On Wall Street

May 3, 2013 6:45 pm

Growth outside QE required to curb distortions in asset prices

We are all bond investors at the moment, and that is not ideal. As the calendar flipped into May this week, the S&P 500 notched up six straight months of gains, its best run since September 2009, and on Friday crowned it by surging beyond 1,600 for the first time.

Heady stuff for equity investors, but it’s a rally that defies the usual characteristics of a bull run, with leadership coming from quality defensive stocks that look like bonds. One only has to look at the performance of Johnson & Johnson, up more than 22 per cent this year, and well in front of the S&P 500’s 13 per cent rise, to see how investors are betting on quality companies that boost their dividends.

Some even term this the ‘SHUT’ rally, as companies in the Staples, Healthcare, Utilities and Telecom sectors have led from the front and remain in favour in spite of trading at lofty valuations, which should raise alarm.

Over in the realm of corporate bonds, investors continue to clamour for yield at ultra-low levels, spectacularly illustrated by the massive demand for Apple’s record $17bn offering this week.

The general hunt for yield in both equities, via companies paying solid dividends, and fixed income markets is the defining element of investor sentiment. It reflects the outsized presence of the Federal Reserve, which this week reminded investors that its monetary pump could run at a higher speed should employment fail to pick up and inflation drop further.

The reinforcement of the ‘Bernanke put’ comes at time when some investors have worried that the recent softer tone in data may be setting the equity market up for another sell-off in May. Since 2010, a spring decline has sunk the market in May and cast a pall over broader sentiment for the economy.

The release of a stronger than expected jobs report for April on Friday, accompanied by upward revisions for March and February, was a relief after expectations were dulled by the recent string of weak job indicators. Beyond the upside nature of the report, job growth is still not strong enough to allay quantitative easing, particularly should inflation keep sliding.

While it remains to be seen whether QE can keep equities afloat into the summer, should economic data remain circumspect, so far it has been very effective. The equity market’s run since last November has been accompanied by no significant setback in the form of a correction in prices. Usually, during an extended up leg, markets pause and retreat in the region of 10 per cent, providing investors with an opportunity to “buy the dip”.

But the biggest one-day sell-off for the S&P during this period has been a drop of 2.3 per cent in mid-April. For investors who missed the boat in January and are seeking an entry point, the market’s lack of a decent correction is a source of frustration and yet another example of how QE is distorting the behaviour of asset prices. It’s most apparent in the corporate bond market, where many companies are issuing debt at absurdly cheap levels and using the proceeds to buy back stock or pay dividends that cater to investors and their current preference for yield.

The harsh reality for investors is that they would be better served by companies ploughing their piles of cash into productive uses that ultimately boost the broad economy. Growth via stimulative tax and fiscal measures, and not extended rounds of QE, is required to restore confidence and reduce the distortions seen across asset classes.

“Without progress on fiscal and structural policies, central banks have no choice but to do more, with diminishing returns and increasing risks,” says Marco Annunziata, at General Electric. “Debating austerity and begging for more QE is a waste of time.”

Policy makers are aware of the costs being imposed by QE. “Fiscal policy is restraining economic growth,” said the Fed this week, moving beyond its previous retort that “fiscal policy has become somewhat more restrictive.”

It’s a plea likely to fall on deaf ears and, as long as QE keeps rolling, the risk is that the economy can’t gain escape velocity and corporate executives focus on financial engineering that only intensifies the current mania for bonds and dividends.

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