Many now argue that QE3’s effect on risky assets should be as powerful, if not more so, than that of QE1, QE2, and “Operation Twist”, the Fed’s earlier bond-purchase programme. After all, while the previous rounds of US monetary easing have been associated with a persistent increase in equity prices, the size and duration of QE3 are more substantial. But, despite the Fed’s impressive commitment to aggressive monetary easing, its effects on the real economy and on US equities could well be smaller and more fleeting than those of previous QE rounds.
Consider, first, that the previous QE rounds came at times of much lower equity valuations and earnings. In March 2009, the S&P 500 index was down to 660, earnings per share (EPS) of US companies and banks had sunk to a financial-crisis low, and price/earnings ratios were in the single digits. Today, the S&P 500 is more than 100% higher (hovering near 1,430), the average EPS is close to $100, and P/E ratios are above 14. Even during QE2, in the summer of 2010, the S&P 500, P/E ratios, and EPS were much lower than they are today. If, as is likely, economic growth in the US remains anaemic in spite of QE3, top-line revenues and bottom-line earnings will turn south, with negative effects on equity valuations. Moreover, fiscal support is absent this time: QE1 and QE2 helped to prevent a deeper recession and avoid a double dip, respectively, because each was associated with a significant fiscal stimulus.
Even if the US avoids the full fiscal cliff of 4.5% of GDP that is looming at the end of the year, it is highly likely that a fiscal drag amounting to 1.5% of GDP will hit the economy in 2013. With the US economy currently growing at a 1.6% annual rate, a fiscal drag of even 1% implies near-stagnation in 2013, though a modest recovery in housing and manufacturing, together with QE3, should keep US growth at about its current level in 2013.
