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Central Bank Easing

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Last Thursday, Mario Draghi, head of the European Central Bank (the ECB, Europe’s “Fed”), announced a much bolder step of “quantitative easing” (QE) to combat Europe’s financial crisis.  Markets cheered.  Specifically, the ECB will buy government bonds of troubled European nations to force yields down if needed.  This program (the OMT, “Outright Monetary Transactions”) will involve money creation (“printing”).  This is a stronger action than anything the ECB has done to date, and is one of their most powerful tools.

It’s subject to the target country requesting help from Europe’s bailout fund (which requires deficit reduction).  And two other challenges also loom: the German Constitutional Court will rule soon on the constitutionality of the Eurozone bailout fund, and Dutch elections could also weaken support for Europe’s bailout program.

On the same day, China announced new fiscal stimulus measures.  And expectations for another round of quantitative easing (QE3) from our Federal Reserve are high, fueled by Ben Bernanke’s recent speech stating that the fed “will provide additional policy accommodation as needed”.   And Last Friday’s weak Jobs report raised expectations as well: payrolls in August grew by only 112,000 – down from 141,000in July and short of expectations.

What does this mean for investors?  Since 2008, markets have reacted to a series of actions from the Fed and other central banks.  Our QE1 was announced in late 2008 and significantly expanded in early 2009 – confirming the stock market’s bottom and propelling a powerful market rally of over 100% over the course of the next year or so.  QE2 was hinted at in Bernanke’s Jackson Hole speech in August of 2010 and markets moved up over the next six months or so, but the size of this rally was about one third of the rally following QE1.  A somewhat different form of monetary easing, “Operation Twist”, was announced by the Fed about a year ago and that was followed by a market rally that lasted until April which was substantial, yet smaller still. More recently, in June, the Fed announced an extension of that operation, hinted at QE3 last month, and Draghi hinted at the ECB’s new easing last month, announcing this new “OMT” last week.  Markets have generally moved higher for the past three months, with the S&P 500 advancing more than 12%. 

Central bank quantitative easing is nearly always a near term positive for markets.  But in series, they do appear to be producing diminishing market impacts.  Furthermore, central bank easing does nothing to correct the deficit and budgetary problems of the governments involved, nor their countries’ respective competitive positions worldwide.  Still, in a crisis, such a Band-Aid is sometimes necessary, it’s just never sufficient.   At best, easing averts a panic driven crisis and buys time for policy makers to match spending to revenues and to make other necessary reforms.  At worst, easing may simply fuel inflation down the road.

So far this year, markets have moved up nicely in spite of heightened risks from several quarters. We are pleased that market returns have exceeded our expectations in the short run.  But we continue to see greater than average risks ahead and continue to work to mitigate portfolio risks, particularly with the domestic “fiscal cliff” looming in 112 days.  If the Fed announces a QE3 in the next few weeks as is expected, we would anticipate that markets would continue to react positively in the near term.  Our response would most likely be to seek to reduce oversized equity positions.  We would also be more likely to reassess inflation hedges in portfolios and might accelerate previously planned increases in inflation protection exposure.  We still see little inflation likely in the short term, but the more central bank easing that occurs worldwide, the more likely inflation becomes a threat later.