QE Never Left Us: The U.S. Economy And Stocks Will Grow Faster And Higher
On October 29, 2014, the US Federal Reserve officially announced the termination of its quantitative easing (QE) policy - as had been widely anticipated for many months prior. In the lead-up to and immediate aftermath of the termination of QE, a great many commentators in the financial media predicted doom for the US economy and stock market as a result of the termination. These predictions were based on the erroneous inference that the growth of the economy and gains in stock indices such as the S&P 500 (SPY-NY) and the Dow Jones Industrial Average (DIA-NY) during the prior years had been primarily due to QE. It also was based on a completely misguided theoretical understanding of how QE impacts the economy and the stock market.
As I explained in detail in this radio interview, and in various articles on Seeking Alpha, the impact on the US economy and US stock market of QE, although significant, has tended to be misunderstood and exaggerated - particularly as it relates to the period between 2010 and 2014. Most importantly, I have argued that the expansionary impacts on the US economy and stock market of the terminated QE program would actually accelerate in the one- or two-year period after the conclusion of QE.
In this article, I will provide a brief overview of how QE is still with us and how it will impact the economy and stock market in 2015.
The Effects of QE Are AccumulativeQE was an operation that injected liquidity into the US economy. In its initial phase, it was merely replacing liquidity that was destroyed during the financial crisis. However, in later iterations, QE propitiated a historically unprecedented accumulation of liquidity relative to the normal requirements of the US economy. As I detailed in this article, US businesses and households (particularly the wealthiest households) in the aggregate are currently holding record amounts of liquidity relative to their incomes. More specifically, the total stock of liquidity accumulated by households and businesses surpasses by record amounts what they need under normal economic conditions.
It is extremely important to understand that the termination of QE did absolutely nothing to reduce any of this massive accumulation of liquidity.
To the contrary, the termination has coincided with economic normalization and a concomitant acceleration of US economic growth. This, in turn, has lead to a dramatic acceleration in real (inflation-adjusted) credit growth (from previously depressed levels), as can be seen below.
(click to enlarge) 
As my regular readers know, under normal conditions, the liquidity created through credit creation in the banking system ultimately dwarfs the liquidity created directly by the Fed through open market operations - of which QE is just a specific instance.
Please note that in December of 2013, real credit growth was zero percent, and had on average been negative since mid-2008. The liquidity that was added to the economy during this period of time was primarily via the Fed's QE program.
What has effectively occurred since December of 2013 is that liquidity is being added to the US economy and financial system through private credit creation as opposed to Fed repurchases of securities. This trend toward strong real credit growth should continue unabated throughout 2015. In addition to surging economic confidence, which will increase the demand for credit and banks' willingness to lend, banks and their customers' balance sheets are stronger than at any time since the 1980s.
Thus, not only is the total stock of liquidity not declining after the termination of QE, this accumulated stock of liquidity is actually still growing at a very brisk pace - from already gargantuan accumulated levels - as a result of the resumption of real credit growth in the US economy. Specifically, private credit creation through the banking system is currently adding liquidity to the US economy and financial system at an average YoY pace of about $80-90 billion per month! Note that this current pace of credit-driven liquidity growth is actually comparable to the liquidity growth that was being effected by QE at the peak of this program.
Thus, not only is the stock of liquidity in the US economy at historically unprecedented levels, it is actually growing even larger despite the termination of QE.
I want to hasten to clarify that given the enormous stock of excess liquidity that is already in the US economy, it is not necessary at all that liquidity levels continue to rise. Contrary to popular belief, the economy and/or stock market does not, under current conditions, need ever-increasing amounts of liquidity to grow. In fact, in the current environment of excess stocks of liquidity, a mere normalization of liquidity preferences would in all likelihood be enough to spur accelerating economic growth, asset price inflation and stock price inflation in particular.
The Normalization of Liquidity PreferencesThe concept of liquidity preference refers to the relative preference of individuals to hold liquidity versus spending it - it refers to the propensity of individuals to exchange the liquidity that they currently hold for other types of goods that they prefer to hold. A high rate of growth in liquidity will not cause increased economic demand for goods or price inflation if liquidity preferences have grown to a similar or greater extent. However, when liquidity preferences normalize - as they currently are and will continue to do - this is necessarily associated with an increase in the demand for goods.
How do we know that liquidity preferences are normalizing? There are many ways to observe this. For example, with respect to households, it is clear that consumer confidence is returning at a steady rate.
The improvement in consumer sentiment, according to the Conference Board survey above, is mirrored by the University of Michigan survey of consumer confidence:
As households' confidence in their economic situation improves, their desire to hoard cash wanes and their propensity to spend liquidity on goods increases. This leads to increased consumer spending - something that, in fact, increased steadily in the last three quarters of 2014.
