THE QE2 IS NOT A CRUISE SHIP!!!

 

November 12, 2010



The markets have recovered significantly since the crash of 2008, but the journey has been anything but smooth sailing. This exasperating ride is not likely to end anytime soon. Unemployment is not coming down…there is still much uncertainty about taxes…we may still be facing a double dip recession…housing problems abound…and the mid-term elections have thrown us into gridlock.

The latest adventure is QE2 by the Federal Reserve. Let’s go through a very quick economics lesson: Quantitative Easing (QE) 101.

In a normal economy, the Fed affects monetary policy by increasing or decreasing the Fed Funds Rate, the interest rate banks charge each other for loans. To stimulate, the Fed lowers rates. However, with the rate essentially at zero today and banks not lending, the Fed has to try alternative measures, i.e., Quantitative Easing (QE).

The primary goal of QE is to stimulate the economy and eliminate the possibility of deflation. But how?

  • The Fed prints money.
  • The Fed uses the printed money to buy back Treasuries from the major banks: Citibank, Chase, JP Morgan, Goldman, etc.
  • The banks lend this money to the consumer.
  • This forces money into the hands of the consumer and they start spending.
  • The economy is stimulated and this encourages inflation.

Successful QE relies on the fact that banks will “lend” these additional dollars into the system. It is likely that QE2 will have the following impact:

  • Lower long term interest rates.
  • Lower mortgage rates to help the housing problem.
  • Increase equity/stock prices by making them a more attractive investment than bonds.
  • Weaken further the “dollar”. This will stimulate exports.

 

Will QE2 work? No one really knows, but the Fed has very few bullets left in the gun. And the $600 billion stimulus over 8 to 9 months is their attempt to stimulate an economy stuck in a deep hole. We hope that it will stimulate inflation, which is much preferable to deflation. It is also likely to push commodity prices higher and further undermine the dollar.

This is a bold, complex plan with plenty of risks. Predicting future interest rates is impossible. But it is likely that short term rates will stay low at least through 2011. We also risk alienating our foreign investors, such as China and Japan, who buy 40% of our Treasuries. How long will they continue to lend us money at a near zero rate, especially when the dollar is getting weaker every day?

The Mid Tem Elections = Grid Lock

GOP picks up 60 seats in the House, 6 in the Senate. The 2010 midterm elections are over and frustration has prompted change in Capitol Hill. Republicans will control the House with at least 239 seats; Democrats will retain a narrow majority in the Senate with at least 51 seats.

Here comes gridlock. “We’re determined to stop the agenda Americans have rejected and to turn the ship around,” Senate Minority Leader Mitch McConnell (R-KY) told the press after the election. So will President Obama’s health care reforms be rolled back? Will federal spending be severely reduced?

Through 2012, you may not see much change at all. With Republicans controlling the House, Democrats controlling the Senate and President Obama’s veto pen at the ready, you can expect plenty of legislative stalemates.

Could gridlock benefit the markets? It could be bullish for stocks. With a conservative majority in the House, Wall Street could breathe a collective sigh of relief over the next two years, feeling less regulatory pressure and seeing fewer threats and a more business-friendly environment.

Much of the gains in September and October were likely in anticipation of this event. What we have found to be even more interesting are the reactions from both Republicans and Democrats. Republicans seem to be more optimistic in gaining the house and many new governors, while Democrats seem to be relieved that they were able to retain control of the Senate; and Harry Reid won reelection fairly easily. Let’s hope relief on both sides of the aisle leads to more optimism.

Taxes – will the “Bush” tax cuts be extended?

Both parties want to preserve the Bush-era income tax cuts. Analysts now think Congress may act to extend the EGTRRA/JGTRRA tax cuts through at least 2011. Will they be extended for all Americans, as Republicans want? Or just to households with incomes of less than $250,000, as Democrats want?

Two (lame duck) Democrats have proposed extending these tax cuts for all but the really rich. Senate Banking Chairman Chris Dodd (D-CT) would like them extended for households making less than $500,000; Sen. Blanche Lincoln (D-NE) has proposed setting the break at $1 million. In September, 31 House Democrats wrote a letter to their party’s leaders urging the extension of the cuts for all Americans.

 

Riddle: Joe and Paul both live in the same town, on the same street. They both visit the same hardware store and purchase the same type and brand of product on the same day and at the same time. Paul spends $3.00 on 102, but Joe is charged only $2.00 for 98. Assuming Paul has not been overcharged and Joe has not been undercharged, what have they purchased?


Capital Gains and Dividends

If the Bush cuts aren’t extended, the top rate on long-term gains will rise to 20% from 15% and dividends will revert to being taxed as ordinary income, with a top rate of 39.6%.

The fate of these rates is likely tied to the income-tax outcome, except that the Obama budget has requested a top rate on dividends of 20%.

Outlook

Whether the market will continue to advance over the next several quarters is, of course, impossible to predict. Although we would like to believe otherwise, it seems like Congress operates with a level of careless insouciance, being more concerned with re-election than important legislation. The U.S. consumer continues to work through substantial debt problems. The economic reality is that high unemployment and massive government debt may condemn us to slow growth for years to come.

Fortunately we at Kohlhepp Investment Advisors, Ltd. have investment strategies which can be effective in all climates.

As always, please contact us if you have any questions.

Have a wonderful Fall and a Happy Thanksgiving.

 

Best regards,

 

Edward J. Kohlhepp, CFP®, ChFC, CLU, CPC, MSPA

Edward J. Kohlhepp, Jr., CFP®, MBA


Answer to Riddle: They’ve purchased numbers for the front of their homes at $1/each. Joe lives at 98 Elm St. He purchased two digits. Paul lives at 102 Elm St. He purchased three digits.




 

Sources:

www.wsj.com
Aetna
Capital Mgt, LLC

www.Navellier.com

www.economist.com
Peter Montoya Inc.



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