Tuesday, June 25, 2013

To QE or not to QE

tread carefully in writing this article because whenever anyone discusses the pseudo-religious issue of investing fundamentals and/or why markets move, he is usually met with a gale of fundamentalist abuse. In this case I’m talking about the recent falls in various asset classes, which were caused by Ben Bernanke’s recent statement . I want to look at why the market reacted the way that it did. What does this say about how readers might evaluate investing? In which stocks can we see the repercussions of these changes?

To QE or not to QE, that is the question

In short, the Federal Reserve is expected to reduce bond buying this year because the economy is in better shape. It also expects to end it in 2014, but these expectations are entirely contingent upon the economy getting better. Furthermore Bernanke stressed that he was willing to add whatever support was necessary if the economy didn’t improve. The optimistic among us would conclude that this is actually good news because it confirms that the Federal Reserve believes the economy is getting better. So why did the market sell off so aggressively?

I think the answer is that a new generation of investors is now conditioned to think that asset classes move in tandem with liquidity provision by central banks. ‘Oh look the Federal Reserve is doing more quantitative easing! buy, buy, buy!’ or ‘the latest PMI numbers were crumby but hang on, that means the Federal Reserve will be forced to do more QE!! Buy!’

And lest anyone think this is only a national game, consider the European Central Bank (ECB): ‘What’s that? The Europeans are now writing off hundreds of billions of debt from countries like Greece and also buying their debt in order to keep them solvent? Sounds like QE to me! Buy, Buy, buy!’

How it started and why it has gone on

In truth this all started in 2008 when we all realized (bar some Austrian School enthusiasts) that the global economy would have been toast without massive injections of liquidity from central banks. In a sense we have all lost a certain amount of confidence in the global economy and are more focused on the immediacy of QE as a catalyst for positive equity market returns.

The pattern has been set, and the die has been cast. I guarantee you that after the speech made by Bernanke (and the market falls) the only topic of discussion among young ‘hot-shot’ investors will be over liquidity injections in the marketplace because that is what has guided the returns that they are judged on.

Will it always be like this?

The tricky bit now will be to ascertain whether investors can rid themselves of the notion that markets only move based on QE injections.  If so then good old fashion notions like evaluations and maybe even the equity risk premium could make a comeback. You may say Warren Buffett is a discounted cash flow dreamer, but he’s not the only one. Frankly I have no idea if this will be the case or not but I observe that this type of investment conditioning can go on a lot longer than people think.

What are the stocks to look for?

The key thing in the short to mid-term is to look at the sector/company results for those that are the key markers of the effects of QE.  Within housing, the idea is that as QE is scaled back, the stimulus behind the housing recovery will be reduced.  A key beneficiary of housing would be something like Home Depot (NYSE: HD).

It recently said that it was seeing a broad based recovery in the housing market and since last summer has noted that its growth prospects were diverging from correlation with GDP. The key thing to look for here is whether Home Depot starts to report any deterioration in its market conditions. My view is that it will not because scaling back QE is unlikely to have an immediate effect on housing sentiment.

Another key area will be banking, namely Wells Fargo (NYSE: WFC) and Capital One
Financial (NYSE: COF). The interesting thing about Wells Fargo is that its net interest margin has been falling partly thanks to low interest rates.

So surely rising rates would potentially be a good thing? The answer lies in whether you think the economy is improving and whether loan demand will improve or not. If so then Wells Fargo should be able to make more money anyway. This line of argument highlights the fact that the quality of its loan book and its future prospects are tied to the direction of the economy. If Bernanke is right then Wells Fargo will see increased loan demand. Again it’s something to look out for.

It’s a similar situation with Capital One. It is regarded as a more conservative type of lender and, so far, it has not reported strong loan growth. Indeed, it expects $12 billion of run-off in 2013 and a further $8.5 billion in 2014, and despite a decent automotive market in the U.S. it recently reported a $500 million drop in auto loan origination. As Capital tends to be more conservative, it is useful to follow its commentary closely because it is unlikely to adjust its lending criteria in order to chase business.

Another area worth following closely is the utilities sector, which could be represented by an ETF like the Utilities Select Spider (NYSEMKT: XLU). I think this ETF will be a very useful gauge of interest rate sentiment and/or whether the economy is going to slow down or not. Utilities do tend to be interest rate sensitive (thanks to their tendency to carry debt and pay high dividend yields), and the sector has sold off sharply in recent weeks as the market anticipated Bernanke’s statement.

^TNX data by YCharts

Again it is worth watching this ETF’s movement in order to see what sentiment is over interest rates.

The bottom line

In conclusion, I think the investing fixation with QE will continue for a while yet, and we can expect the Federal Reserve to carry on doing exactly what it has been doing before. If the economy gets weaker (and you will see it in the stocks discussed above) then the rhetoric will turn back into more liquidity provision but, if the economy continues to do well then, and only then, will the QE fixation abate. However we might be headed for some more volatility as this QE obsession continues.

No comments:

Post a Comment