Season Investments

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Pour Some Sugar On Me

Posted on September 18, 2012

Clearly we remain in a policy-driven market. Global Monetary Policy has been one of several items on our Macro Radar since the start of the year, and two major developments have taken place in recent months on this front. First, Mario Draghi announced that the European Central Bank would be open to purchasing unlimited amounts of sovereign debt in the distressed countries of Europe’s Southern periphery. There are a lot of asterisks to put on this commitment from the ECB, but we don’t have time to go into them here. Secondly, the US Federal Reserve announced last week that it would embark on its third round of quantitative easing (“QE3”) since the financial crisis. Combined, the rumor and news of these two monetary policy announcements induced a speculative rally in equities and commodities over the recent summer months.

We have had numerous conversations with our clients over the past week regarding the Fed’s policy actions and how they are affecting our outlook and strategy. We take an opportunity this week to update our clients on how we’re positioned in light of these events. 

QE Review

First, let’s briefly review what QE is exactly. According to Wikipedia, “Quantitative easing (QE) is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective.” In other words, once the Fed has lowered short-term interest rates (their primary tool for affecting the flow of credit) to zero, quantitative easing is the next logical step if low rates alone are not accomplishing what they had hoped.

In practice, QE is simply creating new money and using it to buy securities in the open market. We’re not referring to actually printing physical dollar bills; rather, the Fed simply makes an electronic entry on its books and – Poof! – there is cash where there was none before. By using this cash to purchases securities in the open market the Fed’s intention is to push prices up which results in lower mid and long-term yields (interest rates). This makes credit cheaper for potential borrowers while reducing the interest expense on those laden with heavy debt burdens. Additionally, it increases cash (liquidity) in the economy by virtue of the fact that whoever the Fed is purchasing these securities from is now left with the cash from the sale.

The central bank may target specific types of securities such as Treasuries or Mortgage-backed Securities as well as targeting specific maturities or credit qualities within each specific sector. Some quantitative easing programs (in Japan for instance) have even included the outright purchase of stocks. 

QE I, II & III

Out of all the central banks in the world the US Federal Reserve has been one of the most aggressive since the financial crisis. After lowering rates to the zero bound in the midst of the subprime meltdown, the Fed embarked on its first round of quantitative easing in November of 2008 purchasing nearly $2 trillion worth of Treasuries, Agencies and MBS. By mid-2010 when QE1 expired the Fed’s balance sheet (the amount of securities it owned) was roughly three times larger than when it started. Shortly thereafter the Fed signaled its intention to launch QE2, which it did in November of that year. This time the Fed would purchase $600 billion of Treasury bonds over the course of seven months or so.

Finally, this past week Bernanke announced QE3 which is perhaps the most significant of the three programs. Rather than setting limits on the amount or duration of asset purchases, the Fed committed to buying an additional $40 billion of Mortgage-backed Securities every month until the labor market improves. As such, the size and duration of QE3 are completely unknown at this point.

The chart below shows the expansion and composition of the Fed’s balance sheet as it has changed over the past four years. The area on the far right of the chart projects QE3 out to the end of 2013 for hypothetical purposes.

 2012-09-18_Fed_Balance_Sheet.png

In addition to these new asset purchases, Bernanke extended his language regarding interest rates saying that he planned to keep them low at least through 2015. Remember, it was just a year ago that the Fed’s timetable was projected to be mid-2013 for raising rates. 

Bernanke’s Virtuous Circle

So what’s the point of all this? It is widely known that the financial system has plenty of liquidity while interest rates are already low enough to encourage borrowing and keep the cost of servicing debt manageable for both public and private sector participants. Indeed, the banks are not lending to consumers and businesses not because they don’t have the means, but rather because borrower demand is low (we’re reducing debt, not taking on more of it) and credit quality is not adequate in many cases where credit is desired (too many of us are underwater on our houses and can’t refinance). So what does the Fed think it can accomplish with QE3?

To answer this question let’s look back at a statement Bernanke made in 2010 in a Washington Post article referencing the expected impact of QE2.

 “…higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.” 

In other words, the Federal Reserve is in the mood management business. By implementing open-ended asset purchases it intends to inflate asset prices leading to better moods and looser wallets amongst American consumers. The theory (and hope) is that this will become a self-fulfilling prophecy of economic growth that will gain momentum and eventually stand up on its own two feet without any further stimulus from the Fed. 

We maintain that QE3 will have no real direct impact on economic growth given that it will not loosen any of the “binding constraints” preventing growth from accelerating. Lower interest rates and more banking system liquidity are not going to deliver a material impact where the economy needs it most. Additionally, the empirical data suggests QE has little to no lasting effect on asset prices. Hence the need for the Fed to go another round even after quadrupling the size of its balance sheet since the financial crisis. John Hussman of Hussman Funds recently put it this way: 

“We continue to view QE as being of no real economic benefit, and though it has clearly affected financial markets, QE has typically boosted the stock market by little more than the amount it has lost over the prior 6 month period. That’s another way of saying that I doubt the Fed’s actions will be of much durable effect here at all. 

If we examine the way that QE actually operates, and how and why risk premiums have responded to prior rounds, it is entirely unclear that a further round will have much effect beyond an initial spike of enthusiasm. That is, unless one adopts a superstitious faith that stocks will rise in response to QE, since QE makes stocks rise, because QE equals stocks rising, with no further analysis needed. 

Even the talking heads of the financial media seem to agree with this assessment. The pop in stocks and commodities in the 36 hours following the Fed’s announcement was referred to over and over again as the “sugar rally”, making it analogous to the surge of nervous energy one gets after indulging in too many sweets. 

How This Impacts Our Portfolio Strategy

We have been underweight our long-term targets in risk assets (stocks and commodities) for many months now. Looking back on our allocation decisions we recognize that we underestimated the aggressiveness of global central banks and the ensuing risk rally that would occur in the face of new policy announcements. We have to continually remind ourselves that we are in a policy-driven market environment, and the decision to ignore the old adage “don’t fight the Fed” is often the wrong one. That said, individual investment selections within each asset class as well as our overweight position in gold has enabled us to not fall too far behind in our year-to-date performance versus portfolio benchmarks despite our defensive positioning. 

At this point our conviction is that patience will prove to be a virtue. The global economy is slowing, earnings data are beginning to weaken, European recession is deepening and the fiscal cliff looms in the face of a toss-up election in the United States. There are more than enough reasons to expect that risk assets will face further periods of volatility and consolidation over the course of the next several months. Thus, we would rather wait on better opportunities to put cash to work in the future than chase a “sugar rally” that we have little confidence can be sustained.

Contributor: David Houle,CFA

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Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.