2013 is going to be bumpy.
Consider my forecast for the S&P500 below and where we are now at point G, and past accurate calls I made at points A, B and C.
Source: Own forecast based on market available data.
A: I warned that the US economic recovery was in serious danger of stalling following an exuberant NFP report: - see the article here. Over the next 2 weeks, 200 points were wiped off the S&P500.
B: While most investors were trying to understand what the ECB LTRO program was, I put it into a wider context of coordinated central bank action to explain its removal of uncertainty by underpinning asset prices and reducing volatility, while creating other types of uncertainty - see the article here. The S&P500 rallied shortly afterwards with very little volatility until it hit about 1400 and the upper bound of the forecast band.
C: Using a previous forecast similar to this one, I suggested that the market had priced in the latest QE which was about to be announced. The event would likely be followed by limited upside, a correction of 50-100 points and then resumption of the upward trend - see the article here. This has come to pass, and we find ourselves at point G.
The forecast in the figure above is an updated version of my previous published forecast1.
Last week we had two significant events: negative US GDP growth and increasing unemployment. Yet the market appears hooked on QE and appears convinced that the Fed has our backs. This might not be the case, and the market could get very bumpy very soon. The rest of this article explains why and what would trigger the bumps.
QE in Context
To put QE in context, consider the S&P500 performance around points D, E, F and G. The market at other times has been trading inside the forecast channel.
D: US Fed refuses to act as Lender of Last resort to Lehman Brothers, leading to a collapse in banking confidence. The market quickly works out it will have real economic consequences as there is a re-pricing of banking risks and the financial sector, a wholesale funding freeze and a subsequent deleveraging of banking assets. The ongoing restructuring placed immense liquidity pressures on many banks and a threat to the monetary policy transmission mechanism: enter QE.
E: The Fed begins to morph QE1 into a short term monetary policy measure to support the economy, as the recovery is weak. The knock-on effect is to support equity prices, which once QE1 ends, return to channel and price on fundamentals. At its height, the S&P500 is trading about 150 points rich compared to underlying mean expected value.
F: The Fed, concerned with the pace of economic recovery, launches QE2, and ends it at a time when the economy, while growing, has significant weaknesses (point A). Once again, the market trades outside the channel during QE2, rapidly returning to lower half of the channel on weak fundamentals once QE2 ends. At its height the market is about 100-150 points rich compared to underlying mean expected value.
G: Continued weakness in the economy leads the Fed to announce open-ended QE3 followed by an extension in December 2012. The market anticipated the first part but wasn't sure about the arrival of the second part. With private sector debt shrinking, spare capacity in the economy and the velocity of circulation of the money supply going down, there is room for the Fed to increase money supply in support of economic growth without threats to inflation. This particular flavor of QE is designed to operate through the asset price channel, and there has been an upward pressure on stock prices since. We are currently trading about 150 points rich compared to the underlying mean expected S&P500 value.
Open-Ended QE Is Not Never-Ending QE
The Central tenet of US Fed monetary policy is and remains interest rates.
With the addition of a 6.5% unemployment threshold to signal when the Fed will begin to consider firming these, and a Fed forecast of 6.5% unemployment for 2015 (or beyond), there is a clear signal that these will remain low.
This does not mean QE will last until unemployment falls to 6.5%. Indeed the Fed cautions that
If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until such improvement is achieved in a context of price stability…. [and] appropriate account of the likely efficacy and costs of such purchases.
Source: US Federal Reserve FOMC Press release, 30 January 2013
(my own emphasis added)
My interpretation of this is that the US Federal Reserve is looking to taper QE4.
The criteria for doing so are:
- increasing asset prices (its objective for QE4 which is on the way to being achieved in the housing market, and look at the equity market!);
- falling unemployment (at least in line with the optimistic end of it central forecast);
- inflation approaching or exceeding 2% (ignoring transitory effects).
With QE starting out as liquidity support for the banking system, it has now morphed into a fully fledged economic support tool. Will the conditions for pulling QE arise sooner rather than later?
Capitol Hill Shenanigans in Context
While the politics of The Hill will certainly move markets one way and another, both parties are committed to reducing the difference between Government spending G and Taxation, T.
In all economies at any given time, the following relationship must hold:
(G-T) + (Investment-Savings) + (Exports-Imports) = 0
The US is a net importer of goods and services (approximately $740bn trade deficit) with a government deficit of $1 trillion. These numbers imply the difference between investment and savings is about $260bn, largely funded as capital flows from abroad, but increasingly through a reduction in US domestic private sector debt. A reduction in the government deficit, G-T would have to be met by a combination of reduced savings, increased investment or an increase in the trade deficit.
With energy imports making up almost half of the trade deficit, and in decline given the growth of shale gas and US oil production, non-energy imports could rise, with goods and services from abroad substituting for US production. Combined with a reduction in government spending, both effects could lead to an increase in unemployment and weaker economic growth (than forecast).
To maintain growth and employment, the likely reduction in government spending has to come from investment growth and not a reduction in savings or increase in net imports. With private sector net debt being paid down, the main changes in the Investment-Savings balance has to come from an increase in investment and/or a decline in the net inflow of capital to the US. If foreign investors start selling government bonds, this will put upward pressure on interest rates on the one hand, and will weaken the dollar on the other.
