Quantitative easing (QE) is just a fancy way of saying that the Federal Reserve is injecting more money into the economy. It does this by buying securities from banks—usually government bonds (Treasuries). Flush with new cash, banks then lend the money, which is spent into the economy and juices growth.
The Fed said that it would stop shrinking its balance sheet $50 billion per month and would start expanding it by $60 billion a month.
The Fed’s balance sheet is a measure of the assets (like government bonds) it owns. So when the balance sheet is expanding, it tells us that the Fed is buying Treasuries, also known as QE.
But Federal Reserve chairman Jerome Powell went out of his way to declare that this move was “not QE.”
“I want to emphasize that growth of our balance sheet for reserve management purposes should in no way be confused with the [quantitative easing] that we deployed after the financial crisis,” Powell said.
Call it whatever you like, Mr. Powell, but it doesn’t change the outcomes.
Since the Fed kicked off “QE that’s not QE,” its balance sheet has ballooned $400 billion to $4.16 trillion… the highest in 14 months:
If the balance sheet continues to expand at this pace, it will hit a new all-time high by April 2020.
So what happens when the Fed expands its balance sheet?
Remember the good old days of earning 5% on a bank savings account?
The Fed and QE have ended that. That’s because the goal of QE is to push people out of conservative investments like money market funds and bonds, and into riskier assets like stocks.
The Fed does this by lowering the benchmark interest rate known as the federal funds rate. This is the “base rate” that banks, credit card issuers, and other lenders use to set their own interest rates. So when the federal funds rate falls, so does the interest rate on other interest-bearing investments.
The MILLION dollar question: What happens to the market when the Feds stop pumping?
The National Federation of Independent Business (NFIB)’s confidence index showed significant improvement. The one before that was mixed. Now 2019’s last quarter ends on a more negative note. Add it all together and we see little net change, suggesting both bulls and bears are missing something.
- The NFIB Optimism index fell two points in December to 102.7. This is historically strong but well below the last peak.
- Six of the 10 index components fell from the prior month, two improved and two were unchanged.
- Hiring plans, job openings and compensation increases all fell slightly.
- Capital spending plans weakened and inventory expansion was unchanged.
- More owners reported better economic and sales expectations, but fewer said now is a good time to expand.
Bottom Line: The NFIB sentiment gauge has never regained its August 2018 peak and is only a little above the 2016 post-election celebratory high. Despite lots of noise and some important developments, small business owners seem no more or less confident than they did three years ago. That they don’t see conditions worsening is good, but at some point there needs to be sustained improvement. It’s not happening yet.
Stocks LOVE QE!!!
QE is highly stimulative and clearly good news for stocks in the short run.
This wall of new money has to go somewhere. And a lot of it is going into stocks.
Since the Fed announced its QE on October 8, 2019, the S&P 500 is up 12%:
Just over a year ago, the ECB and the Fed were on the path of gradually reducing their massively expanded balance sheets, and the Fed was increasing interest rates from levels first adopted in the midst of the global financial crisis.
Both institutions were attempting to normalize their monetary policies after years of relying on ultra-low or negative interest rates and large-scale asset purchases. The Fed had raised interest rates four times in 2018, signaled further hikes for 2019, and set the unwinding of its balance sheet on “autopilot.” And the ECB had ended its balance-sheet expansion and begun to steer away from further stimulus.
A year later, all of these measures have been reversed.
Rather than hiking rates further, the Fed cut them three times in 2019. Instead of reducing its balance sheet, the Fed expanded it by a greater magnitude during the last four months of the year than at any comparable period since the crisis. And far from signaling an eventual normalization of its rate structure, the Fed moved forcefully into a “lower-for-longer” paradigm.
This dramatic policy turnaround was particularly curious in two ways.
First, it materialized despite growing discomfort — both within and outside central banks — about the collateral damage and unintended consequences of prolonged reliance on ultra-loose monetary policy. If anything, this discomfort had grown throughout the year, owing to the negative impact of ultra-low and negative rates on economic dynamism and financial stability.
Second, the dramatic reversal was not a response to a collapse in global growth, let alone a recession. By most estimates, growth in 2019 was around 3% — compared to 3.6% the previous year — and many observers are expecting a quick rebound in 2020.
Rather than acting on clear economic signals, the major central banks once again succumbed to pressure from financial markets.
By allowing financial markets again to dictate monetary-policy changes, both the ECB and the Fed poured more fuel on a fire that has been raging for years.
Yet, given mounting medium-term uncertainties, central bankers cannot assume tranquil conditions in 2020. While ample and predictable liquidity can help calm markets, it does not remove existing barriers to sustained and inclusive growth.
It will require a level of pain to wean the markets off of ongoing liquidity. In 2018, the Fed learned their lesson of what would happen as the small adjustment to monetary policy they did make resulted in a market decline of nearly 20%, yield curves inverted, and threats of a recession rose.
