Is The Fed Going to Quit QE: What’s at risk?

By Mitch Zacks, Senior Portfolio Manager at Zacks Investment Management, Inc.

“The market is always looking out six to eight months. For this reason, investing using macro-economic data is not necessarily a winning strategy. Macro-economic data tends to be backward looking. The unemployment numbers tell you what has happened in the past; however, they don’t give a good read as to what might happen in the future. The S&P 500 does not care what the GDP numbers were last quarter. Instead, it is looking at what GDP growth is going to be in the coming quarter and, most importantly, whether that growth will come in stronger or weaker than current expectations. For this reason, I almost always prefer to follow an investment strategy that focuses on forward looking metrics, like changes in analysts’ earnings estimates, rather than trying to decipher what the latest CPI number is telling us about the market.

Recently, however, the macro-situation has begun to take center focus. The reason for this is the Federal Reserve. The current strength of the market is really due to two factors. First and foremost, the worst-case scenarios of a financial contagion spreading from Europe did not materialize. The market was pricing in a chance of this scenario occurring of maybe 25-30% in late 2012. When the contagion did not materialize, and Greece did not collapse, the market re-priced the risk and shot up. The second factor driving the market higher is the quantitative easing by the Federal Reserve.

There has been an ongoing battle in the market place which pits the so called “sophisticated money” of hedge funds against the so-called “dumb money” of long-only equity investors. The hedge funds have basically been betting that Bernanke will eventually have to fold his hand. This reasoning embraces the idea that Bernanke will not be able to continue quantitative easing because it will eventually cause inflation. There is a limit to what Bernanke can print, just like there is a limit to what the Bank of England can do to support the Pound. The money to be made for the hedge funds is to engage in a “Soros-like” bet against the Fed.

Eventually, the Hedge Funds think the Fed will capitulate and the mother of all panics will develop. A mad rush out of interest sensitive securities will occur. The hedge funds view the Bernanke intervention, and the follow-up copycat move by the Japanese central bank, as almost a blasphemous activity doomed to failure. They believe that quantitative easing goes against the belief in the ascendency of the capital markets.  Eventually, the thought goes, no one, not even the Fed, can shape a market.  The market eventually wins and interest rates will rise. Under this belief, the Hedge Funds short the thirty year treasuries in anticipation of the inflation demon Bernanke has unleashed with his activist Fed policies.

On the other hand, the long-only investors look at the current Fed situation the same way they saw the 2008 financial crisis. Something interesting that may dislocate markets in the short-term, but has no real barring over the long-term. To the investor with a time horizon of decades, these headline dramas of the day don’t alter the underlying upward trend of the market. The market rises over time, the data shows that this is the case.  Good fences make good neighbors, the long-term investor tells his hedge-fund friends. There is wisdom in the simple concept of fencing out the problems of the day and betting that the next two decades will look something like the past ten decades.

There have been major and minor wars, oil shocks, terrorist attacks, moments of existential political crisis for the country, recessions, depressions, financial panics, for the last century of American economic history. That history, to the long-term investor, shows one thing.  The U.S. equity markets are a testament to the triumph of the optimists. The market always finds a way to overcome the problem of the day and head higher.

History has shown the ascendency of the U.S. equity markets over problems does not occur some of the time, or even most of the time, it happens ALL of the time without exception. It may take five years, or even ten years, but over the long haul equities will outperform hedge funds in aggregate, as well as fixed income securities, and almost any other form of risk based investment. This has always been the case and it will likely remain the case moving forward.

For the hedge fund, trying to bet against the Federal Reserve’s quantitative easing has proven to be like playing poker against an opponent with an unlimited stake. No matter what happens, the opponent is never going to fold. Bernanke has the ability, and the will, to print money until he starts to see an increase in inflation or unemployment falls to a reasonable level. Additionally, as much as we like to collectively complain about our political institutions, the Federal Reserve is for the most part free of politics.

Yes, quantitative easing is unnatural, and once the whiff of the end of quantitative easing enters the market it will be like yelling fire in the crowded theater of treasury securities. However, it is also the case that the Federal Reserve will be able to engage in quantitative easing for longer than many investors anticipate because wage inflation is contained. Adding to the strength of the U.S’s quantitative easing is the fact that the rest of the developed world is now beginning to emulate Bernanke’s actions. What we saw with the Bank of Japan is likely going to be duplicated by most developed markets. This helps explain why the developed markets are dramatically outperforming the emerging markets. Year to date the EFA is up about 10.5% while the EEM is down about 2.1%. Basically, global investors are saying the global economic slowdown is going to hurt the emerging markets more than the developed markets.  They are betting that the central banks of the emerging markets do not have the sophistication, ability, will, or political independence to engage in quantitative easing.

Additionally, the dividend trade should continue to work. In a low interest rate environment, stable U.S. multinationals remain desirable. There are some rumors even of foreign central banks buying U.S. multinationals as they have no other place to put their cash. Furthermore, some of the weakness in Gold may be from financial buyers selling gold to invest in dividend producing equities. While there is some concern of this trade becoming crowded, the trade will remain as long as the ten-year treasury yield does not tick up too much. What ultimately will kill the dividend trade are rising interest rates, not rising P/E multiples of defensive sectors.

Despite all the worrying about what happens when quantitative easing ends, inflation remains benign and wage inflation remains non-existent. While there is something to be said about the long-term social pressures that will develop if risky assets keep rising in value, while median family incomes remain flat to down, in the immediate future there seems to be very little pressure on the Fed to pull back the quantitative easing. With a dogma that past stewards of the Federal Reserve erred by doing too little in the face of financial crisis, Bernanke has, for better or worse, decided to try and reduce unemployment through inflating risky assets such as the equity and housing markets. The basic idea is that as a result of rising asset prices, individuals will be wealthier and spend more. We still are waiting for corporations to follow the lead of consumers.

If we look at the recent GDP numbers, they reveal that the strength of the economy is coming more from consumers than corporations. Even with corporations having massive cash on their balance sheets, they are simply not deploying the cash. This, along with earnings for the first quarter that remain relatively unimpressive, will eventually give the current rally some headwinds. Interestingly enough, the means by which consumption has remained so strong is by a lower savings rate.  When asset levels rise, people become wealthier and save less money. Their view of the future becomes more positive because the market is rising and they are psychologically more willing to make purchases. They begin to save less which is good for the economy. My main concern is the last GDP numbers showed that business investment, – what companies spend on structures, plants, and equipment, fell.  We saw a broad decrease in capital expenditures. This helps explain why technology has been under pressure relative to other sectors. Additionally, earnings are not as strong as I would like, and revenue growth in aggregate appears to be decelerating.

A pull-back would not be out of the question at these levels. This, however, does not matter for investors. It does not alter the long-term direction of equities. It does not change the bet. What happens over the short-term is largely meaningless. We know how the game ends; we know the final scene of the movie. Yes, there will be a pull-back, there will be another market crash, and there will be another financial and political crisis. But we know that at the end of the day the market will move higher. That is the beauty of the equity markets.  It is not a question of if the market hits new highs; it is a question of when the market hits new highs. Until that time, someone should get rid of those old oil paintings of Alan Greenspan – we need a sculpture of Ben Bernanke”.


Source: Mitch Zacks, Senior Portfolio Manager

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