In terms of the liquidity preferences of businesses, various surveys of capital expenditure plans and hiring intentions clearly show that businesses are less inclined to hoard cash and are increasingly inclined to spend it. This is already being reflected in strong capital expenditure growth in 2014, as well as record high job openings and extremely strong growth in new hires in early 2015.
Note that some of the increase in the demand for goods - the flip-side of declining liquidity preferences - will take the form of an increase in demand for consumer and/or producer goods (including new hires), which will cause an acceleration of economic growth. And once the economy is operating at full capacity (not the case at the present time), this could potentially lead to inflationary pressure in consumer prices indices. However, some of the decrease in liquidity preferences and the concomitant increase in the demand for goods will result in an increased demand for investment goods. And in the current environment of ultra-low interest rates and yields, an increased demand for investment goods is likely to translate to an increased demand for publicly traded equities (i.e. stocks) in particular. Furthermore, since the total stock of investment goods such as publicly traded equities is relatively fixed at any given point in time, an increase in the demand for such goods will lead to an increase in their price.
The Impact on Stock PricesPlease note that the framework that I have laid out above was fundamental in enabling me to correctly predict the path of the US economy in the past three quarters, as well as the path of the US stock market during that period of time. My bullish projections for the second through fourth quarters of 2014, outlined in my 2014 Economic Outlook
, were entirely ratified by subsequent events. Furthermore, my correct economic predictions led to a high percentage of correct predictions regarding the investment sectors that would likely outperform in 2014.
Understanding this linkage between the colossal excesses in the total stock of liquidity in the US economy, the evolution of liquidity preferences and its relationship to the demand for investment goods was one of the keys to understanding the behavior of stock prices in the past couple of years, and it will continue to be the key for the next year or two.
As I explained in a Seeking Alpha article in October of 2014, excess liquidity in the financial system, combined with the normalization of liquidity preferences essentially helps place a floor under stock prices. Every dip will be met with strong demand. At the same time, there is virtually no ceiling to stock prices in this environment. Why? Because when faced with zero or near-zero interest rates, an investor with normalizing liquidity preferences is faced with virtually no apparent alternatives. The earnings yield on stocks may be historically low (i.e. PE ratios are high), but the yield on cash and other liquid instruments is near zero, and so the earnings and dividend yields on stocks seem extremely attractive by comparison.
TINA (There Is No Alternative) is a factor that will favor equities for several years - even after the Fed starts to raise short-term interest rates from their currently extremely low levels. A "normal" level for Fed funds would be somewhere around 4.0% (+/- 1%). How long will it take for the Fed to get short-term interest rates to that level? Probably a couple of years, at least. However long it takes largely determines the length of time that equities will likely continue to remain in a bull market. Why? Because given high levels of liquidity and the normalization of liquidity preferences, it will likely take "normal" or even "above-normal" interest rates to ultimately persuade households and businesses to hold their excess liquid assets in interest-bearing accounts as opposed to purchasing higher-yielding equity investments.
Stock Prices in 2015Obviously, the accumulated supply of liquidity and liquidity preferences are not the only variables that drive stock prices. Many other factors must be considered
Due to length constraints, I will not analyze these other factors in detail in this article. I will merely say at this point that I think that multiple factors suggest a significant risk that stock prices could experience a significant correction in the first half of 2015, before ultimately rising to significant new highs before the end of 2015.
For example, the extreme strength of the US dollar will have a detrimental short-term effect on the US economy and corporate earnings in particular. There are various other risks that could negatively impact markets in the first half of 2015, such as the fallout from the risk of a Greek exit from the eurozone, potential conflict over Ukraine and several other international risks.
Given the degree of excess liquidity in the financial system and the ongoing normalization of liquidity preferences, a stock market correction in response to such risks may not actually materialize. The main point I want to get across is that in a one-year time frame, my outlook for stocks is positive.
Fundamentally, it is my view that after a one- or two-quarter lull in the pace of economic growth at the beginning of 2015, the US economy will re-accelerate by the second or third quarter and for the rest of 2015. This re-acceleration of the economy will coincide with a decline in risk aversion and a further normalization of liquidity preferences across the board. Therefore, looking at 2015 as a whole, I expect that the combination improving fundamentals, high stocks of liquidity and the further normalization of liquidity preferences will propel stocks to significant new highs during the course of the year. I make this prediction despite my awareness that stock valuations are currently not particularly attractive from a historical standpoint.
In a report that I plan to publish in April, I will outline a detailed plan for investing in this difficult environment in which stocks are fairly unattractive, but in which they are likely to continue to provide returns over a 12-month time frame that exceed the return on cash or other investments such as US Treasury bonds (TLT-NY), corporate bonds (LQD-NY) or other alternatives such as commodities or gold (GLD-NY). |
