Volatile trading in global equities continued this past week (to October 8), but there was some glimmer of good news that boosted the market for a while. This at least moderated the growing concerns during recent weeks about an apparent faltering US economic recovery and the continuing eurozone crisis. This welcome good news helped produce a strong rally during the week in global equities.
The ‘good news’ was in three, mutually reinforcing areas. First was a rise of 103,000 US (non-farm payroll) jobs, nearly double the consensus forecasts for this key statistic. Second was the strong movement midweek towards a coordinated response by EU leaders to the recapitalisation of Europe’s banks. The third move was further major (and extraordinary) support for markets by the Bank of England. The latter support was mitigated somewhat, though, by the governor of the Bank of England’s strong comment on the severity of the present crisis. These are not helpful comments when markets and confidence are so fragile.
The Bank of England has made a bold move in launching a second round of QE (Quantitative Easing), raising its total QE so far from £200 billion to £275 billion. In practice this means that the Bank is printing an extra £75 billion by buying assets like Government and corporate bonds. QE, together with keeping UK interest rates at historic lows (at 0.5 per cent), is targeted to help ‘fire up’ the flagging UK economy.
No one knows for sure the impact of QE, but the theory is to pump more spending power (money) into the economy which should help boost economic activity. The companies (mainly banks and insurance companies) that sell the bonds bought by the Bank of England receive this additional money, which can then be used to help stimulate the wider economy via more spending on goods and services. The basic mechanism at work here is that bank reserves are increased by this QE process and this should enable them to lend more, which increases spending throughout the economy.
Analysts believe that the ‘riskier’ cyclical stocks (those that rely more heavily on consumer and company spending) will perform better from this kind of QE. During the last (March 2009) round of QE (when £170 billion was pumped into the economy), for example, cyclical stocks like banks, car manufacturers and miners benefited most. But there are differences this time around. The latest QE (at £75 billion) is less than last time and this time there is also less global cooperation (for example, the European Central Bank failed to cut its interest rate last week).
The initial market reaction to QE appeared good. Equities rose and gilt yields and sterling fell, which (in theory at least) should help lower company borrowing costs and improve competitiveness. Longer term, though, it is hard to predict the impact of QE on markets and business sentiment. Another challenge is that QE is likely to ramp up inflation risks.
A big question with this new QE is whether the banks will lend more. The continuing eurozone worries, the slowdown of the UK and US economies, and new UK banking regulation may all conspire to make banks even more cautious in their lending. With growing moves towards a recapitalisation of European banks as the Greek crisis unfolds, banks may remain leery about increased lending. But the good news is that the last (2009) round of QE appeared to be a positive stimulus to economic growth. The Bank of England reckoned that it helped to grow GDP in the UK by between 1.5 and 2 per cent.
Nevertheless, QE has its strong critics. Some worry about inflation, which is currently heading towards 5 per cent. A leader in the Sunday Times (David Smith on 9 October) emphasises the distinction between QE and credit easing. QE is designed to increase the quantity of money in the economy, whilst credit easing is concerned with boosting the flow of credit. The two are not necessarily interchangeable. Rising inflation (together with the present fiscal squeeze) reduces real income. This leader advocates amongst other things a tighter control on rising inflation (to bring in below forecast inflation returns to help boost real incomes and spending power) and combined Bank of England and Treasury moves to boost lending to SMEs. A proposal for the latter is for the Bank of England, acting for the Treasury, to buy bundles of SME loans. This would bring an ‘official buyer’ (the Bank of England) into the market to help fund company borrowing. Such moves, it is argued, will help boost confidence through easing investor fears about purchasing or funding such assets.
Another, perhaps unintended but unfortunate consequence of QE is the impact on pensions. QE is likely to reduce annuity rates through the process of buying up gilts (Government bonds), which lowers their yields. It is these yields that are used by insurance companies to determine how much annuity income they can offer over a pensioner’s life. So pensioners face a kind of ‘double whammy’ of reduced annuity rates and falling pension values because of the stock market slump.
Already there are warnings that further QE rounds may be needed soon as the UK employment hits its worst patch for 17 years and the economy is predicted to shrink in 2012. All the evidence that we have at this time suggests that QE can help, although complementary moves are surely needed, together with a recognition of the inflation and other challenges with deploying QE.
The present ‘crisis’ will be much easier to handle as we return to a stronger economic growth and boosting bank lending is an important part of the overall economic solution needed. At least the UK is facing up to this challenge with some strong action. Too much ‘gloom and doom’ can generate self- fulfilling prophecies and should be avoided when market sentiment and confidence are fragile and at a low ebb. At the same time, the strong statements by the German chancellor and French president to protect Europe’s banks has to be good news
Professor Bullion
