• Global share and bond markets got a big lift over the past week as first Larry Summers dropped out of the race to replace Ben Bernanke as Fed chairman, reducing fears of a more bearish Fed, and more importantly the Fed surprised markets by maintaining its asset purchase program at $US85bn a month. The combination saw bonds, shares and commodities rally sharply and the US dollar fall.
• While the Fed may have confused investors, it clearly became concerned by the combination of mixed data recently, the rapid back up in bond and mortgage rates, the approaching government funding and debt ceiling debate and a concern that the leadership transition at the Fed may render its forward guidance less credence. As a result it elected not to taper. The key message from the Fed is very supportive of growth. It won’t risk a premature tightening in financial conditions via a big bond sell off and tapering won’t commence until there is more confidence that its expectations for 3% growth in 2014 and 3.25% growth in 2015 are on track. In terms of timing, it hard to see tapering commencing before the Fed’s December meeting and it may not come until early next year. The downside though is that the Fed has likely just delayed the inevitable and arguably an opportunity for a smooth reduction in quantitative easing has been lost with more volatility a likely consequence.
• The decision by Larry Summers to withdraw from the race to run the Fed and the re-elevation of current Fed vice-Chair Janet Yellen as the favourite has substantially boosted confidence that the Fed will continue with its current growth supportive approach. However, there is a fair way to go yet but at least the other alternatives are perhaps seen as a bit less uncertain than Summers might have been.
• In Europe, the focus in the week ahead is likely to be on the reaction to German Federal election (Sunday 22 September). This is likely to see the return of Angela Merkel as Chancellor with the main uncertainty relating to whether she will lead a coalition with the Free Democrats (as at present) or the Social Democrats (as over 2005-09). Either outcome is unlikely to pose a threat to Germany’s relationship with the rest of Eurozone and so is unlikely to have significant investment implications, beyond any initial kneejerk response.

Major global economic events and implications

• US economic data released over the last week indicated that tapering has just been delayed and is still ahead of us. Industrial production showed a nice gain and regional manufacturing surveys point to further improvement ahead. The NAHB home builders’ survey also held at a high level and existing home sales rose solidly suggesting that the softness seen in housing starts and permits is temporary. One thing is clear though and this is that inflation remains benign with August data showing headline inflation of 1.5% year on year and core inflation of 1.8%.
• In the Eurozone inflation also remained benign in August at 1.3% year on year and ECB officials remain rightly dovish.
• Chinese house prices continued to rise in August, but the authorities seem less concerned about it of late – perhaps realising that the only real solution is to address supply side constraints.
• While the pressure on India has faded a bit this month, with the Fed’s non-taper decision helping, its outlook remains problematic with inflation increasing again in August despite soft growth.

Australian economic events and implications

• It was a quiet week in Australia with the Minutes from the last RBA Board meeting being the main focus. Two key points emerged. First, the explicit easing bias is back after being absent yet again from the post meeting statement earlier in the month. While the RBA has reiterated that any move is not imminent, declining mining investment, restrained non-mining investment, soft consumer spending, rising unemployment, the bounce back in the $A and benign inflation indicate the risks are still tilted towards another rate cut. Second, the RBA looks to be getting a little bit more concerned about the risk of a new housing bubble – even though RBA Assistant Governor Edey and Board member John Edwards pointed out its not one yet – with the Board being briefed on RBNZ moves to limit high loan/valuation ratio loans, Board members agreeing it’s important banks maintain prudent lending standards and concern about property gearing in self-managed super funds. I must admit I am not a fan of old fashioned/back to the past “macro prudential controls” because they just distort the financial system. But a direct move to limit home lending growth (such as raising the capital banks are required to put aside for home lending) is preferable to raising interest rates if the property upturn is getting too hot. So far it’s not too hot (housing credit is running at just 4.7% versus 21% in 2003), but it’s worth keeping an eye on.
• Meanwhile the downgrading of WA’s credit rating to AA+ by Standard and Poors highlights how some Australian governments have squandered the mining boom. After a massive boom WA should have minimal debt and big budget surpluses but unfortunately that’s not the case. More broadly it highlights risks for the new Federal Government if it doesn’t maintain the path back to surplus. Privatisation should be back on the agenda big time as it is the quickest way to get public debt down, at the same time that it will help keep super funds in Australia and put public assets into private hands where they can be managed far more efficiently.

