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Additional central bank stimulus may be on its way. Despite continued signs of strength from the corporate sector, the consumer sector remains anemic. Between entrenched high unemployment, continued weakness in housing, and lackluster GDP, it appears that it is only a matter of time before a second round of quantitative easing (QE2) is launched. QE2 can stimulate the economy in four different ways:

 1.) Drive down real bond yields: Each 1% off the real bond yields would add 20% to the fair value of equities on Credit Suisse’s discounted cash flow model, 10% to housing prices and .5% to consumption

 2.) Funds flow effect: every dollar of quantitative easing gives asset allocators that much more money to invest

3.) Force other central banks to participate in QE: Right now, countries want weaker currencies to help their export base. If the US engages in additional quantitative easing, the dollar should drop against other currencies. For countries to protect their export base from cheaper US goods, they will have to react with their own easing, thereby creating additional global stimulus. In fact, on October 5th the Bank of Japan cut rates, which helped contribute to a nearly 200- point rally in the Dow.

 4.) Psychological impact: So long as the government can continue to borrow money on the cheap, they should not be worried about fiscal tightening too soon. Premature fiscal tightening can prolong a recovery. According to the Federal Reserve’s September 21st policy statement, the Fed stands ready to “provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate”. Why does the Federal Reserve want to use quantitative easing to boost inflation? About 70% of inflationary pressure comes from wage growth. So, when the Fed says that it wants to increase inflation, what it is really saying is that it wants to see job creation. To get job creation we need economic growth. According to Credit Suisse analysts, GDP growth of 2.5% is needed to stabilize unemployment. On September 30th, 2Q GDP numbers were revised upward to 1.7%, 80bps below the 2.5% threshold, supporting the case for QE2. According to Carl Lantz, Credit Suisse’s US interest rate strategist, “The FOMC (Federal Open Market Committee) passed a point of no return on QE2…the Fed almost never disappoints in an easing cycle”. In other words, expect another round of easing.

 Growth stocks, companies with high free cash flow yields and companies with high dividend yields and dividends per share stand to benefit from QE2. As rates go lower, investors become more willing to bid up the price of longer-term earnings growth as there is not as much opportunity to make money through fixed-income interest. Similarly, if QE2 is implemented and succeeds in driving down bond yields, than investors interested in generating income should look towards companies with strong dividends and strong free cash flow as investment opportunities.

A second round of quantitative easing will not help everyone. Some industries depend on higher bond yields and a steeper yield curve for their business model. The life insurance industry, for example, derives a portion of its profits from interest rate spreads. Insurers take incoming premium payments and then loan or invest that same money at a higher rate of interest than what a client earns on their policy. As rates potentially head lower with QE2, life insurers, as well as other companies that have longer duration liabilities than assets, may find it increasingly difficult to generate the kind of lending spreads or investment yields that contributes to their profitability. Also, companies with high unfunded pension liabilities may be hurt by QE2. Pension funds typically hold conservative investments like investment-grade corporate bonds and CDs. Pensions need every dollar they can get to offset pension obligations. If QE2 succeeds in pushing rates lower, than underfunded pensions could face additional pressures from declining annual interest revenues.

Longer term, the Federal Reserve, the President and Congress have to walk a fine line by bringing the deficit under control without squashing the recovery. On October 4th, Fed Chairman Ben Bernanke summarized, “economic conditions provide little scope for reducing deficits significantly further over the next year or too…premature fiscal tightening could put the recovery at risk…over the medium and long-term, however, the story is quite different. If current policy settings are maintained…the federal budget will be on an unsustainable path in coming years”.

 Fortunately, the Federal Reserve remains committed to supporting this economic recovery. There is an old trading adage which advises “don’t fight the Fed”. Right now, the Fed is ready to come out swinging to kick the economy into gear.

Contact Us to learn more about working with Vaughn Woods Financial Group.

Best Regards,

Vaughn L. Woods, CFP®, M.B.A.

*Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views off Delta Equity Services Corp. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA00103

The following sources were used to research and write this newsletter:
- Marketedge.com, Pershing NetExchange Pro, Bloomberg, Credit Suisse, Briefing.com, Standard & Poors
- Garthwaite, A, et al. How to Play QE? Credit Suisse Global Equity Strategy, September 30, 2010