Politicians in the US have allowed large parts of the Federal Government to shut down because they cannot agree a budget for the fiscal year that started on 1st October. At first, equity markets seemed relaxed, benefitting perhaps from inflows normally seen on the first of each month/quarter. However, as last week wore on, without any progress on the budget, some caution did set in and equities gave up some recent gains.
The budget impasse, however, plays a second fiddle to the looming debt ceiling which, according to Treasury officials, should be reached on 17th October. If policymakers do not increase the debt ceiling in time then we should expect a serious shakeout in financial markets.
Politics being what it is, we expect a solution to be “crafted” in time for the worst case scenario to be avoided. The solution may not be very elegant, but it should allow financial markets to revert back to normal. But the question is, what is normal?
If we accept the view that the Central Banks’s Operation Twist from late summer of 2011 to December -2012 was a form of QE, then the Fed has been continually printing for over two years and at a rate of US$85 billion per month since last December. QE is now normal! The chart below illustrates the relationship between the Fed’s balance sheet and the S&P 500. As the first phase of balance sheet expansion, QE1 only really gained traction in early 2009 at which time the equity market started to rally strongly. Every time further stimulus has been applied, the equity market has risen. In fact, the only period in the last three years that the Fed stopped stimulating (the summer of 2011) the equity market declined.
By coincidence, the summer of 2011 was the last time that Washington had to raise the debt ceiling. As soon as this was resolved, together with extra stimulus via operation twist, the S&P 500 started to rise rapidly again. With the Fed printing $85 billion per month, the Bank of Japan now printing the equivalent of $75 billion per month, and the ECB ready to do “whatever it takes”, we have to believe that developed market equities will enjoy a rally into year-end once the fiscal impasse is over.
Although we don’t doubt that equity markets will enjoy a year-end rally, there are two important questions. First, from what level does the rally start, and second, just how sustainable is the rally in the longer-term.
The answer to the first question is that it depends on Washington. We suspect that the time to buy will be nearer to the middle of the month assuming politicians will insist on taking important issues down to the wire. The answer to the second question depends on how long the Fed continues with QE, whether the market continues to believe in the efficacy of QE and the architects of QE e.g. Benanke and Yellen, remain (see below).
Having previously been very comfortable with the idea that the Fed would begin to reduce QE later this year and finish by mid-2014 when they predicted that unemployment would be about 7%, we were shocked not just by the “no taper” announcement, but by just how dovish Ben Bernanke was in his subsequent press conference.
The Fed is boxing itself further and further into a corner. If they announce that they intend to reduce QE, markets may take fright and this worries the Fed. On the other hand, if the Fed just keeps going then at some point (at a time when equity markets are likely to be higher though) the unintended consequences of QE will override the benefits.
Will the Fed reduce QE in 2014? Well, that depends on who is in charge from the end of January. If it is Janet Yellen, there is a possibility that she is even more dovish than Ben Bernanke, and QE will not be reduced for a long time. But what happens if Janet Yellen is not the next Fed governor? It has been three weeks since Larry Summers withdrew from the race, and Obama has still not nominated Yellen. Why not? Obama keeps talking about the need for a Fed that does not create asset bubbles and it seems that he is extremely concerned about rising income inequality. It may be that Obama is searching for a candidate other than Yellen who will focus on income redistribution rather than asset price manipulation. That would be a shock to equity markets and would probably stop a year-end rally dead in its tracks.
The chart below shows the share of income in the US going to the top 1% of earners. Whether capital gains are included or not, the message is the same; the top 1% are taking an ever increasing share of the nation’s overall income. It appears that the administration are beginning to recognise this rising inequality and, more importantly, want to do something to reverse it.
We have previously made the case that the Fed’s bond buying has a natural limit because at some point they will own too much of the Government bond market for it to function properly. Furthermore, when they buy US Treasuries, the Fed effectively removes high quality collateral from the repo market, which could cause problems in the event of a market seizure.
So, our near term view is that a year-end rally is likely once the fiscal impasse is overcome. The Fed and the Bank of Japan are printing like mad and the ECB stands ready to do whatever it takes; this combination should be enough to lift asset prices. Most equity markets should rise, core Government bond markets are likely to struggle and the US Dollar should remain under pressure. This party will end at some point, but probably not before year-end unless there is a strong signal that the Fed is ready to start reducing QE.