The odds of the United States launching another round of quantitative easing (QE3) are growing. There seems to be a near meltdown in Europe, with the risk of contagion overwhelming both Italy and Spain. Global equity markets have gone into free fall, causing heightened volatility and shaking investor confidence. Economic data are weaker than consensus and talk of a global double-dip slump is starting to gather momentum. The recent downgrade of the US sovereign credit rating by Standard and Poor’s has spooked the markets further.
However, the most important factor is the disappointing economic data released by the US. Ultimately, it is the fear of renewed recession in the US that will force the US Federal Reserve to opt for QE3.
It can’t be denied that the recent US economic data have been disappointing. Revisions show that the economy grew just 0.8 per cent at an annualised pace in the first half of 2011. The level of gross domestic product (GDP) was also revised downwards by one per cent, implying an even bigger output gap than originally thought. America’s GDP per capita (adjusted for inflation) today is at the same level as in mid-2005, implying six years of total stagnation. The US economy today is smaller than at its peak in 2007. The Fed and many economic commentators continue to believe that this weakness in the data is temporary and that growth will return in the second half of the year, even if growth were to significantly accelerate from the current pace. However, it will still mean growth of less than two per cent in 2011.
Growth of one or two per cent is not a stable equilibrium for the US economy: it never stays at these subdued levels for long. The American economy either grows at or above trend or falls deep into recession, it does not stay at current levels of growth for sustained periods of time. Historically, two per cent GDP growth has been a kind of stall speed for the US. Whenever growth has downshifted to below two per cent, downward momentum has carried the economy all the way into a recession. Unfortunately, GDP growth slipped below this critical two per cent barrier in the second quarter of 2011. The US economy is highly vulnerable at present, and going by past experience, is heading towards another recession.
The Fed’s willingness to risk “unconventional stimulus” and go in for QE3 is driven by its determination to avoid another US recession at all costs.
The starting point for this recession would be an unemployment rate that is already over nine per cent. During the 2008-09 recession, unemployment rose by almost six percentage points. Another deep downturn can push unemployment in the US to 15 per cent — there is no way the political system there can accept this level of joblessness. The U6 number, which is a broader measure of underemployment, would reach near 25 per cent, from 16 per cent today. If the US gets anywhere close, it would seem like a near depression.
US Fed Chairman Ben Bernanke is a student of the Great Depression, and has publicly outlined three key lessons from that period:
- the Fed’s unwillingness to quickly ease policy turned a recession into the Great Depression;
- the devaluation of the dollar and subsequent easing of monetary policy played a critical role in bringing about a recovery;
- policy makers should avoid an early exit from stimulus. Premature tightening in 1937 caused the second leg of the Depression.
Given the dent in confidence, driven by the market sell-off, and continuing weak economic data, the Fed will be forced to adopt some form of quantitative easing to reduce the risk of another recession. It will have to do all the heavy-lifting itself since there is no room on the fiscal side to provide the economy any support. The US will have a fiscal drag of over 1.5 per cent of GDP over the coming year, as spending cuts start to bite.
To ensure there is no premature exit from the stimulus, nor a continued weak dollar, the Fed will move into a QE3 programme. The Fed has already taken the first step in that direction. In its recent statement, it committed to keeping interest rates at effectively zero at least till mid-2013 (giving an explicit timeline for the first time) and mentioned that internal discussions were going on about additional policy tools which could be deployed when necessary.
Beyond buying government securities (conventional quantitative easing), we may see the Fed implement more aggressive steps such as rate caps (a form of quantitative easing in which the Fed agrees to buy as many securities as needed to hit a particular yield target), a nominal GDP target or even interventions in private (non-government) securities markets.
One will also see more aggressive measures by governments everywhere to closely monitor and target commodity markets. One of the main criticisms of QE2 was that it led to a huge surge in global commodities, especially oil, thus sapping the purchasing power of consumers the world over. Expect far more serious measures to control the volatility of these markets, including margin requirements and other regulatory oversight. Policy makers will do all they can to avoid another overshoot in commodities.
When QE3 does get announced, many people will comment on how ineffective QE2 was, and how this is once again kicking the can down the road. In reality, the Fed has little choice — it has very little ammunition left and has to prevent an economic free fall.
Markets will hopefully stabilise once these new measures are announced and implemented. In the long term, this will strengthen the case for investors to diversify overseas. Given the weak dollar and tepid growth, US investors will once again be drawn towards the emerging market asset class.
India, therefore, would do well to get its domestic political house in order and move forward on the policy front. The building blocks of a strong performance from Indian equities are slowly falling in place: stable commodity prices, weak global growth, easy liquidity and a search for strong domestic growth stories with a weak correlation to economic growth of the Organisation for Economic Co-operation and Development. Also, India has to be very close to the peak of its rate cycle. Indian valuations are, however, still not cheap.
Just as an aside, watch for the ability of France to keep its AAA rating. Any risk to that and all hell will break loose, which may even lead to a break-up of the Eurozone. If France loses its AAA status, the whole European Financial Stability Facility construct will collapse and Germany will be left holding the bill to bail Europe out single-handedly.
The author is fund manager and CEO of Amansa Capital
