A twist of fortune?

The Federal Reserve's Operation Twist fiscal program is building the case for an equities rally.

PORTFOLIO POINT: SMSF trustees and investors should steer clear of government bonds. Recent action by the Fed to buy US treasuries will not be enough to drive up the bond market.

Now is not the time to lift cash and bond holdings

I’m always nervous giving short-term tactical advice because I don’t think that is a good way to invest.

However I have been asked numerous times recently what recent events mean for investors? (notwithstanding my medium-term view). Given the recent turn of events, including the Fed’s extension of 'Operation Twist’, investors could be forgiven for feeling a bit glum and for thinking they bode ill.

It’s a perfectly reasonable and logical thought. After all, if the Fed has thought it necessary to extend 'Operation Twist’ then it must hold dire concerns over the economy. If there are dire concerns, if the outlook is that risky, we should be underweight equities and pile into cash and bonds, correct?

That certainly seems to be the growing consensus, with at least one major global investment bank recommending investors short US stocks. And this does seem to be backed by a string of indicators out recently. Last week, for instance, we saw a number of global manufacturing indicators deteriorate. Most importantly for the market, the US Philly Fed manufacturing index dropped sharply, which acted as a catalyst for an aggressive sell-off on Wall St, coming as it did after a slowdown in jobs growth.

Chart 1: Philadelphia Fed manufacturing index

You can see from the chart that the Philly Fed index is at the lowest level since August 2011 and well below the average of 7.7. An ominous sign, there is no question, and US equities fell about 2% in response.

Despite this, I’m not yet concerned that the economic data is signalling a genuine turn. For instance, look at what happened to the Philly Fed index after August 2011 – the most recent trough. Within two months, by October, the index had rebounded over 30 points to sit at an above average 10.8. This is a level it broadly held until the recent slump.

Now this is just one indicator, and despite the significant market reaction it is a minor one. Nevertheless, moves on this index are indicative of a broader point and there is a similar pattern with the major indicators. Take the US employment numbers.

Chart 2 below shows how volatile these numbers are as well. At about the same time that we saw the Philly Fed index slump last year, jobs growth slowed as well. But, as with the Philly Fed index, jobs growth subsequently rebounded and in the ensuing seven months with 1.5 million jobs created. This is a significant number of jobs, annualising to just under 2.5 million. When you consider that the maximum number of jobs created in any year since 2003 has been 2.5 million, this is a very good achievement. There is a limit to how much employment can reasonably be created in one year – and US payrolls are pushing that limit.

Chart 2: US payrolls growth

The Federal Reserve was nevertheless correct in highlighting that employment growth has slowed and the Fed unquestionably remains concerned about the outlook for good reason. There are genuine downside risks. That doesn’t mean however that 'Operation Twist’ reflected a meaningful change in the Fed’s view or an intensification of those legitimate concerns. That’s probably why the Fed, in extending 'Operation Twist’, didn’t make any material changes to its forecasts.

Table 1: Forecasts of the Federal Reserve Committee Members

You can see from the table above that US growth has been revised down a touch – to something a little below trend in 2012, from what they thought would be trend growth in April. Certainly not something that would spark or necessitate additional stimulus, given the extent of stimulus already.

This is why I don’t believe recent events are a signal to shift your asset allocation too much at this stage. At the very least, any move to extend bond or cash holdings would appear to be premature at this point – notwithstanding the Fed’s decision to extend operation twist. In fact if anything it should signal a preparedness to move in the opposite way.

Look at it this way. The US Congressional Budget Office (impartial budget forecaster) reckons that the US budget deficit will be $1.2 trillion in 2012, before declining to about half of that in 2013 and one-third in 2014.

Chart 3: US Congressional Budget Office: projected budget deficits

For this year at least then, the US treasury needs to raise $1.1 trillion not including amounts to replace maturing bonds. So, at the very least, that is $1.1 trillion in new bond issuance the US Treasury must undertake. If 2011 is any guide there is an additional amount of about $600 billion or so, which they’ll need to raise to replace maturing lines and the like. So, for instance, total Treasury note issuance in 2011 was about $1.9 trillion to fund a $1.3 trillion deficit. These are jaw-dropping figures. In 2012 then, you’re looking at about $1.7 trillion in debt issuance of which they’ve already issued $800-900 billion, with about $470 billion of this in the 5-10 year maturity range.

So if the Fed’s recent decision to extend operation twist means $267 billion worth of longer dated bonds will be purchased, then the US government will be buying just over half of all longer term issuance off itself. Funding it by selling short dated bonds.

As strange as it feels to say it, this is actually a step back for the Fed. The original 'Operation Twist’ announced late last year was for $400 billion of longer-dated bonds to be bought by mid 2012. Given the US issued about $480 billion of longer-dated bonds over that period, you can see the Fed pretty much bought the whole lot (not directly). By extending 'Operation Twist’, it has gone from buying almost 100% of longer-dated bonds to buying around half of them. That’s a material move and one that, all else being equal, could actually see bonds sell off some.

To be frank, I just think the government bond market is far too risky for SMSFs or others to be invested in. It’s a bubble not dissimilar to what we saw for commodities or equities in 2008. They could indeed rally further, if sovereign wealth funds or Asian central banks decide to snap up what the Fed doesn’t take. Be very clear though, governments are the biggest players in the US treasury market, so regardless of your view on the fundamentals, I would keep well away.

What can we say for equities then? Well if history is any guide, when the Fed acts, equities rally, and if they don’t, the Fed acts again. Look at the timeline in Chart 4 below.

Chart 4: S&P500 and Federal Reserve actions

When you look at the above chart, you can’t help but get the sense that maybe the Fed is actually targeting the equity market. There is no shortage of people who advocate that. Whatever the case, there is a pattern and it is wise not to ignore it. Don’t fight the Fed as they say. It controls the printing presses after all – or the modern-day equivalent.

In conclusion then, I think it is too early to be looking at recent economic data, Fed moves and price action, as a signal the global economy (and especially the US economy) is slowing. Consequently, I wouldn’t be looking at recent events as a signal that worse is to come and that you need to take precautionary measures. Similarly, recent Fed action will likely prove insufficient to drive the already considerable bond rally forward. 'Operation Twist’ may provide some support to any selling pressure that may develop, but much less than what it did in the first half of 2012.

If anything, the Fed’s action is probably more reflective of the desire of global central banks to continue to support confidence. That being the case, and given that most forecasters still expect solid global growth this year, then 'Operation Twist’ simply adds to the case for an equity rally.

Indeed history suggests this is the most likely outcome. Consider also that at recent meetings, the BoE governor wanted to expand quantitative easing and an ECB member is on record as having said that banks will actively consider cutting rates at the next meeting.

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