Admittedly, it is a small sample. Since Quantitative Easing (QE) is expiring June 30, we can only look at the period between the expiry of QE 1 at the end of March 2010 and the start of QE 2 in September 2010 to see what might happen this time around. Quantitative Easing, the purchase of hundreds of billions of dollars of bonds by the Federal Reserve, is a monetary stimulus tactic that has never been tried before on such a grand scale. Other interventions by the Federal Reserve do not qualify as relevant models for comparison.
From the end of March 2010 to the beginning of September 2010, the S&P 500 dropped by 10.7% with a lot of volatility in between. Of course, things are never the same. In 2010, there was a deep concern over a double dip recession. Today, we see evidence of slower growth in China as that country tries to control inflation. Strategists debate whether China will have a soft or hard landing. But any change in China’s rate of growth will have an impact not only on emerging economies in Asia, which depend on China for a large portion of their exports, but on global growth, as well. And problems in the euro-zone are not confined to Greece. Even Germany is showing measurable signs of a slowdown, prompting an improvement in the dollar and the bond market.
In retrospect, it does seem that QE 2 boosted the stock market, which was one of the stated goals of Fed Chairman Bernanke. The Federal Reserve’s QE 2 target for its System Open Market Account (SOMA) portfolio is $2.6 trillion after completing $600 billion in purchases. By way of comparison, Americans have invested around $190 billion in mutual funds each year over the past decade. So, $600 billion in nine months is more than Americans typically invest in three years. Although the Federal Reserve has clearly telegraphed its intentions and the market knows what it is going to do, removing such a large distortion to normal market flows is likely to affect stock prices. The Fed has also made clear that it will maintain its SOMA portfolio at $2.6 trillion by reinvesting maturities into treasury securities. While the stimulus will not be withdrawn, there are no plans to add additional liquidity to the system.
What will the cessation of QE 2 mean to the markets? It might mean a market pull back of 10%, similar to what we saw last time. We have already seen a pickup in volatility, although anxiety levels are no longer as high as they were last summer. However, in addition to the withdrawal of $19 billion in weekly asset purchases by the Federal Reserve, there are a number of other factors influencing the US economy. Even though the recovery has been lackluster, everything seemed pointed in the right direction as we entered the new year. But the surge in commodity prices, particularly in food and energy, offset the benefit of the reduction in the payroll tax. First quarter growth slowed from the fourth quarter. Recently released information indicates that domestic consumption was weaker than previously thought (2.2% from 2.7%) but in line with downward revisions to personal income (up 0.8% instead of 2.9%). Higher inventory growth compensated for the smaller consumption figures, but that offers little comfort as inventories may be liquidated in the second and third quarters, which would hurt the economic recovery.
Although we do not feel the same level of stress that we experienced last summer, the economy is clearly undergoing a transition. The conversation in Washington is focusing on fiscal restraint. Housing has yet to turn around. In fact, house prices are on track to decline an additional 5 – 10% in some markets, putting further pressure on household balance sheets. Slowing growth in Asia (Japan, China, emerging markets) is accompanied by ongoing struggles in Europe. Disruptions in the Middle East are affecting their economies, too. The recent sell off in commodities is a precursor to slowing global growth.
We are underweight equities. Although slower growth will reduce pressure on the price of oil and industrial commodities, we remain overweight energy and agriculture. We still favor precious metals.