Wednesday, March 26, 2014

FOMC Asset Purchases And The S&P 500

by Lance Roberts

I have been pretty rough on the market over the last couple of days (see here and here) as to why the markets are unlikely to repeat the secular bull market of the 80's and 90's anytime soon.  However, as I have stated repeatedly over the last several months, such comments do not mean that the markets can not go higher in the near term.  We are reminded of this fact in a recent note from Bespoke Investment Group which discussed the impact of the FOMC's large-scale asset purchase programs (known quantitative easing or QE) on the financial markets.  To wit:

"Throughout the last couple of years we have been updating a version of the chart below which overlays each of the FOMC’s asset purchase plans on the chart of the S&P 500. As one can clearly see in the chart and the table below, periods where the Fed was buying bonds have seen stocks rally, whereas periods where the Fed was not actively purchasing bonds saw two of the largest pullbacks for the S&P 500 during this bull market."


This is something that I discussed previously.  The chart below shows the historical correlation between increases in the Fed's balance sheet and the S&P 500.  I have also projected the theoretical conclusion of the Fed's program by assuming a continued reduction in purchases of $10 billion at each of the future FOMC meetings.


If the current pace of reductions continues it is reasonable to assume that the Fed will terminate the current QE program by the October meeting.  If we assume the current correlation remains intact, it projects an advance of the S&P 500 to roughly 2000 by the end of the year.  This would imply an 8% advance for the market for the entirety of 2014.

Such an advance would correspond with an economy that is modestly expanding at a time where the Federal Reserve has begun tightening monetary policy. (Yes, Virginia, "tapering" is "tightening.) David Rosenberg charted this in his note yesterday (via PragCap):


With this in mind, Bespoke made a very salient point.

"With the benefit of hindsight it was easy to see that the economy was not strong enough to stand on its own following the last two times the Fed ended its bond buying programs.

While the S&P 500 has continued to rally since the taper was announced, volatility has seen an uptick. This leads to the question once again over whether the US economy can stand on its own when QE3 completely winds down, not to mention when the Fed actually hikes rates?"

This is a crucial question considering that the economy is already growing at sub-par rates.  As I discussed recently:

"Since 1999, the annual real economic growth rate has run at 1.94%, which is the lowest growth rate in history including the 'Great Depression.'  I have broken down economic growth into major cycles for clarity."


Such weak levels of economic growth does not leave much wiggle room to absorb an exogenous event, or even just a normal downturn, in an economic cycle.

With deflationary pressures still prevalent in the economy, from rising productivity, excess labor supply and sluggish wage growth, there is little ability for increases in consumption to drive continued economic expansion.  The chart below shows the "consumption function."


Through 2008, consumption as a percentage of the economy, grew from roughly 62% to 68%. That increase in consumption, which supported economic growth, was derived through an $11 Trillion increase in real, inflation adjusted, household debt.  However, therein lies the problem.  If the Federal Reserve does begin to hike interest rates in an already anemic economy, can consumers absorb higher borrowing costs without impeding their consumption?  The answer is shown in the comparison of real personal consumption expenditures as compared to economic growth.


It is unlikely that the consumer can increase debt enough to substantially increase economic growth.  With economic growth heavily dependent on personal consumption, even the much anticipated revival in corporate capex spending will be unlikely able to "carry the ball" on its own.

It is here that Bespoke's question of whether the economy can survive without the support of the FOMC becomes critical.  As I stated yesterday:

"It is quite apparent that the ongoing interventions by the Federal Reserve has certainly boosted asset prices higher.  This has further widened the wealth gap between the top 10% of individuals that have dollars invested in the financial markets, and everyone else.  However, while increased productivity, stock buybacks, and accounting gimmicks can certainly maintain an illusion of corporate profitability in the near term, the real economy remains very subject to actual economic activity.  It is here that the inability to releverage balance sheets, to any great degree, to support consumption provides an inherent long term headwind to economic prosperity."

The real challenge for the Federal Reserve is deciphering between economic statistics at the headline and the real economy.  While much of the economic data does show improvement from the recessionary lows, it also suggests that the real economy is far too weak to stand on its own.

If the Fed is indeed caught in a liquidity trap, then the current withdrawal of support will quickly show the cracks in the economy pushing the Fed back into action.  I think the real question that needs to be asked is:

"When will the financial markets fail to respond to Fed actions?"

It is at the point of "monetary impotence" where the word "risk"  takes on a whole new meaning.

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