Mario's Marvellous Medicine
What happens as QE ends?
With the Fed and ECB unwinding QE, what happens when we come off the meds? There are signs that the patient (the economy) has healed, suggesting limited withdrawal effects. While addiction and placebo effects could still increase risk premia, low inflation reduces the risk of going ‘cold turkey’.
I was off work ill a couple of weeks ago ...
... one night in particular, I couldn’t sleep without taking painkillers ...
... and it got me thinking ...
… what happens when we stop taking medicine?
This is a regular question from clients now the Fed and ECB are unwinding quantitative easing (QE).
It depends on what the medicine is for and the underlying health of the patient.
1. Temporarily ill
In my case, the painkiller was to help me sleep. My body could then rest and fight off the virus.
Needless to say, I don’t need to take painkillers to sleep now as I’ve recovered. So withdrawing the medicine has no effect.
2. Permanently ill
But some medicines need to be taken for a prolonged period of time (sometimes indefinitely) to keep an illness and/or pain at bay.
Withdrawing medicine too early can therefore cause the patient to get ill again.
3. Addictive drug
Too much medicine can also cause problems. There are fears that over prescription of antibiotics are leading to superbugs. Moreover, the US opioid addiction epidemic is blamed on excessive painkiller prescriptions.
Regular readers will be familiar with my own sugar addiction (it’s even in my bio). I always try and eat sweets before presenting to give myself a buzz. But there’s an inevitable dip when the sugar rush wears out.
The final form of medicine is a placebo. A dummy pill that has no direct medicinal effects but can still indirectly affect the patient through the mind and possible self-induced chemical reactions.
So what happens when the QE meds end? To answer this we need to understand the symptoms of the patient and the type of medicine used.
Financial markets and economies are self-reinforcing. That’s why we get business cycles. At the start of 2016, financial markets were struggling on the back of default fears due to the collapse in commodity prices. This is self-fulfilling because wider credit spreads make it more difficult for firms to borrow.
To avert a credit crunch, the Fed stopped raising interest rates and the ECB and BoJ stepped up asset purchases, including for corporate bonds. Financial markets have duly recovered. But there’s also been an underlying improvement in the patient (the economy). Global capital expenditure is strengthening as banks in both the US and emerging markets (EM) report that they have stopped tightening credit conditions.
Addiction and placebo effects cannot be ruled out. I previously showed how funding flows to EM recovered after the medicine was increased in 2016 ("Money talks"). Some of those flows could reverse if ending the medicine pushes up US Treasury yields. But it is surely safer to withdraw the medicine today, when the economy is in a self-reinforcing upswing, than a year ago when confidence was more fragile.
On balance, Lars believes that stronger earnings and a typical bull-market PE expansion justify current equity valuations. We maintain our long dollar positions as a hedge, just in case the patient has an adverse reaction to medicine withdrawal. But with inflation low, central banks can err on the side of caution, reducing the risk of going cold turkey.