estimates that without this unprecedented rise in inventories, “GDP would rather have declined by some 2½%!” He also said in a recent research note that: “The US economy is struggling and the Fed will ultimately re-engage the QE spigot.” QE or quantitative easing is the technical term that economists use for a central bank printing money and pumping that money into the financial system to keep interest rates low.
Until October 2014, the Federal Reserve had been printing money and pumping money into the financial system by buying government bonds and mortgaged backed securities. The idea was to flood the financial system with money by buying bonds and drive down interest rates. At lower interest rates, people were more likely to borrow and spend money. This would help businesses and in turn, the overall economy. While this happened to some extent, what also happened was that institutional investors borrowed money at low interest rates and invested them in financial markets all over the world. This led to stock market rallies all over the world.
Hence, while Yellen might keep making statements about the stock markets being overvalued, she needs to back it up with some concrete action(like raising interest rates) for investors to take her seriously.
The trouble is Yellen can’t raise interest rates. At least, not in near future. Given the American economic growth scenario, an era of low interest rates and easy money is likely to continue in the days to come. And what this means is that BSE Sensex just might go back to rallying despite the recent fall.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on May 7, 2015