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of all guest columns written by Dennis C. Butler, CFA
Quantitative Easing, or �QE� as it has come to be known, is one of those obscure banking and finance terms that has emerged into the media spotlight, so much so that it seems assured a prominent place in the economic histories of this era, and in the popular lexicon as well. Its rise to public consciousness is the result of its role as an important financial tool used by policy-makers grappling with the lingering aftereffects of the financial crisis and economic downturn that began in 2007. For those who understandably remain confused about these matters, QE refers to a mechanism that central banks employ to encourage economic activity by reducing borrowing costs and increasing the amount of money in circulation. Bankers turn to QE when the standard stimulus methods, such as cutting short-term rates, fail to work. In QE the bank purchases fixed-income securities in the open market (typically high-quality ones, such as treasury notes), in the process putting upward pressure on bond prices, which in turn reduces interest rates and injects cash into the financial system. The added cash, it is hoped, will find its way into the real economy, giving a boost to activity and adding jobs. The U.S. Federal Reserve is now in its third round of such easing (�QE3�) since the financial crisis began. The European Union and Japanese central banks have also initiated QE programs. Such are the challenges facing monetary policy-makers as financial stresses continue and threaten to include ever-greater regions of the world.
QE is not without controversy. It is a seldom-used policy instrument that seems �radical� because it results in a greatly expanded central bank balance sheet. Critics argue it is inflationary and also deny its effectiveness. It is inflationary � that�s the whole point � but the latter objection is more difficult to address. The aggressive measures taken by authorities since 2008 were in some cases ad-hoc, untested, and implemented hurriedly in an attempt to avert disaster � serving a different purpose than goals that are more measurable in a quantitative sense, such as economic growth rates or the number of new hires by industry. QE may work in a similar fashion, as a financial measure that acts over time to restore trust and confidence, thereby preventing worst-case scenarios from becoming realities.
If you liked QE, you�ll love its relatively unknown poor cousin, �Qualitative Easing.� This kind of stimulus has the central bank purchase bonds lying further down on the risk scale from sovereign issues. The intent is to bolster particular sectors of the economy that the bankers judge to be critical for economic health. In the U.S., for example, the Federal Reserve is buying mortgage securities in an attempt to help the housing sector, which is important to the U.S. economy and particularly hard-hit since 2007. Japan�s bank has included corporate bonds, commercial paper, and even Exchange Traded Funds in its purchases. The European Central Bank may take this route if it acquires the sovereign bonds of troubled �peripheral� countries whose debt ratings now rest at such low levels that they are virtually shut out of the debt markets. Difficult times breed extraordinary measures.
Moving away from the rarified regions of central bank operations, we noted another type of �Qualitative Easing� taking place that could have a more immediate and possibly painful impact on some investors� pocketbooks, and one that is happily avoidable. This is an old phenomenon that we see almost every time there is a lengthy bull market for some financial asset; this time it�s bonds. Funds that invest in bonds have had a difficult time doing well relative to their �benchmarks,� indexes reflecting the returns achieved on average by the bonds that the fund in question might focus on. The solution? Buy securities not found in the index! So, for example, a fund that supposedly invests in high-quality corporate bonds might throw in a few higher-yielding junk issues to goose returns. Who�ll know? And, you�ll be able to attract more assets from your more circumspect peers in the money management business.
This trick was played on a grand scale in the late 1990s, when supposedly conservative stock funds would load up on high-flying technology shares. The ultimate outcome was as deplorable as it was predictable. A similar destiny probably awaits the more aggressive bond funds this time. Sooner or later rates will rise, the funding environment will become less favorable, and speculative issuers will meet the fate they deserve.
However, that�s not happening yet. Investors of many stripes did well in the summer quarter as rates remained low and stocks defied Wall Street�s old dictum, �sell in May and go away.� (They even avoided the �September swoon,� and rose smartly for the month.) Most people (at least those who had not retreated to the comfort of bank savings accounts) were probably surprised at the positive outcome for the period due to all the talk about European logjams, potential inflation, a slowing Chinese economy, potential confrontation in the South China Sea � and we haven�t even gotten to the Middle East. Rest assured that when things are talked about so much their potential impact is probably already discounted by the investment community, so it shouldn�t be surprising if markets often respond positively when the worst-case scenario doesn�t come to pass. Markets may seem to defy logic in such cases, but they are really being perfectly reasonable. What is even more confusing to the novice is that these things sometimes happen for no obvious reason � the cause only being revealed later on.
At quarter�s end stocks had returned 6.4% during the third period, as measured by the broad S&P 500 index. The S&P continues on the roll that has garnered a return of 16.4% so far in 2012 (including appreciation and dividends). A solid double-digit return such as this would normally make for a very strong annual result, but it is truly remarkable in a year marked by endless �headwinds.� Indeed, such has been the year-to-date strength, that stocks could decline by 5-6% during the fourth quarter and investors would end 2012 still achieving gains in the 9-10% range, an average year for equities.
Bond results were respectable as well at positive 2.5% for the quarter and 6.1% year-to-date for the intermediate index � characteristically not as strong as equities, although the �junk� category has returned over 11% for the year so far, an equity-like result. The Federal Reserve�s bond-buying activities and low rates continue to stimulate record issuance of fixed-income paper, especially by lower-rated issuers. Finally, the hedge funds, which some in the investment business refer to as a separate �asset class,� have delivered truly exceptional results for their investors this year � �exceptional� in the sense that almost everything has done well except hedge funds. Exceptional fee structures set these funds apart as well, which is why a 3.5% average return for the eight months through August is probably hard to swallow for their investors who could have gotten 13.5% from an S&P 500 index fund at a small fraction of the cost. Still, $38 billion has been thrown at these creatures this year, lifting the hedge fund universe�s total assets to about $2.8 trillion. It will be interesting to see what happens at year-end when investors at many funds will have an opportunity to withdraw their money.
Everyone is aware by now of the coming �fiscal cliff� of tax increases and spending cuts that the U.S. faces at year-end, barring some kind of action by the Congress. We don�t mean to discount the importance of the issue or the severity of the potential impact (it could make the difference between moderate growth or a recession in 2013), but it is, in fact, to some extent �discounted,� at least in the financial markets. The problem is, we don�t know by how much, or in which direction. If the markets expect the worst, then almost any compromise in Washington would likely be viewed in a positive fashion, in which case prices could continue the ascent we have enjoyed this year. If, however, investors have been too complacent, expecting some sort of resolution prior to reaching the cliff�s edge, then sharp declines could occur as reality sets in.
We don�t know how these issues will play themselves out, and, quite frankly, we care little, either for the end result or for speculating about it. We expect volatility, but that is the nature of the beast. If volatility is high enough, and in the right direction, we will increase our holdings of long-term securities � our preferred investment vehicles. In the long run, this controversy will, as with all others, have been a passing disturbance.
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Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 27 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.
"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
President
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
Telephone: 617.441.9695
Email: [email protected]
URL: http://www.businessforum.com/cscc.html
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