I also noted at the start of this year that if our history books are any guide, we had good reason to remain bullish on equities as the third year of the US Presidential term has proved a goldmine for equities; the Dow Jones Industrial Average has risen in pre-election year every time in the past six decades, and by an average of almost 18 per cent since the mid-1960s.
However, I am also fully aware that the markets are being driven by factors that are clearly not 'normal', the most important of which is the ultra easy monetary policy of the US Federal Reserve and its Treasury buy-back programmes, otherwise known as quantitative easing (QE). We are now at an important juncture, as the second of these programmes ends next month once the US central bank has completed its $600bn buy-back target. Not to understate matters, the policy statement from the next Federal Open Market Committee (FOMC) meeting, scheduled for 21-22 June will be of critical importance for a multitude of asset classes.
Analysts Julien Garran, Tom Price and Angus Staines at investment bank UBS point out: "The Fed's view is that QE2 operates through portfolio choices. When the Fed buys Treasuries, it lowers yields relative to other risk assets - forcing portfolios to shift up the risk curve. That shift incorporates strong capital flows overseas - which can be seen in the dramatic rise in foreign exchange reserves in recent months. In turn, emerging market authorities tend to print domestic currency to buy US dollars, to prevent excessive currency appreciation. This then raises deposits at banks, inducing a lending boom, which is very commodities intense - bullish for commodities, with knock-on effects on commodity currencies and speculative flows."
Moreover, the permanent open market operations of the New York Federal Reserve are not only supportive of the short-dated end of the US Treasury bond market, whereby the US central bank buys in government bonds on specific dates as part of a short-term asset purchase programme, but liquidity has clearly been flowing out of US government bonds into equity markets. Or as Jeremy Batstone-Carr, head of equity research at stockbrokers Charles Stanley, remarked: "When Fed officials refer to 'getting the job done', what they mean is raising the price of equities." Having trebled its balance sheet to $2,600bn since the end of 2008, the equivalent of almost a fifth of US GDP, the question is whether the Fed believes it has now done enough?
That's important because when the Fed ends QE, UBS expects many of the above factors to reverse. Treasury yields will rise relative to other asset classes, making them more attractive and forcing portfolios to shift back down the risk curve. "That induces capital to flow back to the US - directly boosting the US dollar. It forces emerging market central banks to retire domestic currency as the dollars exit, leading to stalling bank deposit growth and stalling loan growth. This in turn triggers a reversal of speculative flows and tends to precipitate credit stress among weak credit," the UBS analysts say.
Some big-name investors have already been positioning themselves for a post-QE world, including Bill Gross who manages the Total Return fund at PIMCO, the world's largest bond investor. In fact, Mr Gross has bailed out of US government bonds entirely. It's not difficult to understand why as US government bond yields are so depressed that a $1,000 investment in three month Treasuries returns the princely sum of a nickel (five cents) in interest!
He is not alone in his cautious approach. The renowned value investor Jeremy Grantham, who co-founded global investment management firm GMO, has noted that while a third round of quantitative easing "would very probably keep the speculative game going", without it there seem to be "too many unexpected special factors weighing against risk taking in these overpriced times." Mr Grantham, who by his own admission has a record of being early on his market calls, adds: "The S&P 500 may still get to, say 1,500, before October (it is currently 1,340), but I doubt it, especially without QE3." The risk-reward balance has tilted against prudent investors, and Mr Grantham's advice to them is not to "hang around hoping to get lucky", but to flip the old bond-market axiom on its head: "Now is not the time to float along with the Fed, but to fight it."
We will shortly find out whether this caution is warranted, or for that matter whether the Fed leaves the door open for another round of QE. Either way, next month's FOMC meeting will have major implications on the path of commodity, currency, bond and equity markets for the rest of this year.
