Market Viewpoints

Summary

Last week, the US Federal Reserve began buying short-term US Treasury debt at an initial pace of $60 billion a month, but Fed Chair Jerome Powell insisted it was not Quantitative Easing (QE). Whether this round of asset purchases is QE or not, is a moot point, and there is no point quibbling over this. Most importantly, these operations expand the Fed’s balance sheet. Over the last ten years, we have had QE1, QE2, QE3, Operation Twist, and now “Not QE”. The US government is running a trillion-dollar annual deficit, without any plans to reduce it, and the Fed will be forced to run more “Not QEs” to make sure these deficits are sustained. We are likely to see more QE sequels than Star Wars movies!

Last week, UK Prime minister Boris Johnson pulled off a remarkable political coup, proving his detractors wrong. The Withdrawal Agreement was reopened, the Irish Backstop was abolished and the regulatory alignment was watered down. Johnson’s passionate plea to colleagues to back his Brexit deal however fell on deaf ears in Parliament. Instead, an amendment requiring Johnson to seek a delay to allow for more scrutiny of the details of the deal was passed. Johnson had no choice but to send a letter to the European Union (EU) seeking to delay the UK’s departure from the bloc, for the third time.

The US Congress is weighing the impeachment of President Donald Trump, the Middle East looks unstable, Brexit remains unresolved, Germany is “in recession”, China’s GDP growth is at a 30 year low of +6% and the US and China are still mired in a trade war – yet last week, the S&P 500 index (SPX) climbed above the 3,000 level and is now within 2% of its all-time high. Well, look no further than the Fed for answers!

Quantitative Easing by any other name

The US Federal Reserve (Fed) is buying assets again; just don’t call it Quantitative Easing (QE). At least that’s what Fed Chair Jerome Powell would like you to think.

Last week, the Fed started buying short-term US Treasury debt at an initial pace of $60 billion a month, because officials concluded that the Fed had shrunk its balance sheet too much and caused the recent dislocation in the money markets. Last month, a sudden need for cash led the overnight lending rates to jump to 10% in the repurchase, or repo market, and the Federal Funds rate briefly rose above the Fed’s target range, forcing the New York Fed to intervene and inject emergency cash into the system.

In a question-answer session at the National Association for Business Economics (NABE) meeting in Denver last week, Powell said – “This is not QE. In no sense is this QE”, and added – “I want to emphasise that growth of our balance sheet for reserve management purposes should in no way be confused with the large-scale asset purchase programs that we deployed after the financial crisis.”

It’s interesting that in January 2009, former Fed Chair Ben Bernanke had a similar refrain. At the Stamp Lecture at the London School of Economics, titled “The Crisis and the Policy Response”, Bernanke said – “The Federal Reserve’s approach to supporting credit markets is conceptually distinct from quantitative easing, the policy approach used by the Bank of Japan from 2001 to 2006 “. Bernanke also told everyone that he wasn’t monetising the national debt because he had an exit strategy. The Fed then went on to conduct QE1, QE2, QE3, Operation Twist, and now we have “Not QE.”

The US government is running a trillion-dollar annual deficit, without any plans to reduce it, and the Fed will be forced to run more “Not QEs” to make sure deficits are sustained. We are likely to see more QE sequels than Star Wars movies!

US Federal Reserve balance sheet in millions USD

Source: Bloomberg

Whether this round of asset purchases is QE or not is a moot point and there is no point quibbling over it. Just as a rose by any other name is a rose, when a central bank prints money to buy government bonds, then it is QE by any other name. This recent operation, therefore, at least in scale – $60 billion per month – is akin to past QE operations. Recall, the Fed bought assets at the rate of $75 billion per month during QE2 (2010-11) and $85 billion per month during QE3 (2012-13).

In addition to $60 billion in Treasury bills, the Fed is buying up to $20 billion every month in a wider range of Treasury securities to replace maturing mortgage securities. Therefore, in aggregate, the current purchase rate is at $85 billion per month i.e. similar to the QE3 rate. Most importantly, these operations expand the Fed’s balance sheet – and that is generally risk positive, as it adds liquidity to the market.

