SATURDAY, JUNE 4, 2011
The World After QE2
By MICHAEL SANTOLI
Despite investors' worries, the markets and economy won't be doomed when the Fed's massive stimulus program ends.
The ripest source of Wall Street chatter, investor anxiety and pundit prognostication these days is the impending end of the Federal Reserve's second "quantitative-easing" program on June 30. By then, the central bank will have bought $600 billion in Treasury securities to help fund the federal deficit and injectconjured money into the financial system. QE2, launched last autumn, follows what's now called QE1—when the bank soaked up $1 trillion-plus in mostly mortgage-backed securities—from late 2008 through March 31, 2010.
Just how much impact QE2 has had and how its demise will affect the nation are matters of debate. But it's clear that the Fed won't pull the plug abruptly. While the central bank will cease enlarging its balance sheet (now $2.8 trillion, up from around $900 billion before the 2008 financial crisis), the bank will keep it stable by reinvesting interest payments and principal from maturing securities, until the economy looks to be on firmer footing.
Also, hundreds of billions of dollars that the Fed's policies added to U.S. banks' coffers will be sloshing around for years, available for use as the economy expands. Also clear: A QE3 is unlikely, even though last week's disappointing data on housing, manufacturing, job growth and consumer confidence kicked up the predictable chorus calling for exactly that. Economic numbers, inflation data and financial conditions probably would have to stay dismal for many months for Fed chief Ben Bernanke to launch a third bout of pump-priming.
Ethan Harris, chief economist at Bank of America Merrill Lynch, notes that Bernanke embarked upon QE2 with more reluctance than most investors recall. His now (in)famous Jackson Hole, Wyo., speech on Aug. 27 noted the drawbacks as well as the benefits of such an effort. Then, Harris adds, "It took another few months of soft data to cement the case" for QE2.
In typical fashion, stock investors are dreaming of more candy, while bondholders fret over the cavities and calories that more stimulus could cause. Harris says that equity types are asking when QE3 will come, fixed-income investors when the Fed will tighten monetary policy. His answer to both: "Not this year."
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There is plenty of irony here. Stock investors should fear a revival of the conditions under which QE2 was deemed necessary—heightened recession risk, stagnant labor markets and a brush with deflation. The Fed would feel justified in initiating QE3 only if the inflation threat receded, something likely only in a global economic-stall phase, which wouldn't be great for share prices.
For investors, positioning for the end of QE2 requires assessing its true effect on the markets. But that isn't easy. The common perception is that QE2 and QE1 helped to inflate risky assets, such as stocks and commodities, sank the U.S. dollar, buoyed credit markets, boosted inflation expectations and failed to lower interest rates. The circumstantial evidence for this interpretation is strong. The Standard & Poor's 500 Index has gained 23% since Bernanke's Jackson Hole address, after rising more than 20% during QE1. As the bottom left table shows, both QE periods coincided with a weak dollar and surges in oil and other commodities. In equities markets, energy and industrial stocks thrived. Analysts at Bespoke Investment Group calculated that stocks were stronger on POMO days—when the Fed was conducting permanent open-market operations, a.k.a. purchasing assets—than on other days.
Those who attribute the market action of the past nine months exclusively to the Fed's generous hands invoke what happened in the five months between the two QEs. During that stretch, stocks suffered a swift and stinging 9% decline, oil prices receded, the dollar firmed and Treasury yields, somewhat counterintuitively, fell—even as the Fed quit acting as bond buyer of first resort.
But while the correlations between the Fed's asset-acquisition appetite and market behavior are certainly strong, other factors played a role, too.
As QE1 lapsed, the European sovereign-debt tinderbox caught a spark, creating a conflagration of concern in both government and corporate-debt markets, and feeding fear of a "double-dip" into recession in the U.S., whose recovery remained fragile. This goes a long way toward explaining last summer's stock-market correction, the substantial decline in Treasury-bond yields, and the dollar's flight-to-quality rally. In other words, a global-growth scare coincided with the end of QE1, and may have caused investors to pull back.
