Is It Quantitative Easing, and not Fundamentals, that Has Driven Stocks Higher?

April 9th, 2012 by

Stock markets in many regions worldwide have finally begun to post significant advances. Bulls argue these are a reflection of the fact that economic fundamentals look more upbeat: consumer confidence is rising, early signs of a turnaround in the troubled US real estate market and an improving jobs market in the United States.

But while economic fundamentals in some parts of the world are showing signs of improvement, other regions – notably the eurozone – continue to struggle, while debate about whether China’s economy is in for a hard or soft economic landing remains unresolved. So this week’s chart of the week, which displays an intriguing relationship between the willingness of central banks to inject liquidity into the financial markets be a major contributor to the strength of global stock markets?

As seen in the chart below, while the initiation or expansion of quantitative easy programs by the Federal Reserve in the United States have been met with sharp gains in the MSCI World Equity Index, the reverse also has been true. Whenever it appears clear that the US central bank has been poised to withdraw from the financial markets and leave them to fend for themselves, stock prices have slumped. More recently, when the Fed’s QE2 program expired, the European Central Bank stepped into the fray by introducing the Long Term Refinancing Operation (LTRO) — and markets rallied. Most recently at all, the signs that the Fed has no intention of forging ahead with a QE3 plan has generated some weakness in equity markets.

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Certainly, the actions of the Fed, by keeping interest-rates at such low levels that investors have complained they have almost been “forced” out of Treasury bonds and into higher-risk assets, such as bonds, have been supportive of higher stock market valuations. The question that lingers is whether without those supportive measures, stock prices could have achieved their recent gains – and whether in their absence, those gains can be sustained. Is the stock market rally being driven by economic fundamentals – or by central bank liquidity? As the weeks pass, an unwinding of quantitative easing in the United States, in particular, may produce higher yields and a higher US dollar – not necessarily good news for stock prices in the United States and definitely not good news for emerging markets equities. We’ll keep you posted on how the scenario unfolds.

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