FT Alphaville " Morgan Stanley on fundamentals versus monetary policy Central bankers in the US and Europe may think they're engaging in policies accommodative to economic growth, but two can play in this game of acronyms! The team at Morgan Stanley fights letters with letters, in a note released on Friday (emphasis ours): Global central banks have done all in their power to rescue the financial markets from the doldrums. Markets have clearly noticed their unwavering intent to "do whatever it takes" and the open-ended nature of the response. Notwithstanding this central bank resolve and despite QE, OMT, et al., we remain strategically cautious. Our stubbornness is quite simple - fundamentals. On the other side of QE and OMT are IP, PMI, and GDP, which continue to look worse, not better. As such, the key to our call is very simple: we think poor fundamentals will trump central bank action. Time will tell. The barriers to effective monetary policy easing and backstops are many. And, of course, how "effective" is defined is itself debatable, and dependent on what the goals of policy action are. Those goals are, in theory, defined by the respective central bank mandates. But as someone that the internet cannot consistently identify said, "In theory, theory and practice are the same. In practice, they are not. And then there's just not wanting to be the guy that everyone blames. As Edward Harrison wrote back in August: Exasperated with political gridlock on Capitol Hill, everyone has turned to the Fed as economic savior. But the Fed is not going to save us because it can't. Following up on this Wednesday: That doesn't mean it can't try, right? Isn't that what QE3′s all about? Bernanke wants to be able to say - especially if the US economy falters and lapses into a Japanese-like state - that he did everything possible, especially because a lot of people have been saying just the opposite about him. As for QE's limpness, Harrison looks at it as effectively a glorified asset swap: Will it [QE] work? I know a lot of people tell you it would or it could. But I don't see how it can. QE is just an asset swap. The Fed creates reserves and swaps them for existing financial assets. It drains the private sector of those assets and adds an equivalent amount of reserves. It's not creating the preconditions for more lending since loans create reserves. Given all of that, assets are less likely to be affected by QE than they are by the fundamentals that the team at Morgan Stanley refer to in their Friday report referenced above. They further point out that the conditions present in QE3 are quite different than in previous rounds. Demonstrating with some graphs, the Morgan Stanley strategist observe that credit markets are pretty tight already, i.e. the market is currently rich: Making a perhaps more subtle point, forward price-to-earnings ratios are on the high side, comparatively: Subtle in that the yellow bar on the last graph is based off of US equity strategist Adam Parker's 2013 earnings forecast of $99 for the S&P500 and his forecast is $16 below the current consensus on the Street. If your head is hurting a bit from "the risky assets rich but fundamentals are bad" message in the above, welcome to the pain of being a bear. Welcome. Do sit down. Make yourself at home, while we try to reiterate. In short, what the strategists are saying is that some risky assets are expensive, but they are longer term bearish because of deteriorating fundamentals, like these purchasing manager indices for example: Fundamentals like these around growth are ultimately in the driving seat with risky assets, say the strategists. The strategists do list a few caveats. Here are a few things that could knock their predictions in either direction: China hard landing. Growth fails to pick up because of an external slowdown, delay in policy easing intensification to spur growth, and inflation risks. Political election cycles. US election and the fiscal cliff lead to ineffective or counter-productive fiscal policies. Upside risk: Policy break-through in Europe on moving toward fiscal integration. There is even the considered acknowledgement of this: Upside risk: Recent monetary policy easing from central banks gains traction with growth. Time will tell indeed. All this is before we have even begun to discuss the role of inflation expectations. We refer you to Cardiff's post for those, and instead offer you this... If thinking this far out into the future, or about fundamentals, on a Friday is too many F's much to deal with, here's the Morgan Stanley strategists" take on the nearer term horizon for various assets: And, because we acknowledge that your brain may have switched off by now, a not completely unrelated moment of Zen (fast forward to 2:30 to cut to the chase, but we do recommend the whole thing): OK, fine, it's unrelated. But it's still a Friday and that clip is genius... [quietly exits the office, heads for pub]. This entry was posted by Lisa Pollack on Friday, September 21st, 2012 at 17:09 and is filed under Capital markets. Tagged with ben bernanke, Fed, Monetary policy, QE3.