Driving on Cheap Credit from QE
Callum is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The FOMC held a meeting this week from July 31 to August 1. During this time they talked about Europe's problems, slowing foreign growth, and a lackluster US economy. They also talked about quantitative easing, or QE as it is known, but didn't say they were going to do any more easing at this time. On September 12-13 there will be another FOMC meeting and thus another possibility of QE 3. Already our Federal Reserve has bought 2.3 trillion dollars’ worth of securities, such as mortgage bonds and US Treasuries, through QE 1 and QE 2. The Fed has also undergone Operation Twist parts 1 and 2, turning 667 billion dollars’ worth of short term securities into 667 billion dollars’ worth of long term securities to push down borrowing costs, thus stimulating growth. The problem with this plan is that you can't grow the economy simply by pushing down on the print button on your computer.
Examples of over printing
Chile used to have an inflation rate of 700% before Milton Friedman came along and advised Pinochet to use his monetarist thinking and stop printing money to fund the government. This, along with many other things Milton advised Pinochet to do, caused an economic boom known as the Miracle of Chile and brought down both the inflation rate and the poverty rate drastically. A similar story played out in England: In 1976 Britain had to be bailed out by the IMF because it had printed itself to death. The inflation rate was 10% and the economy was stagnating. It wasn't until Margaret Thatcher stepped into office and clamped down on the printing before the economy took off again. Both of these economies used to use inflation to fund themselves but were forced to stop once their schemes stopped working.
What if QE 3
While QE 3 wouldn't really do much for the economy, the stock market would bounce upwards for some time as investors cheered on the Fed to continue pumping the economy full of cheap credit, and it would marginally help the housing market as well. Supporters of QE 3 say that it would lower borrowing costs by enough to stimulate economic growth, but the flaw in this logic is that we have had a zero interest rate era for a few years now and a recovery is yet to show its head. Plus, how much lower can mortgage rates and treasuries go? Mortgage rates, according to Fannie Mae, are at all-time lows. A 30 year fixed mortgage is 3.49%, with 15 year fixed mortgages at 2.80%, and a five year ARM is at 2.74%. Even if these rates were to go down, would it really be worth the extra inflation to have borrowing costs marginally lower? Treasuries are also at all-time lows, with the 10 year at 1.51%. Many borrowing costs are linked to the US Treasury market, and lower US Treasury yields mean lower borrowing costs. But, there is one market (other than housing, which still is doing pretty poorly) which will benefit from QE.
How to benefit
One way to play these low interest rates is to look at companies selling expensive products that consumers buy on credit. The perfect market for this is the auto market. Currently the average lifespan of a US car has risen to an all-time high of 10.8 years, much higher than the 8.4 years in 1995. This would point to some pent up demand for new cars to replace America's aging fleet. That demand will also rise because of cheap borrowing costs, which enables car buyers to buy a car with little to no interest on it. Plus, US auto sales have been a strong spot in the domestic economy, with 12.8 million cars sold in the US last year, up from 11.6 million in 2010. For 2012, estimates range from 13.5 million to 14 million cars sold this year. Polk, an automotive research firm, expects US auto sales to hit 13.7 million this year and for the US to hit 16 million auto sales in 2015. One auto company to play this growth is Ford Motor Company (NYSE: F). Ford is experiencing some headwinds in Europe due to the recession, and they have aging inventories in South America, but their success in the North American market is subsidizing those losses. Another way to play this is General Motors Company (NYSE: GM). The government needs to sell its stake at around $53 a share, which will take some time to get to from the $19-$20 a share it is trading at now. But with a PE of 5.70 (TTM) and estimates calling for a PE of 4.50 next year, General Motors is currently looking quite cheap, especially with the potential for Europe to turn itself around and the US auto market getting stronger every year. General Motors is facing the same problems in Europe as Ford is, but both companies are looking for ways to trim down their costs and are well prepared to wait out the storm.
Ford had $13.7 billion in debt at the end of the first quarter in 2012, but hopes to bring that down to $10 billion by 2015. It has about $20 billion in cash, but pension liabilities are still going to be a problem going forward. In order to bring those costs down, Ford is "buying out" some of its older workers by offering them early retirement and a one time lump sum. This is a great idea and will help bring down their liabilities. This quarter, Ford did lose $404 million in Europe and expects to lose $1 billion for the entire year in Europe, which is hurting Ford's earnings. But, Ford is currently slimming down its European operations to bring down costs, such as laying off temporary workers and shutting down some facilities to rein in spending. Plus, Ford offers a 2.2% dividend yield, which is nice to help ride out the slowing global economic growth. At around $9 a share, Ford is a great buy right now with an expected PE of 6.9 this year and an expected PE of 5.8 next year.
General Motors, the other
While GM bulls will point to its low valuation and strong auto market recovery in the United States, I'm not entirely sold on it. I am not saying it’s not a good buy, but if you wanted to play the auto market recovery, Ford is a much better bet. The reason why General Motors went belly up is because of the SUV boom. In the 1990's and early 2000's SUVs seemed to be all the rage, and with margins on SUVs being rather high (auto makers could make $10,000 per SUV), the "big three" domestic auto makers started making tons of SUVs and putting a lot of R and D money towards making SUVs. The problem with this is when oil prices started to rise in the 2000's many consumers started to look for compact cars instead of SUVs. Well, the big three domestic auto makers were left out to dry as they had a pathetic line up of compact cars, which is what the consumers wanted. With rapidly declining profit margins and no profits, General Motors and Chevrolet had to be bailed out. Ford, on the other hand, had Bill Ford and Alan Mulally. Bill fired himself as CEO of Ford and hired Alan from Boeing. Alan took out $23.5 billion in debt, offering up Ford's logo and brands as collateral, and spent that money revamping their product line and restricting the entire company. Because of this move, they had money to spend on R and D towards compact cars and light trucks and were able to ride out the recession while the other two had to seek out taxpayers' money. That is why I think Ford is a better bet; it has shown its shareholders and the world it has the ability to change, while General Motors hasn't. If you go bankrupt once, you can do it again. Plus, according to edmunds.com, General Motors pays out $3,446 in incentives to get consumers to buy their cars, while Ford only pays out $2,360. GM's spending for incentives increased 14.3% year over year, while Ford's only increased by 0.8%. This means Ford will be able to have higher margins, as it doesn't have to shell out an extra $1,000 just to get consumers to buy their cars.
While there is no way I could know what Ben Bernanke is thinking right now, if I was to guess, three months of sub - 100,000 jobs created and weakening economic data will probably lead to some form of easing from the Fed sometime soon. Unless this Friday's job report is very bullish, I wouldn't be surprised to see more easing. Just remember to look for stocks which benefit the most from low borrowing costs, and to be careful when buying into speculation that central banks will do more to stimulate economic growth. US auto makers are poised to benefit from this cheap credit and a strong US auto sales recovery and would make good buys going forward. I am bullish on Ford because of its willingness to pay down debt and its ability to make cars people actually want to buy.
callumturcan has no positions in the stocks mentioned above. The Motley Fool owns shares of Ford. Motley Fool newsletter services recommend Ford and General Motors Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.