Monday, June 17, 2013
2013 Mid-Year Update
The Tapering of QE Infinity
- The private sector economy has shown surprising strength since the withdrawal of fiscal support.
- As the impact of federal cutbacks and tax increases fade next year, growth should accelerate.
- The tapering of quantitative easing should cause short-term concern with investor sentiment already too optimistic, but should not derail the cyclical uptrend.
- Consumers and businesses are well placed to absorb an orderly increase in interest rates.
The Federal Reserve is on pace to buy over a quarter trillion dollars of Treasury and mortgage-backed securities in the second quarter alone, bringing the total value of securities held outright above $3 trillion. For all of the quasi-sarcastic comments economists have made about “QE-infinity” (“QE” being short for “quantitative easing”, which is the introduction of new money into the money supply by a central bank), the Fed will not finance government spending via money printing forever. And the stock market has shown concern about this.
When recent data suggested that the private economy has been steadily improving, and Fed Chairman Bernanke himself hinted at an eventual tapering of QE, the markets reacted by pushing interest rates higher. Thus we find it timely to examine the implications of a potentially new interest rate regime on the economy, on the stock market in general, and on the dividend-yielding stocks in particular – all of which have benefited from a suppressed interest rate environment.
Especially considering an unemployment rate at a still uncomfortably high 7.6%, the growth during the four-year-old recovery has been disappointing, but still remarkably stable. Real GDP has grown around 2% per year since the Great Recession ended, and employment has increased at an annual pace close to 2 million. So far the economy is posting the same kind of numbers this year.
What has changed over the last four years is the mix of growth as the baton has been passed from the public sector to the private sector. The recovery was kick-started in 2009 by massive fiscal stimulus; temporary federal tax cuts as well as increases in government spending added about 2.5 percentage points to growth that year. Over the next few years the fiscal boost faded, and government policy became a drag on the economy. Tax increases combined with sharply reduced spending will cut roughly 1.5 percentage points from GDP this year, the most since the military drawdown after World War II.
Fortunately, the private economy has stepped up as the government has pulled back. In 2009, the private sector shrank by an amount equal to 5.5 percentage points of GDP. But this year the private sector is on track to grow strongly, equal to 3.5 percentage points of GDP. Housing, no longer in free fall, has made the biggest turnaround and is adding steadily to growth. Consumers and businesses are also doing their part to support the recovery.
Indeed, the transition from government-led to private sector-led growth is going better than anticipated. The pace of growth was expected to slow further this summer, but while tax increases have taken some steam out of retail sales, vehicle sales remain sturdy. The federal government’s budget sequestration and other spending cuts are having an impact, but the ripple effects from government layoffs and furloughs on the rest of the job market are not as dramatic as initial concerns suggested.
Fiscal drag ebbs
This augurs well for the recovery after the fiscal drag moderates later this year. Under current law, which the deadlocked Congress and administration are unlikely to change, federal policy will subtract about half as much from growth in 2014 as it will this year, and the effect will be all but gone by mid-decade. Lawmakers this summer need to authorize funding for the government once the fiscal year ends in September, and to raise the Treasury debt limit again. Given the rising political costs, however, this seems likely to happen without as much brinkmanship as in the recent past, and thus less potential shock to the system.
As the fiscal drag recedes, the private economy’s improvement will thus become more visible into next year, and growth will accelerate. This means faster job creation, with payrolls expanding by close to 3 million in each of the next two years. Unemployment will decline more consistently, even with a pickup in the labor force. The economy will return to full employment—estimated as an unemployment rate of 5.75%—by summer 2016. That is the type of growth required to calm the stock markets in the face of rising interest rates caused by the tapering of QE Infinity.
With the economy managing reasonably well, discussion has heated up about the need for continued monetary support from the Federal Reserve. The Fed has been unclear about what will cause it to begin winding down its current round of QE-infinity , but policymakers have said they are looking for “substantial” improvement in the employment outlook before beginning to slow the pace of long-term asset purchases.
