There are reasons to believe that market action over the past 2 weeks will have a negative effect on consumer and business confidence. Reports are reflecting reduced spending trends by business leaders due to concern over the economic outlook. Serious potential hazards seem to be omnipresent, ranging from the Eurozone debt crisis to a China hard-landing to a double-dip recession in the US. The risk of a global downturn is rising by the day. Continued deterioration will most likely result in the Fed instituting yet another QE experiment. This article is meant to speculate on when the Fed may initiate QE3 and the program’s subsequent effects.
As per my latest outlook, I expressed doubt on the Fed initiating the program in the short-term (roughly 6 months) due to the negative effects that QE2 produced. These include a deterioration in housing (which the program was suppose to ameliorate) as well as higher gas and food prices pressuring consumer’s discretionary spending. A lower dollar has also resulted in an imbalance of capital flows. Nations such as Japan, Switzerland, and Brazil have participated in “currency wars” to lower their currency’s value by purchasing dollars in order to protect their export sectors. The Fed has been getting flak from analysts, politicians, the financial media, and foreign governments for pursing QE and in effect a weaker dollar strategy. Internal dissent has also intensified as a rare 3 Fed officials disagreed with the recent commitment to keep rates at 0-.25% till 2013.
One important caveat: while writing my outlook, I completely neglected the scenario of a blowup in the Eurozone. There, political leaders bicker over the region’s future. Germany needs to subsidize debitor nations to keep the Euro experiment alive. Up to this point, they have rejected pursing this path. Markets are getting very anxious over the prospects of a default by Greece, Spain, or Italy which would result in an acute round of risk aversion in my view. Should this happen, QE would come soon thereafter. What will be pivotally important in the weeks ahead is whether contagion in the Eurozone is suppressed. If not, and the markets radically deteriorate further, we may see a QE announcement as soon as Jackson Hole on the 26th.
Should the Eurozone not implode, there are a 2 factors I’ll be keeping an eye on to help me determine when QE would make its 3rd appearance: inflation metrics and Fed speeches. The more important of these is inflation. At the current time, it isn’t signaling an accommodative environment for further monetary easing. I am looking at 5 indicators to arrive at this conclusion: the 5-year inflation breakeven rate; inflation expectations in consumer confidence surveys, gas prices, Core CPI, and changes to the Fed’s own outlook.
- 5-year inflation breakeven rates are higher than a year ago when the Fed took action on QE2. As of August 12, the metric sits near 1.80 vs. 1.20 a year ago. I would need to see this indicator closer to 1.50 (or roughly 16% lower) to consider a QE announcement in the immediate future. This indicator poses a significant challenge against further easing as it does not signal deflation as an immediate threat. (Chart below)
- Second, consumer inflation expectations would need to drop a little more. Of particular interest to me was the “Consumer Expectations of Inflation” component in the latest University of Michigan Confidence survey. While the overall confidence gauge fell to a 30 yr low, 1 yr inflation expectations didn’t budge, remaining at 3.4%. When Bernanke initiated QE2, inflation expectations were closer to 2.5%. The Conference Board’s Gauge of 1-yr Inflation Expectations tells the same story. In July-August 2010, the gauge was averaging 4.95%, today it is at 5.7%. Let’s not write off that both indicators have been declining recently. Taken together, they pose a weakening impediment towards further easing. (Conference Board Chart Below: U of M Chart paired with Core CPI)
- Core CPI also poses an increased risk for embarking on QE3. Comparing the latest YoY reading (June ’11) with a year ago, we see that the gauge is more than 50% higher, at 1.6% vs. 0.9%. Moreover, it may rise further due to its rental component. From a “further easing standpoint”, the gauge remains soundly below the Fed’s yearly inflation growth target of 2.0-2.5%. This metric poses somewhat of an impediment towards further easing. (Both Core CPI and U of M Inflation Expectations below)
- Fourth is more political in nature: gas prices. While they have been declining, I think they need to fall much further. Gas prices have proven to be highly sensitive to monetary easing. Looking at the graph, we are still well above August 2010 levels. The Fed risks $4.00+ gas prices nationwide should it proceed, ruining an already dwindling chance of Obama getting reelected. I’m sure he’s voiced his concerns to Bernanke. This factor remains a strong impediment against QE3. Recent weakness isn’t enough to justify further easing in my view. (Chart Below)
- Finally, I would need to see a further acknowledgement by the Fed of a worsening economic outlook with special emphasis on their inflation forecasts. After comparing 2010 vs. 2011 June FOMC economic projections, I believe recent inflation forecasts are too high to justify further easing in the immediate-term. If they did proceed with QE3, it could be seen as an about-face on their projections and risks damaging confidence. (Tables Below. Source Board of Governors of the Federal Reserve System: 2010 and 2011 – FAQ here)
Regarding Fed speeches, while Kocherlakota, Fisher, and Plosser dissented in the latest FOMC minutes, it’s important to note that they believe economic growth will pick up in the second half. Therefore, it makes logical sense to assume that should continued economic weakness persist and deflationary risks increase, they would be forced to tone down their dissent.
