Fed QE3 edging closer, says Merrill Lynch Wealth Management’s Bill O’Neill

Bill O’Neill, chief investment officer, EMEA at Merrill Lynch Wealth Management, says in his latest weekly outlook that the key test is how markets may benefit from liquidity – assuming there is no more bad news from Europe.

For markets, it looks as if the trend is to trade higher in the absence of further bad news emanating from Europe.

This reflects where equity valuations stand, especially in sectors such as materials and financials. There is a lot of hope imbued in the second long term refinancing
operation (LTRO) from the ECB due in a month’s time. The key test is whether markets will rally on once the liquidity pump has done its job, for now at least. That is where the trend in the European growth cycle will matter, as will the impetus for fiscal reform. We would not be surprised to see stock markets and corporate debt pause after this decent run-up as the first quarter nears its end.

Meanwhile, Mr Bernanke (pictured) continues to expend every molecule of policy in favour of a sustained recovery. With GDP in the final quarter largely driven by a re-stocking of inventories, the challenge is still there. Last week also bore witness to what may prove to be a new era of transparency in the communication by the Fed of its policy intentions to the market. The Fed explicitly set out a 2% long run inflation target – aimed at anchoring inflation expectations – and now each committee member projects the year of the first rate hike. This central bank has in fact moved as far as it possibly could to the other end of the spectrum of what used to be “Fedspeak”: the deliberately delphic statements delivered by former chairman Greenspan.

On this occasion, the Fed used the opportunity to signal to the market that it believed that interest rates would remain at exceptionally low levels until at least late 2014.

That is quite a message to send. The fact that many of the committee members forecast a hike earlier than late 2014 highlights that the dovish members are firmly in charge of interest rate policy and communication. Furthermore, it certainly shows the Fed is more concerned of the risks of low medium-term growth and high levels of unemployment than fears over rising inflation. It is not going to be swayed in its concerns by more positive shorter-term data. 

Asset Class Rating Comment
UK Equities + Further easing by the Bank of England to be supportive but the cyclicality of the market remains a risk.
US Equities + market discounting a negative economic outlook but earnings beginning to be downgraded. Valuations still supportive.
European Equities Peripheral crisis policy paralysis remains, particularly negative for banks, however market valuations are very favourable.
Japanese Equities Yen appreciation unlikely from current levels and equity market fundamentals have begun to deteriorate.
Emerging Markets Neutral Policy easing to be initiated as inflation risks fade. Recent setbacks to provide rebalancing opportunities.
Bonds – Government Government bonds only offer value in a double-dip environment.
Bonds – Credit + Credit should outperform with reasonable fundamentals supporting high yield bonds in particular.
Commodities Neutral Still cautious industrial commodities but prefer gold as a diversified safe haven.
Property Neutral Overweight U.K. commercial property in the long term but near term more cautious.
Foreign Exchange   U.S. dollar to appreciate against major currencies, particularly euro. Medium term case for EM currencies remains.

Source: Merrill Lynch Wealth Management

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