The Fed’s rhetoric suggests that job creation must be consistently stronger than it has been recently. Given that the pace has been stuck near 2 million net new jobs per year, a substantial improvement would likely mean accelerating that near 2.5 million, or more than 200,000 net new jobs created per month. This would be enough to reduce the unemployment rate, even with somewhat stronger labor force growth. Based on our outlook, the Fed won’t be ready to slow down QE3 until late this year.
The timing of the taper of QE-infinity could also coincide with Chairman Ben Bernanke’s departure from the Fed. He has hinted that he will leave when his term ends, and would likely want to leave his successor with a clear path to a normalized monetary policy.
How QE-infinity may be unwound
How to wind down QE3 is the subject of reasonable debate. Which should the Fed scale back first, the $45 billion of Treasury securities it buys each month, or the $40 billion in mortgage securities? Given the importance of housing to the recovery, keeping mortgage rates low as long as possible should be the goal. Somewhat counter-intuitively, this may be achieved by dialing back on mortgage purchases sooner, since the Fed’s purchases appear to be affecting liquidity in the thinner mortgage securities market. A slower pace of mortgage bond purchases would cause mortgage yields to widen relative to Treasury yields, but the rise in rates would probably be less than if Treasury purchases were reduced and Treasury yields rose. At any rate, QE3 is expected to be in the history books by this time next year.
The path to normal monetary policy
The Fed has been much clearer about when it would begin raising interest rates than it has about tapering QE. The Fed would be expected to make that shift once the unemployment rate falls below 6.5%, and even then only if the driver is job growth and not people dropping out of the labor force. Our outlook sees this threshold being crossed in spring 2015.
Normalizing monetary policy will take much more time. To be consistent with an economy operating at full employment, the federal funds target rate would need to rise near 4%. The Fed has said it will be slow to increase short-term rates, implying that a 4% funds rate is not likely until long after the economy is back to full employment. If the outlook sticks to our script, monetary policy won’t reach normal levels until spring 2017.
How will bond investors react?
Of course, the behavior of bond investors could make the job of normalizing monetary policy a lot more complicated for the Fed. Our outlook is based on a steady but orderly rise in long-term rates, with 10-year Treasury yields going from just above 2% to 2.5% by year’s end, 3.5% by the end of 2014, and 4.5% by the end of 2015.
The outlook foresees 10-year Treasury yields peaking above 5% for several months in spring 2016, before settling just below 5% —the normalized 10-year Treasury yield consistent with an economy at full employment. Long-term rates are likely to briefly overshoot their normalized level when bond investors begin to fear that the Fed is raising rates too slowly and inflation pressures are developing. It is typical for the bond market to overshoot during this part of an interest rate cycle.
Job creation trumps mortgage rates
If the interest rates take approximately this path, the economy should be able to handle the increase reasonably gracefully. A faster pace of job creation should largely trump the impact of higher mortgage rates on the housing market, and steadily rising corporate earnings should keep stock prices moving up, even if more slowly than they have over the past couple of years.
But this scenario may be too rosy. Bond investors are an especially fickle bunch, and they understand that at some point long-term rates will normalize. When this happens, investors will see the principal value of their bonds fall sharply. As soon as it becomes clear that the Fed is ending QE and will soon raise interest rates, long-term yields could rise sharply, going from 2% to 5% not over three years as envisaged in our outlook, but within months. This would be too much for the economy to bear; housing and stock prices would wilt, and the road back to full employment would grow much longer.
Don’t bet against the Fed
In theory, the Fed should be able to manage the transition back to normal monetary policy, carefully calibrating its balance sheet to adjust short-term interest rates, and explaining its actions clearly to bond investors. Empirical evidence from the Fed’s management of earlier quantitative easing rounds also suggests that long-term rates need not spike as QE-infinity winds down. Indeed, bond investors who anticipated such rate spikes by selling short (i.e. betting on rate rise and bond price declines) as QE1 and QE2 (the first two iterations of QE) ended were forced to abruptly reverse their positions when no spikes occurred.