Major market moves

• Share markets had a strong week as investors celebrated good news from the Fed.
• Commodity prices were also buoyed by the continuation of QE3 at its current pace as did the $A.
• Bond yields fell sharply on the back of dovish news from the Fed.

What to watch over the next week?

• Monday is PMI day with preliminary business conditions PMIs being released in China, Europe and the US. All are expected to show a continued trend improvement consistent with improving global growth prospects.
• In the US, expect further gains in house prices (Tuesday) and rises in new home sales (Wednesday) and pending home sales (Thursday) after falls in July. Durable goods orders (Wednesday) are also likely to see a bounce after a fall in July, consistent with a broad recovery in business investment.
• The focus is now turning to Congressional negotiations regarding a new Budget (required by October 1) and an increase in the debt ceiling (required by mid-October). Expect the usual cantankerous argy bargy between both sides of politics to cause bouts of financial market nervousness ahead of the usual last minute deal. With the US budget deficit having fallen to 4% of GDP (from a 2010 peak of above 10%) it will be harder for the Republicans to push too hard without risking alienating the public, which they probably don’t want to do ahead of mid-term elections next year.
• Along with Eurozone PMI’s for September, the German IFO index (Tuesday) is expected to show a further improvement. Confidence indicators will also be released Friday and will likely show a further gains.
• Japanese inflation data (Friday) is expected to show further evidence that deflationary pressures are fading.
• In Australia, the RBA’s financial stability review (Wednesday) is expected to show that Australia’s financial system remains sound with banks seeing improvement in asset performance and funding, business balance sheets in good shape and households exercising prudence. However, the RBA is likely to reiterate the need for banks to maintain “prudent lending standards” and that it is keeping an eye on the increase in property gearing in self-managed super funds. August job vacancies (Thursday) are likely to have remained soft.

Outlook for markets

• Shares are still at risk of hitting a speed bump in the month ahead as we go through the seasonally weak September/October period with potential triggers being the budget and debt ceiling negotiations in the US and a return of Fed taper fears.
• However, any pullback is likely to be just another bull market correction which should be seen as a buying opportunity as the broad trend in shares remains up. Valuations remain reasonable, monetary conditions are set to remain easy, and profits are likely to improve next year as global and Australian growth picks up. So by year end we see further upside in global and Australian shares with gains continuing next year.
• Government bond yields are falling after having risen too far too fast, but are likely to resume a gradual upwards trend as it becomes clear that the global economy is picking up momentum and as Fed tapering comes back into focus. Low yields and an unwinding of years of massive inflows into bond funds point to poor sovereign bond returns ahead.
• The short covering rally in the $A was given a boost by the Fed’s decision not to taper, but the downtrend is likely to resume once extreme shorts have been squeezed out, tapering comes back into focus and as the RBA retains an easing bias.

By Dr Shane Oliver, Head of Investment Strategy & Chief Economist, AMP Capital

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Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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Back in the dark days of post-Lehman 2008, the Federal Reserve adopted a new framework for monetary policy with the introduction of quantitative easing, or QE, and an era of central bank balance sheet expansion was born.  (In truth this approach pre-dates Ben Bernanke with its origins in post-bubble Japan; however the magnitude and impact of Federal Reserve QE far out-weighs Japan’s half-hearted attempt).

Fast forward to the present day and it seems everyone in developed markets is now playing the QE game to one extent or another. Whilst the approach taken has varied in its format across the developed world, we have seen non-traditional policy adjustments from the ECB, the Fed (in three different shapes and sizes) the Bank of England, Bank of Japan, and Swiss National Bank. In just four years the balance sheets of the G3 central banks have expanded by US$5 trillion.
 
