QEII Boosts Global Asset Prices

Global capital markets rallied dramatically today on the back of yesterday’s announcement by the FOMC that the Fed will expand its balance sheet by another $600 billion though the purchase of US Treasuries at a rate of $75 billion/month. This is in addition to the announcement in August that the Fed would reinvest principle payments from its portfolio of mortgage-backed securities. In total, the Fed is expected to purchase $850 to $900 billion in US Treasury debt, or about $110 billion/month, through June 2011. According to the New York Fed, purchases will have an average duration of five to six years.

While stocks, bonds, and commodities all rallied, gains were paced by the commodity complex. The Dow Jones-UBS Commodity Index rose 2.70%. While strength was broadly based, performance was led by the precious metals, softs, and to a lesser degree, the industrial metals. The precious metals and the softs both gained more than 4% and the industrial metals rose more than 3%. Further quantitative easing, or QEII as the additional monetary ease has been dubbed, will likely result in continued depreciation of the US Dollar. This, in turn will place upward pressure on commodity prices because commodities are priced globally in the US Dollars. The impact of QEII on the Dollar was the driving force behind today’s gains in commodity prices in general and precious metals in particular, which one would expect to rise when the world’s largest fiat currency is devalued.

We are far from market technicians, but we do note that the Dow Jones-UBS Commodity Index has risen to a new 52 week high. While this is generally supportive of further price gains, commodities have rallied 20% over the last four months and the index is currently trading just below the range-bound levels at which it spent roughly 21 months from 2006 through 2007. As such, it may encounter some resistance or suffer a correction in the near-term. Yet the Fed’s decision to implement additional quantitative easing is clearly negative for the US Dollar and therefore supportive of higher commodity prices. While a near-term correction is certainly possible, the path of least resistance over the intermediate term is higher.

Market Returns and the Election Cycle

GMO has studied the relationship between US equity market returns and the US presidential election cycle back to 1932. In his recent quarterly letter, Jeremy Grantham, one of the firm’s founders, provided data on election cycle market performance from 1964 through 2007. His work indicated that, compared with the average, changes in Fed Funds in year-three of the election cycle were negative, i.e. there was a greater tendency toward monetary easing. Grantham also indicated that while this had little impact on economic performance during year-three, it had a dramatic impact on stock market performance measured by the return on the S&P 500. While there was a modestly positive impact on both the market and the economy in year-four of the cycle, Grantham states that the economic impact is largely attributable to the wealth affect of the prior year’s gains in equity markets rather than monetary ease.

While Grantham studied real returns in excess of the market average, we thought investors might also gain insight from the absolute returns associated with this analysis. Our first chart provides the simple average (i.e. not annualized) and median returns from 1964 through 2007 for each year in the election cyclical (i.e. 1964, being an election year, was the fourth year in the cycle). As you can see, year-three, and to a lesser degree year-four, of the election cycle have produced outsized gains.

While returns in each year of the cycle have been wildly divergent over the last 44 years, the third year is the only year in the cycle never to have experienced a negative return (Chart 2).

The above data includes 11 full election cycles and demonstrates a dramatic differential in market performance over the final two years of a president’s term relative to the first two years. However, we felt it was important to include 2008 and 2009 in our analysis. From 1964 through 2007, the worst performance of the S&P 500 during the final year of a presidential cycle had been a decline of 9.1% in 2000. However, the market plunged 37% in 2008. Additionally, while year-one had been a laggard with an average return of 6.99%, the S&P 500 gained more than 26% in 2009. While year-four typically experienced modestly higher than average Fed tightening according to Grantham, massive ease occurred in 2008. For all of these reasons, we thought it wise to review an additional full cycle, adding years 1964-1965 and 2008-2009 to our analysis. As you can see, while this took some of the luster off year-four and increased the attractiveness of year-one, year-three’s performance remained far superior to that of any other year in the cycle (Chart 3). Also, as noted earlier, the addition of these four years significantly impacted the range of returns for year-four, with the benchmark’s performance in 2008 being not only the worst year-four performance, but the absolute worst year over the entire period (Chart 4).

Grantham’s data from 1964 through 2007 suggests that Fed easing has a more robust impact on US equity markets than it does on GDP growth. Given the massive easing in 2008, strong equity market performance in 2009, and a less than stellar recovery, adding the last two years to the study further supports that finding. Importantly, Grantham’s indication that year-three of the cycle typically includes above average monetary easing suggests that the Fed is not as politically independent as one might think. Yet it is worth asking whether the collapsing of equity, credit, and real estate bubbles over the last decade has altered the linkage between the election cycle and equity market performance. In 2003 the market delivered the exceptional performance typical of year-three. Yet 2007 was the second worst year-three performance over the last 12 cycles. While the market’s performance in 2004 was in line with year-four trends, returns in 2000 and 2008 were by far the worst of the year-four returns over the last 48 years. Finally, the S&P 500’s return in 2009 far exceeded the median level for year-one performance while that of 2001 was the second worst year-one performance out of 12 observations.

Next year will be the third year in the election cycle. As this is being written, the Fed has just announced a plan to further expand its balance sheet through the purchase of an additional $600 billion in Treasuries. This, and the surge in corporate profits over the last 12 months, is supportive of US equity prices. However, it seems likely that the aftermath of bubbles in US equities, credit, and the US housing market, have significantly altered the playing field. While a combination of record fiscal and monetary largesse prevented the economy from falling off a cliff, it has yet to restore it to health. With the Fed embarking on a second dose of quantitative easing and interest rates at historical lows, its policy action may not be the game changer it has been historically. Furthermore, additional quantitative easing is likely to result in further depreciation of the US Dollar, placing upward pressure on commodity prices. As such, if it does not provide economic traction, it may well result in stagflation. In short, its far from a safe bet that domestic equities will enjoy the surge in performance that has historically accompanied the third year of the presidential cycle.