It is also encouraging that households and businesses are refinancing debt and locking in the current low interest rates. Consumers and firms are financially insulating themselves, at least partially, from higher rates. The banking system is also preparing, as the Fed has required banks to run stress tests that include spikes in inflation and interest rates. The banks have enough capital and liquidity to withstand this if it happens.
The economy is being weaned off the unprecedented fiscal and monetary stimulus that helped end the Great Recession. For fiscal policy, this process is well advanced. Adjusting to a smaller government hasn’t been painless, but the pain has been dulled by the Fed’s aggressive support. The time is fast approaching for the monetary stimulus to wind down as well. This won’t be trouble-free, but given a much healthier private economy and some reasonably good stewardship at the Fed, it is doable.
Rising Rates’ Impact on the Stock Market in General
Historically, rising interest rates have been bearish for stocks because they have increased borrowing costs for companies and because they have provided competition for investors’ dollars. But deflationary concerns over the past decade have altered the relationship. With nominal rates so low, marginally higher bond yields have not dramatically increased interest expenses, and relative valuations have still favored stocks over bonds. Instead, rising rates have reflected optimism that the economy can grow fast enough to avoid crippling deflation.
Over the intermediate-term, Fed tapering should mean that the economic recovery is sustainable without Fed support. One way to measure sustainability is the output gap. Calculated by the Congressional Budget Office, the output gap compares actual GDP to potential GDP (potential GPD is based on the labor force, capital growth, productivity, and non-accelerating rate of unemployment). The output gap has narrowed since the financial crisis, but at -5.6% it remains low by historical standards.
Historically, a negative output gap has been positive for stocks, as investors anticipate the eventual return to stronger growth. As long as the output gap remains negative but is improving, the stock market should be able to digest Fed tapering and modestly higher interest rates over the intermediate-term.
Rising Rates’ Impact on Dividend Paying Stock in Particular
Dividend paying stocks are far from proxies for bonds, but conversationally we are hearing concerns about the possibility of underperformance, or even capital loss from the price drops of this asset class should interest rates on bonds rise.
Dividend paying stocks are still stocks, stocks that tend to have lower betas. If rising interest rates were to trigger a deeper correction, the defensive nature of dividend payers could trump the interest rate risk. Dividend paying stocks could come under pressure as rates rise, but if broad market conditions deteriorate, there may be opportunities to hide within the dividend universe, allowing income-oriented investors to have some exposure to dividend paying stocks. A larger concern for aggressive, growth-oriented investors is not capital loss but rather under performance. The risk is not what happens in the bond market, but what happens in the stock market. Just as dividend paying stocks would likely outperform if rising interest rates were to unexpectedly cause a stock market crash, should stocks in general explode to the upside the higher-beta stocks would leave behind the lower-beta dividend payers.
Geeky Support of the Dividend Paying Stock Story
As discussed earlier, a narrower output gap would mean that the Fed’s objectives are being accomplished. We screened for dates when the output gap has been negative and has risen by at least one percentage point from a trough. Stocks in general have done well, with the equal-weighted S&P 500 rising at a 17% annual rate. The average of different types of yield strategies (for example, highest yielders, fastest growers, longest-term payers, etc.) outperformed the overall market with an 18.52% annual rate.
Also, bond yields have risen in anticipation of the Fed tapering. We screened for dates when the 10-year Treasury rate was moving up and away from trend. The equal-weighted S&P 500 struggled with a 3.1% annual rate of gain, but the same set of dividend paying strategies again outpaced the market with a 4.1% gain per annum.
Then we screened for when both the output gap was narrowing and Treasury note yields have been rising. In that scenario the market has risen generously with a 9.0% gain per annum, while the dividend paying strategies averaged a 12.2% annual rate.
Bottom Line: Don’t bet against the Fed. Should the Federal Reserve allow interest rates to rise it will be tied to better and sustainable growth. Consumers and firms are financially insulating themselves, at least partially, from higher rates. The banking system is also preparing, as the Fed has required banks to run stress tests that include spikes in inflation and interest rates. The banks have enough capital and liquidity to withstand this if it happens.