This article was originally published on RealMoney.com at 10:00am EDT on Dec 28th, 2015
We hear that Quantitative Easing (i.e. fiscal stimulus) has ended and it must be assumed that without training wheels, the economy will fall down and scrape its knees on the sidewalk. How easily we forget that the economy seemed to get along okay prior to the housing/credit boom of 2005-2007 and its subsequent bust in 2008-2009.
Without the bold, crisis time efforts of our Federal Reserve, it’s very possible our economy and world might look drastically different today than it does. This is as near a certainty as I can imagine. But what happens when your car battery dies—do you abandon it on the side of the road and hail a cab to the local dealership to buy a new one? Or do you replace the battery, remembering that the rest of the vehicle’s engine is still functional?
So what is QE, anyway?
This seems like a rhetorical question. At this point everyone knows that QE stands for Quantitative Easing, which was the Federal Reserve’s name for fiscal stimulus—“injecting” trillions of dollars into the system by buying up Treasury Bonds and Mortgage Backed Securities from late 2008 to 2014. In reality, the Fed didn’t actually inject any dollars into the system, the exercise simply pushed interest rates to the lowest levels on record which was meant to spur investment and spending. While questions still remain as to what extent, and whether there have been some unintended, negative consequences, the experiment has clearly worked.
We know that the QE program has been over for more than a year now (QE3 bond purchases officially ended in October 2014). This means the economy has been operating sans stimulus since then, right? Not exactly…
The [Positive] Effects of QE are Far from Over
Remember that the true purpose of QE was not for the Federal Reserve to own $4.5 trillion worth of bonds; the purpose was to push interest rates down to a level which would encourage spending and investment (and discourage saving). Ideally, this is a “greater good” situation, as there is no doubt savers and retirees are being forced to look in different places for their cheese.
Interest rates are lower today than when QE began. And bonds of all stripes have rallied—virtually in uninterrupted fashion. Those who, for one reason or another, chose not to abandon their overweight bond allocations have not been punished. In fact, they have been rewarded.
The rally in bond prices over the past six years has masked the declining rate of interest earned by fresh money put to work in fixed income instruments. In other words, the fact that a high quality piece of paper is paying me a miniscule 3.00% coupon isn’t quite as painful if that piece of paper is worth more than I paid for it after a year or two.
But what happens when it isn’t worth more than I paid for it after a year or two?
We have yet to see a meaningful period—more than a quarter or two—since the conception of QE in which a portfolio of low-risk fixed income investments actually lost value. We will. And given the insultingly low coupons on bonds that haven’t yet been called, interest rates don’t have to move [higher] by much to create total return losses in such portfolios. When that happens, we may finally see some capitulation among bond investors.
And where will they go to improve on their cash flows with less long term risk to their principal? How about US Large Cap Value stocks?
An improvement in fund flows, coupled with a little break in the US Dollar’s strength, and we could see a resumption in the uptrend for large cap, dividend-paying stocks. How likely is a break in the USD? The chart below shows it may be already underway….
The current yield on the iShares Select Dividend ETF (DVY) is 3.27%—that’s better than the 30-year Treasury, which comes in just under 3.00%. Top holdings include Lockheed Martin (LMT), Philip Morris International (PM), Kimberly Clark (KMB), McDonalds (MCD), and Chevron (CVX). There are many ways to skin a cat, though. The yield on the Energy Select Sector SPDR (XLE) is 3.29%, though this fund is likely to be volatile over the short term for obvious reasons. The iShares Russell 1000 Large Cap Value ETF (IWD) sports a yield of 2.36%, which is still better than the 10-year Treasury.
I could make the argument that the effects of QE will be felt for many years to come.
Have a wonderful rest of the Holiday Season and a Happy New Year!
Adam B. Scott
Argyle Capital Partners, LLC
10100 Santa Monica Blvd, #300
Los Angeles, CA 90067
(310) 772-2201 – Main
Adam Scott’s profile on RealMoney can be found here.