Bon Voyage, QE2
Time for another visit from the Marshallian K. For those who even remember this obscure economic theory we’re sorry to have to go over this again, but we have to go over this again. The theory goes that excess money in the economy (that is money supply over and above the transaction demand for money, or the price of goods times the volume of goods divided by the velocity of money) will seek its best use and that use is usually in the securities markets in the short run. Money can be more effective when used for investment in physical plant and equipment or inventories or some other largely illiquid investment. But, when the supply of money rises suddenly the easiest way to make that money return anything is to put it in the securities markets (think in terms like putting it in a money market fund instead of as cash in your pocket). So, when QE2 began last October the securities markets started rising, though not right away. This is an element in the Fed’s outlook that the end of QE2 won’t have a meaningful impact on the real economy. Most of this money never reached the real economy in the first place.
When the Fed started QE2, they decided to have a long program of bond buying at fairly level rates spread over eight months. They pretty much kept to that script all along. Later this week that program will end, if it hasn’t already. Going forward, the Fed won’t pump an incremental $75 billion a month into the economy. What they will do is roll-over all the interest income they receive on over $2.8 trillion in assets on their balance sheet, mostly from their purchases of mortgage-backed securities in 2009-2010 and from QE2. Since there has been a rash of prepayments on mortgages owing to the lower rates engineered by the Fed in QE2, they have a lot of principle to reinvest as well. The Fed has been buying some $50 billion to $60 billion in roll-overs each month lately as well as the $75 billion from QE2. Now, they will only buy the $60 to $70 billion of roll-overs.
We have touched on the imminent end of QE2 a couple of times recently, but this week it actually ends. Watch on Friday and see if the sun comes up again in its usual fashion. Our guess is that it will. See if the economy suddenly becomes unwieldy and begins to falter. We doubt that it will. What we might see is a slow rise in interest rates as the artificial demand for Treasury securities from the Fed fades.
What the Fed wants to happen in the bond market is nothing at all. They would prefer to have prices remain elevated both from the safe-haven trade as well as their on-going buying. We suspect they will be modestly disappointed. There is no obvious replacement for the Fed’s demand for Treasury notes on an on-going basis. We will probably see choppy markets without the lift of Fed buying pulling the market higher.
What the markets fear is the reverse of the Marshallian K, that money will not be ample to keep inflated commodity prices and bond prices elevated and that this will cause other markets to falter as well. We suspect that this expectation will also be thwarted. We suspect that $600 billion spread-out over eight months was never enough to do what QE2 was intended to do, nor was it big enough to do what a lot of people accuse it of doing, boost commodity prices, boost bond prices, boost inflation.
Coincidence is not causation. Just because inflation rose during QE2 does not mean that QE2 caused inflation. If inflation continues to rise now, will it mean that the end of QE2 caused inflation? Monetary policy maneuvers work with surprisingly long lead times, when they work at all.
We saw a direct impact on bond prices because that was the direct action taken by the Fed. The Fed did not go out and buy a bunch of Brent Crude contracts in hopes of elevating oil prices. But, we got higher Brent Crude due to the substitution of Brent for Libyan oil that didn’t reach markets due to the uprising in Libya. There is a long list of other worries on a commodity by commodity basis that explains most of the recent rise in commodities. On top of this, the nascent inflation has sent a small army of hedge funds in search of an inflation hedge and most of them found commodities. This is why commodities get lumped-in with stocks and some currencies in the risk-off trade that comes along every time there is some crisis that elevates the dollar temporarily.
Issue of the Week
This was a big week for the Greeks, their financing crisis, their austerity plan and their demonstrators. Despite a series of bloody clashes with police, demonstrators were unable to persuade the Greek Parliament to vote-out the current administration of Prime Minister George Papandreou. Papandreou is the guy who negotiated the austerity plan that met with approval with the Greek’s bankers, the International Monetary Fund, the European Central Bank and the other members of the European Union. Greece will cut its spending, raise its taxes, increase enforcement of its tax laws and a bunch of other things to try and square its books. The IMF, ECB and EU will front Greece more money.
Importantly, this sets the precedent for the other highly indebted European nations collectively known as the PIGS, Portugal, Ireland, Greece and Spain (we intentionally left out Italy, as it increasingly looks like they will manage without assistance), who will all need to have a similar program of austerity, loan guarantees, debt roll-overs, outright grants, higher taxes and lowered services in order to put their financial houses in order. Though the problems are a little bit different in each country, the impact is roughly the same.
Regardless of the apparent progress on this front, the markets didn’t seem to realize a lot of relief from it. At the eleventh hour, the whole deal seemed to be coming apart, but it was salvaged. The cost of letting Greece default is widely seen as higher than the cost of saving it, so they will be saved. Though we almost wish someone sometime would let someone go broke and face the consequences, that day won’t be soon. So, the ‘crisis’ continues unsettled.
We face so many crises that it is easy to see why anxiety has risen. Not only do we make a big deal about every crisis (kind of a mountains-to-molehills simile), we tend to use each to reinforce all the others. So, the Greek crisis means the US debt ceiling crisis is all the more important. With respect to the US debt ceiling crisis, the talks that were supposed to lead to a solution to that crisis broke down last week over the refusal by Republicans to consider tax increases as part of the deal. As a part of the dwindling tax-payer cohort in this country, we find that modestly encouraging. But, for the majority of Americans who get more from the government than they pay for, that might not seem so obvious.
