Fed Delivers another Big Dose of QE
Advisors Asset Management
By Scott Colyer
September 18, 2012
Doping….Bad for Athletes; Great for Economies.....What will the Hangover Feel Like?
the Fed delivered the much anticipated dose of Quantitative Easing (QE)
announcing that it would continue to buy U.S. Agency Mortgage Backed
Securities (MBS) in an effort to further
drive growth in the U.S. economy and decrease the ranks of the
unemployed. The monthly purchase rate of $40 billion will be in addition
to the already $10 billion that is being reinvested from QE 1&2 in
mortgage-backed securities. This new money balance sheet
expansion by the Fed accompanies additional guidance that the Fed would
stay low on interest rates likely until mid-year 2015. Even more
enticing is that the Fed will maintain the “punch bowl” long after the
economy begins to heal. What are the short and long-term
effects of this historic action? Will the hangover be worth the party?
How should an investor look at this?
Here is our take on what these actions will do:
· We Are In Uncharted Territory Globally
Never at any time in history has there been monetary policy this lax. From the United States, to Europe, to Asia, the world economies are being juiced by the easy monetary policy drug. In fact, sustained U.S. Treasury yields have never been this low, mortgage rates have never been this low and the Fed’s balance sheet has never been this big. The dollar continues to weaken as the Fed produces billions of new greenbacks monthly.
· Risk Assets Continue to Gain
The Fed has been intent on driving down interest rates and loosening up the credit markets. By reducing returns on U.S. Treasury bonds and other interest-bearing bonds, investors hungry for yield will seek those returns in other assets. However, the empirical data is that investors are very under invested in equities. Since 2008, assets have been drained from the equity markets and shoved into bond funds. If history is any indication of how the individual gets treated in the market, this move has and will prove to be exactly wrong. Since the bottom of the market in 2009, the equity markets have doubled. In fact, the U.S. equity markets remain undervalued today versus most of history. Having everyone on the outside looking in provides plenty of gun power for much higher prices. The prudent investor should be an owner of assets where the Fed is pushing money and not be in an asset class that will become the source of those funds.
· Housing Recovery Continues
The U.S. housing market has begun a recovery. Many have speculated that this recovery will be short lived as U.S. growth lags. The Fed has been resolute at targeting a recovery in the U.S. housing market. Mortgage rates are at their lowest level in history and poised to go lower. This means that housing affordability will continue to be at its highest level and promote home ownership. As housing and equity values rise, consumers will become more optimistic so they will spend and invest. Spending and investing consumers translates into GDP and jobs. We would argue this is working and buying MBS will put this effort into high gear. The prudent investor will concentrate investment in areas where a housing recovery will benefit. Mortgage originators, financials, home builders, materials, infrastructure should be winners.
· Income and Yield is King!
The demographics of the United States and other economies globally are facing a secular thirst for income and yield. They are searching for yield just at the time that yield has largely disappeared from traditional markets. The world has used the U.S. Treasury market to stuff their safe money as other sovereign markets have presented risks they cannot afford to take. As loose monetary policy takes hold, those funds will leave the sanctuary of “no yield” to search for yield. Assets that produce rising streams of income and dividends will be sought. The prudent investor would concentrate investment in high-dividend and income-producing assets that are likely to be sought after by the masses.
· Inflation is Dead; Long Live Inflation!
We believe that record currency production by world central banks unchecked will likely lead to inflationary pressures in the future. Thus, as the Fed weakens, the paper currency further hard assets are likely to benefit. Hard assets would include real estate, materials, metals and those companies that deal in them. We are believers in secular cycles and have been fans of this category since the turn of the century. We feel that there are still a couple of "innings" left in this cycle. Remember, the fireworks generally don’t appear until the ninth inning and prices can climb to levels that baffle everyone. Remember stock prices in 1999? The hangover from this chapter in economic history will likely be a big dose of inflation. The prudent investor would position a portion of their portfolio in hard asset investments. Fixed-rate long-dated debt would suffer in this scenario so larger coupon bonds and variable rate debt would be better choices. These choices would likely be a natural and effective hedge against inflation.
· Europe is Likely Investable
Recent European Central Bank (ECB) actions are twins to the U.S. Fed easing. With the mandate that the ECB will buy bonds for any European Union (EU) country in unlimited amounts provide assured access to capital to these sovereigns. On this announcement European markets turned on a dime. No one expects that Euro economies will escape recession. However, the markets discount the future and not the past. As of today, all EU markets are positive for 2012 - except Portugal. Yes, even Greece is up 10%. Just as we would want to not fight the Fed, the prudent investor should not fight the ECB. We believe that EU markets are investable and they provide some very compelling upside from here as they emerge from recession. Remember that historically as the structural problems are repaired that prosperity generally follows catastrophe.
· QE is Global; Get Ready for Emerging Markets to Emerge
Emerging markets have been weak because developed markets have been weak. Emerging markets depend on exports to developed markets to boost their growth. As developed country economies are juiced-up by easy policy, demand for goods and services for developing countries rises. The blueprint is for a recovery to take hold and most likely will as confidence returns and credit eases. We are already seeing this in the United States. We expect China to unleash its own anticipated stimulus. Parts of it have already been announced. They have clearly demonstrated in the past that they will stimulate big, if needed, and we would expect nothing different this time around. The prudent investor seeking growth with a bit more volatility would be a buyer of investments tied to emerging markets. Given the weakness we expect in the dollar from QE, we believe this also could magnify returns from international markets.
· Duration RISK is at all time high; Caution Light For Bonds
If there is a bubble forming out there we would point to U.S. Treasury prices as the “elephant” in the room. As U.S. Treasury yields have been pushed to new lows on Fed buying of the debt; the prices have hit all-time highs. These prices have greatly eclipsed anything seen in history. As the debt has hit high prices and yield at lows, the coupons of this debt have all but disappeared. Thus, as the Fed leaves buying nearly 80% of new issuance and the rest of the world feeling better about growth and stability look for money to fly out of the asset class and prices to suffer. The Fed has committed to keeping short rates anchored near zero until 2015 but that does not control long rates. The prudent investor would seek to control duration by either raising the cash-flow (coupon) on their bond holding; seeking more credit risk; or buying variable coupon debt. Treasuries and Agency debt in any flavor (even TIPS - Treasury Inflation Protected Securities) are not compelling to the prudent investor as the risk is much greater than any possible reward.
is truly a historic time to be an investor. Is it a new normal? The
laser-like focus of the Federal Reserve in this recent move has an
enormous impact on markets as well as the overall U.S.
economy. Though we expect the larger macro-economic impacts to take a
quarter or two, the effect on housing and net worth will be substantial.
With the net worth of the consumer rising with very little assistance
from housing over the last two years, this
should increase the net-wealth effect on consumption and sentiment
overall. At the end of the day, the announcement from the Federal
Reserve with this action and potential other “out of the box” actions
coordinated with other central banks around the world,
should give investors on the sideline the needed push to invest in the
myriad of markets that still represent historical discounted values.
(c) Advisors Asset Management