Newsletters 2010 Newsletters Bernanke’s Virtuous Circle
Friday, 12 November 2010 10:24
The stock market continued its year-end ascent last month with the S&P 500 Composite, Dow Jones Industrial Average and NASDAQ Composite rising 3.69%, 3.06% and 5.86% respectively. These important benchmarks are now up 6.11%, 6.62% and 10.50% respectively year-to-date through October. The composite of all equities under management at Osher Van de Voorde Investment Management rose 3.27% in October and is now up 8.71% year-to-date. Importantly, we are bettering our key benchmark, the S&P 500 Composite, with far less risk. Please make sure to read the back page of this newsletter, Core Equity Analysis, which highlights the quality, safety and growth features of Osher Van de Voorde core equity holdings against that of the overall market.
Results of the recent national elections and the Federal Reserve’s newly announced commitment for another round of quantitative easing (QE2), up to $600 billion through the second quarter of 2011, has buoyed investor confidence and helped the stock market break through previous levels of resistance. Indeed, the S&P 500 seems poised to reclaim territory not seen since August of 2008 or just before the collapse of Lehman Brothers and ultimate peak of the financial crisis.
As we opined in last month’s newsletter cover Currency Wars Simmer, we are not sold on the merits of QE2 and remain skeptical of its ultimate purpose and potential outcome. To the extent that Bernanke and the Fed wished to alter the landscape for inflation expectations, they may have already succeeded. Signaling rising fears of percolating inflation, the long end of the yield curve has steepened markedly to all-time highs. Through QE2, the Fed will do its best to manipulate yields on intermediate bonds, the middle of the yield curve, but will have little influence on 30-year bonds or the long end of the curve. Investors are avoiding long-term bonds on the prospects for higher inflation down the road and the likelihood that long-term bonds will lose value once rates begin to rise. The sharp steepening of the yield curve is a clear indication that inflation expectations are on the rise Perhaps an even greater sign of heightened inflation expectations, a recent $10 billion auction of Treasury-inflation-protected-securities (TIPs) sold with a yield of negative 0.55%, the first time in history that the Treasury has issued TIPs with a negative yield.
On the one hand, there remains sufficient economic slack for the Fed to justify its new quantitative easing campaign. Unemployment has been mired near 10% for many months now and GDP, while positive, is not growing fast enough to create sufficient new jobs. The initial estimate for third quarter GDP was for an improvement of 2%, approximately 1% below the rate of growth required to foster employment gains. Meanwhile, industrial production unexpectedly fell in September by 0.2% after rising 0.2% in August, causing capacity utilization to fall for the first time since June of 2009 to 74.7%. And the most recent inflation data continues to be muted, further boosting the Fed’s cause. Consumer prices rose only 0.1% in September after gaining 0.3% in August. Excluding food and energy, core consumer prices remained unchanged for the second consecutive month. On a year-over-year basis, core consumer prices rose 0.8% in September. This is the lowest level of annual growth since 1961 and well below the Fed’s target for growth between 2.0% and 2.5%.
On the other hand, other economic indicators continue to point to a strengthening recovery, albeit unspectacular. Retail sales rose by a better-than-expected 0.6% in September after increasing by an upwardly revised 0.7% in August. Consumer confidence continues to improve with the Conference Board’s Consumer Confidence Index rising to 50.2 in October from 48.6 in September. Indeed, the recent third quarter GDP report revealed surprising strength in consumer spending, as consumption rose by 2.6% in the quarter, the highest growth rate since the fourth quarter of 2006. Emblematic of this rising consumer tide, existing and new home sales topped consensus expectations in September, auto sales rose in October to their highest level since September 2008 and consumer credit increased by $2.1 billion in September, the first monthly increase since January.
Meanwhile, it is not just the consumer that is exhibiting strength. Led by growth in airplane orders, new orders for durable goods rose 3.3% in September after falling 1.0% in August. The September reports for the Chicago PMI and Philly Fed both reveal an expanding manufacturing base – it was the first such increase in the Philadelphia region since July of this year. Factory orders grew 2.1% in September after no change in August and the ISM Manufacturing Index outpaced expectations with an increase to 56.9 in October from 54.4 in September. The ISM Service Index surpassed the consensus with an increase to 54.3 in October from 53.2 in September. Even recent payroll gains reveal an improving trend. Private payrolls increased by 159,000 in October, well above expectations for a gain of 60,000 new jobs. The private sector has now created in excess of 100,000 new jobs per month for the last four months. The last time such a streak occurred was between October 2005 and April 2006 when over 100,000 new jobs were created monthly for seven consecutive months.
The case or lack thereof for QE2 based on empirical economic data notwithstanding, Fed Chairman Bernanke revealed the true secret of QE2 in a recent Op-ed to the Washington Post:
“Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And 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.”
As referenced in last month’s newsletter, the “Fed’s motive may be to ignite the market’s animal spirits”, since targeting “higher equity and real estate prices would boost consumer spending and GDP through what’s commonly known as the wealth effect”. Bernanke could not have been any more transparent that the targeting of asset prices in general and the stock market specifically is part and parcel to its latest phase of monetary policy. So, in addition to its stated “dual mandate” of promoting a high level of employment and low, stable inflation, it seems clear that the Fed also has an interest in promoting a higher stock market as a tool to spur economic activity and help thwart deflation.
Evidenced by the sharp recent steepening of the yield curve, the Fed runs the risk that inflation expectations become unanchored, driving up inflation premiums and interest rates beyond what the market presently anticipates, an unintended consequence that cannot be ruled out. So, while QE2 may indeed drive the stock market higher and may further boost economic growth, we can’t help but think it is potentially toxic for bond investors, particularly for owners of long-term bonds, even as the short-term impact of QE2 happens to drive intermediate interest rates lower. At some point, inflation and interest rates will rise and the Fed, focused instead on its QE exit, will no longer serve as a source of liquidity and buyer of last resort for the bond market. As long as the Fed is a willing buyer of bonds, it may be good policy to sell them.
The steep recent rise in commodity prices is yet another unintended consequence of QE2. While the Fed has targeted the stock market, investors are driving up the price of other asset classes such as commodities, including oil, agricultural commodities, gold and other industrial and precious metals. The extent to which these commodity prices continue to rise could backfire on the Fed as higher energy prices and input prices for consumer goods could eventually dampen discretionary consumer spending.
The rhetoric around simmering currency wars as discussed in last month’s newsletter has become heightened in the wake of QE2 with leaders from China, Germany, Brazil, Russia Turkey, Thailand and Malaysia all lambasting the Fed for “manipulating” the dollar lower. The imminent two-day summit of the G-20 in Seoul, South Korea should serve as an important platform to make sure today’s currency battles don’t end up as tomorrow’s trade wars.
In spite of all the noise around QE2, the recent wave election in favor of Tea Party Republicans bodes well for an imminent compromise on the looming expiration of the Bush tax cuts. Even if the current lame duck Congress does not resolve the issue before year-end, we are highly confident that it will be resolved and made retroactive by the newly elected Congress by early 2011. Eliminating this enormous source of uncertainty is bullish for the economy and bullish for the stock market.
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