June 24, 2013
The announcement by Federal Reserve Chairman Ben Bernanke that he would wind down his debt monetization program called quantitative easing (QE) as early as the Autumn of 2013 has sent shockwaves around global markets. Although he has promised to keep the Fed funds rate at 0% well into 2015, global markets have sold-off dramatically as investors fear the removal of liquidity from the financial system. Emerging markets have been slammed and the Indian market has been no exception. The CNX Nifty index is now down more than (5%) year-to-date (YTD) and the Nifty Midcap index is down a mind numbing (22.5%) YTD.
QE successfully prevented the process of debt deflation that began in 2008 with the bursting of the US housing bubble. The current discussion about the removal of QE only makes sense in the context of an improving American economy. The US economy and more importantly investors globally have become addicted to easy money and unlimited liquidity. By removing some of this excess liquidity, both the economy and investors are going to go through withdrawal symptoms. The current volatility in global markets is simply a reflection of these withdrawal symptoms.
Despite all the rhetoric, we must remember that the Fed always lags markets. This has been the case historically because the Fed primarily focuses on unemployment and inflation, which are both lagging economic indicators. The markets dictate policy to the Fed and not the other way around. Growth remains anemic and Bernanke has made it clear that his decision to remove QE will be dependent upon the state of the economy.
In my view, the current cycle will end like prior cycles. The Fed will remain accommodative for too long and eventually inflation pressures will start building. The Fed will then rush to tighten interest rates in order to make up for their earlier hesitancy. The Fed will eventually go too far, the yield curve will invert and a recession will follow. However, we are a long way from an inverted yield curve or a recession in the US. The entire discussion about the demise of QE is premature. The Fed will be late in raising rates and removing liquidity from system as it has been in every prior cycle. The current cycle is no exception.
The Problem with Indexing
Doug Barnett runs Quest Management, a Thailand based investment management firm. You might not have heard his name but he’s quietly racked up one of the best performance track records in the investment management industry over the past 20 years. The chart below shows that an investment of USD 1,000 in Doug’s fund in April, 1990 would have grown to USD 59,301 by April, 2013. Over the same period an investment in the Thai index (SET) would have turned USD 1,000 into USD 1,677. Doug’s performance on a stand-alone basis is truly impressive. But I think what’s more interesting is that over the same period the Thai index (SET) went absolutely nowhere. If anyone ever tells you that alpha generation is not possible in an efficient market and that passive indexing is the best way to invest, please show them the chart below.