The perils of quantitative easing
There are worries that one of the biggest consequences of more easing is inflation.
Federal Reserve Chairman Ben Bernanke sounded subdued Monday in his current assessment of the economy. It is uncertain whether the current pace of jobs growth is sustainable, he said.
Furthermore, Bernanke said that the number of jobs added lately outpaces other actual economic data. This was taken as good news, of course, because it left the door open for more quantitative easing and continued rock-bottom interest rates.
You've probably heard the analogy by now. The stock market is like a junkie with an insatiable craving for another hit. Of course, the "hit" is another round of quantitative easing, or QE. Monday, the junkie received the news it most wanted to hear: its supply of QE will remain intact for the foreseeable future. And Mr. Market threw a celebration, climbing higher by more than 1% on the session.
Of course, we have seen what happens when Mr. Market is denied his drug of choice, and it isn't pretty. It comes crashing down like an addict following a three-day bender (see August of 2011 for details). It's crystal clear that the market has become dependent on Bernanke and his QE policies.
In real life, we know that the all-too-common outcomes for the addicted include either time behind bars, or even worse, significantly diminished health or death. So, naturally, the question becomes, is the market and economy headed towards this dreaded path?
In my March 26 post on four overpriced stocks, I stated that I believed we are currently in the midst of the "Bernanke Bubble." This isn’t an original viewpoint, of course, but it is one to which I hold strong conviction. Just as Alan Greenspan helped to create the massive housing bubble, by keeping interest rates very low even during a time of strong economic expansion, Ben Bernanke has propped up stock prices artificially through QE policies that have kept interest rates at historic lows.
Much has been said, and many pundits have touted the supposed benefits that QE has created. The argument is that by purchasing treasury bonds from banks, banks will then have more cash to lend out to consumers and businesses. Also, the low rates foster a positive environment for the housing market, and businesses can borrow money at nearly no cost to expand. The hope, or ultimate goal of QE is too entice and stimulate people and businesses to spend more.
Weak consumer spending and income
If indeed the goal is to stimulate more spending, the success of QE is highly questionable. From January of 2011 through January 2012, personal income and spending have essentially flat-lined, and may perhaps be in the early stages of decelerating. In the 2003-2007 period, personal income grew between 4-8% annually, and today is topping out at 4%.
Spending has not been very encouraging either, coming in flat in December, and then inching up to 0.2% growth in January. From the summer of 2010 through the spring of 2011, personal spending was never below a .3% growth rate.
This anemic spending and income growth, combined with the spike in fuel prices, is why I have been bearish on the consumer discretionary sector of late, and feel that the SPDR Consumer Discretionary ETF (XLY) is overdue for a pull-back.
Consequences of QE
The most frequently talked-about consequence of QE is inflation, which has not been an issue up to this point. But, if we look at what is happening across the Atlantic, we can see clear evidence that QE can ultimately cause inflation.
In England, the country is implementing a program in which it will purchase ~ 275 pounds worth of gilts. U.K. inflation has consistently overshot its target rate, and when combined with stagnant income growth, has resulted in depressed demand for goods and rising job loses.
Banks are also not lending at desired levels because there is a fear that once rates go higher, households will struggle make their mortgage payments.
Consequently, banks have been hesitant to pass on the easy money from the Fed to consumers, constraining economic growth and the impact of QE. But, with the economy showing some improvements, banks will begin to feel more confident and comfortable. At that point, the trillions of dollars that the Fed pumped into banks will turn into loans, flooding the market, with the potential to cause a significant bout of inflation.
This expectation for higher inflation is a primary reason why more money managers and investors are parking money into precious metals, and into funds like the SPDR Gold Trust (GLD). The creation of more treasury bonds for the Fed to sell, in order to buy back bonds from banks, has also greatly devalued the dollar. This, of course, is also a catalyst for GLD.
When inflation begins to rear its head, the Fed will act by raising interest rates. The concern is that when the Fed does raise rates, the underlying economy will still be too fragile to handle it. Considering that personal income and spending have not shown clear signs of improvement – remember, 70% of the economy is driven by consumer spending – we may either be in a seemingly endless cycle of QE, or the Fed will cease its QE polices and the stock market will tumble. If inflation becomes problematic before spending and income improve, or if the dollar becomes so de-valued that it loses its reserve currency status, the Fed may have to act before it wants to.
Hedging your bets
It is impossible to predict how this will play out. After all, the actions by the Fed are unprecedented. But, what is certain is that this Fed-engineered rally by the stock market poses very worrisome risks. There are ways to protect yourself, however.
For instance, adding stocks to your portfolio that perform well during periods of rising inflation can be one safeguard. Potash (POT), the provider of fertilizer and feed products, is one such stock. When food prices rise, so do farmers’ incomes, creating a favorable business climate for POT and other fertilizer stocks.
Another option is to look towards energy stocks with high yields, such as ConocoPhillips (COP). The premise here is that energy prices escalate during times of inflation, and its exposure to commodities such as crude oil, LNG and natural gas will be a positive for its stock. Also, its dividend yield – currently at 3.50% -- will help insulate investors.
Finally, an easy way to protect yourself is to buy the ProShares UltraShort S&P 500 ETF (SDS). This ETF takes a leveraged bet against the S&P 500, corresponding to twice the inverse of the daily performance of the S&P 500.
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