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The Muddle Through Market
New York: March 12, 2012
By John Stephenson

The market has been volatile lately as a constant stream of economic developments has resulted in a manic market that has alternated from risk on to risk off as investors react to the latest cross currents. China's cut to its 2012 growth forecast from 8 percent to 7.5 percent had Sino sceptics crying hard landing-sending resource stocks tumbling. The successful shakedown of private investors by the Greek government and a solid U.S. non-farm payroll number on Friday buoyed the market.

Stronger employment data from the U.S. coupled with a shift higher in credit generation suggests that the American economy may be slowly coming out of its funk. While America's economy may be turning the corner, European worries continue as headwinds for investors. The precedent created by the Greek shakedown of private investors will begin to rattle investors once the soothing effects of the European Central Bank's €1 trillion gusher of cheap loans to European banks begins to wear off. Already, Portuguese bond yields are pushing toward 14 percent, a near doubling in a single year.

China's economic growth, which had been a big positive for resources and other "risk on" assets, seemed to dull a little with the government's revised GDP growth target. But the good news for investors is that actual growth rates posted by the Middle Kingdom have managed to eclipse the official targets by as much as 2.5 percent in recent years. Slowing inflation pressures in China may pave the way for further policy easing which could be a boon for investors in the months to come.

But it is the possibility that central banks may remove the financial heroin in the form of quantitative easing that has investors fretting. Now governments are propping up securities by expanding the money supply, buying up assets and keeping rates artificially low but what happens when you take away that prop? A rally in the U.S. dollar faltered last week on news that the Fed is considering "sterlized" bond buying, once Operation Twist concludes in June.

The Fed's previous QE experiments have increased the nation's money supply, with the fed electronically crediting the accounts of banks with new money when it purchased from them mortgage debt and Treasury securities. Faced with weak economic conditions, the Fed has tried to reduce the holdings of long-term securities in the hands of investors and banks. By reducing the amount of long-term bonds in the system, the Fed believes that long-term interest rates will fall, spurring spending and risk taking. To do this, the Fed has conducted two rounds of QE as well as Operation Twist where it sells short-term Treasury securities and uses the proceeds to buy long-term bonds.

Since January 2009, the Federal Reserve has more than tripled its balance sheet to more than $2.5 trillion. It now owns more than $800 billion of mortgage-backed securities and $1.6 trillion of treasury debt. With the Fed's balance sheet more than tripling in the last three years, many have suggested that the Fed's actions have increased inflationary pressures in the economy.

But it is the Fed's approach to bond buying that matters to investors. Unrestrained bond-buying through an expansion of the nation's money supply without any offsetting (sterilization) would push commodities and stock prices higher, or send the dollar lower. But if the Fed manages to buy up long-term bonds without increasing the country's money supply, then those betting on a weakening US$ may be disappointed.

And while many within in the Fed believe that the bank reserves it has created in its previous rounds of QE aren't an inflation threat, this view flies in the face of the popular perception.

The latest rumoured form of QE that Fed officials seem to be musing is a variant on Operation Twist, where long-term bond purchases would be funded by short-term borrowings. This new form of QE would effectively mute the growth in the money supply and therefore reduce inflation expectations since the amount of long-term bond purchases (inflationary) would be offset by an equal amount of selling (deflationary) of short-term bonds.

The Fed's more modest attempts to stimulate the U.S. economy stand in sharp contrast with the more aggressive forms of quantitative easing worldwide. In the last few weeks, the ECB has announced that it had distributed almost €530 billion to European banks, bringing its balance sheet to more than €3 trillion, while the Bank of Japan recently announced that it was expanding its asset purchasing program.

Markets are likely to be range bound and news driven as worries over the ongoing European debt saga are juxtaposed by improving macroeconomic conditions in the U.S. Buy and hold investors should take shelter from the market's likely volatility in the shares of large cap dividend payers, while more aggressive investors will have plenty of opportunity to benefit from an ongoing series of rallies and routes that mark this muddle through market.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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