REPEAT Rudi’s View: Life Beyond QE2

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

(This story was originally written and published on Wednesday, 9 February, 2011. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere).

By Rudi Filapek-Vandyck, Editor FNArena

The Australian share market is up every day now. For most investors this marks a pleasant reward for being in the market. Everybody's "making" money, so everybody's happy. To others, however, this is the time when one starts preparing for what lies inevitably around the corner: weaker prices.

As far as my personal gauge for investor exuberance is concerned, I note this month's newfound interest for undervalued banking stocks has now pushed Commonwealth Bank ((CBA)) shares well past consensus price target while Westpac ((WBC)) shares are about to do the same thing. Both National ((NAB)) and ANZ Bank ((ANZ)) have moved within 5% of their respective consensus targets. It's getting "bubbly" again. Consider this an official warning.

For those readers who are new to my personal market indicator, for years I have observed that banking stocks in Australia act as a near perfect indicator for investor sentiment. In short: when share prices for major banks in Australia move beyond price targets, investors have become too bullish and a correction shall follow. Maybe not immediately, as in tomorrow or the next day, but I would expect the share market to start showing signs of rally fatigue pretty soon.

It thus comes as no surprise that I picked up earlier this week that some hedge funds have started preparations for market weakness. The motivations are wide and diverse, but they all have one element in common: this rally is getting long in the tooth. Investors have started to ignore negative developments (Egypt, interest rates in China, labour data in the US, et cetera) and are simply piling up, day after day after day. Certainly, it feels good when and for as long as it lasts.

Time to reconsider.

Some market experts anticipate slower economic data from here onwards. This could potentially put a dent into investors' optimism. The past few years have shown developments in emerging markets precede those in developed markets, or so the theory goes. Most emerging economies started to decelerate in the final quarter of last year. If historic relationships remain intact then data in the US – but above all in Europe – should take a few steps back in the weeks ahead. Also note that some market watchers have observed the Chinese share market often leads the rest of the world by approximately three months. The Chinese share market sold off in late 2010 while Wall Street marched on merrily and we'll have to wait and see what local investors' response will be to another interest rate hike by the PBoC.

I don't have a personal view on any of these two subjects, but I have observed this year's opening rally for the new calendar year has once again been supported by a sharply lower US dollar. Up to the point that stronger US economic data, or at least "anticipation of", became another reason for more USD selling. If European data start disappointing this could well reverse the euro's strength and thus allow USD to stage somewhat of a come-back. Remember: FX markets have been leading other risk assets since late 2007 and they will likely continuing doing so.

The most important factor in today's markets, however, is without any doubt the monetary stimulus by the Federal Reserve in the US. To put it simply: the Zimbabwean Stock Exchange has been by far the best performing market since 1999 (in local currency), but last calendar year the share market moved sideways (up by less than 1% over the year). Previously, the central bank in the country couldn't find enough printing presses, but since the government adopted a multi-currency system, and effectively put a stop to blunt currency devaluation, there's no more hyper-inflation in Zimbabwe. Companies can now repair balance sheets and grow "normal" profits again, but the stockmarket has stopped running as well.

Will the same thing happen in the US? Nobody knows the exact answer, but there's a whole army of sceptics out there and the outperformance for the US market ever since the Fed announced it would move to QE2 has been profound and there for everyone to see. Central banks in countries such as Brazil, India and China have been tightening instead. Even if the story is not quite as simple (because China is at the same time stimulating as well) the difference between rallying markets in the US and lower markets in these tightening countries has been remarkable, to say the least.

While the Federal Reserve is by no means ready to cease its stimulus program, some experts correctly point out it could be merely investors anticipating the end of QE that could put the brakes on this market. Just as the anticipation of QE1 and 2 led to share markets rallying well before the Fed moved into action. This could become "interesting".

It hasn't gone unnoticed that several members of the FOMC seem to have started spreading hints in US media that US monetary policymakers are now contemplating life beyond QE2. Even if it turns out these hints are premature and maybe even wrong at a later date, this will become an issue that will attract everyone's attention.

Craig Ferguson, Director at Antipodean Capital Management, represents one of the hedge funds I talked about earlier. He believes equity markets are poised for a correction, precise date unknown. Ferguson also believes the outlook for equities will become ever so tougher as the market will prepare, and then have to adjust, to life without Fed stimulus.

Here are a few of his thoughts on the subject:

– For equities, it means that the stimulus plank that kick started the rally last year will slowly be removed by mid year. Stocks may continue grinding higher, but they will have to do so via better data, earnings and the M&A cycle alone, rather than with extra stimuli. It will be a challenge.

– For fixed income markets, QE removal will mean a few things. First given that Treasury purchases were concentrated in the short end of the curve under 7 years duration, Ferguson would expect 2 and 5 yr yields to be less supported. Second, because there was no long end buying of note, and markets feared QE to be inflationary, the long end sold off more than the short end. QE removal and tighter policy will encourage long end investors to buy bonds as inflation may not be let out of the bottle. In short, the US curve 2-10 and 2-30 will bear flatten sharply.

– For FX markets, a flattening US curve with higher short yields will be USD supportive. Indeed, it could be quite an earthquake for FX investors, given that USD shorts on the IMM have been sharply rebuilt in the last 6 weeks. It also should be bad news for AUD and NZD.

– For commodity markets, a higher USD will make gains tough, at a time when base metals stockpiles are rising, and when tighter potential policy in the developing world will complement tighter emerging world policy. This should favour precious over base metals.

For better or for worse, this is going to be the all-overpowering theme that will come to dominate this year's outlook, and trading and investment returns. Note Fed Chairman Bernanke is testifying tonight before the Congressional House Budget Committee.

 

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