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Sizing Up Jackson Hole

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The Jackson Hole Fed Conference will find attention later this week.  Media leaks indicate that the title of the conference this year is Global Dimensions of Unconventional Monetary Policy.  The meeting comes in the wake of a report from the San Francisco Fed which indicated that $600 bln in large scale asset purchases (QE) contributed only 0.13% to GDP growth and 0.03% to inflation.  At the same time, Fed research is suggesting that the signal on interest rates has more impactful on economic activity than QE.        

The Fed is trying hard to bolster growth:

The Fed is giving its best effort to try to help the economy, but it seems to realize that its tool kit is limited and there are risks to its policy.  The recent surge in home prices and historically low level of 10 year treasury yields are examples of policy impact which can lead to imbalance and distortions. The title of the Jackson Hole Conference further illustrates the Fed is operating in an unusual time and is pushing the limits of policy.

The Fed is probably trying to exit QE gracefully:

The Fed seems like it is looking for a graceful way to exit it current QE program.  The recent round of QE, QE3, started in September 2012.  The Fed has run with the program for about one year without a material change in economic activity or inflation.  The Fed probably sees the risk or cost of continued balance sheet expansion outweighing the benefits.

The table above highlights the change in a number of key economic indicators from the end of September 2012 to the present time.  Without a doubt, the biggest beneficiary of QE has been the equity market.  The S&P 500 has been up over 200 points or close to 14.8%.  The flat level of single family housing starts is the most surprising indicator in the table.  Other points include:

Personal income growth was down in real terms.  The Fed did little to bolster the incomes of the average American. Blame higher taxes.

Spending levels did not change materially in real terms.  The growth rates of real personal expenditures and inflation adjusted retail sales were marginally lower.

Employment conditions improved.  Payroll changes were faster and unemployment claims fell.   The unemployment rate also declined. However, weak wage and income growth question the strength of the expansion and dampen the Fed's victory.

Treasury yields rose, but expectations play a big role in shaping the prices. The markets get ahead of the Fed's actual policy.   Likewise, the rise in the trade weighted dollar was a bit surprising.  A more dovish ECB and weak emerging market conditions may have played a role in the dollar’s strength.

Durable good orders, excluding defense and transport, have risen sharply.  This base is easy for growth but the direction is a positive.

Housing was mixed to improved. The weak growth is single family starts is a disappointment, but the existing home sales did rise sharply and total starts increased.  Existing home prices surged and increased at a pace much quicker than income growth.

There are probably enough signs of economic strength in the labor data and housing numbers for the Fed to claim some type of success with its QE efforts and exit.  The Fed’s balance sheet has expanded nearly $770 bln since late September 2012.  This is a lot of liquidity and activism for a marginal increase in employment growth and little change in income growth.

In light of this, there may be pressure within the Fed to start tapering and exit the program. Don't be shocked by a $15 or $20 bln reduction at the September FOMC meeting.  This is probably the expectation and priced.

Get fiscal policy involved:

The table indicates that fiscal policy through changes in taxes, spending, and regulation needs to play a bigger role in bolstering growth.  However, to this point Washington has done a poor job formulating and executing fiscal policy. Blame both parties.   Given an adjusted to higher taxes, which began at the start of the year,  the Fed may believe it can back off on stimulus.  This may put some pressure on the politicians to act and take leadership, but don't hold your breath.

Investment implications:

The capital markets are in the process of pricing the end of Fed QE.   The process has come a long way over the past six weeks, but could continue into the FOMC meeting September 17 and 18.  The treasury market is the best indicator of QE expectations.


My model suggests that the 10 year treasury yield fair value is around 3.25% ex-Fed intervention.   At this level, the 10 year treasury will have about 300 bps of carry – premium to the overnight rate.  The graphic shows the weekly 10 year yield.  The 2003 low around 3.20% is a natural level of yield resistance beyond the channel and the April 2009 high just below 4.00%.  

Equities will still look attractive to the10 year treasury in the 3.50%+ area assuming the economy does not dramatically slow.  Earnings yields are still high compared to corporate and treasury yields.

Stocks will need to see signs of economic growth, a favorable flow of corporate news, or stability in the treasury market to restart the rally. The Fed story, which has been a positive, is fading to the background.  Another reason to invest needs to surface.   Equity valuation is not stretched, but is a fickle catalyst.

Final thought:

It might be worth looking at stocks which are not highly tied to interest rates and have strong upward earnings revisions.  Two suggestions rest in the biotech space.  Beta is hard to remove from your portfolio without a market hedge, but biotech should be less sensitive to interest rates and less vulnerable to the ups and downs of economic growth.  Here are the ideas:

First, Gilead Sciences (GILD - Free Report) , Zacks Rank #1 (Strong Buy).  This company is sporting a PEG ratio of 0.80 against a 10 year average of 1.01.

Second, Biogen Idec (BIIB - Free Report) , Zacks Rank #1 (Strong Buy).  It has a PEG ratio of 0.93 verses its 10 year average of 1.38.  

Both stocks look cheap on the basis of historical growth and are priced less than their expected growth rates.

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