Quantitative Easing Prospects Lift Stocks

by Bob Doll, Chief Equity (Fundamental) Strategist, BlackRock.

After a pause in the rally a couple of weeks ago, equity markets resumed their upward course last week, with the Dow Jones Industrial Average climbing 1.6% to 11,006, the S&P 500 Index advancing 1.6% to 1,165 and the Nasdaq Composite rising 1.3% to 2,401.

Last week's economic highlight was the September labor market report, which showed an overall decline in payrolls for the month due to a loss in temporary government employment, but a gain of 64,000 private sector jobs, slightly less than the 75,000 consensus expectation. The report also pointed to upward revisions in private sector jobs gains for both July and August. Unemployment, however, remained unchanged at 9.6% and other details on the report were mixed. On the whole, the report was consistent with our expectations for low levels of positive economic growth, and we are continuing to expect the US economy to grow at around a 2.0% real rate.

With the start of the new quarter, we are currently at the front end of the third-quarter earnings reporting season. On the whole, we are expecting to see another quarter of strong results. Second-quarter results generally surprised on the upside, but analysts did not significantly raise their expectations for the third quarter, suggesting that there is room for further positive surprises. We are expecting good corporate earnings results to remain a key driver of market returns in the coming quarters and will be watching this quarter's results carefully for guidance about 2011 earnings prospects.

One factor that has been helping corporate earnings results has been the weakening of the US dollar. In this, the United States is not alone. It seems as if every country is eager to depreciate the value of its currency in an effort to boost exports. There has been an effective "vote of no confidence" in paper currencies, which has certainly helped commodities (particularly gold) to rally.

One of the factors that has been driving risk assets higher in recent weeks has been the prospect of additional quantitative easing on the part of the Federal Reserve. Most observers are targeting the Fed's next policy meeting in early November as a potential starting point for the central bank to take action. In addition to the rally in equities and commodities, Treasury bonds have also rallied as yields have dropped even further than their previously low levels (the yield on the 10-year Treasury fell to 2.33% last week, its lowest level since January 2009). In addition to the prospect of action in the United States, the Bank of Japan also recently enacted some quantitative easing measures and it appears that the Bank of England will also be taking some action soon.

Despite the fact that Treasury yields have moved lower in recent weeks (usually a sign associated with increasing downside risks to economic growth), we expect that the Fed's actions (along with those of other central banks) will help reduce deflationary risks and will act as a positive for global economic growth. Stock markets and commodity prices have been pricing in a reflation outcome and we believe those markets have it right in that central banks will do what is necessary to fight deflationary forces. The intentions of central bankers is quite clear at present and this appears to be a case where the old saying "don't fight the Fed" seems prudent advice, suggesting that, from an investment perspective, risk assets should continue to grind higher.