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● We think there are five key issues in the market now: i) the degree
of overheating in GEM; ii) the roll-over in lead indicators; iii)
peripheral Europe; iv) the sustainability of corporate margins and
v) the end of QE2. We would place QE2 as being the least
important among these.
● The end of QE2 is not like the end of QE1: The end of QE1 was a
problem as: a) employment growth was just 0.3%, with a 93%
correlation between employment and the S&P 500; b) core
inflation was falling (it is rising now); c) there was no bail-out
facility in place for peripheral Europe (there is now and a 52%
haircut is priced into Greece).
● The end of QE2 has three areas of concern: a) bond yields: We
think a rise in bond yields only becomes a major problem if 10-
year real yields rise to 2%+ b) on equity valuations, bond yields
would need to rise to c4¼% for equities to cease to be cheap; c)
on funds flow: banks can partly (as in the UK) replace the Fed as
buyers of bonds.
● Trades: if bond yields rise, high dividend yield stocks tend to
underperform (69% of the time) and this style is now expensive
(so only focus on yield with DPS growth); investors should be
concerned about leverage.
Figure 1: Initial jobless claims and S&P 500
Source: Thomson Reuters, Credit Suisse research
The end of QE2 is not like the end of QE1
While we believe that the consolidation in equity markets will continue
near-term, we also think that markets can rally by year-end and hence
we maintain our 1,450 year-end target on the S&P 500 (our US
strategists have a more cautious 1,275).
Last year, markets peaked on 23 April, three weeks after the end of
QE1, and then corrected by 16%, while VIX rose from 16% to 46%
(the market trough was 2 July).
The impact of the end of QE2
We look at the potential impact of the end of QE2 from three angles:
1) Bond yields: Clearly bond yields are the focus of attention. While
clearly losing a major buyer can be a problem, we believe that 10-year
bond yields will only rise to around 3.5–3.75% this year because: a)
What the Fed holds is more important than what the Fed buys; b) Our
model suggests the fair value for 10-year bond yields is 3.4%; c) We
continue to believe that core inflation will remain low, in spite of the
recent increase; d) Private sector credit growth remains weak; e)
There is likely to be another buyer of US bonds: the banks, as in the
UK; f) We highlight bond yields typically trough two months after the
ISM; g) Positioning.
What level of bond yields would become a problem for growth or
markets? We think a rise in bond yields would affect markets and the
economy in three different ways: a) The impact on the fiscal
arithmetic; b) The impact on economic growth; c) The impact on
equity valuations.
2) Funds flows for equities: We think the dominant issues on fund
flow are: a) The relative under-ownership of equities by long term
investors; b) 85% of mutual fund inflows have gone into bonds since
the start of 2009; c) Other long-term investors may consider
increasing their equity weightings; d) Most importantly there is
significant scope for corporate net buying.
3) What about liquidity? Investors are concerned that the end of
QE2 will have a negative impact on liquidity. We note that historically
a decline in global excess liquidity has been associated with a
derating of equities and currently the global excess liquidity is close to
neutral levels. However, with the spread between 3M Libor and the
federal funds rate (TED spread) at only 20bps (less than half the longrun
average), the supply of liquidity to the banking sector does not
appear to be a problem.
What happened in Japan after the end of QE
The BOJ announced the end of QE – i.e. the reduction in the Y35 tn
(7% of GDP) target of the current account balances held by depository
institutions at the BOJ – on 9 March 2006. After the announcement,
Japanese bond yields rose by around 30bps in two weeks and the
market peaked in the first week of April and then underperformed
global equities by 13% in the following 8 months.
What matters is a change in the FOMC statement or a rate rise
We believe that to get a significant correction in equities, investors
need to see a clear indication from the Fed that a rate hike is
imminent and thus that the dollar carry trade is set to unwind. Along
with our US economics and interest rate teams, we believe that a rate
hike will not take place before the second half of 2012 and a change in
the FOMC statement will not happen before the end of this year.
Investment implications of the end of QE2
We think the end of QE could be a tactical headwind for trades that
have benefited from extremely low real rates and now have expensive
valuation: high leverage stocks, high dividend yield, short USD, US
equities relative to global and gold.
1) Be cautious on companies with high leverage
2) A slight warning on straight dividend yield
3) The dollar can strengthen, particularly against Yen… favouring
Japanese exporters
4) Stay underweight the US
5) Gold: remain bullish but maybe tactical headwinds
6) We remain bullish of cheap inflation proxies
