What QE2 Means for Your Portfolio
By Greg Sweeney, CFA, Chief Investment Officer, Bell State Bank & Trust
QE2, the second round of cash injections into the U.S. economy, is about to be announced. Our predictions of the potential effects are as follows:
1. Baseline: Probability 55% – A large-scale asset-purchase program of roughly $500 to $600 billion focused exclusively on the purchase of Treasury bonds.
2. Shock and Awe: Probability 15% – The Fed surprises to the upside with a program of $1 trillion to $1.5 trillion, intending greater economic and financial effects well beyond expectations.
3. Gradual Pace: Probability 30% – The Fed does not stipulate a fixed size or duration for QE2, but only the amount of its initial purchases, around $100 billion per month.
Little economic impact
The Federal Reserve keeps pulling on this lever—although it has had little positive impact on the economy—while continuing to support a back-door bailout of money-center banks. Growth will likely stay below trend, inflation as measured by the consumer price index (CPI) below target (with actual experienced inflation well above measured inflation) and unemployment uncomfortably high. The risk of a “double dip” recession is reduced. For the Fed to come close to fulfilling its dual mandate of full employment and price stability, a new plan is needed. At some point, investors will begin to wonder what happens when medication is removed from the markets.
• U.S. growth is up just 0.1%, with “shock and awe” growth (attributed to major stimulus measures) up just 0.2-0.3%.
• U.S. inflation as measured by the CPI is up 0.1% to 1.0%. (experienced inflation is in the 3 to 5% range due to increases in commodity, energy and healthcare costs.)
• Our baseline scenario makes no discernible difference to global growth.
Growth forecasts of 1 to 2% in the U.S. economy are half of what they were over the last 10 years, but are more “core” in nature. During the last 10 years, we experienced a period of economic growth that exceeded income growth, with the difference made up by easy credit terms. Now that easy credit is gone and consumers are targeting reduction of their own debt levels, it seems growth will be more consistent with income and population changes. This is not a bad thing, just different from recent past experience. It does have its challenges for municipal and federal tax budgets, as spending has increased at a pace well ahead of even the best expectations for economic growth, since the government was lulled into expecting much higher tax revenues.
• Commodities: There is limited upside from here, unless the market expects further declines in the dollar and looks to commodities to preserve value.
• Currencies: Dollar weakening may be more gradual in view of the U.S. Treasury Secretary’s effort to calm currency tensions ahead of the G20 and plans to avoid competitive foreign currency risk management policies
• Rates: The flattening of the U.S. Treasury curve likely has run its course for all but a shock and awe scenario. The Federal Reserve’s own model for Treasury values shows that U.S. government securities are too expensive. This model shows Treasuries to be the most overvalued since the financial crisis before December 2008, just before 10-year note yields nearly doubled in the following six months. In that case, 10-year note holders saw 13% of their market value disappear.
• Emerging Markets: These are the main focus of the U.S. capital outflow. So much has been priced in, but the portfolio shift is likely to continue, causing near-term outperformance, but sowing the seeds of future bubbles. Some emerging markets are taxing new capital coming into their markets in an effort to slow it down.
• Credit: There are still expectations for bit of upside here. With investment-grade and high-yield credit tightening, emerging-market and high-yield corporates are likely to issue into strong demand as spreads rally a bit more.
• Equity: Both developed and emerging-market equities likely have already gone too far. Eventually, disappointment will set in as QE2 lacks any meaningful impact.
What does this mean for investment portfolios moving forward?
The U.S. Treasury yield curve serves as the foundation for measuring the “spread” or additional yield available on all other fixed income securities. The thinking is that U.S. Treasury rates accurately reflect the yield available on “risk-free” assets. In this case, “risk free” means free from risk of default. The additional spread available on non-Treasury bonds (e.g., corporate bonds, mortgage backed bonds, asset backed securities) is intended to adequately compensate investors for risk that comes from owning bonds not issued by the U.S. government that may default on their payment of interest and/or principal.
The system of measurement is flawed in this environment. The basis for using Treasuries as the risk-free rate is not adjusted for the manipulation by the Fed. In other words, the Fed is intentionally overpaying for government bonds in the open market in an effort to force investors into more risky assets. These riskier assets are themselves overpriced both because demand increased, and because the basis for calculation value (U.S. Treasury rates) has been artificially lowered.
Where is the risk?
Coupon income historically makes up about 80% of the return on fixed-income securities. Today, coupon income makes up only 30% or less of the total return on bonds. Using the 10-year Treasury again, the YTD return through September 30 is 14.6%. Coupon income makes up 2.88% (20%) of the return, with market value appreciation making up the other 11.72% (80%). The fixed-income market has been turned upside down. Why does it matter? 14% is a great return. Because most fixed income investors never earn any more than the original yield on the security. Why not? Because to capture the market value gain, the bond or bond fund needs to be sold. Why don’t investors do just that? Because then they need to reinvest in the current interest rate environment, which is lower than the interest rate earned on the existing holding. Isn’t the gain in the bond or bond fund locked in if an investor just holds it? No—because over time, the market value gain (or loss) drifts back toward par until the bond eventually matures, and the investor is left earning just the original purchase yield.
When the market gets turned upside down, benchmark comparisons are less meaningful, because their returns reflect large market value gains that will not be realized by investors unless bonds are sold. This return illusion is encouraging investors to put money in fixed-income investments without realizing the situation outlined above.
How low are treasury yields right now?
The 10-year Treasury yield is 2.51%. An investor in a 35% tax bracket has an after-tax yield of 1.61%. Over the last 12 months, the measured CPI inflation rate has been 1.1%. This security would have real final yield to the investor of 0.51% after one year, even though the total return reported is 14.6%. If inflation or taxes went higher, the real yield would quickly go negative, and the market value portion of the total return would quickly disappear.
What options are available?
The goal is to capture the best yield possible while moving through current economic conditions, with the idea of investing at higher yields when the market environment goes back to normal—in other words, trying to avoid a large portion of the loss in market value on bonds that occurred in the first six months of 2009. If bonds go back to par at maturity, wouldn’t losses be avoided? True, the fact that there is a market value loss at all means that current interest yields are higher than when the bond currently owned was initially purchased. If the bond currently held was shorter term and near maturity, its proceeds would be available to reinvest in this higher interest rate environment, providing better coupon income and avoiding or at least limiting market value losses. It is a delicate balance between being far enough out on the yield curve to capture the best coupon income while having short enough maturities to reinvest dollars when yields move higher.
There are a couple of portfolio strategies to generate incrementally more yield while moving through this type of environment.
1. Accept lower credit quality
2. Move out longer on the yield curve
3. Sector concentration
4. Some of each of the above strategies
5. Accept the market conditions as they exist and continue with the same strategy as normally used.
The first three strategies offer some form of yield enhancement with their own unique contribution to changing the risk profile of a portfolio. Lower credit quality exposes the portfolio to greater default risk. Moving out further on the yield curve exposes the portfolio to reinvestment risk and yield impairment if interest rates rise. Sector concentration introduces more allocation risk and the prospect that the sector being over-allocated remains under pressure.
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