From: US GIO To: Undisclosed recipients:; Subject: J.P. Morgan Macro Skinny: when the S&P becomes a policy tool Date: Sun, 16 Sep 2012 20:18:23 +0000 Attachments: 2012-09-16_When_the_S&P_becomes_a_policy_tool.pdf Inline-Images: image002.jpg; image003.png; image010.png; image012.png; image013.png Macro Skinny J.P.Morgan September 16, 2012 When the S&P becomes a policy tool 1/ In the summer we argued that the Fed's purchases of high duration assets have been forcing a massive divergence between the economy and the stock market (see "Macro Skinny: Fed policy — carry today, growth tomorrow", available upon request). The decision to embark on `open ended' QE3I will likely make this divergence even greater in the coming years. At the risk of making our role a economists obsolete, we would argue that US data are now much less relevant for the stock market because the stock market itself is now used as a policy too12. By implication, stock prices will likely normalize faster than growth. 2/ The Bernanke Fed is betting on the existence of wealth effects: as stock and house prices rise, consumers feel wealthier and are more willing to spend3. But historically the wealth effect in the stock market has been weak. And since the housing bust, the transmission of monetary policy through the housing market has been severely constricted as well. With 31% of homeowners still in `negative equity', wealth extraction from housing will likely remain limited, at least over the next few years. Bottom line, the Fed is banking on wealth effects from stock and house prices, but it may need to create a lot more wealth for a unit of growth than what past research suggests. 3/There is a tendency to assume that markets are efficient and that QE3 is now almost fully priced into equities. The market has certainly rallied impressively into the FOMC announcement and right after it too. But based on prior rounds of Fed moves (QE2, Twist!, Twist2), it appears that once the knee-j