No matter what the Federal Reserve does to jump-start the stalled economy — and no matter what that effort is called — financial advisers should anticipate more downward pressure on interest rates.
“Whatever form the quantitative easing takes this time around, we know that higher-beta stocks are more likely to rally, and that should mean that small-caps will perform stronger than large-caps,” said Michael Souers, a mutual fund analyst at Standard & Poor's.
A spate of worsening economic data — including a Labor Department report released Sept. 2 showing that the U.S. economy added no new jobs in August — significantly raises the likelihood that the Fed will announce dramatic steps to try to revive the economic recovery when it meets Sept. 20 and 21.
Although it remains to be seen what those steps will be, Mr. Souers said he expects that the central bank will increase its purchase of Treasury securities.
“All bond funds should suffer, but there is so much more risk on the long end of the curve,” he said.
Consequently, investors should avoid low-rated fixed-income funds holding long-term government bonds, Mr. Souers said.
During the first two rounds of easing enacted by the Fed, longer-term Treasuries were the biggest losers.
The $1.2 trillion first round of bond buying, extending from March 2009 to March 2010, saw 10- to 20-year Treasuries decline by 4.8%. The $600 billion second round, known as QE2, which wrapped up this June, saw long-term Treasuries fall by 2.7%.
The U.S. dollar lost ground during those periods, but equities, commodities, gold and Treasury inflation-protected securities stood out as winners.
During the first round of easing, the S&P 500 gained 50.5%, the S&P GSCI Commodity Index jumped 51.2%, gold rose 18.2% and TIPS were up 6.4%. During QE2, stocks gained 26.1%, commodities rose 31%, gold was up 21.2% and TIPS gained 6.3%.
“The precedent is there for another knee-jerk reaction from the markets; however, there are some new variables at play this time,” said Sam Jones, president of All Season Financial Advisors Inc., which has $110 million under management.
“The problem is, as each easing has happened, we've gotten closer to economic weakness or a double-dip recession,” he said. “So with QE3, we just feed the baby a little more candy and she smiles for a little bit.”
There are multiple quantitative-easing scenarios being considered by the Fed, with the most likely outcome expected to be along the lines of a so-called Operation Twist, which involves selling shorter-term Treasuries and buying longer-term ones.
Although the swap strategy doesn't alter the government's ownership of Treasuries, it could have a psychological impact on the markets and trigger a reaction, according to Matthew Lloyd, chief investment strategist at Advisors Asset Management Inc. The firm oversees $7.5 billion in investor assets.
“I think Operation Twist would have a marginal impact on the yield curve, but really it's a confidence thing,” Mr. Lloyd said.
He thinks that the equity markets in general are anticipating a rally that could be triggered by a third round of easing by the Fed.
“I like large-cap dividend payers because of the international exposure, potential participation in acquisitions, potential stock buybacks, and we're seeing a large amount of insider buying,” Mr. Lloyd said.
In terms of valuations, he pointed out that the average per-share cash flow of the S&P 500 is at $156, which compares with $83 in 2007 and $75 in 2001.
Even if the market's response is more muted this time around, mutual funds that expose investors to riskier assets should benefit, according to Rob Stein, global head of asset management at Astor Asset Management LLC, which oversees $1.3 billion.
“Look at stocks, metals, oil, commodities — anything you would put money into if you were to take it out of Treasuries,” he said. “That's the purpose of quantitative easing, and they're already telling you you'll get nothing for Treasuries for at least the next two years.”
Meanwhile, Mr. Stein isn't convinced that the economy even needs another stimulus at this point.
“Have we become a society now that can't take a couple of lukewarm days?” he said. “The markets are up 10% from a year ago and GDP is not great at 1%, but it's not -6.5% like it was at the end of 2008.”
Email Jeff Benjamin at [email protected]
