William Riegel, Head of Equity Investments
Lisa Black, Head of Global Public Fixed-Income Markets
September 14, 2012
U.S. equity markets surged in the wake of the Federal Reserve’s much-anticipated announcement of a third round of quantitative easing (QE3) to stimulate the sluggish economy. The S&P 500 Index gained 1.6% on September 13, reaching levels not seen since 2007, well before the financial crisis and Great Recession. Financial stocks fared especially well, rising 2.6%. Through September 13, the S&P 500 is up almost 8% quarter-to-date and nearly 18% year-to-date. European stocks have also posted robust gains in the third quarter to date: the MSCI Europe Index is up 10.6%, led by Spain (+15.5%) and Italy (+14.8%).
Most fixed-income sectors also rallied on the QE3 news, building on a rally that had begun several days before in anticipation of the Fed’s announcement. “Spread products” (higher-yielding, non-Treasury securities) such as mortgage-backed securities (MBS) and corporate high-yield bonds were among the strongest performers. Inflation-linked bonds also outperformed. The Barclays U.S. Treasury Inflation-Protected Securities (TIPS) Index returned 0.74% on September 13, reflecting optimism about QE3. That may have potential inflationary effects, which could increase demand for inflation-protected assets.
Gold, also considered a hedge against inflation, saw its price climb nearly $35 on the day of the Fed’s announcement.
Meanwhile, U.S. Treasuries were hit hard. After closing at 1.59% as recently as the previous week, the 10-year Treasury yield stood at 1.75% on September 13 and was approaching 1.9% on the morning of September 14.
QE3 seen as a substantive, aggressive policy move
Details of the QE3 announcement revealed a program that was larger and more far-reaching than most observers had expected.
Open-ended purchases. The Fed committed to buying $40 billion in mortgage-backed securities per month with no specified end date. Monthly purchases will continue for as long as the Fed deems it necessary to bolster the prospects of the U.S. job market.
Extension of near 0% short-term interest rates. The Fed committed to maintain its target federal funds rate at between 0% and 0.25% at least until mid-2015. Previously, the low-rate pledge extended to the end of 2014.
The Fed hopes that QE3 will put downward pressure on long-term interest rates and spur economic growth. Moreover, the Fed indicated that it will remain committed to its low-rate bias even after the unemployment rate begins to come down. "We are not going to rush to tighten policy," said Fed chairman Ben Bernanke. "We are going to give it time to make sure the recovery is well established." Meanwhile, the "Operation Twist" program, in which the Fed sells short-term securities on its balance sheet and replaces them with long-term securities, is scheduled to continue through the end of this year.
Weekly jobless claims disappoint, but other recent releases have surprised on the upside
First-time unemployment claims rose by 15,000 for the most recent week, to 382,000, while the four-week moving average climbed to 375,000. Much of the increase was attributed to delays in unemployment filings by people affected by Hurricane Isaac. Economists generally consider claims that are consistently at or below around 350,000 to be indicative of improving labor markets, while claims above 400,000 signal deteriorating employment conditions. Claims have been within a tight range for the past several months.
Other recent indicators have been more promising. The Citigroup Economic Surprise Index, which tracks the extent to which economic data releases vary from consensus expectations, moved sharply into positive territory during the past week. The index hit +26.1 on September 12, well above its recent low of -65.3 on July 19. The higher the index reading, the more that economic indicators continue to surprise favorably.
Among data releases issued during the past week:
A good week for Europe
The latest hurdle in addressing Europe’s sovereign debt crisis was cleared. The German Constitutional Court issued a favorable ruling on the establishment of the permanent €500 billion ($644 billion) bailout fund known as the European Stability Mechanism (ESM). The decision was widely expected and added to the sense of relief generated by the previous week’s announcement of a major bond-buying program by the European Central Bank (ECB). Financial markets view the latest signs of progress in Europe as having measurably reduced the risk of a systemic shock such as a breakup of the eurozone.
Improving global outlook tempered by real risks
Recent data and developments suggest somewhat improved prospects for the U.S. and global economies. In addition to positive economic surprises and major policy initiatives in Europe and the U.S., policy makers in China appear to have moved toward greater economic stimulus via the announcement of several new infrastructure projects. Although China remains a concern based on company surveys and weak August data, there has been a major reversal in the long-slumping Shanghai “A Share” market. In our view, the trajectory of this market is the primary indicator of the extent to which real stimulus has been applied.
Barring geopolitical shocks or significant weakening in the global economy, the effects of newly announced policy actions, along with a respite from the European debt crisis, position the markets to hold on to their recent significant gains. However, the risks remain real:
Given recent developments, short-term trading sentiment in the equity markets has become more bullish, but not to an extreme level that would potentially signal an imminent market correction. Long-term sentiment gauges remain bearish, which supports the case for further upward market movements heading into 2013.
In fixed-income markets, the Fed expects its ongoing commitment to a low-rate environment will continue to drive investors to seek higher-yielding securities, assuming that demand for the riskiest of these assets (such as venture capital, private equity, and high-yield bonds) may lead to greater business investment and job creation. This would allow the Fed to fulfill its dual mandate of promoting maximum employment and stable inflation. With this view in mind, the Fed has upgraded its economic forecasts to include a drop in the unemployment rate, to a range of 6% to 6.8%, by 2015.
The information provided herein is as of September 14, 2012.
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