By Emil Emilov
The Federal Open Market Committee ((FOMC)) minutes from its meeting held on August 9, 2011 were released a few days ago. With the word "uncertain" and its deviations used about 10 times in the document, what the minutes clearly showed was the FOMC members see the US economy as falling behind what they were expecting. That's something the markets started to speak about in June and July and yelled aloud in August.
According to FOMC members, the danger to the U.S. economy is expressed mostly in the continuously higher unemployment level combined with insufficient level of growth. The members expect inflation to cool down during the next months even though they revised their expectation upwards in the report.
A notice worth mentioning was made by one of the members. The member noted that the current high level of long-term unemployment, which as of July accounts for about 44% of all the unemployed, might signal a mismatch between the skills of the unemployed and the jobs currently available. If that proves to be true it would mean an increase in structural unemployment is happening, which could hardly be fought only with monetary or fiscal short-term measures, including any form of QE.
Such a notice is interesting in the light of the rapid technical progress that continues despite the current crisis. The urge to decrease corporate expenses could successfully lead to further mechanization of work activities that were previously done mostly by people. The expenses of introducing new technologies could be offset in the future by decreases in various benefit payments or other types of employee expenditures, including wages. At the same time the continuing long-term unemployment could make many people fall behind the work requirements once the businesses start to hire again.
Let's elaborate for a while on that idea.
The current unemployment data shows the highest unemployment rates to be in Construction and Extraction occupations (13.7% as of July, 2011 down from 15.9% in July, 2010), Farming, Fishing, and Forestry occupations (11.9%, up from 10.9% in July, 2010) and Production occupations (11.5%, down from 12.3% in July, 2010). The lowest rate is in Management, Business, and Financial operations occupations (4.6%, down from 4.7% for an year). At the same time if described by educational attainment the highest current unemployment rate of 15%, up from 13.9% in July, 2010, is seen in the group of people with less than high school diploma. The unemployment rate of those having Bachelor's degree or higher stands at only 4.3% and is down from 4.5% measured in July, 2010.
The data does not automatically support the idea that structural unemployment is in place, as the occupations with the highest rates belong to industries basically involving a high level of human labor and have been hit hardest by the crisis. However the development of unemployment by educational degree suggests that a certain mismatch between the skills of the underqualified unemployed and jobs currently available could be in place. Thus a decline in overall unemployment rates could heavily lag a possible increase of economic activity and GDP.
FOMC members expect the inflation to calm in the next months, mostly because of decreased energy prices and imports. A big part of increased imports were attributed to "increases in spending on petroleum products, mainly the result of higher prices rather than increased volumes". In addition "the large increases in consumer energy and food prices seen earlier this year were not expected to be repeated.” The notion of uncertainty in the businesses about the pace of growth in next quarters contributed to the idea that inflation is not expected to rise in short-term. Core inflation rose in previous months also because of higher prices in motor vehicles due to disrupted supply which lead to lower inventories. In general the participants in FOMC expect the consumption of autos to increase in following months, thus increasing personal consumption. This would affect GDP as well as is expected to decrease the price pressure and core inflation respectively.
All those lower short-term inflationary expectations suggest a QE3 might be an option to FOMC.
At the same time there were concerns expressed by some members that further monetary measures alone may not bring much improvement over the current situation but would only boost inflation. The QE3 has been on the table throughout, but it was opposed as not being sufficient alone to give enough fuel to economic activity. There were voices saying that a combination of monetary and more fiscal measures should be adopted. I believe that was one of the core reasons Mr. Bernanke in his speech last Friday took time to address U.S. policymakers by saying that "most of the economic policies that support robust economic growth in the long run are outside the province of the central bank." Reuters reports of a mortgage relief plan as a possible inclusion in the President Obama's speech on job creation next week which could be the first step of a pack of measures.
What would a strong QE3 mean to inflation, growth and financial markets?
The past year has shown the impact of quantitative easing on commodity prices given an economy not sufficiently strong enough to soak up the liquidity. The idea that additional easing will not have an inflationary effect is in conflict with what history teaches us.
If another round of easing were to pass, we would see a significant increase in commodity prices. A weakened US Dollar would not be able to boost exports in a weak global environment sufficiently as to offset the higher prices of petroleum products paid and higher manufacturing costs. The higher energy and food prices would again slow growth and erase any possible increase in the nominal income of households by increasing inflation.
For investors a strong QE3 could present short to medium-term profit opportunities in the commodities and metals. One option would be in the United States Oil Fund (USO) ETF, which has an expense ratio of 0.45% and is currently priced around $34.50. If oil prices were to climb to their previous highs, set back in May, the fund would appreciate significantly. For the more risk-loving investors the Ultra DJ-UBS Crude Oil (UCO) could be an option, too. The ETF uses derivatives to leverage the gains to the fund. Its expense ratio (.95%) is higher to cover the additional management and operations and currently trades around $35.
A weaker dollar would also reinvigorate the gold trade. Central bankers are no doubt looking at ways to decrease their exposure to the world’s reserve currency and another round of easing might exacerbate this trend. For gold exposure, the popular choice is in the SPDR Gold Trust (GLD), which tracks the spot price of gold. An article by Efficient Alpha contributor Joseph Hogue was published last week presenting a possible pair trade in GLD and the Market Vectors Gold Miners (GDX). Either fund will do well with a weaker dollar and increasing gold prices.
The currency trade would be a short position in the dollar with an accompanying position in foreign currencies. Commodity exporters, notably in Latin America, would see their currencies appreciate with the increased liquidity and higher commodity prices. The dollar short can be achieved through the DB USD Index Bearish (UDN) while the long component can be achieved through a variety of fund options.
Over the long-term, however, monetary measures alone could hardly support enough growth and history would repeat with higher inflation and low economic output. Keeping in mind the effect of previous QEs and the opinions inside the FOMC itself, a combination of stronger fiscal stimulus measures and a lighter form of QE seems to be a more favorable option. If that happens to be the case and aggressive monetary easing comes off the table, investors could expect a marginally stronger US Dollar and stability in commodities. The trades listed above, while they would still benefit from easing, may need to be reversed.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: The views expressed by the author are his own and do not necessarily reflect the views of Efficient Alpha or its consultants. Investors should perform their own due diligence before making investment decisions.