Where will the QE3 spending make the most difference in asset prices?
As soon at the Fed announced its open-ended commitment to buy MBS at the rate of $40 billion a month, the market sold off the dollar, bought stocks and bought investment grade corporates and junk bonds, sold Treasury Long Bonds, bought non-dollar currencies, and bought just enough MBS to keep prices almost flat (up 2 basis points in yield for the day).
Think about that for a minute — the Fed says they’ll buy MBS, and the price of almost everything else moves more than the price of the MBS.
So the thing to think about is what else might happen as the Fed steps in like the Duke brothers to buy the market (and some day, to sell).
Our task is to figure out where the “disturbance” of QE3 will have the biggest potential effect. Like the proverbial butterfly wings leading to a hurricane on another continent, the financial world has its own set of transmission mechanisms that can lead to unexpectedly large consequences. In the bond world, that mechanism is yield spread.
Perhaps the most striking change that followed the Fed’s announcement was the new all-time low yield for junk bonds. That was in face of rising yields on US Treasuries, with the fall in prices blamed on increased expectations of future inflation. In other words, the spread narrowed more in a single day than we’ve seen for years.
So where will the QE3 program magnify itself most? My bet is on corporate bond rates. They have gone so low that they are now trading at lower yields than the bank loans to those same borrowers, even though the bank loans have higher credit priority should the borrower default.
We are seeing huge increases in corporate debt issuance now that QE3 is in action. Drug chain Walgreens takes the prize for fastest out of the gate. They raised a whopping $43 billion in new corporate debt the day after the announcement. But the flood of other issuers is just getting started.
Perhaps most interesting, though necessarily with a delay, will be the effect on private equity and LBO (leveraged buyout) deal-making.
As we’ve seen before, the differential in tax rates embedded in our tax code can make all the difference in how people choose to invest, or disinvest. Since the 1980’s, the huge difference in capital gains tax rates has provided a strong incentive to make money by taking profits from selling or refinancing rather than from building enterprises and reinvesting.
After all, the essential arbitrage built into our corporate tax code makes all interest payments an offset to profits, so that loading a company with enough debt to soak up all the profits has an automatic tax-shielding benefit for those who control the allocation of profits. By simply borrowing enough (and taking the money out of the enterprise), a smart team of financial operators can make huge amounts of money, and even the money they make can be shielded from paying taxes literally forever, as long as they “make” the money offshore and don’t bring it back (directly) to America. Even if they do bring the trading profits back onshore, it is only subject to capital gains tax rates, and only years later if they delay.
So here’s what I expect QE3 to do, but I can’t predict individual stocks that will benefit, unfortunately. I can tell you what the companies that have outsized gains will look like, however.
They will be takeover targets, and some of them will be in industries that never looked attractive to private equity shops before now. For example, grocery stores. It’s a famously high-volume, low-margin industry. But even grocery store chains make profit margins in the mid-to-high single digits. Junk bonds can be issued now at roughly 6.5%, so even that thin profit margin can support the debt service of a junk bond. If the target company owns real estate or employee benefit surpluses like retirement funds, so much the better. If it has unions that can be “busted” by new ownership, that’s a trifecta.
Another sector that might have a surprise or two is developmental drug companies. Since Big Pharma can now borrow nearly unlimited funds at very low rates thanks to QE3, I wouldn’t be surprised to see Big Pharma go shopping for new drugs just starting on their patent protection time window. We might even see hedge funds or private equity funds step in ahead of Big Pharma, and attempt to gobble up a bunch of prospects before the big boys finish making their shopping list.
Finally, I’d be looking at resource companies (miners, energy extraction equipment makers, etc.) that are following Chinese demand downward, but have a better oil field drilling widget or a pile of ore waiting to be dug up. The last group is a little dicier, since the global pressure on pricing through oversupply can lead to a lag in cash flow, along with the natural delay to payment from the moment you dig it up until you get paid.
If you are lucky enough to own a target company, chances are you’ll see a nice short-term gain on those stocks as this trend gathers momentum. Knowing which target companies will actually be taken over is the 64 billion dollar question.
The one thing I’m quite sure of is that owning MBS while the Fed is buying them won’t be the best game in town.
Of course, the biggest payday will be for merger and acquisition bankers, private equity fund managers, and the lawyers who service them, but I’m not sure how you get onto that gravy train unless you’re already there.