Ed Golding explains quantitative easing as it’s being actioned to support global markets during the COVID-19 pandemic. What exactly is it, how it works, and why it’s so important?
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For Episode 3 of the MD Market Watch Podcast, Ed Golding, Assistant Vice President and Portfolio Manager of the Multi-Asset Management team, explains what quantitative easing is, how it works and why it’s so important to global markets during the COVID-19 pandemic.
We’ve seen policy makers around the world jump in to support global markets. An example of the support is quantitative easing, which has been in the headlines lately. What is quantitative easing?
Ed [1:02] So, yeah, quantitative easing – it’s not the easiest topic to explain. So, maybe before going into a formal definition of what quantitative easing is, I can take a step back and differentiate between two types of support that economies get from policy makers.
The first support is fiscal policy. Fiscal policy is the use of government spending and tax policies to influence economic conditions, especially macro-economic conditions, including aggregate demand for goods and services, employment, inflation and economic growth. So, a recent example of a fiscal policy that we've had here in Canada is the Canadian government's recent announcement of the $73 billion wage subsidy program. So that's an example of a fiscal policy.
The second type of policy, Alex, is monetary policy. Monetary policy; This refers to the actions undertaken by the nation's central bank, such as the Bank of Canada or within the United States, the Federal Reserve. And they control the money supply to achieve macroeconomic goals that promote sustainable economic growth. An example of monetary policy is the Bank of Canada's recent decision to lower its target overnight rate, which is a rate that banks lend to each other. They lowered that by 0.5% to just 0.25%.
Those are the two types of policy that governments can enact to help support economies.
Now back to your original question, Alex. Quantitative easing, or better known as QE, is a form of monetary policy in which a central bank purchases longer term government debt securities from the open market in order to increase the money supply and encourage lending and investment. Buying these government debt securities adds new money to the economy and serves to lower interest rates by increasing the price of fixed income securities. It also greatly expands the central bank's balance sheet.
So, when short-term interest rates, Alex, so you know, are at or approaching zero, the normal open market operations which target those interest rates are no longer effective. Central Banks can push interest rates to zero, but at some point, you hit that zero lower bound. You cannot push interest rates any lower. So instead, the central bank will implement a quantitative easing program to try to get longer term dated interest rates lower. And they can do this by targeting specific amounts of government debt assets to purchase. So quantitative easing increases the money supply by purchasing these government debt assets with newly created bank reserves in order to provide banks with more liquidity.
Prior to the global financial crisis of 2008, quantitative easing was rarely used, and considered unconventional, up until that time period. However, the central bank of the United States, the Federal Reserve, has used this policy extensively since 2008 – to the point that it is no longer considered unconventional any longer. Since the end of 2008, the Federal Reserve has completed three rounds of quantitative easing and is currently implementing its fourth. While the impact of quantitative easing on economic factors such as inflation, employment and productivity are heavily debated, the impact of quantitative easing on equity markets is not debated at the moment.
Equity market returns in the U.S., represented by the S&P 500, have been very strong during periods where the Federal Reserve has implemented a quantitative easing program. During QE1, which was between March of 2009 and March of 2010, the S&P 500 increased by 51%. Huge increase. Alex, during QE2 between November 2010 and June 2011, the S&P 500 increased by an additional 11%. During QE3, which was between September 2012 and October 2014, the S&P 500 increased by 38%. So huge returns from what we've seen from past quantitative easing programs. And now QE4 is currently underway, which has only been under way for just over a month now. This was implemented on March 16th. The S&P 500 is up already by 21% since it was implemented.
The results of previous rounds of quantitative easing are impressive and dramatic, but are there risks? What are the drawbacks of using quantitative easing?
Ed [4:55] Yea, it's a good question, Alex. I mean, obviously, just like the benefits of quantitative easing, there is considerable debate about the drawbacks.
