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The Post-QE 3 Crisis Has Begun

The third quarter took a very heavy toll on global equities. The Dow, NASDAQ, S&P 500 and FTSE 100 all fell 9%. The DAX and Nikkei lost 14%. The Hang Seng Index fell 20%. Shanghai plunged 29%. The market capitalization of the world equity markets has sunk by $13 trillion or 18% since the beginning of June. In my opinion, this slide is likely to continue. Why is this happening?

It’s nearly a perfect storm. The US Liquidity Gauge turned negative in the third quarter. When Liquidity is negative, asset prices tend to fall. Meanwhile, US credit growth remains too weak to generate strong economic growth in the United States, so US imports remain weak. China’s export-dependent, bubble economy was unable to cope with such a prolonged period of soft US demand and finally began to deflate. Weakening demand from China caused commodity prices to crash back to levels last seen in the Twentieth Century. The hopes, dreams and currencies of the commodity producing countries around the world collapsed. Falling commodity prices translated into sharp earnings declines for mining, energy and commodity-trading companies, pulling down their share prices.

Normally, equity markets discount the future earnings prospects of the listed companies. Currently, what the markets can see coming is less investment, rising unemployment and deflation, leading to much lower share prices, less wealth and, therefore, less consumption. This vicious downward spiral is now underway.

The global economic bubble came very close to collapsing into a new great depression in 2008. Policymakers around the world managed to keep that bubble inflated with massive fiscal and monetary stimulus. In that coordinated global stimulus program, the Fed played the leading role by undertaking three rounds of Quantitative Easing. Each time the Fed launched a round of QE, US stock prices rose and the economy strengthened. And, each time a round of QE ended, stock prices fell and the economy began to move back toward recession. Therefore, it should not come as a surprise that the same thing is happening again now. Eleven months ago the Fed stopped printing money and buying financial assets. Without that support, stock prices are now once again falling.

The pattern is the same, but this time the global environment is very much worse than it was when QE 1 and QE 2 ended. That is because this time China’s economy is in crisis. Trees don’t grow to the sky and economic bubbles don’t continue inflating forever. The Chinese bubble is the greatest in the history of the world. It continued inflating long after I expected it to stop. But it has stopped now and it has begun to deflate. With tremendous luck and much skill, it may deflate very gradually, the way the great Japanese bubble has deflated over the past 26 years. However, China may not be that lucky. Much worse scenarios can easily be imagined. Be that as it may, China has ceased to be a driver of global economic growth. Its imports have contracted at a double-digit rate every month this year compared with one year before. That makes the current, post-QE 3 equity slump and economic downturn much more dangerous than what came before.

So, what happens next? I’ll give you (QE) 4 guesses. That’s right. I suspect that the global stock market selloff will become worse (gradually and then suddenly) and act as an increasing drag on the global economy. The Fed has a low tolerance for pain. Before the S&P 500 loses another 10%, the Fed is likely to launch a new round of Quantitative Easing. As soon as Fed governors begin dropping hints that QE 4 is on the way, global stock prices will soar once again and rising stock prices will begin to reflate the global economy.

As I have written many times before, investors should own stocks when the Fed is printing money and take profits when the Fed stops printing. That strategy is likely to work just as well during the fourth round of Quantitative Easing as it did during the first three. Watch for the hints. They probably won’t be long in coming now.

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