The unintended consequences of quantitative easing

The Federal Reserve’s program of quantitative easing has caused the size of its balance sheet to increase from its long-term average level of about $800 billion to its current $3.5 trillion. This flood of liquidity may have been necessary to pull us through the Great Recession. However, any program of this size contributes to distortions and volatility. And that is where we sit today.

In the first several months of 2013, the S&P 500 moved with an 87% correlation to the size of the Fed’s balance sheet. That balance sheet has been ballooning by approximately $85 billion per month as the Fed maintained its commitment to quantitative easing III (QE3).

But suddenly that commitment is in question just as investors have become quite addicted. The thought of quantitative easing being tapered down has made investors jumpy, and volatility in the U.S. stock market, as measured by the VIX index, has spiked 39% since late May. During that same period, we’ve had a record-breaking number of 200-point moves in the Dow Jones Industrial Average.

Volatility has spread across all financial markets. The 10-year U.S. Treasury Note began May with a yield of 1.67% and that yield crossed 2.63% in late June. Currency markets have been roiled by worries about the withdrawal of quantitative easing, too. Countries such as India, Poland, Turkey, Brazil, and South Africa have had to intervene on both sides. Earlier in the year, they hoped to lower the value of their then-strong currencies, but today, they worry about their weak currencies as investors and capital retreat.

Interestingly, one of the primary behavioral goals of QE3 has been to lower interest rates enough to encourage consumers and businesses to invest and take risk. Think of it this way: If the cost of financing is pushed artificially low, it becomes easier (less costly) for your neighbor to decide to buy the new car. You may decide to buy a bigger house. A business in the local industrial park may finally pull the trigger and expand. Federal Reserve Chairman Ben Bernanke desperately hopes businesses begin to hire.

It is almost counterintuitive, but it appears almost the exact opposite consequence haunts us. A low-yield environment certainly lowers the cost of financing, but it also lowers the expected return from an investment. With rates as low as they are, it has become easy for businesses to postpone investment and do exactly what Ben Bernanke does not want them to do — sit on their cash. Or “invest” it in less economically productive activities such as share repurchases and/or increased dividends. 

Not that there is anything wrong with that! But when decisions to repurchase shares usurp decisions to hire and expand, the result is less-than-robust economic growth. Combine this phenomenon with the uncertainty and volatility mentioned above, and today’s economic and investment environment becomes easier to understand. 

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So what should an investor do in this environment? The best answer is to carefully review your investment objectives and make sure they align with your investment portfolio. And dig in. If your investment objective is to “beat the S&P 500,” challenge yourself and ask why this is so important. Perhaps it is more important to have a portfolio that performs more steadily with less volatility than the market as a whole; or perhaps there is a lifetime goal such as a part-time position that enables you to volunteer with a favorite charity. That goal may be very attainable with far less risk than a goal of simply beating an arbitrary stock market index, so think about it.

Recently, a Facebook shareholder was quoted as saying to Mark Zuckerberg that Facebook’s stock has been a “disaster.” Really? A move from its initial price of $35 to $24 — that’s a disaster? Not all stocks go up all the time. If that move, in what should be one stock from a well-diversified portfolio, qualifies as a “disaster,” perhaps that investor should visit Moore, Okla.

After a reality check, any portfolio adjustments should be given time. The U.S. economy has proved its mettle time and again. Widely forecasted disasters rarely seem to come to fruition. For example, just five years ago headlines about global energy shortages were plentiful. Today, we’re talking about U.S. energy independence. A carefully constructed, well-balanced investment portfolio is the best way to participate in the amazing resilience of the U.S. economy. It is also the best way to help you attain your true long-term financial goals.

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