By Joseph Hogue, CFA
The Fed’s policy of Operation Twist, allowing short-treasuries to expire and buying long-term treasuries, will be completed in June. Though the outcome has generally brought rates down and accomplished its intent, the economy is still entirely too sluggish going into next year. Last week brought more meetings, summits, and rumors on the European front, but there is little evidence that the sovereign debt crisis is anywhere close to being solved. With global growth trending down, things may get worse before they get better.
As inflationary expectations come down, this opens the door for more easing or policy adjustments by the Fed. The Federal Reserve’s forecast for core PCE inflation in 2012 is between 1.5% and 2.0%, slightly lower on the downside than their 2011 central tendency of between 1.8% and 1.9%.
A More Accommodative Fed
The most vocal dissenters among Fed voters this year have been Governors Plosser, Fisher, and Kocherlakota. Dallas Fed President Fisher, whose stance is a far cry from more accommodative members like Bernanke and Yellen, has compared inflation to a, “sinister beast,” and has insisted that monetary policy must be complemented by responsible fiscal policy. While this may be true, waiting for responsible fiscal policy from Congress before enacting any further stimulus would leave us long in waiting. Fisher, and fellow voting member Plosser, use terms like ‘printing press’ freely to express their stance on accommodation. Whether you agree with the Fed Hawks or not, the central bank is about to make a hard left in terms of voting members next year and it may present an opportunity for investors.
The ‘Hawk-o-Meter’ shown below, provided by CRT Capital, shows the change in voting status effective after this week’s Fed meeting. Notable are the non-voting membership of the three hawks, replaced by Williams, Pianalto, and Lacker. As Operation Twist winds up and the U.S. economic picture drags on, the Fed will be increasingly likely to announce some additional measures. Recent speculation has revolved around some form of policy with mortgage backed securities (MBS) but it’s unknown if this would entail outright expansion of the balance sheet, selling shorter-term securities, or some change to Operation Twist.
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A useful source of information may be the returns to specific sectors and the overall market for the preceding forms of Fed accommodation. The chart below, from the website Calculated Risk, shows the timeline for the previous two rounds of quantitative easing against the S&P500. Whether the accommodative policies actually aided the economic recovery or not there is certainly a relationship leading to strong gains in the markets.
Next, we look at the returns to the S&P500 SPDR (SPY), its nine sector funds, and the iShares MSCI Emerging Markets Fund (EEM) for four periods; during QE1, from QE1 to QE2, during QE2, and QE2 to present.
On average, the market rose by 29.7% from the time QE1 was expanded in March 2009 to when the policy terminated around May of 2010. From that time until Bernanke’s QE2 ‘hint’ at Jackson Hole in September 2010, the market only increased by about 0.2% with some sectors seeing notable downward movement. Markets rose again during QE2 by about 20.4% but have since fallen by 6.1% after the expiration of the second round of easing.
From the sector analysis, four groups significantly outperformed the market during QE1. The Industrial Select SPDR (XLI), Consumer Discretionary Select SPDR (XLY), Financial Select SPDR (XLF), and the MSCI Emerging Markets Fund were the top four performing sectors during the period. This relative performance was repeated during QE2 for the industrials and the consumer discretionary funds. A particularly strong relationship may exist between the industrials and easing as the sector was also one of the top laggards within the non-accommodative periods.
Of note is the contrary performance in the Utilities Select SPDR (XLU) relative to the other sectors within the four periods. The utilities sector was the top performing sector during both the non-accommodative periods and the weakest sector during easing. As a regulated market, utilities would not be able to pass along price increases with rapid inflation and the typically defensive nature of the sector may have contributed to the performance.
I do not expect much in the way of policy change or language from the Fed’s meeting this week, but will be watching economic data during the first half of next year. Europe is widely expected to slip back into a recession in the first half and forecasts for Chinese GDP are as low as 7.5%. If we were to see little improvement in U.S. data, I think it is a fairly good bet the Fed will hint at policy changes before June’s expiration of the Operation Twist program.
In this scenario, investors would overweight industrials and consumer discretionary, while underweighting utilities. I am also positive on the financials and emerging markets though the analysis here is more detailed than simply the relationship with easing. Among specific companies, investors could look to the largest share holdings within the funds.
General Electric (GE) makes up 9.7% of the industrials fund while sporting a higher dividend (3.6%) and a lower price-to-earnings ratio of 12.5 times trailing earnings. The $173 billion company is fairly diversified across technology, industrials, energy, and services so may not be a pure play on the sector.
McDonald’s (MCD) totals 8.2% of the consumer discretionary fund, though some consumers might argue that two all-beef patties on a sesame seed bun is hardly discretionary. The company is relatively more expensive than the fund with a trailing p/e of 19.1 times but pays a higher dividend yield at 2.9%.
The Southern Company (SO) makes up 8.9% of the utilities sector fund and operates generally in the southeastern United States. Electrical generation is fairly well-diversified across coal, nuclear, oil/gas, and hydroelectric. The company beats out the fund’s already high dividend with a yield of 4.2% but is also more expensive at 18.0 times trailing earnings.
Conversely, if global economic data does not continue downward or if U.S. numbers come out particularly strong, many of these sectors may perform well despite the lack of additional easing. Financials, down 16.0% over the last twelve months, would certainly rebound given better economic data and reduced uncertainty as would the emerging markets.
Granted, this is a relatively arbitrary way of looking at the effects of monetary easing and the markets. Other factors played key roles within the time periods and specifics to each program will mean different effects to different sectors. Going forward, future easing may not affect these sectors as in the past. Looking at past performance, combined with what we know and hear out of the current environment, can help to take advantage of opportunities as they present themselves.
Disclosure: I am long XLF.