In theory, quantitative easing increases the money supply as the central bank purchases bonds. This increase in the money supply should lead to more dollars chasing fewer goods, which in theory should lead to a rise in inflation. Obviously, one of the central bank's main goals is to ensure stable growth and inflation. It doesn't want wild variations in inflation. So, in theory, quantitative easing in the longer run could lead to higher variations in consumer prices.
Another potential drawback is malinvestment. As the central bank engages in quantitative easing, it depresses the price of money – better known as interest rates. The suppression of interest rates in the economy can lead to malinvestments, which are defined as badly allocated business investments, essentially. The lower interest rates can have the effect of making some projects appear profitable with a lower discount rate. However, if or when interest rates rise, these projects no longer are profitable and can lead to a mass liquidation event, which can lead to a recession.
And the final one, a further drawback, Alex, of quantitative easing are asset bubbles. You know, an abundance of money created by central banks always finds its way into equity and bond markets. We've seen this quite easily in the past. Lower interest rates ease the debt burden on corporations and boost profits and salaries, leading to more euphoria and higher and higher valuations. Sometimes it's believed that the market then becomes addicted to the quantitative easing provided by the central bank and the Federal Reserve, in the case of the United States. And once a central bank pulls the plug on additional stimulus, market participants could begin to pull their money out of the market, leading to a significant correction in prices, which could lead also to a recession. An example of that we saw, has now been about 20 years now, it's hard to believe, but we saw this play out during the tech bubble of the late 1990s.
The U.S. Federal Reserve has been making headlines recently with the latest round of quantitative easing. What's going on there? Given some of the concerns that you mentioned earlier, what's the rationale to support the move?
Ed [7:04] So that's a good question, Alex. The most recent quantitative easing program announced by the Fed is its fourth since the end of the global financial crisis. I call it QE4, so I'll probably refer to it as that going forward. QE4 is very comprehensive and massive in scale relative to its three predecessors, so I will just go into the highlights of the most important aspects of this new round of quantitative easing.
The Federal Reserve in the U.S. will purchase an unlimited amount of U.S. treasuries and mortgage backed securities. They will establish a new program that will provide up to US$300 billion in credit to businesses and consumers, facilitate the flow of credit to municipalities and most radical of all, to provide a new facility that will purchase, in the secondary market, corporate bonds issued by investment and junk grade U.S. companies and investment and junk grade U.S. listed ETFs.
So, the foray into private credit markets is a first for the Federal Reserve and is designed to stabilize credit markets. Credit markets froze early in the COVID crisis and credit spreads widened considerably to reflect the risk of corporate bonds relative to government bonds. The Federal Reserve's actions to purchase private corporate bonds has provided the liquidity needed to ensure credit markets function and that credit flows. However, you know, support for credit markets has sparked a fierce debate, Alex, within the investment community, as market pricing has become very disconnected from underlying fundamentals. The pricing of corporate bonds, regardless of where they lie within the rating spectrum, no longer represent the risk embedded within and in propping up companies with weak balance sheets and who buy back their shares instead of prudently investing free cash flow, leads to a moral hazard that parlays into future bailouts at the hands of taxpayers.
So finally, you know Alex, talking about putting QE4 into context, the Federal Reserve's balance sheet has ballooned by US$2.3 trillion in just six weeks compared to an increase of US$2.6 trillion for QE1 to QE3, which encompassed a period of three years and nine months. So, it put it into further context Alex, it is expected within the first two months of QE4 that the current round of QE will meet or surpass the Fed's total quantitative easing response over the almost 4 years following the global financial crisis.
The Fed is spending a significant amount of money to buy a lot of assets. What does that mean for the Fed going forward?
Ed [9:25] We don't know the answer for sure. Obviously, the Federal Reserve knows, but we think we can make some educated guesses on what the actions of the Federal Reserve in the U.S. could be going forward.
The Federal Reserve's response to future economic crisis, it is my expectation that they will be larger than what they've been in the past. They will encompass additional forays into private markets. As I just mentioned, the Federal Reserve began its first foray into private credit markets, so some are asking and wondering how long before it begins to intervene in equity markets. Some speculate in the next crisis, we'll see the Fed purchase the popular ETF SPY, which is a proxy for the S&P 500, and it wouldn't necessarily surprise me to see such an action taken by the Federal Reserve in a future economic crisis.
