Submit to the Fed – or else

Euromoney Skew, Sid Verma
Published on:

Investors risk once again missing out on a rally by snapping up perceived safe assets, even amid monetary stimulus from the Fed. This time quantitative easing is taking place against the backdrop of rising asset prices, a fillip to the bulls, say Barclays Capital analysts.

Amid epic monetary expansion in the G7, which continues to depress yields on investment-grade assets, sell-side analysts are redoubling their calls for investors to move down the risk curve – both on the basis of economic fundamentals and technicals.

First, for a sense of how yields have collapsed, real returns on investment-grade industrial bonds are now in firmly negative territory, boosting the relative value of high-beta assets.

The US Federal Reserve’s open-ended quantitative-easing (QE) commitment intensifies the strategy of using asset price movements to reflate the real economy. However, this new round of QE is qualitatively different than the first two rounds, since it also coincides with a cyclical upturn in asset prices, which should further engender bullish sentiment, say Barclays Capital analysts:

“To be sure, US growth indicators have been soft of late, but we see this as short-term noise around a basically stable, if modest, expansion trend. The recent signs of a turn in housing – both in activity levels and prices – are potentially important. The improvement in activity will help offset the deterioration in exports due to weakness abroad. More importantly, however, the continuing fallout from the collapse in house prices is correctly perceived as the key restraint on growth and risk to ongoing expansion. A convincing upturn in housing will thus reassure investors that the expansion is sustainable, further undermining the rationale for caution."

A US fiscal-cliff crisis will be averted, the analysts reckon:

“With a presidential election coming up in less than two months and the so-called “fiscal cliff” – consisting of a combination of tax increases and spending cuts amounting to around 4% of GDP – due to hit the economy in early 2013, there are policy risks in the US as well. However, our base case is that neither of these events are likely to be “game-changers” for Q4, as far as financial markets are concerned: the policies of the elected president will take time to shape, and Congress is likely to manage to delay or avoid a majority of the currently scheduled fiscal tightening."

This will boost the current bull market, thanks to an upward shift in house prices and the central bank’s liquidity punch bowl:

“The Fed is acting when asset prices across the board are already rising (even including house prices), and in the case of stocks to new cyclical highs. This is reminiscent of what happened in the past two business cycles, and it highlights that asset price movements have become a key channel through which monetary policy impacts the economy. It started with Fed chairman [Alan] Greenspan’s shift away from monetary orthodoxy in the late 1990s (citing a “new economy”) which resulted in Fed easing into an economic and asset price boom. It happened again in the mid-2000s with the introduction of "unconventional" easing when the Fed fought a 6% unemployment rate with a promise of low rates "for an extended period". During both episodes, asset prices surged, supporting activity for a time, but eventually plunged more or less under their own weight, despite efforts by the Fed to limit the damage. While memories of the past two episodes may limit investor willingness to jump on the bandwagon again, the promise of sustained negative real financing costs and already upward trending asset prices will be tough to resist for a still generally under-exposed investor base, particularly if risks to sustained growth appear to be fading."

Overly bearish investors once again risk missing out on the rally by under-stating the impact of loose G7 policy, and the subsequent costs of holding perceived safe assets:

“During the current bull market, many investors have sought safe havens, fearing that the recovery was "fragile" and concerned about a repeat of 2008. The search for safety, however, reflected a misjudgement of the drivers of risk and return in the current environment and has turned out to be very costly (Figure 2). A modestly growing economy with the cyclically sensitive sectors at still-depressed levels is a relatively stable and safe, if not exciting, environment. When this is combined with a central bank committed to aggressively supporting growth through higher asset prices, it amounts to a very attractive environment for taking risk, as the performance of stocks and other risky assets since 2008 has demonstrated. But while the error thus far has been to overestimate near-term risks, a propensity to underestimate the risk of a sharp reversal in asset prices."

And the story in picture form:

With US GDP revised down from 1.7% to 1.3%, and the astonishing news on Thursday that bond- and money-market assets at $849 billion now eclipse Fidelity Investments' equity holdings, new money appears to be flowing into less risky assets amid global growth fears, despite Barclays' recommendation to add risk.