Moment of Surrender: Musings on the Election and Fed Policy

Moment of Surrender: Musings on the Election and Fed Policy

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

November 3, 2010

Key points

• Neither the midterm elections nor the Federal Reserve announcing another round of quantitative easing (QE2) brought surprises relative to expectations.
• Tax clarity needs to come next while uncertainty about the implications of QE2 remains front and center.
• Investors will likely be winners, but need to understand the pros and cons of Fed policy.

Rarely are there two events so anticipated, debated and analyzed as this year's midterm elections and the Fed's decision on another round of quantitative easing (QE2). Interestingly, though, the question I've been getting most is not about the substance of either of these as it relates to the market, but whether this will be a classic example of "buy on the rumor, sell on the news."

We only have one day under our belts (and the market's not even closed as I write this), but there's clearly no immediate sell on the news. In sum, there were no big surprises during the past two days.

I'll leave a lot of the post-election policy and sector analysis to Schwab's Mike Townsend and Brad Sorensen, respectively. But I will opine on its relationship broadly to the economy and markets. One of the things market watchers were hopeful about was a decrease in some of the uncertainty that had been plaguing sentiment.

Is gridlock really good?
If gridlock means no clarity on taxes in the lame duck session, though, the market could be dealt a blow. The consensus is that we will get an extension of the Bush tax cuts, likely fully up the income spectrum. We believe this would be good news for the economy and the markets.

Of course, many believe raising taxes now is one of the only credible ways to fight the deficit, but the message emanating from the election is that spending restraint is the real key.

Many Keynesians continue to fight for more spending and fiscal stimulus, but I now have a report from the International Monetary Fund (IMF) to back up my view that it's time for spending restraint to take center stage.

Released at the end of October, the report provides evidence for countries seeking to minimize the contractionary effects of fiscal consolidation. When spending is cut and/or taxes are increased, it causes economic contraction (at least in theory).

A key confirmation of the study is that fiscal consolidations based on spending reductions are significantly less contractionary than consolidations based on tax increases, as you can see in the chart below. In other words, the study shows that tax increases hurt more than spending cuts.

Effects of a 1% of Gross Domestic Product (GDP) Fiscal Consolidation

Click to enlarge
Source: IMF, as of October 2010. All effects are two years out, except policy rate, which is one year out. pp = percentage point.

Interestingly, when it comes to spending-based consolidations, the IMF study found that cuts to politically sensitive spending such as government transfers, and cuts to government consumption such as government wages, are far less burdensome than cuts to government investment. The rationale is that they provide a stronger signal of fiscal discipline. It's this discipline that we believe will be the focus during the next year.

Many observers feel the economy will sink under the weight of austerity, but there's a growing camp (of which I'm a member) that believes we might see some positive "non-Keynesian" confidence effects which could at least partly offset the negative Keynesian impact on the economy of some austerity.

More job growth coming?
Most readers know I've been relatively optimistic about the economy for the past 18 months. I continue to believe there is stronger employment growth coming, and it may be sooner than many believe.

If I'm right, debates will surely break out as to whether the election was the catalyst, but I think there were already enough pillars in place to support better jobs numbers in the near term:

• Corporate profits and cash balances are booming.
• Recent surveys of businesses show increased hiring intentions.
• Initial unemployment claims have turned decisively lower.
• The latest survey of purchasing managers strongly suggests that manufacturing may be a surprising source of job growth.
• The latest readings on both the services and manufacturing sides of the economy were well ahead of expectations.

Let's not forget that the best prescription for burdensome debt and deficits is a growing economy. The stock market continues to send a message that a double-dip recession is not in the cards and that we might even be pleasantly surprised by the level of economic growth we're able to muster.

The consensus among economists for GDP in 2011 is 2.4%. You may lament that "new normal" pace of growth, but historically, when GDP growth has been between 2-3% (there have been 10 years since GDP records have been kept in which growth has been in that range), the average total return for the S&P 500® index in those years was 13.3%.

Great seasonal tendencies ahead
In addition, the midterm election ushers in what has historically been the strongest phase for the stock market, typically lasting well through the pre-presidential election year. But given the rally we've already had, it's not surprising to feel some angst.

This table may help alleviate some of it. Markets that had rallied leading into the midterm elections tended to keep on rallying. Years highlighted in gray indicate years when the S&P 500 rallied more than 5% in the two months leading up to the election.

Source: Bespoke Investment Group (B.I.G.), as of November 2, 2010.

Back to Keynes and Fed policy
Let's not forget that John Maynard Keynes was known not only for his views on fiscal stimulus during economic crises, but also for his "paradox of thrift" views. I believe the reason we are experiencing such an anemic recovery so far relates to the concept of thrift.

The US private sector is paying down debt and boosting savings at a breakneck pace. This has been to the benefit of private sector balance sheets but to the detriment of our consumer spending driven economy.

