Second Quarter 2011 Perspectives Newsletter
QE2 Redux?
Marian Kessler
On June 30, the Federal Reserve wrapped up its second round of monetary stimulus or “quantitative easing,” coined QE2. This $600 billion Treasury security purchase program, initiated in November of last year, was implemented to stimulate private sector borrowing by driving interest rates lower, theoretically igniting consumer and business confidence, encouraging economic growth and stanching the decline in housing prices. This controversial program of “printing our way to prosperity” was designed to counter deflationary economic forces that many believed threatened to propel the US into a full-blown depression. Fed Chairman Ben Bernanke explained the program’s rationale in a Washington Post Op-Ed piece on November 5, 2010:
“Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
By these measures, QE2 has not been successful. Nor have the Keynesian tactics employed by policy makers. Thus far, direct tax rebates, temporary tax cuts, increased unemployment insurance and duration, bailouts of state and local governments and infrastructure incentives have yielded precious little employment rewards. Counter to expectation, interest rates have risen since the implementation of QE2 and home pricing and demand have stumbled from what had been a tepid recovery at best. GDP growth tailed off in the first quarter (1.9%) from late 2010 levels (3.1%); second quarter growth estimates have fallen from 2.5% to 1.6%, impacted further by the unexpected May increase in the trade deficit. More downward revisions in economic growth are likely as we move into the second half of the year. Stimulus programs have yet to generate the virtuous circle envisioned by Chairman Bernanke. Weak housing and poor jobs growth, in conjunction with European sovereign debt concerns and the aftermath of the Japanese tsunami, are threatening the nascent economic recovery and leave us wondering if a QE2 redux may be in the works.
What did QE2 accomplish?
- Stocks, as measured by the S&P500, are up 25% since the program was intimated in August 2010. Market appreciation positively impacts both business and consumer confidence.
- Most agricultural and energy commodities have risen sharply as well—the S&P Goldman Sachs Commodity Index (GSCI) is up 35% in the last year. Commodity inflation is not particularly positive for either most businesses (margin pressures from rising input costs) or individuals (higher living expenses without a concomitant increase in employment or wages).
- Financial liquidity expanded as the Treasury’s printing presses made possible the exchange of risk-free government securities for non-performing bank assets. Thus, bank capital ratios rose and bank earnings improved. Banks are better capitalized and probably more conscientious (and tight-fisted) underwriters than any time in the past decade.
- Businesses, notably sizeable companies, appeared to benefit the most from monetary stimulus. Corporate earnings and profit margins have soared in the last several years and are expected to continue their double digit growth in the second quarter of this year. Low interest rates, earnings recovery and investor appetite for corporate debt has made borrowing virtually free for higher quality corporate America. In May for example, Google sold $1 billion each of 1.25% three year notes, 2.125% five year notes and 3.625% ten year paper—the deal was oversubscribed three to one. Google, and many other respectable firms, have been able to borrow at a phenomenally low 20 to 70 basis points over Treasuries. Not surprisingly, eyeing low borrowing spreads and anticipating the end of easy money, corporations floated 30% more investment grade bonds than in the same period a year ago—a record $400 billion through mid May. Issuing newly minted cheap debt while refinancing existing high cost debt makes sense and should result in increased corporate profitability and wider capital reinvestment spreads, even if companies have no immediate need for the cash. However, it was just a couple short years ago that fear dictated investors’ appetite for risk. Today, given government sponsored liquidity and what many believe is a Federal backstop on financial disasters, the market’s seemingly insatiable enthusiasm for debt is worrisome.
While large corporate balance sheets, bond and equity investors and corporate earnings clearly benefited from QE2 and other stimulus programs, the vast majority of individuals and small businesses have been largely excluded from the prosperity. According to Case-Schiller, housing has officially double-dipped; the CoreLogic House Price Index has fallen 10% in the last fourteen months. Un- and underemployment remains high, wages and income are stagnant and tax increases loom. Policymakers were probably hoping that a government sponsored business recovery would yield an improvement in consumer confidence, spending and jobs. The trickle–down strategy has been a failure. We may have made progress in corporate recuperation, but for a variety of reasons, businesses have been reluctant, or have not found it yet necessary, to hire or increase wages.