One of the direct consequences of this monetary printing machine has been currency debasement – or so-called “currency wars”. The basic law of supply and demand suggests that if you increase the supply of something then, all else being equal, the price should decline.  It is true to say that the initial effect of QE1 was to turn a strong dollar weaker.

However history shows that since 2008 the dollar has moved broadly sideways, although it has weakened from its post-Lehman stress highs. Global co-ordination and monetary easing across the developed market landscape suggest to us that the true effect of QE on the home currency is difficult to ascertain as so many players are up to the same tricks. “War” feels like an excessive term when market volatility levels seem to be on a continuous declining trajectory.
 
The effects are more noticeable, however, against currencies or real assets where no supply adjustments are taking place. Gold for example, has rallied 160% since its 2008 lows, illustrating the true magnitude of debasement.  Certain emerging market currencies have also felt the pain of QE. The direct consequence has forced some countries to become more interventionist in an attempt to mitigate the currency effects of global QE. Brazil is a telling example, with interventionist rhetoric and action virtually omnipresent as USDBRL approaches 2.00.
 
While a more co-ordinated QE has tended to suppress volatility amongst developed market currencies, less benign effects are perhaps occurring elsewhere.  Real asset prices across the globe have been rising, and in the case of essentials such as food, the geo-political consequences can be significant. 

What seems likely is that whilst QE may successfully deliver us from the threat of deflation, the risks associated with expanding and broadening this aggressive global monetary action mutate, from economic to social and political. The beggar thy neighbour consequences of incredibly easy monetary policy can quickly lurch from discomfort to market fracture. An interesting case in point is the current situation in South Africa.

Higher commodity and food prices, perhaps as a direct result of global QE, are causing social unrest and mass strikes in South Africa’s mining industry. Cost push pressures are reaching flash point and causing the market to reassess some of the “benign outcomes” priced by financial markets. QE is perhaps the most regressive of economic policies, supporting the rich developed market stock portfolios whilst taxing the cost of living of the poorest workers in countries whose currency and commodity prices are inexorably rising.
 
As investors in global currency markets we are constantly alert to these tensions coming to a head and broadening into wider geo-political concerns.  History tells us that the unintended consequences of austerity policies have at times proved dramatic and life changing.

We view the benign nature of today’s foreign exchange markets, where volatility seems to fall daily, with a healthy dose of concern and scepticism that the status quo can be maintained in the medium to longer term.

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“The third slug of monetary stimulus from the US Federal Reserve Bank came just days after the European Central Bank (ECB) delivered on its promise in July to do ‘whatever it takes’ and after outgoing Chinese premier, Wen Jiabao, turned on the infrastructure spending taps again.”

Mr Stevenson notes: “The latest quantitative easing (QE3) from the Fed is different from its forerunners in two key ways: it is open-ended as to size and duration. There is no ceiling to the stimulus which will continue ‘for a considerable time after the economic recovery strengthens’.

“It is clear which element of the Fed’s dual mandate matters now – growth is the target and if the price is inflation, well, so be it.

“Even if you believe that the long-term impact of all this shock and awe must be negative, it would be a bold call in the short run to stand in front of the central bank juggernaut.”

He suggests there are five ways in which investors might ride the QE wave.

1 –“First, they should have exposure to equities. According to Credit Suisse, US shares rallied by 10-15% in the first few weeks of previous bouts of quantitative easing, but rolled over again within a few weeks of the end of the stimulus.

“The open-ended nature of the latest round offers the prospect of the rise without the fear of the imminent peak. Shares have tended to rise in an environment of rising inflation expectations until they reach 4% or so. We are some way off that point yet.

“Rising inflation expectations will also increase investors’ appetite for cheap real assets, the most obvious example of which is US property. The fact that the Fed is pouring money directly into mortgage-backed securities at a time when the US housing market has already turned the corner is a very bullish signal for the sector. US funds are the best way of playing this for a UK investor, although some companies on this side of the pond, such as building materials group Wolseley, could benefit too.