The purchase of assets will focus on short-term Treasury bills. Thus, this operation will not support asset prices in the same way as past QE operations, which focused on longer maturities. This should be positive for bank stocks as it will help the yield curve steepen moderately as long end rates are not subdued. It will also meet the demand for interest-bearing reserves for banks to park excess cash in.

“Super Saturday” but no super ending

This past weekend, UK Prime Minister Boris Johnson opened the first Saturday sitting of the House of Commons in 37 years- in what was billed as “Super Saturday.” This was the day that the House Commons would finally approve the Withdrawal Agreement (WA) that would see the UK leave the European Union (EU) and transition into a new set of EU-UK discussions with the prospect of a Free Trade Agreement (FTA) by December 31, 2020, at the earliest.

However, “Super Saturday” didn’t live up to its marquis billing, and, with a somewhat lackluster outcome to the first sitting on a Saturday since the Falklands War in 1982, the Withdrawal Agreement didn’t even come up for a vote! Johnson’s passionate plea to colleagues to back his Brexit deal and “heal this country,” fell on deaf ears. Instead, an amendment requiring Johnson to seek a delay to allow for more scrutiny of the details of the deal was passed by a majority of 322 to 306. Johnson had no choice but to send a letter to the EU seeking to delay the UK’s departure from the bloc for the third time.

Passing the deal on Saturday would have probably released some of the tension that’s built up in the country on both sides of an increasingly polarised Brexit divide, but politicians wanting the UK to remain in the EU had their way, once again.

Yet, early last week things were looking all so positive. Johnson pulled off a remarkable political coup, confounding his detractors in both Parliament and the media, by securing a new deal with the EU. For weeks Johnson was pilloried for suggesting that he could persuade the EU to reopen the Withdrawal Agreement and abolish the “undemocratic” Backstop. Johnson’s threat of “No deal” was seen as more an act of self-harm and national humiliation rather than a serious negotiating tactic. Conservative MP Rory Stewart channelled the disdain that Remainers have for Johnson’s negotiating tactics by saying – “Anyone who knows anything about Europe can assure you there is not the slightest hope of getting a new deal through Europe by 31 October. Not a hope.”

How wrong they were made to look as the Withdrawal Agreement was reopened, the Backstop was abolished and the regulatory alignment was watered down. Unlike former UK prime minister Theresa May’s deal, which would have left Britain a rule-taker and regulatory satellite of the EU, Johnson’s deal represented a clean break from the EU. The UK would no longer be bound by EU laws, taxes or the jurisdiction of the European Court of Justice (ECJ) or the rules on immigration. Gone were the legally binding “level playing field” commitments which would have scuppered future trade deals that the UK looked forward to signing. The renegotiated deal was a diplomatic and negotiating triumph for a PM who had been in office for less than 3 months. The cherry on the cake would have been the approval of the deal by the House of Commons- but it wasn’t to be.

So, we move on to more delays. As I mentioned in the September newsletter, a general election couldn’t come soon enough.

An election victory and a Conservative majority government is the prize Johnson is seeking as he knows full well that the next stage of negotiation with the EU, to get an FTA, will be even more torturous. Only a majority government, speaking with one voice, strengthens the UK’s and Johnson’s hands in such negotiations. Thus far, Johnson has played it remarkably well, put himself firmly on the right side of history and is set for a victory despite the efforts of the overwhelmingly Remain Parliament to thwart his efforts. The more games the Remainers play, the more they damage themselves. Brexit will be over soon, but the personal damage the Remainers have inflicted on themselves will endure. MP Rory Stewart is also on the record to have said the following:

“If he (Johnson) does get a deal through, I would not stand again. I would be the first to apologise. I would get down on bended knees in front of Boris and admit I’d been wrong.” I look forward to Mr. Stewart getting down on bended knees in front of the prime minister.