Judging by the issuance and strong performance of investment grade and high yield bonds and the stock and commodities markets’ appreciation, it’s clear that stimulus programs have increased investors’, not businesses’, appetite for risk. As a result of the financial crisis and ensuing recession, large companies cut costs aggressively. Post stimulus and subsequent economic recovery, cash on Fortune 500 balance sheets is piling up faster than most are able or willing to spend it. At the end of the first quarter, S&P500 companies held more than $1.1 trillion in cash, despite the fact cash is yielding next to nothing. Dividend increases, share repurchases, capital expenditure growth and acquisition activity have been moderate relative to the level of balance sheet improvement. Companies have been hoarding money as a buffer against future economic disruptions. The challenge policymakers currently face is exactly how to incentivize big business to reinvest in their employees, technology and competitiveness.
We would argue QE1, QE2 and other monetary stimulus programs executed in the last two years have fueled financial market and commodity speculation with little substantive regulatory restrictions on debt creation, consumption and function. While legislators negotiate issues like caps on debit interchange fees, the derivatives and debt markets remain unchecked and still pose a very real ongoing risk to global economic stability. Wells Fargo CEO, John Stumpf, recently criticized the Dodd-Frank bill, arguing many of the bill’s tenets were more about politics than consumer or financial system protection. To paraphrase Mr. Stumpf’s comments: if one asked the average citizen what caused the downturn of 2008, not a one would say, “It’s those darned debit fees.” But most everyone would mention the housing downturn, exacerbated by poorly underwritten, excessive debt and credit default insurance. When the economy grows slowly, as it is currently, the need to invest aggressively actually grows. Pension plans, entitlement programs and foundations, for example, have future obligations that need to be met by investments with high current and expected returns. It’s a dilemma—how do you regulate, limit risk and create accountability and transparency without impeding returns so desperately needed to meet future commitments? Chairman Bernanke’s vision of a virtuous circle crafted from the printing presses seems unconvincing given the push-pull of widely disparate economic, political and social agendas.
One of the challenges confronting policymakers in the near term is to de-risk and de-leverage the US financial system while encouraging cash-rich companies to take a chance and spend their hoard on people and infrastructure. The potential for future stimulus programs is growing daily as recent employment and GDP growth numbers have proved disappointing. One option before Congress currently is a Senator Schumer sponsored “tax repatriation holiday.” This bill, still under construction, proposes a window for repatriation, or bringing back into the US, the approximately $1 trillion in cash (according to Moody’s) generated and held overseas by US-based businesses. Foreign produced income would be taxed at a proposed 5.25% versus the 35% corporate tax rate. The purpose of this proposal is to both raise US tax revenue and make cash available for deployment in the US; cash that could be used for hiring, capital expenditures or expansion. Cash on domestic company balance sheets has grown exponentially in the last several years: 45% of Google’s cash is trapped overseas. 90% of Cisco’s and 85% of Microsoft’s cash likewise.
The last tax repatriation holiday was enacted in 2004, titled the Homeland Investment Act (HIA). HIA created a 12 month window where US corporations could repatriate overseas earning at a 5.25% tax rate. Nearly $300 billion of funds came home, but there were no stipulations about putting that money to work by actively reinvesting in one’s company. Such mandates will hopefully be an integral part of today’s proposal, HIA-2.
The domestic economy—housing, employment, consumer spending and GDP growth—is softening as we move into the second half of the year. Concerns regarding a potential double-dip, aggravated by the European sovereign debt crisis unfolding now, may induce policymakers to push through further stimulus programs to not only provide financial markets with liquidity ala the QEs, but enact specific programs aimed at increasing tax revenue and stimulating employment through temporary or permanent fiscal measures. Activating the printing presses, to the tune of $2.3 trillion between QE1 and QE2, seems to have benefited big business and inflated stock and commodity prices with little discernible benefit to small businesses and individuals. In the next several quarters, we believe it likely we see not only stimulus programs, but new fiscal measures that address a broader economic and consumer base. It is difficult to predict what these specific programs will look like, but their construction and implementation will be critical to a broader and sustainable economic recovery.
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