Talking points: quantitative easing
After a summer lull comprising four entirely uneventful weeks, local markets finally appear to be waking up to what promises to be one of the most important and action-packed months in, well, months.
Local investors will be most focused on whether the imminent prospect of further monetary accommodation by the US Fed, the European Central Bank (ECB), and possibly even the People's Bank of China, signals a buying opportunity.
The last round of monetary easing from the ECB in late December 2011 triggered a sugar rush that saw the Hang Seng Index rally more than 20 per cent in just two months. Could it happen again?
On paper, the chances appear good. Recent communiques implying financial intervention from Fed chairman Ben Bernanke at Jackson Hole the week before last and "unlimited bond buying" by ECB president Mario Draghi in Brussels last week have been unusually positive and direct. If we are to believe that US and European bazookas are being primed, surely now is the time to buy?
To answer this question, it is helpful to remind ourselves that quantitative easing (QE) is a two-stage process whereby, initially, central banks print money and buy bonds, causing interest rates to fall. The logic then assumes that private money that might have been tempted to invest in risk-free assets is subsequently tempted towards riskier assets - such as equities - which boosts confidence as prices rise and encourages further investment. In the jargon it's called a "positive feedback loop".
The problem is, only the first bit appears to be working. Yes, interest rates are low and likely to remain so for some time. More importantly - and where the jury is still out - is the question of whether QE has engineered stage two of the process: generating the so-called wealth effect caused by rising prices for risk assets (such as stocks and bonds).
Firstly, we have to ask whether QE will actually happen. Bazookas tend only to be fired when the situation has become truly dire. One might ask, after the recent run of reasonably positive data in the US, if things are really that bad.
Then there's the question of sustainability. Yes, equities have tended to rally ahead of and during periods of intervention, but with subsequently diminished returns over ever shorter periods of time.
During QE1 in March 2009, for example, the HSI rally extended over 20 months for a gain equivalent to 120 per cent. As we suggest above, the latest ECB rally - fuelled by a promise to lend money at cheap rates to European banks - lasted little more two months.
The other problem with QE initiatives is that they tend to be widely expected and, as such, priced in well ahead of time. Indeed, the reason the Standard & Poor's 500 Index is trading just a few percentage points from its post credit-crisis highs - even as US corporate profit growth declines - is simply because investors are hoping to sell into the bid generated by the much anticipated QE3 event.
Yet a willingness to hold - or refusal to sell - has two unintended, albeit linked, consequences. Firstly, equity market turnover, globally, has collapsed; indeed, turnover in the S&P is now back to levels last seen in the late 1990s. It's as if investors have simply given up and gone home. And with prices at elevated levels on thin volume, markets have also become relatively more expensive, thereby limiting their potential upside if, or when, the intervention happens.
For example, during QE2 in 2010, the HSI price to earnings ratio was equivalent to a relatively cheap seven times; now the ratio is at a more expensive 10 times.
All of which is simply a way of recommending caution. In the unlikely event the US and Europe do roll out the big guns, risk assets will respond proportionately and probably rise. But be nimble. The rally's gains and its duration are likely to be less than you might think. And when it comes to timing, momentum trading compared to value investing is always a much trickier strategy to get right.
John Woods is the chief investment strategist, Asia Pacific, for Citi Private Bank