Markets and the Economy

The US Congress is weighing impeachment of President Donald Trump, the Middle East looks unstable, Brexit remains unresolved, Germany is “in recession”, China’s GDP growth is at a 30 year low of +6% and the US and China are still mired in a trade war – yet last week, the S&P 500 index (SPX) climbed above the 3,000 level and is now within 2% of its all-time high.

What’s going on you ask?

Benchmark Equity Index Performance (Year-to-Date)

Well, look no further than the US Federal Reserve for answers. As outlined in the section above, the Fed is back expanding its balance sheet and having cut rates twice this year, the odds for a rate cut at the Federal Open Market Committee (FOMC) meeting next week are approximately 90%. Therefore, the risk of an imminent recession in the US looks very slim. US equities are headed higher. Expectations that the major central banks will step in to prevent an economic downturn in their economies have made it easier for folk to stay invested in stocks.

US Housing starts, another key piece of economic data (chart below) still show no signs of rolling off. The 12-month moving average smooths out the volatility in this monthly data. This moving average has peaked and rolled over well ahead of every recession dating back to 1967. The current set of data has started to turn higher again.

US Housing starts in millions (12-month moving average)

Source: Bespoke Group

In another positive sign, the New York Fed’s recession probability model (discussed in September’s newsletter) which reached 38%, recently down ticked to 34.8% (chart below). Keep in mind; this model looks at the 3-month / 10-year yield spread. With this spread now in positive territory, the NY Fed’s recession indicator has likely peaked and a recession has been averted for at least two quarters, if not more.

Source: New York Federal Reserve

The SPX is up +19% for 2019 but less than +5% since January 2018, i.e. this year’s stellar performance is more of a catch-up rally and not an out-performance versus expectations that investors have from stocks. Meanwhile, the Fed’s support and Chair Powell’s rhetoric, make investors feel that the Fed has their back.

In signs of how things are changing in the world of asset management, brokerage firm Charles Schwab which cut commission fees for online trading in US stocks, Exchange Traded Funds (ETFs) and options to zero and saw its quarterly revenue rise will now let investors buy and sell fractions of shares in the coming months. Cheaper access means more investors. It is worth noting that of the most well-known and popular companies have high price tags, making owning a share difficult for smaller would-be investors. A share of Amazon.com for example costs around $1,765. Trading fractions of shares would help small investors diversify their portfolios by spreading relatively small pots of money over a broader range of stocks. This would also increase trading volumes and attract new investors to equity trading. That would, in turn, increase the liquidity and breadth of the US stock market. All welcome developments.

Eurozone stocks have had a good run for the last three weeks and this is likely to continue. You will recall in September’s newsletter, I made a case for Eurozone equities, on the back of the new round of QE by the European Central Bank (ECB). The rationale being that the presence of a persistent buyer in the form of the ECB means that the Eurozone sovereign bond yields will not rise for at least the next five years. Furthermore, drastic reductions in interest expense, will, therefore, have enormous implications for Italy and other similarly indebted Euro area economies. It will automatically free up considerable room for fiscal stimulus. Eurozone bank stocks (SX7E), are the biggest beneficiaries as their recent performance has indicated – up over +10% in the last three weeks.

Globally, monetary policy will remain on the easy path and neither the Fed nor the ECB will raise rates anytime soon. In the Eurozone, the annual rate of inflation fell further to +0.8%, well below the ECB’s target for price rises, which is set at just under+2%. Therefore, I feel very comfortable holding on to long US and Eurozone equity positions. If growth in China and the Eurozone trends up, helped by a fiscal stimulus in their respective economies, then there is little (if any) concern of a market sell-off for the rest of this year.

In the US, I prefer to be long Financials (XLF), Consumer Discretionary (XLP), Energy (XLE), Healthcare (XLV) and Industrials (XLI) stocks with an overweight position in Energy and Healthcare as the two sectors play catch up for the year. Individual stocks in the Technology (XLK), Communication Services (XLC) and Materials (XLB) sectors also offer good upside. For specific stock recommendations, please do not hesitate to get in touch.

Best wishes,

Manish Singh, CFA