There’s another important day next week and it rather coincidentally occurs on Wednesday – the day after Election Day .. (it) is the day when the Fed will announce a renewed commitment to Quantitative Easing – a polite form disguise for “writing cheques.” The market will be interested in the amount (perhaps as much as an initial $500 billion) as well as the targeted objective (perhaps a muddied version of “2 per cent inflation or bust!”). The announcement, however, has been well telegraphed and the market’s reaction is likely to be subdued. More important will be the answer to the long-term question of “will it work?” and perhaps its associated twin “will it create a bond market bubble?”

Whatever the conclusion, not only investors, but the American people should recognize that Wednesday, .... represents a critical inflection point in determining our future prosperity. Of course we’ve tried it before, most recently in the aftermath of the Lehman crisis, during which the Fed wrote $1.5 trillion or so in “cheques” to purchase Agency mortgages and a smattering of Treasuries. It might seem a tad dramatic then, to label QEII as “critical,” sort of like those airport hucksters, I suppose, that sold whale blubber for a living. But two years ago, there was the implicit assumption that the US and its associated G-7 economies needed just an espresso or perhaps an Adderall or two to get back to normal. Normal just hasn’t happened yet, and economic historians such as Kenneth Rogoff and Carmen Reinhart have since alerted us that countries in the throes of delevering can take many, not several, years to return to a steady state.

The Fed’s second round of QE, therefore, more closely resembles an attempted hypodermic straight to the economy’s heart than its mood elevator counterpart of 2009. If QEII cannot reflate capital markets, if it can’t produce 2 per cent inflation and an assumed reduction of unemployment rates back towards historical levels, then it will be a long, painful slog back to prosperity. Perhaps, as a vocal contingent suggests, our paper-based foundation of wealth deserves to be buried, making a fresh start from admittedly lower levels. The Fed, on Wednesday, however, will decide that it is better to keep the patient on life support with an adrenaline injection and a following morphine drip than to risk its demise and ultimate rebirth in another form.

We at PIMCO join with Ben Bernanke in this diagnosis, but we will tell you, as perhaps he cannot, that the outcome is by no means certain. We are, as even some Fed Governors now publically admit, in a “liquidity trap,” where interest rates or trillions in QEII asset purchases may not stimulate borrowing or lending because consumer demand is just not there. Escaping from a liquidity trap may be impossible, much like light trapped in a black hole. Just ask Japan. Ben Bernanke, however, will try – it is, to be honest, all he can do. He can’t raise or lower taxes, he can’t direct a fiscal thrust of infrastructure spending, he can’t change our educational system, he can’t force the Chinese to revalue their currency – it is all he can do, and as he proceeds, the dual questions of “will it work” and “will it create a bond market bubble” will be answered. We at PIMCO are not sure.

Still, while next Wednesday’s announcement will carry our qualified endorsement, I must admit it may be similar to a Turkey looking forward to a Thanksgiving Day celebration. Bondholders, while immediate beneficiaries, will likely eventually be delivered on a platter to more fortunate celebrants, be they financial asset classes more adaptable to inflation such as stocks or commodities, or perhaps the average American on Main Street who might benefit from a hoped-for rise in job growth or simply a boost in nominal wages, however deceptive the illusion. Cheque writing in the trillions is not a bondholder’s friend; it is in fact inflationary, and, if truth be told, somewhat of a Ponzi scheme. Public debt, actually, has always had a Ponzi-like characteristic. Granted, the US has, at times, paid down its national debt, but there was always the assumption that as long as creditors could be found to roll over existing loans – and buy new ones – the game could keep going forever. Sovereign countries have always implicitly acknowledged that the existing debt would never be paid off because they would “grow” their way out of the apparent predicament, allowing future’s prosperity to continually pay for today’s finance. .....

...A similar fate, by the way, awaits stockholders, although their ability to adjust somewhat to rising inflation prevents such a startling conclusion. Last month I outlined the case for low asset returns in almost all categories, in part due to the end of the 30-year bull market in interest rates, a trend accentuated by QEII in which 2- and 3-year Treasury yields approach the 0 per cent bound. Anyone for 1.10 per cent 5-year Treasuries? Well, the Fed will buy them, but then what, and how will PIMCO tell ..investor(s) ....that the Thanksgiving Day axe has finally arrived?

Equities Bullish Factors
• Developed country policymakers remain highly alert to not removing stimulus too soon.
• At about 12.5 times forward earnings based on Thomson Reuters consensus forecasts, US and global equities are attractively valued and are discounting zero profit growth.
• In the second quarter, US capital spending showed its first ma-jor improvement since the Great Recession. However, it will be a while before capacity expands enough to erode profit margins.
• Neither inflation nor deflation is a significant near-term risk.
• Despite concerns about a tightfisted US consumer, back-to-school and same-store-retail sales have been solid if uninspiring.
• Fed tightening appears to be a long way off. US and global eq-uity returns have averaged at least mid-teens in the year before the first tightening and 8% and 12%, respectively, in the year after; concurrently, US Treasury returns are poor.
• Historically, periods of negative trailing 10-year US equity re-turns have been followed by 9%-to-10% per annum returns over the next five- and 10-year periods. While these returns are close to the historical "average," what is not average is the absence of negative returns during these subsequent periods.

Equities Bearish Factors
• Long term, unemployment is likely to stay higher than desired. A long economic recovery will be needed to bring the US unemploy-ment rate down to the 50-year average of 5.9%.
• The IMF is concerned that policy actions in Asia and Latin America to limit the rise of their currencies could provoke protectionism. If the G-20 is successful in framing foreign exchange coordination as part of an effort to balance world growth to be less reliant on the US con-sumer, this issue could move from the forefront to the backdrop.
• Financials have lagged during the most recent equity up move.
• Sentiment has gotten fairly bullish in the last several months.
• Sovereign debt burdens are too high in several developed countries. Hard political choices need to be made or currency values are at risk.
• If the secular bull market in Treasury bonds that started in the early 1980s ended in 2008, as we believe, higher price/earnings ratios are unlikely to contribute to the total return of equities in this bull cycle.
• Two countries remain out of synch with globalization and the end of the Cold War: Venezuela and North Korea. Neither appears likely to reverse course soon.