So, where does Fed policy fit in? Higher private sector savings can be an economic stimulant if those savings are recirculated in the economy via investments or loans. That is obviously not happening at a significant enough pace to generate meaningful jobs growth. The post-crisis strategy of government and the Fed has been to throw money at the problem versus creating an environment that generates sustainable growth and investment.

Fed to the "rescue" with QE2?
Today, the Federal Open Market Committee (FOMC) members announced they will buy an additional $600 billion of Treasuries through June 2011, equating to about $75 billion per month. The $600 billion was a bit north of the $500 billion consensus, but the $75 billion per month was light of the $100 million consensus.

Including Treasury purchases from reinvesting proceeds of mortgage payments, the Fed will buy a total of $850-900 billion of securities by next June, or about $100 billion per month.

Kansas City Fed President Thomas Hoenig cast his seventh straight dissent about the decision today, believing "the risks of additional securities purchases outweighed the accommodation." I'm sympathetic to his dissent. But FOMC members did note they would "adjust the program as needed to best foster maximum employment and price stability." This ostensibly gives them an out to pare back purchases if the economy gains traction.

The stated purpose of QE2 is to lift the level of core inflation closer to the Fed's target of about 2% and generate better employment growth. An obvious question is why record-low interest rates and the first round of QE have failed to boost the latter.

But a less-stated purpose of QE2 is to get investors to sell their Treasuries (to the Fed) and move into riskier investments—boosting asset prices and, by extension, confidence.

This has been under way since the Fed first telegraphed its QE2 intentions back in August, but the bond vigilantes are already having their say as the 10-year Treasury yield has moved higher since then, suggesting inflation concerns may be rising.

Inflating asset prices via QE2 does have some benefits, including downstream effects on consumption and even pension finances. Rising asset prices replace some need for rebuilding savings and could encourage more spending. And rising asset prices also improve pension-fund balances, meaning contributions could be reduced.

However, some of effects of asset-price inflation may have already been priced in, hence the concern about a "sell on the news" reaction. In addition, QE2 definitely stimulates something else: more frustration among savers, who continue to get slammed in a zero-rate environment.

Unintended consequences
In an investment climate that has become very focused on the short term, it's easy to argue the salutary effects of QE2. But as we've been noting, there are worrisome longer-term consequences, including the risk of more asset bubbles and/or credit bubbles and a further ballooning of the Fed's balance sheet.

On the former concern about bubbles, the Fed's policies don't really take into account some unintended consequences. They exacerbate the downward pressure on the US dollar, which increases the risk of a commodity bubble—hurting the 70% of the economy that relates to the consumer while benefiting the 12% of the economy that is export-driven.

On the latter concern about the Fed's balance sheet, there was an interesting article in The Wall Street Journal today detailing these risks.

In conducting monetary policy, the Fed has historically purchased short-term Treasuries, but that changed amid the financial crisis as the Fed grew its balance sheet to $2.3 trillion today from $900 million in 2007.

Today's balance sheet is loaded with mortgage-backed securities (MBS) valued at $1.1 trillion, Treasuries valued at $821 billion and Fannie Mae and Freddie Mac debt valued at $154 billion.

In the short term, these investments have provided a revenue windfall for the US government, earning $76 billion in fiscal year 2010, a 121% increase from the prior year. As such, the Fed has become one of the Treasury's biggest cash cows, helping to mask the real size of the budget deficit. And as The Wall Street Journal points out, this revenue stream is the result of taking new risks.

Prior to 2008, short-term government debt was the Fed's traditional monetary instrument, yet today's Fed portfolio has an MBS maturity of more than 10 years and a Treasury securities maturity of more than five years. This means greater interest-rate risk.

If interest rates on 30-year fixed-rate MBS were to rise to 5% from 4%, the Fed's MBS portfolio would decline in value by more than $160 billion. And given the Fed's low capital-to-assets ratio (half that of commercial banks), the entire Fed system has a leverage ratio of 47-to-1.

As noted in The Wall Street Journal, more leverage together with extended maturities means that if there is a sharp rise in the yield of long-term bonds, perhaps due to increased inflation risk, the Fed's balance sheet could look "very ugly, very fast."

But the optimist in me thinks the economy is finding its footing and won't need much "help" from the Fed, allowing the FOMC to pull back on QE2 sooner than many investors think. In the meantime, there is an implication for the Fed from the midterm election results.

Republicans get the House … pressure heats up on the Fed
Given the near-inevitability of spending restraint with a Republican-led House, if the economy doesn't gain traction, the onus will remain on the Fed to use its printing press tools to stimulate growth.

However, further intervention from the Fed is likely to put pressure on the new Congress to increase the Fed's transparency so the public is better informed about the risks inherent in the Fed's expanded balance sheet. Some uncertainty is past, but certainly not all.

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