Second part of your question is also a good one, Alex, and I'm not sure I know the answer, but is there a limit to how much a central bank can buy? Obviously, I think there is a limitation to what the central bank can do with initiating quantitative easing programs because it is dependent on the federal government increasing its debt essentially. Obviously further deficit spending increasing to the debt of the federal government, will increase more bond issuance and that additional bond issuance can then be purchased by the Federal Reserve to implement its quantitative easing program. So, they are limited to what the federal government does with respect to deficit spending. But where is the line and how much they can actually purchase, If the federal government continues to go further and further in debt, no one really knows at this point.
Quantitative easing, as I mentioned earlier, was considered quite unconventional just 10 years ago, and now it is a tool used frequently and more aggressively. While we can see that the approach has short-term benefits to stabilizing financial markets, the long-run impact – and by long run, I'm talking about decades, not just years – are highly unknown. Maybe the long-run impacts will be benign and concerns of pricing distortions in financial markets will be considered overplayed. However, this is still a big unknown and all the potential drawbacks from inflation, to malinvestments, to asset bubbles are factors that could play out and lead to further economic consequences.
Has the latest round of quantitative easing changed our strategy? What are the things we're watching with regards to this whole situation?
Ed [11:35] We are watching everything right now. Every piece of new data that comes in also comes with debate over what does it exactly mean.This is a very unusual time in history and there is little reference for us in history to guide our thinking and view on making investments. One new piece of information we are watching is COVID outbreaks and death rates. As morbid as that sounds, it’s critical to understanding where the virus is going and how it's expected to play out over the next weeks and months. We're also watching government policies on relaxing social distancing laws and reopening of the economy and creating scenarios on possible second waves of a virus outbreak.
When it comes to, you know, how are we managing our clients’ money – have we made any changes? I would say we have not made any material changes in how we are managing our clients’ money at the moment. We acted early on during the crisis to reduce the risk within our client portfolios by raising cash. But have since reduced that risk mitigation strategy, as policymakers have stabilized both equity and bond markets significantly over the past few weeks.
Remember, this is a highly unusual situation that we have found ourselves in at the moment. And you've got to remember, this has materialized, Alex, over just eight weeks. Eight weeks ago, we were all coming into work, we were not social distancing, the economy was moving along at a decent pace, and over two months we've seen that just absolutely change. So, this is a very, very short time period where we've had a chance to try to react and try to ensure we're doing what's right for our clients, with respect to investing their hard-earned capital.
So once, you know, the social distancing laws relax, once people are going back to work, once the economy begins to pick up, it'll give us a bit of time to catch our breath and begin to reflect. Some of the items that we're going to reflect on will be the role of government going forward in private financial markets and what that means.
Value investing versus growth investing – we’ve seen within the U.S, the historical value premium over growth investing no longer materialising with growth investing significantly outperforming value investing.
We want to look into small cap investing versus large cap. As with value versus growth, there was always a small cap premium relative to large cap investing, but that has not played out over the last 10 years and has accelerated towards large cap over the last 6 to 12 months.
We want to understand the future of energy markets. We've seen energy prices, oil prices go negative as future contracts come near to rolling out to the next month. So obviously significant impact on energy markets.
We want to understand the duration of bear markets. During the global financial crisis, once a bear market hits is when it’s down 20% from its highs. Once that played out during the global financial crisis, it took another one year and five months just to get back to that 20% down from the all-time high. What we've experienced over the past eight weeks, we've seen equity markets decline over four weeks and then recover back up half of that loss and out of bear market territory in just three weeks. So, a very different dynamic has played out during this economic crisis, than what we have seen in the past. We need to be able to tailor our thinking going forward on how to approach these types of situations and manage our clients’ money the most prudent manner going forward during those periods.
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