Are we preparing for a quick refuel or a 12 hour delay?

Published 2nd May 2024

QE, QT and Inflation - a medium term issue.

The media has been awash with an economic ‘Soft Landing’ scenario, for the best part of the last 9 months. This is where economic growth is sustainable, interest rates are falling and unemployment tops out at 5%. A ‘Hard Landing’ scenario was the odds on favorite 2 years ago, which was represented with recession and economic collapse. A ‘No Landing’ was also on the cards which is economic growth and minimal inflation.?

Inflation has been a thorn in our side for many months. It is hovering at uncomfortable levels for the collective wisdom of select Central Banks. While this has been occurring, the US Federal Reserve (Fed) have tried to shrink their own balance sheet post the GFC and COVID Quantitative Easing (QE). In a 12 year span they grew debt from $1 trillion to an astonishing $9 trillion (Chart 1). As a result of this blow-out, they implemented Quantitative Tightening (QT) in 2022, which is when they don’t replace the maturing bonds on their balance sheet. QT has continued into 2024.

In the first 9 months of QT they reduced the debt by $400 Billion. However, when the US regional banking crisis erupted they needed to inject liquidity to stop a good old fashion bank run. Yep you guessed it . . .? that number was $400 Billion. It is a neat magic trick of debits & credits and rabbits & hats that has kept the popcorn flowing for economic devotees for years.? It was dubbed “QE forever”, except it was only a temporary solution for 12 months and not anything like the original QE that persisted for over a decade.?

Central banks’ ability to control liquidity and enact QT is still the major aspect of global monetary policy that perplexes me – as per my previous articles. Inflation, interest rates and its economic consequences are a relative known known; QT did not come with a rule book…

Chart 1

Sweet Freeways

When we look at the last 12 months and in particular November 2023 – March 2024, we can all agree the markets have been in a “Sweet Spot”. Strong economic growth, interest rates peaking, decreasing inflation and governments running massive deficits means risk assets (shares, crypto and property) have had a steady stream of tailwinds and produced ~20% returns.

Coming into 2024, US markets were expecting 7 interest rate cuts. They expected the “Sweet Spot” to turn into a ‘Sweet Freeway’. However, the Goldilocks Economy and ‘Soft Landing’ expectations baked into expectations look to be dissipating. There is uncertainty around where inflation will settle as the US Fed is obliged to hit a fixed 2% target.???

Our consultant Mike Hawkins believes “As things stand today, labour cost pressures in the US are not yet at a point that would suggest services inflation is set to cool further (Chart 2); commodity prices are bubbling higher (led by oil) (Chart 3) and the slump in Chinese export prices looks to have found a base in early 2024 (Chart 4).??

Chart 2

Chart 3

Chart 4

To be a problem, the latter two factors will need to strengthen further through the June Qtr, but if they do, overall inflation momentum in the US could conceivably accelerate in the December half – at the very least the Fed’s “2%” target will remain elusive.”

Our positioning at William Buck has been cautious around US rate cuts, with an expectation inflation will be stubborn, potentially becoming embedded if the above forces combine in an economy which has proved very resilient.?

The picture in Australia is a little different. Our GDP Per Capita has been in a down trend since the late 1990’s (Chart 5) impacted by our stellar population growth but lacklustre productivity. As such, the job market is cooling – a trend that is likely to intensify from here.? While inflationary pressures in Australia persist (largely via services), economic weakness and rising unemployment should allow the RBA to adopt a more balanced view on interest rates in the December half. ??Inflation containment does not require a depressed economy – the RBA will want to ensure that a struggling private sector does not weaken further in FY25.?

Chart 5

Overall valuations have hit a high point at the end of March. Any slippage in company earnings will be treated harshly by the market. Even though some valuations are being supported by earnings growth, this is the exception and not the norm. On the S&P500 the mega 8 stocks carry 30% of the index weight, all of the earnings growth (10.2%) and almost double the PE multiple (29.7). (Chart 6).?

Chart 6

Historically, when these distortions are present, the market requires a bit of time for a ‘breather’. This facilitates profit momentum to return and valuations to reset. The current pause could roll on for a few months before the fundamentals swing into action.

Another indicator of full valuation, that we monitor closely, is the implied risk premia built into markets.? This gives us an insight into the risk tolerance of the marginal investor. In both Australia and the US (refer Chart 7) this indicator is nearing the “Greed” zone.

What to do today?

As per page 4 of every Investment Review we produce:

Lock in gains when they arise – as we have seen, volatility can erode a paper profit very quickly.

Again, from our Investment Consultant Mike Hawkins “Given the prevailing valuations – both absolute and relative to bond rates – it is very difficult to see further upside for equities on a 3-6mth view – the chances of a 10% pull back look a lot higher than a 5% rally.”?

While we do not profess to be traders or wish to time the market, we do know that the share market can overshoot and undershoot on momentum. Being nimble and protecting capital during the cycle is critical to long term investment success.

Please speak to your advisor if you are sitting on outsized gains.?

Spending time surveying which ‘Landing’ scenario will play out is a moot point, as we clearly can’t predict the future. We can however have a plan that enable us to make the most of either a quick refuel or a 12 hour delay, irrespective of the type of landing that eventuates.

More reading in-case you have not had enough!

There are two shareholder letters that I read each year, or endeavor to read in their entirety. The good thing is there is no rush as they hold their value through time.

Berkshire Hathaway - Shareholder Letters (berkshirehathaway.com)

And?

JP Morgan - Jamie Dimon's Letter to Shareholders, Annual Report 2023 | JPMorgan Chase & Co.

Our national investment consultant Craig Ferguson pointed me towards JP Morgan and Jamie Dimon’s letter, whom he describes as “the best CEO of the last decade’. The below passage is a very simple and araldite explanation for where we currently find ourselves in the world today.?

Dimon said “there seems to be a large number of persistent inflationary pressures, which may likely continue. All of the following factors appear to be inflationary: ongoing fiscal spending, remilitarization of the world, restructuring of global trade, capital needs of the new green economy, and possibly higher energy costs in the future (even though there currently is an oversupply of gas and plentiful spare capacity in oil) due to a lack of needed investment in the energy infrastructure. In the past, fiscal deficits didn’t seem to be closely related to inflation. In the 1970s and early 1980s, there was a general understanding that inflation was driven by ‘guns and butter’ i.e. fiscal deficits and the increase to the money supply, both partially driven by the Vietnam War, [which] led to increased inflation, which went over 10%. The deficits today are even larger and occurring in boom times—not as the result of a recession—and they have been supported by quantitative easing, which was never done before the Great Financial Crisis.”

He writes further on the topic of QE and QT:

“Quantitative easing is a form of increasing the money supply (though it has many offsets). I remain more concerned about quantitative easing than most, and its reversal, which has never been done before at this scale.”