First quarter GDP was revised to growth of 1.9% from 1.8% (seasonally adjusted at an annual rate). The modest gain was the result of somewhat higher inventories than initially guessed and a downward revision on imports. Lower imports, all other things remaining static, means that more domestic demand was satisfied with domestic production and less by foreign production. All in all, this was very close to what was expected.
Existing home sales came in right in line at 4.81 million (saar) in May. That doesn’t mean this was a good number, just not surprising. The forecast was for sales to be the lowest they’ve been in the last six months. This is for May, the start of the strongest part of the year for homes sales. The next few months often see the bulk of the year’s home transactions. Let’s see, there are about 330 million people in this country, with a little over 2 people per household that makes 160 million households, two-thirds of households are owner-occupied, so roundly 100 million homeowners out there. If we trade 5 million homes a year, that means that on average we stay in our homes 20 years. That doesn’t make sense. Between moving to get take a new job, upgrading as we progress in our careers and down-scaling as we exit the labor force, most of us will move every 7 or 8 years. We need to be buying and selling more than twice as many homes as we are these days.
New home sales were more or less in-line with expectations at 319,000 (saar), but way below the levels of even a year ago.
In a stronger sign for the housing industry, FHFA home Prices were higher by 0.8% in April. While the Case-Shiller number keeps showing declining prices in the major metropolitan areas, the FHFA number, which tracks price trends in more affordable homes largely outside the big cities, has started to stabilize.
Saber rattling in the Middle East, demonstrations in Athens, worried bankers, political stalemate, sounds like a typical week for investors these days.
For those among you who are Indiana Jones fans, recall the scene in the third movie, something about the Holy Grail, when the Nazis have captured the Joneses and are departing, the hot Austrian gal gives Indy a big kiss and tells him that is how they say goodbye in Austria, thereupon the SS Colonel socks Indy on the jaw, telling him that this is how they say goodbye in Germany. Indy says he likes the Austrian way better. Well, the markets are kind of the same, kisses then punches. The difference is that we remember the punches a lot more. We have an asymmetric risk/reward outlook. We love the reward, but the risk just hurts too much. Yes, the kiss from the pretty Austrian fraülein is nice, but he punch from the Nazi jackboot is quite a deterrent.
So a decline of 100 Dow points feels a lot worse than a rise of 100 Dow points feels good. So, in a week where we net lose about 0.6% in the Dow, we generally feel like the decline was much worse. We remember the days when stocks fell by 100 points or more and wonder how we could have only fallen by this paltry bit. Well, the gains were quite forgettable among all the carnage. This is actually good news. Since we have seen a huge increase in bearish sentiment while actually suffering very little damage to prices, the outlook has improved. Good old contrarian thinking again.
Last week’s fall was centered in the large cap stocks that are supposed to start leading the markets now. Funny how the consensus view is so often contradicted. But, the consensus is seldom right for more than a couple of weeks and often quite right over several months or quarters and wrong most of the time. Yes, confusing but true.
We saw two important shifts this past week, the return of emerging markets as a contributor to performance and a return of the NASDAQ stocks to market leadership. We also saw the return of small caps, which is contrary to the above noted consensus that large caps, especially multi-nationals, will lead the market now. The move in the emerging markets is not only welcome news to those of us who hold those stocks, but welcome news to anyone who hopes the world will continue growing. Virtually all the growth in the world is now coming from the emerging markets. Europe can’t seem to get any traction. Japan is recessing again. US growth is slow. Were it not for China, Brazil, India and a bunch of other emerging markets, we’d all be facing a much more daunting outlook.
This growth has been met by declining prices in many emerging markets due to the simple fact that those governments have gone from trying to stimulate their economies to trying to fight inflation. Rising interest rates have been the answer and the rising rates have meant a tougher environment to grow a business. But, the good news is that they have growth strong enough to worry about. Compared to the US, Japan and Europe, that is a good problem to have.
Bonds did well last week across most of the globe. It is easier to note the areas that didn’t follow this trend. That would be some emerging markets and US high yield.
Real estate prices were generally lower. Not only were financials in general down, but there was some unsettling news on the real estate front. Residential real estate has reentered a downturn and just as it happened before, commercial real estate gets tarred with the same brush. However, as we have noted, maybe real estate securities deserve a little critical assessment after the huge move they have had with little support from the underlying property markets.
Commodities were very interesting last week. The big news was the coordinated release of strategic stocks onto the market to fight high prices. Though most of these reserves were built with the idea of having a strategic reserve in case of a major political, terror or weather-related interruption in supply, high prices finally got the best of the good intentions of the politicians in charge of the inventory. A release of 60 million barrels over 30 days was supposed to replace lost Libyan crude, but Saudi Arabia had already replaced those barrels. The impact on prices was huge as Brent crude fell almost 10% one day and West Texas Intermediate declined about 4%.
The energy complex was not alone in feeling some heat. Grains fell, industrial metals fell, precious metals fell. Only livestock seemed oblivious of the trends around them. Maybe that is because only livestock hasn’t been broadly impacted by the shortage theses floating around or the safe-haven trade in metals. The major commodity indexes are now down for the year to date. Had you told someone on say February 28th that by the middle of the year commodities would be down, they’d have called for someone to have you put in the loony bin.
Have a great week.
Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.