2 – “Favouring the US market, my second strategy, is not just about backing a recovering housing market though.
The Fed’s move this week is a clear indication that it will do what it must to offset any tightening in tax and spend as the US belatedly addresses the fiscal cliff after the presidential election.

3 – “Thirdly, investors should continue to favour income-generating investments. The whole point of QE is to suppress bond yields and to keep the real, inflation-adjusted cost of servicing government debt low, and preferably negative, for as many years as it takes to get the ship back on an even keel.

“This so-called “financial repression” endured for a decade or more after the Second World War and it was many years then before the chickens came home to roost in the form of 1970s stagflation.

“Sustainability of dividend is the key because there are plenty of high-yield ‘traps’ waiting for the unwary investor, but there is no shortage of blue-chips offering reliably high and growing dividend streams.

4 – “Fourth, I think there is more to go for with gold. After a disappointing year or so – even more so for gold producers, which have under-performed the metal itself – the response of the gold price to expectations for and the reality of more quantitative easing points to further strength.

“With no income stream, I don’t really view gold as an investment but, as an insurance policy against dollar debasement and inflation, it is worth its place in anyone’s portfolio.

5 – “Finally, I think the inflationary endgame looks ever more likely as the Fed’s determination to re-kindle growth hardens. Inflation-linked bonds are an obvious hedge and, within the equity market, I would look at shares in companies whose returns have a regulatory link with rising prices such as utilities and some infrastructure companies.”

Mr Stevenson adds: “Investors’ tendency to buy the rumour and sell the news might suggest that markets could consolidate after the announcements of the past couple of weeks. But I wouldn’t count on it.”

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. Prior to making an investment decision, retail investors should seek advice from their financial advisers. Investors should also obtain and consider the Product Disclosure Statements (“PDS”) for any Fidelity fund mentioned in this document. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise.  2012 FIL Responsible Entity (Australia) Limited.  Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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• Open ended quantitative easing (QE3) in the US is likely to continue into 2014. While it can’t solve all America’s problems it should help economic growth recover to 2.5% in 2013.
• Notwithstanding inevitable corrections, QE3 is positive for shares, commodities, gold and cyclical stocks.
• QE3 is likely to result in modest upwards pressure in bond yields.

Meanwhile in Australia, the minutes from the RBA’s last rate setting meeting revealed a somewhat more dovish tone than indicated by the post meeting statement released straigh after the meeting, with significant discussion regarding the risks to global growth and China in particular, the risks to the mining boom and even the observation that the benign inflation outlook provides scope to ease policy if needed.

We remain of the view that the RBA will cut the cash rate to 2.75% over the next six months, starting with a 0.25% rate cut next month. To read the full article, click here.

The post Oliver’s Insights – Q&A on QE3 appeared first on AdviserVoice.

The plans announced by US Federal Reserve Chairman, Ben Beranke, were welcomed by investors and traders as financial markets across the globe witnessed a buying spree that sent global equities surging higher. 

CMC Markets, Senior Trader, Tim Waterer said:

“The FOMC’s plan to spend US$40b per week on mortgage-backed securities, which came with no conclusion date, showed traders that the FOMC is digging its heels in. This aggressive move served to comfort US investors, so much so that the Dow and S&P500 have hit December 2007 levels.

“The exuberant buying witnessed in the US last night is similarly being played out across Asian markets today.  With investors clearly pleased with the heavy-handed approach by the Federal Reserve in tackling the struggling US economy.

“Locally the Australian market looks set to end the week in sprightly fashion.  Mining stocks, not surprisingly, are among the best performers given the rosier outlook on the US economy post the Fed announcement. The ASX200 looks like it has a fair chance to conclude the week close to the 4400 level if buying enthusiasm can be maintained in the afternoon trading session.

“Whether the QE3-inspired rally can show some longevity remains to be seen. Whilst the markets have been served a dose of good news this week, the shot of adrenaline may only last as long as the point where economic indicators abroad remind us that global growth remains precarious at best.”

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