“Nowhere to Hide in Bonds”
Buy Low, Sell High is the mantra of the investment world. The Federal Reserve’s motto seems to be Buy More, Sell Never. First we had QE. When QE failed to stoke growth, the Fed extended the program into what is now known as QE2. When QE2 gave similar results, Big Ben initiated QE3 (or QE-to-Infinity) a $40 billion/month bond purchasing program with no definite end date. The Fed now sits at the critical crossroads of increasing QE again or tapering it down. Maybe it is just me, but I believed QE3 was the bottom of the Fed’s toolbox and there were no tools left. An indefinite program certainly gives the impression of grasping at straws. Each of these two main options involves a question of magnitude (e.g. Do you cut off the bond buying completely? Lower the amount? Unwind the purchases?). Each of the options has several potential outcomes. These scenarios warrant a discussion.
On a base level, there are logical reasons (in theory) for increasing QE. The economy has yet to move out of the sluggish growth range of the last 4 years. The labor market, while “improving” in the sense of lower unemployment, is barely adding enough jobs to keep up with population growth. Manufacturing has tailed off in recent months, both domestically and globally. Inflation remains below target as recent price declines are starting to tip the scale of discussion to deflation. Now what could happen if QE was bumped up?
• Talk of asset bubbles forming has escalated in recent weeks as the U.S. stock market approaches 20% gains on the year. Even Bill Gross chimed in, tweeting “#Yen carry trade driving all asset prices higher. Bubbles getting more bubbly. Will #QEs produce growth?” If additional QE fails to materialize in economic growth, it will only serve to further any asset bubbles forming. One may argue higher asset prices will stimulate the economy as individuals become wealthier and thus have more confidence/money to spend. A recent study by Pew Research Center shows though, only the rich tend to get richer in strong equity markets. The wealthiest 7% of the population saw their net worth increase from 2009-2011 while the remaining 93% saw a decline, most likely a factor of where wealth is held. A May Gallup poll showed the lowest percentage of stock ownership by households in the survey history since 1998 with only 52%. The lower income brackets tend to have their net worth tied up in their home while the upper brackets hold investments like stocks. Households earning $75,000 and over had 81% ownership while those under $30,000 came in at 21%.
• An increase in QE could finally ramp the economy up enough to break through the ceiling it is trapped under currently (see Figure 1). However, until the increase in money supply starts flowing THROUGH the economy (i.e. velocity of money), it will only stand to push up asset prices.
Ultimately, an increase in QE only stands to delay the inevitable: the day the spigot gets turned off. Speaking of…
Right now the Fed has an unrealized gain on its books. The unrealized gain is the improvement in the economy from the recession trough in 2009. At some point it has to close its positions. The Fed faces two outcomes if it begins to sell the bonds purchased through its QE program: economy performs worse or economy holds steady and continues to improve. Unwinding purchases too early may cause growth to stall or fall just as selling a stock without enough bid support will cause it to tumble. Most expectations are for further guidance on a plan to cut back on QE to come about in Q4. The Fed will need to see a few more months of economic data to judge whether the economy has legs it can stand on freely and if there are indeed asset bubbles forming.
In my opinion, the Fed needs to decide one way or another and soon. A chart of Wednesday’s price action proves we cannot have Bernanke talking out of both sides of his mouth. Futures moved higher on his initial comments, which appeared to indicate further QE, only to come off highs moments later when he hinted at paring back QE. The release of the FOMC meeting minutes later in the afternoon caused equities to pull back further. Staying in the middle ground will only push uncertainty into risk asset markets and business decisions, especially if comments continue to flow from both sides of the coin.
The minutes displayed more signs of the growing dissent between members on policy action as well as concerns about possible negative outcomes of continuing the current accommodative stance. Included in the minutes were the following statements:
• A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth;
• At this meeting, a few participants expressed concern that conditions in certain U.S. financial markets were becoming too buoyant, pointing to the elevated issuance of bonds by lower-credit-quality firms or of bonds with fewer restrictions on collateral and payment terms (so called covenant-lite bonds)
Although Fed officials have individually made comments about risk asset prices in relation to QE, the release of these minutes was the first time we have seen it directly from the FOMC. Additionally, the first statement above has finally put a date to what I’ll refer as QE0. Prior meetings were marked by singular members expressing the need to start closing the valve while these minutes appear to show more members have joined in the chorus.
After getting the label of being the training wheels of the economic bicycle early on in the program, QE has become known in certain circles as the “only wheels.” (See Peter Schiff’s comments from May 26, 2011) Will the bicycle crash if QE is stopped or will it continue down the road (albeit probably wobbly and nervous)?
– Brian Durbin
Risk-reward ratios are on our radar screen these days as we review the most recent economic data against the backdrop of recent market movement. This is not to say that we are in any way suggesting a top, a bear market, or even that a correction is on the horizon, even taking into account this past week’s movement and volatility—although each of these scenarios remains a possibility. At this point, though, we do have some minor concerns about risk-reward in the markets going forward, suggesting that a slight adjustment in beta or equity exposure from current levels is prudent.
Our investment philosophy is to adjust equity exposure based on the velocity of economic fundamental data, combined with analysis of correlations between assets. Our objective is to adjust asset exposures to create the most efficient portfolio.
To be clear economic data is still positive, but the rate of increase in the positive data has not been accelerating with the market—and in some segments is slowing. For example the three-month trend of employment growth as measured by the jobs report has gone from 208,000/month at yearend, to 209,000/month as of April, which includes a large outlier of 332,000 in February, over half the total.
The ISM Manufacturing Index measured 50.7 in April, up very slightly from the 50.2 at yearend. The four-quarter average GDP growth rate was 1.85% as of Q1 2013, down from the 2.6% at the end of Q3 2012.
Much of the emerging market economic activity data is below expansion levels, and indices in many countries are down for the year. At the same time the U.S. broad market averages are up nearly 24% from the low in November. Simply stated, the last six months appear somewhat out of step with fundamentals.
Many economists forecast that 2013 would be back-loaded. However, I am concerned that it might be front-loaded.
As we have discussed previously, we have gone from uncertainty to visible risk; as a result, investment dollars have flowed into U.S. equities. To be sure, some of the visible risk is uncomfortable and even unpalatable at times, but financial destruction appears to be off the table. Accommodative global central bank activity has gone a long way to alleviate many of those structural concerns for now, while also making financial risk assets look more attractive. Recent outlooks from Fed Chairman Bernanke and members of the FOMC have varied in terms of continued duration and level of QE, but the Fed has nonetheless provided investors transparency into their views, and thus the ability to make calculations to the risk of exiting QE.
Hopefully, we’re just in for some garden-variety economic hiccups that can be managed with only a little indigestion for investors. However, if the data softens from here, and things get really distasteful or start to look queasy, we’ll get more defensive. And, if the Fed alters course and the loose negative-rate environment changes, we will also adjust fixed-income holdings accordingly.
For now, as always, we’ve got a close eye on the economy to see how things are shaping up.
For more insight into Astor’s philosophy, my latest publication, the 2013 edition of “Finding the Bull Inside the Bear” is available. To request a free copy, please email firstname.lastname@example.org.
– Rob Stein