The Federal Open Market Committee (FOMC) opened a new chapter in its battle to return the economy to sustainable growth with a set of decisions that is unequivocally pro-growth, in our view.
As such, it may yet be seen to become as significant an event for markets as when the Fed began purchasing U.S. Treasuries in March 2009. Likely beneficiaries from the Fed’s actions include sectors most sensitive to liquidity and global economic momentum, such as banks and materials, that have lagged broad equity markets this year.
We believe additional Fed easing should also lead to a steeper yield curve, benefit European peripheral debt indirectly and keep the U.S. dollar weaker for longer.
Commodities and emerging market equities that have lagged in the last year may also see some significant buying, though less prominent than through QE2 (second round of U.S. quantitative easing) and dependent upon Chinese policy action.
Why did the Fed feel it necessary to expand its stimulus in this way? It appears its key concern is the labour market where a revival earlier in the year has largely ground to a halt.
Mr. Bernanke has a clear eye on the full employment pillar of the Fed’s. Deflation is not a real threat but the chairman stressed the ‘grave’ consequences of prolonged weakness in employment for the long-term health of the U.S. economy and society. It clearly feels its new measures will be effective.
Its updated GDP forecasts look for stronger growth in 2013 and 2014. Unemployment is expected to fall to within a range of 6.7 to 7.3% by end 2014. Undoubtedly, worries that budget gridlock in Washington, post election,would add to alarm also played a role.
The manner in which the Fed is seeking to implement its latest version of stimulus is of particular relevance to investors. Liquidity will be expanded as in the previous two versions of QE, but with the Fed holding only 15% of the Morgage Backed Securities Market, there is scope for a lot more if necessary.
Interest rates will be repressed again given the undertaking to maintain rates at current low levels for almost another three years. Investor desire for income generating assets is therefore likely to continue.
A new aspect is that the Fed may be overtly targeting support for collateral to be offered against loans, especially mortgage finance. It is targeting the real estate market just at a time when nationwide house prices (as measured by the S&P Case-Shiller 20 City index) have risen 3.6% since their cycle low in early-2012 and mortgage demand is moving gradually off the floor in response to record affordability.
Inflating collateral in the banking system will help accelerate a rebound in credit availability and capacity. This all looks favourable for investors wanting to add risk to their portfolios. Yet, the move has to be placed in the context of weak underlying activity across the global economy this autumn and of course the conditional back stop offered to the eurozone periphery bond markets by the European Central Bank (ECB) last week.
Word from the weekend meeting of euro finance ministers in Cyprus suggests Spain is preparing the ground to request a form of assistance at the government heads’ meeting in October.
Likewise, the outgoing Chinese leadership looks prepared to offer fiscal support to the economy through the transition with a barrage of infrastructure initiatives and export subsidies.
Bottom line: the stimulus is coming early and it is larger and more sustained than most expected. The net result is that stock markets and commodities may reappraise growth and corporate earnings’ prospects over the coming year and move higher – leading to a possible year-end rally. We see lowly valued, discarded eurozone equities as particularly well positioned to respond, despite the recession now underway there.
We can already make some early educated guesses about the impact on fixed income markets. We expect the most likely outcome is for the overall market for mortgages to be stimulated. New issuance has not been supportive of housing activity, and this could make a difference. Other risky fixed income markets have already responded well, especially high yield credit. With spreads already below 600 basis points on the Merrill Lynch High Yield Master Index relative to U.S. Treasuries, we believe the Fed decisions are likely to lead to further compression.
The addition of liquidity to the market is likely to lend support to spreads remaining lower for longer. The initial reaction from U.S. Treasuries was for longer-term yields to rise and for inflation-linked markets to outperform.
In our view, the market is looking for some initial upgrading of growth expectations in the short to medium term.