Similarly, just as Bernanke & Co. were mustering the will to initiate QE2, the economic data were improving, the European situation was (temporarily) stabilized by the European Central Bank, and emerging-market growth was reaccelerating. The rally in risky assets that began around last Labor Day can be linked to the Fed's extending of extraordinary help to an economy that suddenly seemed not to need it all that much. But the money buoyed financial assets, not economic activity.
The ambiguity surrounding investments' behavior after the end of QE1—defensive plays were the big winners back then—hasn't stopped market handicappers from forecasting a straight replay when QE2 runs out.
THEY EXPECT QUIESCENT Treasury yields, underperformance by commodity-related investments, a pullback in stocks and a bounce in the dollar. In fact, the markets have started down this course. Since April 11, when the 10-year Treasury began a descent from 3.58% to 3%, the dollar has attempted a bounce. Stocks have moved choppily, with the major indexes down 4% from their April highs. And oil and other commodities have come off the boil.
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But these moves can be explained by the sloppiness of recent economic data and the resumption of the European-debt melodrama, along with fear about the expiration of QE2. The Citigroup Economic Surprise Index, a measure of economic-data releases compared to forecasts, has plunged.
Says Henry McVey, chief of global macro and asset allocation at Morgan Stanley Investment Management: "The [stock] market may have sold off [in May] not because of the end of QE2, but because there will be no QE3." He notes, however, that the Fed has telegraphed that it will "drag its heels on the end of QE2."
In a sense, here we are again, with corporate profits strong, the macroeconomic numbers softening, with stocks not far off a multiyear high and stubborn fears of a recession relapse in the air. It's all reminiscent of last spring, after QE1 petered out.
So, what will happen after QE2?
"Hopefully, not much," says Michael Darda, chief economist at the institutional broker MKM Partners. He and others see important differences in the macro backdrop between today's environment and the one that prevailed in March 2010.
Darda takes crucial cues from the credit and interbank money markets, both of which are rather unperturbed, compared with their states a year ago, when the travails of peripheral Europe fed fear of Lehman-like contagion across global debt markets.
Jeff Kleintop, the chief market strategist at LPL Financial, adds that the labor market, while not booming, is certainly on a stronger path today than it was in March 2010. Back then, the economy had lost jobs on a net basis in 10 of the prior 12 months. Today, we have seen net payroll growth in each of the past 12 months.
A year ago, the banking system was still suffering declines in commercial-loan production, whereas business lending now has turned higher. Broad measures of money-supply growth are also far more positive. And, even though the stock market is a good deal higher, corporate-profit growth has outpaced share prices. As a result, equity valuations are no more extended today than they were in early 2010.
Mix it all together, and it would seem that the economy has built a somewhat bigger cushion to absorb any shocks related to the cessation of the Fed's money injections. Which leaves us with an economy and a market left to their own devices, with both in a nervous, deceleration phase.
As the Fed stops rampant creation of new dollars, and economic growth gets a bit bumpy, inflation jitters will decrease. The collapse in the two-year Treasury note's yield, from 0.85% to below 0.5% since April, reinforces this view. It also indicates the Fed isn't likely to tighten monetary policy until deep into 2012. That certainly should provide support for bonds.
IT'S ALSO FAIR TO BET that volatility and the divergence among sectors and styles might both rise in the stock market, at least temporarily. In such an environment, growth stocks of the old Nifty Fifty sort should continue their recent run of outperformance.
McVey, of Morgan Stanley Investment Management, favors companies that have clear pricing power in a deflationary world with an uncertain 2012 growth outlook. This leads him toward tobacco, railroad and oil-services stocks, such as Philip Morris International (ticker: PM), Union Pacific (UNP), Kansas City Southern (KSU) and Schlumberger (SLB).
While fashioning a plan for a post-QE2 world, one should be mindful of Mike Tyson's wise quip: "Everyone has a plan, until they get hit." But the blows, should they come, probably will be from some financial accident in Europe or elsewhere, a downshift in global growth or another shot to corporate confidence—not the end of QE2.
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