LP L FINANCIAL R E S E AR C H

Weekly Market Commentary

October 22, 2012

Battle of the Central Banks

Jeffrey Kleintop, CFA
Chief Market Strategist LPL Financial

Highlights
Among the events vying for investors attention this week will be the Federal Reserve meeting on Tuesday and Wednesday. Nearly all of the worlds major central banks have each engaged in a battle to provide aggressive stimulus of similar size relative to their economy in an effort to boost growth and battle the currency impact of the actions by other central banks. With the worlds central banks locked in a currency war, the winner may be precious metals.

Despite Fridays sharp drop as companies reported poor earnings results, the S&P 500 Index posted a gain last week. This week, vying for investors attention from the ood of generally weak earnings reports will be the Federal Reserve (Fed) meeting on Tuesday and Wednesday. The Fed is highly likely to conrm on Wednesday that it is continuing the third round of aggressive stimulus in the form of bond buying, known as quantitative easing (QE), announced at the last meeting. That highly anticipated move by the Fed helped stocks to rally to the highs of the year, despite the most warnings issued by S&P 500 companies ahead of an earnings season in over a decade as companies lowered earnings expectations. The QE program is part of the Feds battle against recession, given how weak the economy is not to mention the threat of the impending scal cliff. But it is also a battle in a war against other central banks. The Fed has engaged in a massive amount of bond buying, yet as a percentage of the economy (GDP) the Feds actions pale in comparison to those of the European Central Bank (ECB) and the Bank of Japan.

Central Bank Assets to GDP

35%

Nearly all of the worlds major central banks have each engaged in a battle to provide aggressive stimulus of similar size relative to their economy.

30% 25% 20%

Sep 2008 Lehman Brothers Bankruptcy

ECB Bank of Japan

U.S. Fed

15% 10% 5% 0%
1999 2001 2003 2005 2007 2009 2011

Source: Bloomberg, LPL Financial 10/22/12

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Since mid-2008, when the worlds central banks aggressively applied stimulus through bond-buying programs and expanding the amount of assets on their balance sheets, the ECB has increased its holdings by 17% of GDP .

Since mid-2008, when the worlds central banks aggressively applied stimulus through bond-buying programs and expanding the amount of assets on their balance sheets, the ECB has increased its holdings by 17% of GDP more than doubling assets from 16% of GDP to 33% currently. The ECBs balance sheet grew sharply after the collapse of Lehman Brothers in September 2008, and then jumped further as the two LTROs, or three year loan long-term renance operations, took place in December 2011 and late February 2012. These most recent operations pumped more than 1 trillion euros into the banking system for the benet of struggling Spanish, Italian, and other European banks. Over the same mid-2008 to current time period, the Bank of Japan increased the assets it holds by 11% of GDP going from 20% to 31%, and the Bank of , England took assets up by 14%, from 7% to 21%. The U.S. Fed accumulated assets equivalent to 12% of GDP from 6% to 18%. Other central banks , have assets relative to GDP well beyond that of the Fed, especially among the emerging markets. For example, the Peoples Bank of China holds assets equivalent to about 25% of GDP . Nearly all of the worlds major central banks have each engaged in a battle to provide aggressive stimulus of similar size relative to their economy. This similar percentage has been not merely to battle recession. It has also been to battle the currency impact of the actions by other central banks. While certainly not the only factor affecting currency values, the central bank actions pump more liquid money into an economy and have the tendency to weaken the currency relative to those of trading partnersunless the central banks of those trading partners are also engaging in a similar amount of aggressive actions. Those countries that have engaged in more bond-buying as a percent of their GDP than the U.S. Fed have seen their currencies depreciate relative to the dollar, while those that have done less have seen their currencies rise versus the dollar.

Those countries that have engaged in more bond-buying as a percent of their GDP than the U.S. Fed have seen their currencies depreciate relative to the dollar, while those that have done less have seen their currencies rise versus the dollar.

Central Bank Currency War

Mid-2008 Present Currency Euro Yen Pound Change in Central Bank Assets as % of GDP Relative to Change in U.S. Fed Assets +5% -1% +2% Change in Currency Relative to US Dollar -6% +34% -20%

Central Bank Eurozone Japan United Kingdom

Source: LPL Financial, Bloomberg 10/22/12 Currency Risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.

The Feds efforts are aimed at both keeping interest rates low for borrowers to stimulate economic activity and keeping the dollar from appreciating versus trading partners and risking damage to the economy from falling U.S. exports.

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At the last Fed meeting in mid-September, the Fed communicated its intention to maintain a stimulative policy through mid-2015. The Fed is unlikely to announce any change to its stance this week. Considering that it will likely take coordination by the worlds central banks when the time is right to begin to rein in stimulus, lest it result in a soaring currency that may imperil the recovery, it may be a very long time before the Fed feels it is able to begin to reverse the actions taken in recent years. With the worlds central banks locked in a currency war, the winner may be the precious metals asset class. Precious metals have the tendency to maintain their value relative to depreciating currencies. For example, the price of gold has roughly doubled since mid-2008, as central banks escalated their battle. The latest and unlimited round of QE by the Fed may be matched by other central banks. After all, the ECB stands ready to enact its unlimited OMT, Outright Monetary Transactions, created in September just ahead of the latest Fed announcement, and the yen fell last week as markets speculated the Bank of Japan would soon boost stimulus. We believe this will likely result in a favorable environment for precious metals for an extended time frame.

IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specic advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your nancial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Gross Domestic Product (GDP) is the monetary value of all the nished goods and services produced within a countrys borders in a specic time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a dened territory. Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by ooding nancial institutions with capital in an effort to promote increased lending and liquidity. The Standard & Poors 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Precious metal investing is subject to substantial uctuation and potential for loss. The fast price swings in commodities and currencies will result in signicant volatility in an investors holdings.

This research material has been prepared by LPL Financial. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an afliate of and makes no representation with respect to such entity.
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