Overall, I think we will ultimately see QE make its third appearance. The immediacy of such an announcement, however, depends on whether we see an acute round of risk-aversion in the Eurozone. If the region doesn’t plunge into a crisis, QE3 will not be implemented until inflation metrics subside from their current levels. Given that 50% of the Fed’s dual mandate is not supportive for further monetary easing when comparing current inflationary conditions to 2010, why would they waste another of its dwindling precious bullets now? Should it hastily do so, it risks further damaging its reputation (ie. market confidence) while at the same time increasing the risk of a serious stagflationary headwind in the near-term. (Reference: the remaining Fed meetings are scheduled for September 20, November 1-2, and December 13)
So now that we’ve considered the circumstances as well as when the Fed could proceed with QE3, what does it mean for risk assets (equities/commodities)? In my Financial Market Forecast, I stated that should they proceed with QE3, it would significantly cloud my outlook. One would think that the risk-on trade would come back with a vengeance. Like QE1 & 2, QE3 could result in risk assets embarking on their next bull market leg, running over the bears and their short positions. Seems like a slam dunk trade right? Well, the certainty of the result makes me question whether QE3 would have the same effect as QE1 and 2. Don’t get me wrong, any announcement would more than likely result in a substantial revival of risk appetite. However, could the effects of a QE3 be more muted than investors expect? I think so for one main reason: circumstance. Today’s economic environment differs substantially from 2010.
For starters, we are in a period where fiscal stimulus is exerting a drag on GDP, in contrast to mid-2010. I believe that fiscal stimulus plays a much larger role on future cash flows than its monetary counterpart. When Bernanke embarked on QE2, one could take comfort that government spending would produce future positive cash flows for companies. Government spending (equatable to end-demand) was guaranteed; an investor knew that positive cash flows would be produced. This was a pivotal tailwind for the equity markets in the latter end of 2010. Monetary stimulus helped in the sense that it acted as “gasoline” for risk sentiment. Rocketing equity prices created a wealth-effect for consumers heavily invested in the asset class. Earnings in turn increased as confidence in a self-sustaining recovery was strong and increasing. However, in order to have produced that belief of a self-sustaining recovery, we had a guaranteed base-demand in the form of government spending. Today, government spending is contracting and confidence is decreasing. It is increasingly clear that private sector demand remains feeble. This may translate to lower cash flows in the future. Let’s not forget that S&P 500 earnings are already near all-time highs; expectations for further growth are lofty at this point. Margins are also near all-time highs. Companies have cut costs substantially. This method of juicing earnings is nearing its end. Would another round of monetary easing act as enough of an impetus to jump start the whole economy absent further fiscal stimulus (ie guaranteed end-demand from the government)? I’m inclined not to think so.
The global economy is a source of demand which has also been diminishing. In the US, the role of increased exports has played an important role in the outperformance of our manufacturing sector. In fact, this sector was the epicenter of the two-year-old expansion. However, as of late both exports and manufacturing have slowed. The latest ISM manufacturing number is only a smidgen away from contraction while the just released International Trade data shows faltering export growth. Perhaps the weakness can be explained by transitory factors such as the Japanese earthquake. But, the FOMC just released its assessment of the US economy where they noted that economic weakness isn’t solely due to these factors. The truth of the matter is that the global economic expansion is slowing. The Eurozone is the largest economy in the world and it’s caught in a major wave of austerity. Most periphery nations are contracting, while core-countries such as Germany and France are showing signs of cooling/stalling. The Eurozone accounts for close to 20% of US exports ending 2010 (Source: European Commission). Next, you have China. China accounts for another 20% of US exports ending 2010 (Source: US-China Business Council). While the communist nation isn’t slowing as sharply as the Eurozone, recent data shows a weakening pace of growth. Manufacturing is very close to contraction as per their PMI surveys and growth in electricity usage has faltered. While export demand accounts for a smaller part of US GDP, the global economy is responsible for a decent sized segment of S&P 500 earnings. Weakness here won’t help the US economy and may have a large negative impact on S&P 500 earnings.
Despite a clear disparity between 2010-11 economic environments, analysts haven’t budged their S&P 500 earnings estimates or year-end targets. While we’ve seen a high amount of bearishness lately, it doesn’t run deep into investors’ minds, which is what I would like to see from a sentiment standpoint. Analysts are also salivating over the prospect of another QE. It seems that they are banking on another round of monetary easing to boost equity markets and earnings. Confidence in the economy and the Fed is greatly diminished from a year ago. Businesses haven’t jumped in with both feet with regards to hiring despite 2 quantitative easing operations already. Why would they this time around? If jobs are still scarce, a key cog for increased domestic end-demand remains missing. If domestic-end demand remains subdued, confidence will be restrained and businesses will not invest (more end-demand gone). Global growth is also slowing as Europe undergoes austerity and China remains gun shy in implementing more stimulus. Continued growth in cash flows would be hard to come by in this type of environment. The trillion dollar question is whether monetary policy alone will be able to pull the economy out of its current rut. I am skeptical that it can. QE acts as gasoline for the equity markets, it cannot replace the wood that keeps the fire burning; just ask Japan.
Whether quantitative easing alone will provide the spark the US economy needs to accelerate in the second half of the year into 2012 is an important question for investors. While I am skeptical of QE’s ability to produce such a scenario, what I think doesn’t matter. What does is how markets react. No doubt, I will make changes to my portfolio the day Bernanke gives the green light for QE3. All I’m saying is that another quantitative easing experiment may not yield the results as its predecessors. I will look to the technicals for confirmation or repudiation of this speculation.