They aren’t willing to make that mistake again. The subsequent policy reversal pushed the markets to new record highs, which has been a function of valuation expansion due to the lack of improvement in underlying fundamentals and earnings.
Jeremy Grantham 7-Year Forecast
One of my favorite forecasters is Jeremy Grantham from GMO. He’s been putting out a 7-Year Real Return Forecast that I’ve been following since the late 1990s. Researchers have found him to be highly accurate.
His bond forecasts have been spot-on, while he has underestimated US equity returns and overestimated emerging market returns. This probably has to do with the unprecedented amount of QE since 2010.
Jeremy believes there will be a reversion to the mean.
The Good News!
- Mortgage applications for home purchase started the year on a strong note.
- The January manufacturing report from the NY Fed (Empire Manufacturing) showed some hopeful signs.
- Economic activity appears to be rebounding in China, as December industrial production and fixed-asset investment exceed market expectations. Beijing may decide to moderate its stimulus efforts.
- The Bloomberg US Consumer Comfort Index is at the highest level in two decades.
China Trade Deal
Export targets to China under the phase-one trade deal:
Phase 1 of the China Deal
Share Buyback Activity
Share buyback activity, which bolstered performance over the past couple of years, has been fading.
Jeffrey Gundlach — 2020 Outlook
Bullet point notes:
- Jeff expects a big decline in global growth: down 70 bps to 3%.
- As a point of reference: for 2020, economists expect 3.10% global GDP.
- He sees rates declining in Europe and Japan. Currently there is $11.82 trillion in negative yields. Down from an August 2019 high of $17 trillion. Expects it to go back up.
- There are $0.52 trillion in negative yielding corporate bonds.
- Low and negative rates impact global markets and bank stocks.
- Japan went negative first. Performance from 1995 to end of 2019: Tokyo Stock Exchange is down 81.25% over the last 25 years.
- European banks are down 11.77% over the last 25 years.
- While US banks are up 329.27%.
- Really bad results for banks, not surprisingly, when rates go negative. US banks rallied from 2009 low back to challenge 1995 bank highs.
- Deutsche Bank has rallied from just above 6 to 8. But still bad performance. Bullish if Euro rates go higher, bad if negative.
- The US financial sector has gained 3.76% since 2007 (just barely above its 2007 peak) while S&P 500 up 130.28% – low rates have been a struggle for banks.
- The Fed:
- December 2018 reversal in interest rate policy to cut rates really helped out US risk assets.
- Now the Fed is on hold. Fed unlikely to make any moves in 2020 – according to current sentiment.
- Jeff expects a lot of potential volatility in 2020 – with geopolitical uncertainty and upcoming election.
- Joe Biden and Bernie Sanders are rising. All others are declining. Jeff doesn’t give Bloomberg much chance to win given lack of love for billionaires. Elizabeth Warren has dropped significantly… Jeff thinks Bernie Sanders most likely to get the nomination – tied in Iowa.
- GDP for US
- 2020 consensus sees 1.80%.
- 2019 was 2.30% (estimate).
- 2018 was 2.90%.
- Jeff mentioned a round-table he just recorded with David Rosenberg and others (more below) and said Rosey believes recession risks are being greatly underestimated.
- Jeff sees a 30% to 35% chance of recession in 2020 and said he’s watching the labor market as the key (some signs of weakening but way too early).
- He showed a chart showing the Leading Economic Indicators and said they always go negative before recession
- I really liked this next chart from Gundlach. What it shows is that recession typically follows after both the year-over-year change in the Leading Economic Indicator (LEI) and the six-month change in the LEI both drop below the middle dotted red line. Currently the red six-month line has crossed lower but the black YoY line remains above. Bottom line: No sign of recession.
Currently, almost every single valuation metric is at historic extremes, yet investors continue to take on increasing levels of risk due to nothing more than “F.O.M.O – Fear Of Missing Out.”
Forward P/E and P/S ratios (see definitions below) appear stretched.
Profit margins seem to have peaked.
The problem front and center is how investors are looking past the continuous earnings rout, betting on a snap-back as soon as the first quarter of 2020. S&P 500 earnings are expected to drop by 0.3% in the fourth quarter of 2019, marking the first back-to-back quarterly decline since 2016, according to Refinitiv.
While “fundamentals” may not seem to matter much currently, eventually, they will.
Repo Issues with the Fed
Repo markets redistribute liquidity between financial institutions: not only banks (as is the case with the federal funds market), but also insurance companies, asset managers, money market funds and other institutional investors. In so doing, they help other financial markets to function smoothly. Thus, any sustained disruption in this market, with daily turnover in the U.S. market of about $1 trillion, could quickly ripple through the financial system. The freezing-up of repo markets in late 2008 was one of the most damaging aspects of the Great Financial Crisis (GFC).
