The Fed’s Easing Will Boost Equities

Last week, the Federal Reserve upped its ante on monetary easing with its announcement that it plans to continue Operation Twist by purchasing $45 billion each month in long-dated Treasury bonds. That’s in addition to the $40 billion of mortgage-backed securities it’s already buying each month, a policy which it intends to pursue until the unemployment rate falls to 6.5 percent or inflation starts to rise. There will be no corresponding bond sales to offset these purchases, so cash stimulus is being injected into the economy via bank reserves.

Thus far, the stock market doesn’t seem too concerned with this overtly inflationary move. Meanwhile, gold prices have actually been dropping since the announcement, and treasury inflation-protected securities (TIPS) have barely budged. I suspect that’s because the Fed’s taken the unprecedented step of tying an eventual tightening of the money supply directly to the unemployment rate rather than to a fuzzier metric. And because unemployment has been falling pretty dramatically over the past few months, there seems to be an end in sight for quantitative easing.

The market also seems buoyed by the fact that a deal on the fiscal cliff appears to be in the offing. Both Republicans and Democrats have been skirmishing over policymaking by selectively leaking details of their negotiations to the media. In fact, most of the battle seems to be occurring in the sphere of public opinion–and that’s gone a long way toward assuaging investors’ anxiety. That’s especially true now that the president has expressed a willingness to cede ground on some entitlement reform, while the Republicans have said they will allow at least some tax increases. Each new proposal that emerges seems to put the two sides closer to the middle ground necessary to secure a deal.

Should such a deal avert the fiscal cliff, I expect the equity markets to really take off. While there will be headwinds from the spending cuts and higher taxes that are sure to be the result of any deal, it will nevertheless take a huge weight off the market.

And with the Fed boosting the money supply, 2013 should prove to be a good year for equities, particularly if the unemployment rate does manage to drop to 6.5 percent. At the same time, if an improving economy boosts employment and causes the Fed to start tightening again, bonds will perform poorly in an environment of rising interest rates.

So for 2013, equities should play a more prominent role in portfolios, especially since a number of surveys indicate investors have been underweighting stocks for some time.

Investors should also focus on stocks from emerging markets, as they will remain a reliable bastion of global growth. Although economic growth in the developed world will help push equities higher, emerging market economies stand to receive a greater benefit from such growth in the form of strong first-world demand for the goods they produce.

So if the stars continue to align, we should be in for a great 2013.

What’s New

Last week, ProShares Advisors launched ProShares Merger Arbitrage ETF (NYSE: MRGR), which invests in companies that are targets of announced acquisitions. In some cases, the new fund will also take short positions in the acquiring company, such as when it uses stock to finance the deal.

The exchange-traded fund’s (ETF) strategy takes advantage of the spread that typically occurs between the market price and the deal price due to investors’ uncertainty that a deal will actually be consummated. Over time, the spread narrows as that uncertainty diminishes.

The ETF holds a basket of as many as 40 ongoing deals in the developed world.

ProShares Merger Arbitrage ETF isn’t the first merger-arbitrage exchange-traded product to hit the market: IQ Merger Arbitrage (NYSE: MNA) and Credit Suisse Merger Arbitrage Liquid Index ETN (NYSE: CSMA) have both been around for a few years. But it is now the cheapest such exchange-traded product available, with its 0.75 percent annual expense ratio a single basis point below that of the IQ fund.

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