Philip Lawlor comments on the impact of the end of US QE2.
Having surged 26% in the eight months between July 2010 and February 2011, global equity markets have subsequently been consolidating as they confront a period of uncertainty.
One of the major considerations for markets over the short term is gauging the impact of the June cessation of the second round of US quantitative easing (QE2). Looking back, we can observe that the announcement that the US Federal Reserve would instigate QE2 acted as a major catalyst behind the rally in equity markets. The Fed deliberately targeted the wealth generation effects (via equity market gains) as a key component of its policy to rebuild consumer and corporate confidence and reduce the unemployment rate. In many ways QE2 worked like clockwork.
Unfortunately, while QE2 did produce rapid 'sugar high' results in the US, it has progressively been seen as creating a negative feedback loop for the global economy.
Inflationary pressures
The primary concern is that the generation of excess liquidity exacerbated both the quantum of the move in commodity prices and the scale of decline in the dollar. This in turn has contributed to a surge in global inflationary pressures, primarily in developing economies, where food constitutes about 40% of living costs.
Indeed, the rise in basic food costs has been seen as a catalyst behind the uprisings in North Africa. To counter the rise in inflation, developing economies, including China, have continued to raise interest rates, denting confidence over their growth trajectory. In the UK (and latterly the US), rising import costs have seen real income growth turn negative, resulting in a loss in economic momentum. Hence, QE2 is perceived as initially stimulating growth but eventually undermining it.
In the UK, the Bank of England's Monetary Policy Committee has consistently taken the view (in the face of staunch criticism) that demand shortfall is a greater risk than rising inflationary expectations in the second half of 2011. This stance looks prescient as it is becoming increasingly clear that the UK economy is too fragile to absorb higher rates.
Rising input costs are also posing questions over the sustainability of corporate margins that are close to prior peak levels. One of the main bedrocks of equity markets has been the strength of corporate balance sheets and free cash flow generation that have produced a pick-up in dividend payouts, stock buy-backs and merger and acquisition activity.
Solvency headwinds
The euro has benefited from positive interest rate differentials relative to the dollar. Unfortunately, the combination of an appreciating currency, rising interest rates and rising bond yields is creating significant 'solvency' headwinds for peripheral Eurozone economies. Debt restructuring is still very much on the agenda.
Markets are evidently confronting mounting uncertainties over the immediate future. Until we get clarification on the consequences of the withdrawal of QE2 liquidity and the direction of global inflation and growth, equity markets are likely to exhibit increased volatility with more downside than upside risk.
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