Will markets make that vital switch after QE?

ON WEDNESDAY, Wall Street sprang to life after several listless days - a move which some wire reports attributed to Apple's unveiling of its new iPhone and watch. Maybe so, but more likely is that prices rose after news that wholesale inventories increased just 0.1 per cent: the smallest rise since July last year.

With June's figures being revised downward, the suggestion is that US GDP growth may not be that great - perversely, a situation that markets have grown to like these past five years since central banks (particularly the US Federal Reserve) embarked on their "quantitative easing" or QE programmes.

The Fed is due to complete tapering its QE programme after its October Federal Open Market Committee (FOMC) meeting. This means that from November, markets will have to stand on their own without the benefit of US QE support. It is not a particularly appealing prospect.

Some commentators have remarked that worry levels might rise as the end date draws nearer and that this will equate to an uptick in volatility; others have either spoken glowingly of Wall Street's prospects (since an end to QE suggests the US economy is in good health) or have raised concern about just how effective QE has been.

The real question which everyone should ask is this: after QE ends, will markets shift from being driven by liquidity to being driven by fundamentals (as they should) or not?

If they do, then the distortions, imbalances and inefficiencies born from years of enjoying free cash (and an absence of real and lasting regulatory reform) may be vanishing. In that case, ending QE can only be good for financial markets. But if the markets don't make that shift, then trouble looms - since it means the resource allocation mechanism that is a free market may have been chronically compromised by over-reliance on QE.

Or to paraphrase an expression that was once famously used to describe the Fed's job: because party-goers have imbibed so much punch since 2008, take away the punch bowl now and not only will they keel over, but it'll be lights out as well.

That the party is winding down has been evident from declining stockmarket turnover the world over. One suspects that if world equity turnover was juxtaposed against the QE tapering which occurred every six weeks starting last December, a very close relationship would be found. From US$85 billion a month, QE is now down to just US$25 billion - and markets are feeling it.

So far, the signs are not encouraging for those who hope for a return to "investment normalcy", where stock prices are determined by earnings, growth and fundamentals for gains instead of central bank largesse.

Last week, Wall Street reacted badly to economic releases which implied the economy was strengthening, because it meant interest rates must rise; and it embraced data which showed a softening - or, at best, stagnant - economy. Ditto for this week and Wednesday's rebound.

Even though the picture is made hazy by rising "geopolitical risk" (namely the conflagrations in the Middle East and Iraq), there is sufficient anecdotal evidence to suggest that as October approaches, the market may be shifting to the "bad economic news is good for stocks" mode of investing that has held sway for most of the past five years.

The wild card in this is the European Central Bank (ECB), which last week announced its own brand of QE through the purchase of private sector credit, including asset-backed securities and covered bonds, in addition to a new cut in interest rates.

Given that Europe's strongest economy Germany staunchly opposes the plan, it remains to be seen whether the cash injections will actually reach the US$1 trillion mark that markets are hoping for, or if they'll eventually be scaled back.

Investment firm Schroders' view of the ECB's actions offers hope for the camp pinning its hopes on liquidity instead of fundamentals. It said last week the rate cuts are irrelevant because short-term rates have been below the ECB's main financing rate for some time, while the bond buying is unlikely to be large enough to have an appreciable impact.

Until more details are known of the ECB's QE, it looks very much as if markets will continue to drift in low volume. Unless, of course, growth slips.