About all that mattered to markets in September was the Federal Reserve's policy announcement on September 13, and it was a doozy. From the FOMC statement (underlining is ours): "The Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee's holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative."
They also "expect that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015."
This is by any measure one of the most stunning announcements in Federal Reserve history. They have absolutely thrown down the gauntlet and dared the labor and investment markets to defy them: "If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved." It is an open-ended commitment to do "whatever it takes"; in short, it is the "all in" moment that clarifies everything.
Markets pundits immediately dubbed this additional Quantitative Easing "QE-ternity". Besides ramping up their mortgage-backed securities (MBS) purchases, the Fed is also telling investors that the yield curve will flatten, and to not expect any higher short term interest rates until 2015. In this scenario, if you don't own MBS or long dated Treasuries, you're not "following the script" and must be brain dead, right?
The problem is, the first two rounds of QE didn't help the real economy (has anyone seen 5% unemployment lately?). Instead, prices of most everything rose (gasoline and food come to mind immediately). Investors globally are increasingly skeptical that injecting more money into the financial markets is going to solve the woes of over-indebted and structurally lop-sided economies. Call it "bailout weariness", especially since there is clear evidence that the effectiveness of further stimulus measures is growing weaker and shorter with each new action. Investors need to ponder how long markets will "float" on these coordinated central bank interventions, and how much more levitation can be achieved if the real economy does not pick up.
Since the US Congress has failed to act with any sense of fiscal responsibility, Bernanke's Fed has decided for whatever reason that now is the time to up the ante on his "helicopter" monetary experiment (maybe it has to do with a potential Republican victory costing Bernanke his job). In any event, it is a gigantic expansion of a theory whose outcome will affect everyone everywhere.
Apart from the Fed's actions, how is the real economy doing? Not good enough. On September 27, final US GDP printed at 1.25%, below even the lowest Wall Street estimates. The GDP "growth" trend should be clear: Q4 2011: 4.1%; Q1 2012: 2.0%; Q2 2012 1.25%.
Manufacturing is flat, and close to contracting, with the latest ISM Index barely above 50%. The US consumer is wobbly too. Unemployment continues at over 8%, and average hourly earnings growth is now just about flat (no increases in wages). Real consumption spending has declined for four and half straight years, and is barely positive at .7%. (Compare that to a pre-crisis trend of 3.6% for the decade ending in 2007.) The standard of living for most everyone has declined.
We have been writing for many years about the coming "Age of Austerity" that is now upon us in the Western world. It is the result of a massive boom and bust "long" cycle, predicated on the systematic expansion of the use of leverage and credit. The unwinding of this process will far exceed any prior era, so our advice to investors (and young job seekers and business builders) is to seek profits wherever more can be done with less. And look to economies with younger populations for more long term growth exposure (Japan, most of Europe, the USA, and soon China all fit the "aging economy in need of structural reform" category).
Meanwhile, earnings estimates for the S&P 500 moved down almost 5% during the quarter just ended, reflecting this "real" economy slow-down. It continues a downward revision trend begun in early 2012.
Stock prices, however, have continued to move up. This "divergence" is a hot topic of debate among market strategists. Some say that a higher stock market is correctly forecasting a revival of the global economy, while others say that stock prices have been "artificially" lifted by newly created central bank money.
A third view is possible: an absence of reasonable return opportunities in cash and bonds has forced savers and investors into stocks where they might not otherwise have gone. (In a delicious irony, Harvard, Yale, and other prominent large endowments who exited stocks in favor of more "sophisticated" investment strategies just reported their annual returns this month, and they badly lagged a simple stock/bond mix.) This is what we call the "marginal dollar" effect, and it is probably going to be with us as long as interest rates stay ultra-low. It may very well be possible for earnings to wilt and yet stocks maintain current levels, as long as they out-yield bonds.
On the other hand, volatility (the "VIX") has been quite low, as have trading volumes. The US election and "fiscal cliff" loom large (and are imminent). We now have the US Fed (and the ECB with their OMT program, a Euro version of Quantitative Easing) explicitly, perpetually, and actively injecting enormous new amounts of money into the markets. Things are about to heat up.
Tellingly, the asset class that rose the most after the Fed announcement was precious metals, seemingly re-discovered after a somnolent year as the best way to protect against the inflationary consequences of these new QE programs. The accepted notion of inflation as "too much money chasing too few goods" may have to be modified, however. The demand for money has crashed (i.e. "velocity"), so there's not much "chasing" going on:
But there certainly is "too much money", otherwise known as "hoarding of cash" (by banks, multi-national corporations, households, etc.), all consistent with the normal progression of a debt deflation:
Investors should like gold because there is no opportunity cost to hold it (interest rates are ultra-low), and central banks can't print more of it (i.e. gold is a natural offset to the risk of holding an asset which becomes more plentiful by the day). It might help during an inflationary period, but it mostly looks good when currencies get abused. Investors should continue to think about how gold and silver fit into their overall investment mix, especially as "insurance" if currencies misbehave.
Investors have a number of profound questions to ponder as October unfolds. Will markets allow the new monetary medicine some healing time, or will they revolt? How will the US Dollar fare? When will Europe get its act together? Can the US economy withstand the shock of sudden and sizeable tax increases and spending cuts simultaneously? Who will win the US Presidential election, and what will that mean for the US economy and markets? It seems to us a perfect recipe for a zesty final quarter in 2012. Here's to hoping everyone can make it through the main meal and stick around for dessert. It looks like it's going to be a smorgasbord.
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