When these excessive “Repurchase Operations” initially began in late September, we were told they were to meet corporate tax payments. The issue with that excuse is that corporate tax payments come due every quarter and are easy to forecast weeks in advance. Why was last October’s payment period so different? But, following October 15th, the “repo” operations should have been no longer needed, however, the funding not only continued, but grew.
As the end of the year approached, we were told liquidity was needed to meet “the turn,” as 2019 ended, and 2020 began. Once again, this excuse falls short as, without exception, every year ends on December 31st. So, after nearly a decade of NO “repo” operations, as shown below, what is really going on?
What is clear, is the Fed may be trapped in their own process, a point made by Mark Cabana of Bank of America/Merrill Lynch:
“It seems implausible to me that the Fed will be able to stop their repo operations by the end of January.”
The Fed’s position is they must continue inflating a valuation bubble despite the inherent, and understood, risks of doing so. However, with no alternative to “emergency measures,” the Fed is trapped in their own process. The longer they continue their monetary interventions, the more impossible it becomes for the Fed to extricate itself without causing the crash they want to avoid.
Stated simply, the longer the Fed avoids normalizing monetary policy, and weaning the “crack addicted” markets off of their “liquidity drug,” the bigger the “reversion” will be “when,” not “if,” it occurs.
The only question is how much longer can Jerome Powell continue “pushing on a string.”
Buy and Hold Strategy Depends on When You Start
The chart above shows the wide swath of amounts that a $100,000 investment in the S&P 500 might be worth during one, five, 10, 15, and 20-year periods that began at different times. As you can see, the ranges are quite broad, even during periods as long as 20 years. When it comes to buy-and-hold investing, the year you begin working and saving is the most significant determinant of whether you struggle or thrive in retirement. The DRP strategy removes the risk of starting at the wrong time.
We are going to have to raise taxes if we want to stay anywhere within shouting distance of fiscal sanity.
That which can’t continue, won’t. It is simply not possible for per capita debt to keep growing faster than the economy in which the debtors live. There are limits.
One last thought. When we do have a recession, which again I point out is likely to be after the election (the only meaningful data point between now and the end of next year), the deficit will explode to over $2 trillion per year and, without meaningful reform, never look back. That puts US debt at $35 trillion+ by the end of 2029.
We worry about US government debt, and rightly so, but it’s only the beginning. Corporations have leveraged themselves to the teeth, and much of that debt could easily turn into government debt.
“Debt Productivity” is the amount of new debt associated with a given amount of GDP growth. Last quarter he found that each dollar of global debt generated only $0.42 of global GDP growth. That was down 11.1% from ten years earlier.
Worse, this isn’t a linear trend. We can expect it to accelerate as debt grows faster than GDP. At some point, debt becomes completely about consumption and, as noted, bringing consumption forward means less consumption later.
In the past couple of years, there have been two important indicators telling us when the next U.S. recession might be coming.
1) The yield-curve inversion
The last seven times the 2-year/10-year Treasury yield curve inverted, a recession has followed.
Since 1965, the average number of months before a market peak is 18.5 and the average number of months before a recession is 19. The 2-10 yield curve inverted in August 2019…
2) Peak manufacturing data
In 1950, the Institute for Supply Management (“ISM”) began compiling its manufacturing index – which measures new orders, production, employment, deliveries, and inventories in U.S. businesses.
Since then, the average amount of time from the index’s peak to recession is 31.5 months, and the cycle may have peaked in the summer of 2018…
This also tells us a recession is likely around March 2021.
If that’s right, it would give us about 15 more months before a recession hits the U.S. economy.
The science is never going to be exact. It’s interesting to me that these two pieces of data line up so closely. I don’t believe these types of things are coincidences.
And it bolsters the case that we’re looking at a recession happening around the spring of 2021.
- Asset managers are now holding a net long position of nearly 30% of the open interest in major equity index futures, the most ever.
- Analysts upgrade technicals, not fundamentals. Wall Street analysts have been busy upgrading the price targets on stocks they cover within the S&P 500. But they’ve been much less inclined to also increase their earnings estimates.
- Deteriorating fundamentals. There is a 15-year high in stocks with negative earnings, both establish companies and new issues. An increasing number of stocks are also seeing deteriorating fundamentals, with a multi-year high in the percentage of stocks with lower operating earnings than a year ago.
- In recent weeks, there has been only one indicator that has consistently shown pessimism, and that’s fund flows. The latest weekly release shows another week with big flows out of equity funds and into bonds.
All content is in the opinion of Brian Decker
Decker Retirement Planning Inc. is a registered investment advisor in the state of Washington. Our investment advisors may not transact business in states unless appropriately registered or excluded or exempted from such registration. We are registered as an investment advisor in WA, ID, UT, CA, NV and TX. We can provide investment advisory services in these states and other states where we are exempted from registration.