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What’s Next for the Economy and Investment Markets

by on March 20, 2011 6:00 AM

In a recent article, I pondered the impact of the Federal Reserve’s policies on the economy, employment and the investment markets (both stock and commodities). 

We are now approaching the end of QE II, which will have pumped, by June 30, between $600 billion and $900 billion into our economy since late last year. As a direct result of QE II, the stock market rallied starting in August of last year (1039.70 on the S&P 500) and apparently only recently peaked at 1343.01, up 29.2 percent. Thank you, Ben Bernanke. 

Gold (as measured by the exchange traded fund GLD) rallied from a low in July at $113.08 to a recent high of $140.61, or a rise of 24.3 percent. 

Finally, the dollar declined 15.2 percent, as measured by the PowerShares Bullish Dollar ETF (symbol: UUP).  Increasing the number of total dollars reduces the value of individual dollars and therefore increases the prices of commodities and stock prices. Normally, there would be accompanying inflation to measure the decline in the value of individual dollars, but with the slack in the economy, especially in residential housing, the CPI (Consumer Price Index) has barely moved during these recent periods of quantitative easing. This is all to cease, of course, as QE II ends on June 30. The question now becomes “What is next?”

The stock and commodity markets are future discount mechanisms. That is to say, their prices reflect how investors believe the economy will look in six months, not how it looks today. Six months from today is mid-August, long after the Fourth of July and the arts festival, and just before Labor Day. So we are now investing in securities or cash depending on what we believe the Federal Reserve will or won’t do with relation to a new round of quantitative easing, or QE III, as it is now called on the street.

Investment advisors are mixed on the future of Federal Reserve easing. Some argue that the QE I, POMO and QE II (quantitative easing one, Permanent Open Market Operations and quantitative easing two) were great for juicing up the stock and commodity markets but did precious little for the general economy, residential housing prices and employment. 

Therefore, QE III is unlikely because QE has proven an ineffective tool with which to stimulate the economy. Others argue that since the Federal Reserve is essentially single-handedly financing the federal budget deficit and keeping interest rates low on federal debt, it is allowing us to run substantial budget deficits—$1.6 trillion as of the latest budget proposal. 

Without QE III, it is feared that the bond market might reject Treasury paper and raise interest rates, shutting the federal government out of the debt financing business. Currently half of the federal debt (about $7 trillion) has to be refinanced in the next 36 months, in addition to the $1.6 trillion deficit the administration proposes in the 2012 budget. This means that the federal government must finance and refinance more than $33 billion each working day next budget year without any potential help from the Federal Reserve. Is this doable without QE III or some variation of QE III? I doubt it. But then, I was holding out for sounder dollar practices and not the QE I program.

Politically, continuing down the same path requires less elegant explanations and more true changes in economic and budget policy at the highest levels. Without the Tea Party members in the House of Representatives, I suspect QE III would likely be a slam dunk. However, the freshmen Tea Party members might just be swamped by the workings of Washington, marginalizing the call for substantial spending cuts (like right now) and sounder monetary policies.

Why am I spending so much time belaboring quantitative easing issues? Because what the Federal Reserve does directly impacts interest rates as well as stock prices, commodity prices and inflation. Once you have the Federal Reserve’s policies figured out, the rest of the investment decisions are straightforward. So here is a potential investment strategy, based on potential Fed policies.

Without QE III, buy candidates include bonds, CDs, money market funds, treasuries and dollars. Sell candidates include stocks, commodities, real estate and precious metals.

With QE III, buy candidates include commodities, stocks, and precious metals. Sell candidates include bonds, treasuries, and dollars.

Of course, this is just my estimate of what might happen. The future often throws in an outlier that makes such straightforward analysis less useful than it might otherwise appear. The point of such work is to frame the potential alternatives in such a way as to illuminate possible outcomes, not to guarantee any outcome.

Current events in Japan and the Arab world, as well as those related to U.S. municipal budgets, can alter the mix of crucial issues surrounding appropriate investment decisions. However, I personally believe we are on a collision course with much harsher economic realities than we have experienced so far. 

I have little faith that our form of representative government will ever become financially prudent again. Those with excess wealth are investors; they don’t get the option to not participate. Their only choice is whether or not they are winners. That is why we pay continuous attention to the markets and the economy.



Dan Nestlerode is the Director of Research and Portfolio Management at Nestlerode & Loy Investment Advisors in State College. A graduate of Penn State University, Nestlerode has been an investment advisor since 1965. He can be reached at danielj@nestlerode.com.
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