The most hilarious (and tragic) thing about QE3 is that if it doesn't work (i.e. if unemployment doesn't fall) the Fed gets to keep on buying securities. How ironic. While there are surely numerous examples of instances where policymakers pursue failed policies in perpetuity, this might well be the only example wherein the cost of being obstinate is $40 billion per month. Indeed, the odds seem to be in favor of it not working, as noted by John Goltermann of Obermeyer Asset Management:
"While it's not clear that the Fed can do anything about long-term unemployment, it's not shy about trying. The Fed has been highly accommodative for twenty years, but unemployment is far higher now than it was at any time during the past two decades." (emphasis mine)
The fact is -- and the Fed itself has been very explicit about this -- the real near-term threat to the economy is the looming fiscal cliff which, without some kind of resolution, will result in $600 billion in tax increases and spending cuts beginning at the first of next year. Last Thursday, after announcing QE3, Ben Bernanke said in a news conference that
" ... if the fiscal cliff isn't addressed ... I don't think our tools [monetary policy] are strong enough to offset the effects of a major fiscal shock ... fiscal policymakers [really need to] work together to try and find a solution for that."
Indeed some analysts have gone so far as to say that QE3 is flat out inconsequential as far as the fate of the U.S. economic recovery goes in light of the upcoming tax hikes and spending cuts. Morgan Stanley, in a note dated August 13, cited the high degree of fiscal policy uncertainty as an important headwind to U.S. economic growth and went on to downgrade its outlook for U.S. GDP growth over the four quarters of 2012 to 1.6% from 2.0% based on "disappointing results for retail sales and capital spending" coupled with high gasoline prices.
Morgan Stanley notes that according to a new measure of policy uncertainty developed by Scott Baker and Nicholas Bloom of Stanford University and Steven Davis at the University of Chicago, uncertainty about U.S. economic policy is near an all time high:
The circled points in the chart are in order from left to right: Lehman collapse, the debt ceiling debate, and the current countdown to the fiscal cliff. Disturbingly, Morgan Stanley notes that the architects of the index found a statistically significant relationship between the index and economic outcomes.
Presumably there will be some resolution to the fiscal cliff issue. Morgan Stanley's prediction is for a last minute fix which extends the Bush tax cuts and delays spending cuts while
" ... the remaining tightening of fiscal policy related to the expiration of the payroll tax cut and the imposition of spending cuts from previous budget appropriations legislation is expected to amount to about 1.5 percentage points of GDP - enough to generate some further slowing in economic activity during early 2013."
Such a drag is likely to ensure that the Fed can justify more asset purchases in the name of promoting growth. As for the effect of those asset purchases on growth, here's Morgan Stanley:
"Our economic outlook is unlikely to be meaningfully impacted one way or the other by ... QE."
While Morgan Stanley's outlook for the economy may not be meaningfully impacted, stock market returns are riding entirely on the ability of QE to deliver on its promise. Consider that the mechanism by which QE is supposed to stimulate the economy is via the so-called "wealth effect." In Bernanke's words,
" ... if people feel that their financial situation is better because their 401(k) looks better or for whatever reason -- their house is worth more -- they're more willing to go out and spend, and that's going to provide the demand that firms need in order to be willing to hire and to invest."
In other words, if by boosting stock prices and home prices the Fed can make people feel richer, they will spend more, boosting demand for products which will in turn drive profits and hiring. The stock market is betting more on this working than you might realize. Consider the following chart which shows revenue growth for the S&P 500 as a whole (orange) and revenue growth for consumer discretionary stocks (black):
As you can see, the market is betting (in a big way) that consumers are indeed going to feel richer and spend more. In Q4 the Street is projecting S&P revenues to grow by only 1.76% while consumer discretionary revenues are projected to grow at 3.2 times that rate (5.69%). You can also see from the graphic that this was certainly not the case in Q4 of last year. As ZeroHedge puts it,
" ... in the past these [S&P 500 revenue growth and consumer discretionary revenue growth] have tracked quite closely - and yet suddenly as aggregate revenues plunge, discretionary revenues will grow exponentially!"
Of course it is quite difficult to imagine how consumers can possibly feel so good about their financial situation when zero interest rate policy (ZIRP) has been sapping the returns they get from income generating investments and savings accounts. Indeed, real rates are negative:
Ultimately then, the market expects consumers, tapped-out by years of ultra low or negative real returns on their income generating investments, to carry stocks -- and indeed the entire economy -- forward via a sudden propensity to spend in the midst of the uncertainty occasioned by the fiscal cliff debate. Strangely, the trigger for this is supposed to be newfound optimism based on an increase in the value of retail investors' equity mutual funds. Apparently the Fed doesn't look at ICI data very often -- retail investors have pulled over $200 billion from domestic equity mutual funds in just over 12 months. In other words, they don't have any stocks left to look at in order to feel richer.
As I outlined in a previous article, the post-QE rally has historically lasted around six weeks. This would put the rally ending just around the election and just in time for both the holiday season to disappoint in terms of the consumer coming to the rescue and the fiscal cliff debate to take center stage. For me, this is compelling enough to recommend a short position in U.S. stocks going into the holiday shopping season.