What Quantitative Easing means for Investors

Gas prices are skyrocketing in Europe as demand surges with winter approaching and Russia flexing its muscles.

Shipping costs from China have been at record levels (though they’ve now slumped), and now we’re looking down the barrel of US President Joe Biden’s US$1.2 trillion infrastructure bill and a US$3.5 trillion spending plan supercharging the world’s biggest economy, which is on top of his administration’s US$1.9 trillion fiscal stimulus package, passed earlier in the year.

All the while, with that big global growth and inflation indicator, US 10-year Treasury bond yields are climbing but remain below 1.6%.

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Is that great bogeyman of history, inflation, rearing its head? Should investors be worried? That’s what we’re here to discuss.

The X-Factor here is the tens of billions still being spent by governments each month on the new central bank weapon: quantitative easing. We continue to be in the middle of an economic experiment where governments are effectively printing money. Will this lead to a spike in inflation and the associated economic carnage? Or is it necessary for economic growth?

Going back a step, QE is the key mechanism central banks, including our own RBA and the much bigger US Federal Reserve, are using to keep interest rates lower for longer. Why is that important? The mortgage you have is based on the benchmark government bond yield because it is considered a safe asset, unlikely to default. The profit margin the mortgage issuer bank makes is based on the risk-free rate, which is the gov bond yield. Mortgage holders benefit because the risk-free rate, as a component of that, is lower.

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Low-interest rates make it easier to access credit for small businesses and mortgagees, giving them more ability to keep making repayments. New homeowners can also access credit more easily.

This is the whole point of QE, but because it hasn’t been done before, to an extent, it’s an economic experiment. But in its absence, mortgage interest rates would be higher, and a business that employs lots of people wouldn’t have as much access to credit. All things being equal, no QE would mean higher unemployment.

There are inflationary pressures, however. Supply chain issues are there, but economists and the bond markets anticipate that these are temporary Covid related supply-side issues that will disappear as conditions revert to normal. Contributing to this belief is that measures of wages and labour costs in the US (employment costs) haven't been moving up, but there is some evidence that labour is withholding its supply to employees at current wage levels.

Hence central bankers also see the inflationary pressures as temporary. They will only halt QE and raise official interest rates if they see a sustained increase in aggregate demand.

Moreover, the market looks at the benchmark US 10-year bond yield of 1.6% and isn’t worried. This will change if it goes towards 4%, which is when it gets scary because of the debt burden resulting from this massive increase in government debt.

Inflation and the consequent raising of interest rates could be a real concern, however. One event to watch is the US$3.5 trillion big budget bill currently before the US Congress. This is a stimulus for an economy already recovering from Covid. To give you perspective, the Australian economy is US$1.6 trillion in size, while the US is US$22.7 trillion.

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Takeout for Investors

We are in an interesting time for equities because there are two clearly conflicting forces.

On the one hand, the injection of massive stimulation would increase aggregate demand in the US. This is favourable for spending businesses and households. A tick for equities.

On the other, we seem to be at an inflection point in terms of where interest rates move. If they keep moving higher that is a negative for equities, because discount rates go up, lowering asset prices.

These two cross-currents make us happy to stay where we are. We are waiting for more data to see which one of those cross currents dominates.

We continue to buy and hold quality stocks to grow our own future wealth.

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Richard Hemming

Richard Hemming

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Richard is a leading market commentator and expert on ASX Small Caps

www.undertheradarreport.com.au provides investment opportunities in Small Caps that you won’t get anywhere else.

Under the Radar Report is licensed to give general financial advice only (ASFL: 409518). The author does not own shares in any of the stocks mentioned.

Under the Radar Report is licensed to give general financial advice only (ASFL: 409518). The author does not own shares in any of the stocks mentioned.

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