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Global markets took a sigh of relief following Sunday's Greek vote. With the election over, the prospects of Greece leaving the Euro-zone, for now at least, has to count as a net positive in these otherwise unsettled times. But with Greece's exit no longer an imminent issue, the market's attention shifted promptly to Spain, where yields on government bonds have lately been moving in the wrong direction.
I have been arguing my near-term and long-term views of the market in this space for a while. As you know, I have been relatively bearish near term given the heavy clouds hanging over the market in the shape of the weak global economic backdrop and the continued unsettled European scene. My long-term view, meaning beyond the next 9 to 12 months, is quite favorable as I continue to see the resolution paths for these issues getting clearer in that time frame. My bearish near-term view notwithstanding, I strongly believe in staying fully invested, but making sure that we have the appropriate strategies in place to navigate these uncertain times.
In today's piece, I want to discuss the macro themes at play in the current market and relate that to my outlook for which way we are headed.
More QE Please
Ben Bernanke appeared non-committal on the question of more quantitative easing (QE) in his Congressional testimony. But investors remain convinced that the Fed will announce 'something' in the FOMC meeting on Wednesday. Some surveys indicate investors put the odds of additional Fed support as high as 67%. In fact, it is the rising expectations of more Fed QE that has been helping sustain the market in recent days, even in the face of negative news flow from Europe and the domestic economy.
The Fed's ongoing 'Operation Twist' program, in which it replaces short-term treasury bonds with longer-dated treasury bonds, comes to an end this month. Of the options available to the central bank, they may decide to extend the current program, though many argue that the Fed no longer has that many short duration bonds on its balance sheet. The Fed's interest rate guidance is another form of market-friendly support, and they may decide to extend that even further. Alternatively, they may decide to start a fresh bond purchase program, where they would buy treasury or mortgage bonds.
The option to 'do nothing' is obviously there as well. And many argue that the utility of more Fed support is low given the already rock-bottom interest rates. Some argue for the Fed to keep its 'powder dry' given the potentially greater need for Fed action down the road with much clearer economic hurdles in the shape of the Fiscal Cliff.
These are all good and valid points and the FOMC will weigh them in arriving at its decision. But I strongly feel that the Fed will come through with more easing this week for two reasons. First, it can't afford to wait for the economy to weaken even more before acting. Given this year's election schedule, the Fed will likely prefer to 'take out an insurance policy' now instead of waiting longer and letting its monetary policy actions become hostage to electioneering. Second, the Fed cares for investor expectations. And rightly or wrongly, the market expects it to come through following the recent run of soft economic readings.
Can Euro-zone Survive?
Spanish government bond yields are up above the dangerous 7% level today, which effectively means a very restrictive capital market access for the government. Greece, Ireland and Portugal needed outside intervention when they reached these levels. Spain's banking bailout a few days back obviously wasn't enough and the G-20 summit has limited room for doing anything good.
A major intervention from the European Central Bank (ECB) in the form of another round of long-term refinancing operation (LTRO) will most certainly break the negative momentum in Spanish (and Italian) government bond markets. But the ECB believes that doing more LTRO will relieve the pressure on Euro-zone political leaders to take the tough decisions needed to 'fix' the problem, such as moving towards a banking or fiscal union. The question is whether Spain has the ability to sustain these above-7% yields, while it waits for Euro-zone leaders to make the right decisions in the summit meeting later this month.
I continue to believe that the Euro-zone will survive the current turmoil, but it will take a long time to get there. Here is how I described the issue in this space some time back:
"Euro-zone's leaders, basically Germany and France, have a good understanding of what needs to happen to resolve the issue in the long run. The politics is very messy, but irrespective of whether Greece stays or leaves the union, the Euro-zone will survive. It is in Germany's interest to maintain the Euro and they will eventually agree to stand behind the call for Euro bonds. The Germans feel that if they release the pressure on the peripheral nations to restructure at this stage, these countries will just go back to their old ways of doing things.
