In Changing Seasons Part I we took a look at the better news that has unfolded on both the economy and corporate earnings. The most important aspect of that article was the observation that companies are doing better than the economy. Below we focus on implications of the U.S. elections and central bank actions.
- Last week’s elections dealt a blow to the policy agenda of the Obama administration, yet the focus of voter anger – deficit reduction – may prove elusive as bipartisanship remains in short supply.
- The expected easing by the Fed to boost nominal GDP growth met with cries of dismay from the EU and may prove misplaced if current U.S. growth continues to improve from its soft patch as we expect.
- Investors should use the price insensitive buying by the Fed in the upcoming weeks and months as an opportunity to reduce duration, Treasury exposure, and potential fixed income exposure in their portfolios.
Republicans gained more than 60 seats in the House and six in the Senate. The GOP also found itself in control of more state legislative seats since 1928. The strong GOP showing in the midterm elections has several interesting implications. The biggest issues of concern in the election process were clearly the economy and the monumental deficits; however, questions associated with the stimulus and health care plans, along with cap and trade, bailout programs, and the growth of government were also issues. The lame duck session of Congress began this week, with the major issue being centered on addressing the expiring Bush tax cuts. Although this issue might not get fully settled until December or even early next year, in all likelihood the end result will be some form of extension (most likely two years) for the bulk of tax cuts.
The clearest message from voters last week is the need to address our monumental budget deficit. The budget deficit is on a path to come in close to $1.3 trillion for the second consecutive year. By this time next year, the Federal government’s total debt outstanding is likely to more than $15 trillion, thus exceeding U.S. nominal GDP. The explosion of our budget deficit reflects bipartisan ineptness that really began in the early 1980’s when our nation’s debt reached $1 trillion dollars. Today, less than 30 years later our nation’s debt obligations have gone up by almost 15 fold. Republicans are right, we do have to cut spending; however, Democrats are also right we have to raise taxes.
On this issue an interesting bipartisan event unfolded last week as Erskine Bowles and Alan Simpson, the co-chairs of President Obama’s Commission on Fiscal Responsibility and Reform, released a bold draft of recommendations to reduce the Federal deficit. The co-chairs’ proposals: cut defense spending, raise the social security retirement age, cut the federal workforce by 10 percent, cut farm subsidies, scrap the deduction for mortgages over $500,000, raise gas taxes, lower corporate taxes (but eliminate deductions), raise capital gains and dividend taxes, simplify individual income taxes, implement medical malpractice reform, and eliminate Congressional earmarks are bold moves that might just be what our budget process needs. The months ahead will provide some insights to the political capital Congress and the White House will seek to spend to implement some of these very difficult recommendations.
The Federal Reserve, as was widely expected, used the press release following the conclusion of the November 2-3 FOMC meeting to announce Quantitative Easing II. The Fed stressed that “to promote a stronger pace of economic activity and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities.” The Committee announced its commitment to spend an additional $600 billion in newly printed money to buy Treasury issues by the end of 2011:Q2. The bulk of the purchases will be targeted between the two- and 10-year sector which, when combined with the reinvestment of maturing mortgage proceeds and coupon payments, will represent about $105 billion net new Treasury coupons each month. Thus, the Fed could effectively soak up all of the new debt issuance by the government between now and the end of June. Although FRB-Kansas City President Thomas Hoenig served as the lone dissenter, comments from a variety of Fed officials over the last week suggest that the support among the voting and non-voting FOMC was not as overwhelming as the “official” 10-1 vote.
The Fed’s upcoming quantitative easing action is an attempt to boost nominal GDP growth and the central bank appears to be willing to accept the potential risk of a moderate rise in inflation. The Fed may ultimately want to be careful what they wish for.
In fact, since the Fed’s announcement, re-inflation fears have placed upward pressure on market interest rates, especially in the 30-year sector which currently is not being aggressively targeted by the Fed. Although a number of people are already clamoring for QE III, it might be premature to say that the Fed action has either failed or backfired as the first outright purchase took place at the end of last week. Nonetheless, our assessment of history suggests that caution is warranted, but not for obvious reasons touted by the pundits.
It is often touted that when a massive price insensitive buyer enters the market, you need to be respectful of the buyer. Remember the early 1990s when Japanese entities were aggressively buying Treasury long bonds or the late 1990s when we saw aggressive buying of technology stocks at extremely high P/E ratios. In both cases, these aggressive price insensitive buyers of what was perceived at the time to be expensive assets made these assets even more expensive when they were buying. However, when they stopped buying the process got very ugly and sharp selloffs ensued. If the Fed follows through with their plan they will effectively buy all of the net new supply of coupon paper over the next 7-1/2 months and by June 2011 they will become the world’s largest holder of Treasury debt. However, unlike the early 2009 quantitative easing program when the Fed bought cheap assets, the assets they will be buying under the QE II program are far from cheap, particularly if the Fed is successful in stimulating higher nominal growth and modest inflation and stops being a price insensitive buyer of expensive Treasury assets before we get to mid 2011.
Notwithstanding the outcries from some in the EU, notably German authorities who see a resulting stronger Euro as damaging to export trade, there is growing interest for the ECB to consider either its own QE II package or a bailout for the more fiscally challenged countries such as Ireland or Greece. For the better part of the last two weeks, sharp bond market sell-offs unfolded in both of these countries as the concerns about the banking system, challenging budget deficits, and the difficulty in implementing fiscal policy restraint spread throughout many parts of Europe. Interest rates also moved higher in Portugal, Spain, and Italy after France endorsed the German proposal that bond holders must share in the pain if these countries need additional financial help. And in another example of “do unto others as they do unto you”, Japan is in the process of implementing a quantitative easing action that will include the purchases of Japanese equity indices and REITS.
In contrast, a sharp 4.4 percent year-over-year food-induced rise in inflation in China has raised fears of another round of tightening by the People’s Bank of China. Alternatively, a stronger upward adjustment in the RMB would also help to temper China’s inflation issues as well as reduce a portion of the geopolitical tensions on the trade front.
The old adage “Don’t fight the Fed” is one that we and many market participants have learned to respect. Over the near term, the Fed’s intervention actions may provide some underlying support in the sectors that they are buying and could reverse the recent week-long sell-off in Treasury notes since the QE II announcement.
The Fed’s aggressive actions may well stimulate stronger economic activity, potentially at the expense of inflation. And, this might happen sooner rather than later and could curtail the Fed’s buying plans before the currently targeted mid-2011 end point. We are also concerned that the Fed has a history of providing too much stimulus at the end of an easing cycle and then not “taking away the punch bowl” when the party really gets started. This was most recently witnessed by the Fed’s panic easing in June 2003 and the failure to remove this liquidity when a sharp reacceleration in the economy unfolded in the second half of 2003.
Interestingly, the U.S. economy has already started to shown signs that it is improving from its late spring/early summer “soft patch” and input costs appear to be increasing. This could be a hint of a faster upturn in nominal GDP growth and inflation. Accordingly, investors should use the price insensitive buying by the Fed in the upcoming weeks and months as an opportunity to reduce duration, Treasury exposure, and potential fixed income exposure in their portfolios.
As for the equity market, the history of the election cycle might provide an interesting guide. Since 1929, the strongest nine-month period for the S&P 500 Index has been from the start of October just prior to the midterm elections to the end of June the following year, with the average nine-month gain coming in just north of 18 percent.
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