Late last year Ben Bernanke and the Federal Reserve moved to ease tensions in the financial system with a new form of accommodative policy that has boosted stocks but not commodity prices. But according to one leading hedge fund manager, the rise in stocks is a temporary one that will be thwarted by the coming period known as “Taxmageddon.”
Bernanke proposed a new type of accommodative policy. Whereas most investors were waiting for another round of Quantitative Easing,Bernanke announced that the Fed would begin to sell a part of its portfolio of short-term securities and, with those proceeds, repurchase longer-dated government Bonds,” a program known as “Operation Twist,” said Pedro Noronha, fund manager at Noster Capital in London, in his monthly letter to investors.
“The difference between this Operation Twist and the previous program of QE is that the former does not engage the printing presses,” he said.
That, in Noronha’s view, led to the 25 percent stock rally markets have witnessed since late last year, but differed from the first and second rounds of quantitative easing in one crucial way.
“With Operation Twist, the Fed has effectively found a way to keep long term interest rates low—which reduces the discount rates that investors use to value future streams of cash flows, thereby increasing equities valuations—while at the same time managing to reduce commodity prices by not printing fresh new money,” he said.
“What this means is that the Fed has cleverly engineered another bull rally. Not only have investors marked-up shares due to the present value increase of future cash flows, but the Fed has created an extra boost because companies are not facing the same headwinds from input cost inflation as commodity prices have fallen,” said Noronha.
While calling the policy clever, Noronha likens the move to attempting to cure a cancer with an aspirin and warns it will do nothing to solve the wider debt crisis.
“All it has done is push equity markets to unsustainable levels and once again saved the over-levered crowd from the fate they deserve,” he said.
Dealing with ‘Taxmageddon’
Noronha, who is flat this year following gains on his shorts but just 1 percent on his long positions, believes 2012 will become more challenging over the coming months as the U.S. election comes to the forefront of investor’s minds.
“The U.S. will have to start dealing with issues that some market participants refer to as Taxmageddon," said Noronha The term, favored by Washington pundits, refers to a slew of fiscal decisions on topics including tax breaks that are on hold until after the November 6 elections.
“The Taxmageddon effect has been estimated at roughly $500 billion in 2013 alone. It includes the [expiration of the] Bush tax cuts, the general payroll tax rate hike, the regular extenders, the death tax (estate tax) and some of the tax hikes from Obama care,” he said.
With a new bill needing to be signed by the beginning of next year to avoid so-called Taxmageddon, Noronha believes it is time to be defensive.
“Conventional wisdom would have said that this will all be dealt with in a civilized manner because politicians wouldn't want to impose a 3 percent drag on an already-fragile and stimulated GDP,” he “This is where our worries start though.”
“We don't think this process will be anywhere near smooth and Mr. Market is drinking the Kool-Aid (once again), and completely ignoring the issues ahead of us,” said Noronha