That said, it will be a long and drawn out process. The problem is not going to go away; it will flare up every now and then, which will have an impact on our markets. But I don't buy into this narrative of the Euro-zone crisis posing a Lehman-like contagion risk to the US or global financial system. What Europe presents is basically a huge headline risk for the market that we have to learn to live with."
There is not much that can be done with Greece that country may be beyond saving, notwithstanding Sunday's election results. But the core of the Euro-zone is the four countries of Germany, France, Italy and Spain. And it is in the interest of Germany to keep this core intact and ride out the current turmoil while making sure that the Spanish and Italian economies remain on the reform path. The way they placate the bond markets is by agreeing to long-term structural changes in the union (banking union for example) while leaning on the ECB to provide room to maneuver through more LTRO-type actions.
Putting It All Together
I agree with those who doubt the usefulness of more Fed QE to the growth issues facing the U.S. economy at present. I seriously doubt if a further extension of Operation Twist or any other easing measure for that matter can turnaround the recent run of soft economic data, particularly on the labor market front. That said, I still believe that the Fed will announce 'something' this week as it has made the markets expect such support. Keep in mind the 'Bernanke Put' (and the Greenspan Put before that) has some history behind it. It will take a deliberate effort on the part of the Fed to wean the market away from such thinking. And we haven't seen that happen yet.
The market has been anticipating favorable Fed action for some time now and will likely respond favorably should it come to fruition. But I am very skeptical of the longevity any positive momentum following such an announcement. The overall near-term market trend remains to the downside, with this Fed inspired positive sentiment lacking in staying power.
My long-term view of the market is quite favorable, but I can't envision additional Fed support offsetting the near-term challenges facing the market. The combination of European instability and questions about economic growth, both in the U.S. as well as in China and other emerging markets, will keep the markets in check.
Focus List Update
We made four changes to the Focus List this week, adding and deleting two stocks each. The two additions to the Focus List this week are American Capital Agency Corp. ( AGNC - Analyst Report ) , a REIT, and BOK Financial ( BOKF - Analyst Report ) , an Oklahoma-based local bank. The two deletions are Fastenal ( FAST - Analyst Report ) and Saks ( SKS - Analyst Report ) .
American Capital is quite a unique REIT as it invests only in fixed-rate agency securities where payments are guaranteed by the U.S. government or government-owned entities, such as Fannie Mae (FNMA), Freddie Mac (FHLMC) and Ginnie Mae (GNMA). The company has a well regarded corporate parent in American Capital Ltd. (ACAS) and pays a mouth-watering dividend currently yielding 15.4% (yes, that's correct; no typo here). Double-digit dividend yields are not uncommon in the so-called Agency REIT space, but American Capital is quite well placed in this area even otherwise.
The addition of BOK Financial ( BOKF - Analyst Report ) is part of our deliberate strategy to add local/regional banks to the portfolio. This pick is along the same lines as Texas Capital Bancshares (TCBI), which is up almost 23% since joining the Focus List in January this year. Our US Bancorp (USB) and BB&T Corp (BBT) positions, other bigger regional banks, have not panned out as well yet, but those are also solid long-term picks. BOK Financial is a roughly $3.8 billion market cap bank, with a diversified and quality asset base, strong growth prospects, and pays an attractive dividend (yielding 2.8%).
We deleted Fastenal ( FAST - Analyst Report ) , the industrial components distributor, as the stock went to a Zacks #4 Rank. This company is essentially a play on the U.S. economy, but the recent run of weak economic readings appear to be having an impact on its earnings outlook as estimates have started coming down. We are booking a 17.7% gain in Fastenal shares since they joined the Focus List in August last year.
Saks ( SKS - Analyst Report ) exits the portfolio for the same reason estimates have been going down in recent days, pushing the stock to Zacks #4 Rank. We had a 16.9% gain in SKS shares since its addition to the Focus List in October 2011.
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