Sequester will delay end of QE and benefit gold and high yield says BlackRock

7th March 2013

US mandatory $85bn spending cuts known as the ‘sequester’ should mean that loose monetary policy continues for longer and in turn benefit gold and high yield bonds according to fund manager BlackRock.

Russ Koesterich, BlackRock’s chief investment strategist says: “Monetary policy — as measured by real interest rates — is a key driver of gold’s performance. Gold typically does best when real (inflation-adjusted) rates are low or negative, as they are today, as this removes the opportunity cost of holding gold. “Looser–for-longer” monetary policy supports this environment and suggests investors should maintain some small, strategic allocation to gold. What would change our view? Should the economy start to accelerate and the Fed signal an end to QE, that would suggest trimming or removing the allocation to gold. But given that the sequester and the challenges still facing the consumer are keeping the economy in slow-growth mode, we believe the Fed will be on hold for at least the first half of the year, which may help bolster gold prices.”

“Another asset class we believe will benefit from continued Fed accommodation and slow but positive economic growth is high yield fixed income. Easy monetary policy and low rates allows companies with lower credit ratings to refinance their debt at favourable levels, leading to continued low default rates. Were the environment to shift toward rising rates, that would change, but we don’t see that in the near term.”

Fund manager Schroders says that a “wall of worry” about sequestration could see US shares surprise on the upside.

Joanna Shatney, head of US large cap equities says: “We are now in the first week of sequestration directly impacting defence and Medicare spending.  While some of these cuts are already partially reflected in Wall Street estimates, there are likely to be some downward revisions to GDP by Wall Street economists – there is probably another ~50 basis points downward revision risk.  We are watchful of these cuts, but we remain optimistic that growth prospects for corporate earnings will be stronger than consensus expects and that government cuts will not translate into a significant headwind.”

Shatney says that the cuts are manageable and expects the multiplier effects to be muted.  “As long as risks remain, there will continue to be a ‘wall of worry’ for investors to climb, which means the market can still upside surprise. There are other dates to watch including the Continuing Resolution (March 27th), which threatens a government shutdown; we think this is likely avoided but don’t expect to see any budget resolution until later in the calendar year.  We see this as a manageable risk as long as the confidence level of corporations and consumers is not significantly impacted.”

BlackRock says the $85billion sequester cuts will have limited impact in the short term but could have big implications in the second quarter of this year.

Koesterich says the sequester differs significantly from the fiscal cliff because its impact will not be so sudden.

He says: “If the United States had gone over the fiscal cliff, the full brunt of the tax increases would have hit disposable income immediately, and by extension, consumption. In contrast, sequester-related spending cuts will not happen immediately, or all at once.”

He says that assuming the cuts are not reversed their initial impact on the economy in April, becoming visible in the economic data in May.

“If the cuts are not reversed, we see the sequestration as a modest negative for the economy and, to some extent, stocks over the next three to six months. In aggregate, the sequester represents roughly 0.5 per cent of gross domestic product (GDP), which is in addition to the previous fiscal drag of roughly 1.5 per cent. Given the current economic environment, the real impact may be even higher. As we highlighted last week, there is evidence that spending cuts and tax increases have a larger impact on growth when interest rates are stuck at zero. The bottom line? We believe the sequester is not likely to have a big immediate economic impact, but the spending cuts do raise the risk of economic and earnings disappointments as we get into the second quarter.”

Koesterich says that one result of the sequester will be that the Federal Reserve is likely to maintain its policy of quantitative easing.

He says: “With the sequester representing yet another headwind, the Fed is even more likely to take its time before withdrawing monetary accommodation. This was evident in Chairman Ben Bernanke’s recent remarks. In delivering his semi-annual monetary policy outlook to Congress last week, the absence of any real discussion of a Fed exit strategy was notable. Interestingly, this reassured investors, who were growing increasingly nervous over the possibility of an early end to quantitative easing (QE). The fact that the Fed is likely to maintain its asset purchase program, at least through the first half of the year, will help mitigate the effects of a slower economy and is supportive of risky assets.”



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