The US Fed may face difficulties to neutralize this with bond purchases for two reasons. Firstly, through Operation Twist, the US already has a large position in government bonds and so has limited scope for buying government debt if it were to be sold off by foreign investors. Secondly, purchasing government debt from foreign buyers offsets the only potential benefit which is a weakening of the US dollar and improved US competitiveness.
With the US Fed committing to low interest rates to encourage investment (further reduction has no meaningful impact on the real economy), the only way to ensure growth in investment is by inflating the price of investment assets, making them more valuable relative to the prevailing interest rates: i.e. direct purchase and QE4's emphasis on buying asset backed securities.
Thus, QE4 can also be thought of as an insurance policy against Capitol Hill; it is aimed at trying to channel the forthcoming structural changes in the US economy into increased Investment. In the process, funds are rotated out of government bonds into private sector investments.
What if Capitol Hill Shenanigans ended as only a can-kicking exercise?
The dangers of a credit ratings downgrade (increased interest rates) could lead to capital flight, a weakening of the US dollar with uncertain effects surrounding reduced investment on the one hand and increased competitiveness on the other, with the latter taking some time to come into play. Inflating US asset prices and encouraging investment relative to the interest rate helps to insure against such effects by boosting economic growth relative to the size of the government deficit.
Monetary Policy in uncharted territory: what does it mean for Investors
QE4 has taken central stage as the policy supporting the economic recovery via a single channel: flow of funds into Investments and corresponding inflation of asset prices relative to returns and interest rates.
Make no mistake that the Fed Policy involves artificial asset price inflation, which the Fed thinks it is in control of. Notice how, when S&P500 values have become inflated outside the trading range at points E, C and F above, they exhibit increased volatility. We are at a similar stage right now.
Volatility of an S&P 500 bouncing up and down off the upper bound however, is small compared to a possible 150 point mean reverting move that could occur in a very short space of time.
The factors that could make such a downside move are a rise in unemployment and reduction in GDP arising from a combination of reduced government deficits, outflow of capital and increased net imports.
Consider the situation where equity prices continue inflating to higher P/E ratios. It becomes obvious that
- at some point in the future (possibly well before 2015) the Fed will begin firming policy and trying to take asset prices off life support;
- investors will find more attractive P/E ratios elsewhere as the Fed stimulus ends;
Either or both events put a cap on upside potential while opening the way to mean reverting downside moves. While no one doubts the Feds' commitment to recovery, questions remain about its likely success.
There is great uncertainty, from an economic point of view, of the extent and nature of US Fiscal restructuring, and the channels into which it could play. Additionally, there is uncertainty about whether these can be offset, not just mitigated, by QE4.
Furthermore, the Fed policymakers will have understood the extent of the above links and the size of the burden they have placed on their own shoulders, and at least some must have trouble sleeping at night. Watch for leakages and odd statements as committee members crack under pressure.
As markets begin to realize the size of the lifting task to be done by QE4, they will be watching closely both future policy announcements and the restructuring of the US economy towards a more sustainable debt path during 2013. We are already in an S&P500 asset bubble. Watch out for it bursting. Given the Fed's commitment, the burst may not be soon. But there is a growing awareness of how closely linked REAL economic recovery is with current monetary policy. I hope this article has helped to explain the linkages in greater depth.
A Final Few Words
As the figure shows, we already have a slight trough ahead of us in 2013 that would represent "normal" market corrections, leading to a possible 100 point fall in the S&P500 from where we are now.
I have shown QE4 lasting beyond this trough, until the end of Q3 2013. This is only an illustration. I feel that is the first real point at which the Fed will begin to firm its "highly accommodative" monetary policy as it waits to get past the trough and the additional events surrounding it.
- Prior to Q3 2013, the US Fed's language will begin to change. The Fed has indicated its commitment to Operation Twist until the end of 2013, leaving QE4 as the main source of adjustment to monetary policy.
- The Fed will be watching closely the net balance sheets of banks for signs of increased credit growth and any growth in the velocity of circulation of money, both of which will signal inflationary pressures.
- The QE4 asset purchase program is likely to be tapered in stages: from $40bn per month to $30bn to $20bn.
- By Q3 2013 there will have been clarification of the nature and extent of the effects of fiscal restructuring (G-T) and broadly speaking they will most likely be going in the direction expected by the Fed and as outlined above. However, how far and to what extent the market comes to believe the effects are a result of Fed actions vs economic forces outside the Fed's control will determine the speed at which the market reverts to channel and how volatile it is.
- Currently volatility is cheap while the market is generally net long with a strong feeling of things being alright and on their way to getting better. In these market conditions, the downside moves tend to happen very quickly.
- In current market conditions, I believe maximum upside to S&P500 is around 1550 by the end of Q1 2013. Capitol Hill Shenanigans could cap that much sooner. Increased Volatility will be noticeable, particularly in Q22013.
- Trading range in Q22013 and Q32013 is likely to be 1400-1500. Any firming of Fed policy sooner and bad timing on their part (equity prices contrary to popular belief are a low priority) could lead to a drop to the lower bound of the forecast.
- Other events not discussed here will of course have an impact on forecast and future price developments
1 The forecasting method and accuracy has been explained in this previous article (with strengths and weaknesses discussed extensively in the comments). In a follow up article, I was surprised that the Fed effectively raised its GDP forecast for 2013-2014, which it has subsequently revised downwards following the December FOMC meeting.