Markets face rough sailing after QE2

Analysis: As the Fed's stimulus winds down, international and domestic risks will spell stormy seas for stocks.

By TheStreet Staff Jun 6, 2011 1:07PM

Image: Life ring (© Gary S Chapman/Photography)By Peter Leeds, TheStreet

 

Even with $600 billion in stimulus money from round two of quantitative easing, job growth has been virtually stagnant (9.1% unemployed), consumer sentiment has fallen (61% in May from 72% in March), and now Reuters is predicting a double dip in home prices.

 

It is clear that QE2 kept the struggling economy on life support but did little to revive it. As it ends on June 30, don't expect smooth sailing for the markets, as myriad of international and domestic risks will conspire to weigh on stocks.

 

With the Federal Reserve's fiscal stimulus ending, an economic vacuum may be left in its wake. The 600-point drop in the Dow over the past month has shown us that we are already beginning to witness the fallout. In fact, QE2 may have done little besides dilute the purchasing power of the dollar and spark domestic inflation.

 

Overseas contagions are beginning to affect things here at home. Inflation in the BRIC nations (Brazil, Russia, India and China) is growing, and their increasing costs of production will eventually be reflected in American pricing.

At the same time, instability in the MENA region (Middle East, North Africa) is pushing oil prices up, resulting in higher costs at the pump.

 

In Europe, nations have used their own version of quantitative easing to distribute massive multibillion-dollar bailouts in an attempt to keep the economies of Portugal, Italy, Ireland, Greece and Spain afloat. As these debt concerns loom overseas, it will add uncertainty to our markets, thus acting to put a damper on American stocks.

 

Defaults, or aggressive austerity measures to avoid the defaults, will become common throughout many parts of the world. Unfortunately, this will include the U.S.

 

When a nation defaults on its debt, pressure rests heavily on the countries to which that debt is owed. A domino effect of debt contagion could be dramatic across Europe, where the nation's economies are linked very closely.

 

The question now really becomes: What does all this mean for America? Once QE2 is over and we begin to feel the effects of the economic difficulties overseas, what do we do?

 

First, and most importantly, we must recognize that America is bankrupt. Once we face this, we'll start to make the hard choices needed to get our economy back on track.

 

To get an idea of America's current fiscal situation, consider the following points. China, one of the biggest customers for our debt, has stopped purchasing. We have hit our debt ceiling for the 10th time in 10 years. We owe $14 trillion, not including more than $110 trillion in entitlements and unfunded liabilities like Medicare. Standard & Poor's recently downgraded our credit rating outlook.

 

We need to sell debt to keep the nation running, meet our obligations and avoid defaulting. To make American debt more intriguing to other nations, we will need to offer a greater return on investment. In other words, we will need to raise interest rates.

 

Besides making our government bonds more attractive, higher interest rates would also dampen inflation. This would be a welcome turn of events, considering that the MIT research team's Billion Prices Project actually calculates inflation at 8% right now, not the meager 2% core rate that the Federal Reserve is touting.

 

QE2 delayed, but did not repair, our economic problems. The wrap-up of the quantitative easing program will take away a good portion of the life support system we've benefited from since November, potentially leaving us exposed to the negative effects of several fiscal concerns, domestically and worldwide.

It will almost certainly be stormy seas for the stock market as the effects of these economic concerns begin to take hold without the buffering of quantitative easing. America will need to steer away from the printing press and make difficult economic choices in order to return to prosperity.

 

TheStreet contributor Peter Leeds is the owner and founder of Peter Leeds Penny Stocks and the author of the new book, Invest in Penny Stocks: A Guide to Profitable Trading. Leeds has been a guest speaker at American Stock Exchange, and has led panels at the prestigious Arch Investment Conferences.

 

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