Fed Hawk Down
The movie “Black Hawk Down” recounts the 1993 U.S. special forces mission into Somalia whose goal was to destabilize the government and bring food and humanitarian aid to the starving population. Using Black Hawk helicopters to lower the soldiers onto the ground, an unexpected attack by Somalian forces brings two of the helicopters down immediately. From there, the U.S. soldiers struggled to return to safety while enduring heavy gunfire.
Central banks around the world are similarly trying to fight their way back to safety. Having been drawn into untested and radical monetary policies by the credit market collapse of 2008, they tried and have so far failed to get policy back to normal more than seven years after the fall of Lehman Brothers. Starting by reducing interest rates to near zero (ZIRP, or zero interest rate policy), then moving to liquefy the banking system via electronic money printing called quantitative easing (QE), and finally, to Europe’s and Japan’s desperate last ditch efforts to stimulate lending and borrowing via negative interest rate policy (NIRP), central banks have pulled out all the weapons in their arsenals to combat the deflationary forces that have kept economic growth rates pinned at low levels since the 2008-09 recession.
This has fueled the debate raging in financial circles today as to whether cheap money and QE have outlived their effectiveness. In the U.S., the Fed ended their third QE program in late 2014, but European and Japanese central banks have redoubled their commitment to this policy. It has not resulted in the boom that finance textbooks assert it should; in fact, growth rates are struggling to stay positive. But Japanese and European central bankers seem intent on proving Einstein’s definition of insanity, which is doing the same thing over and over again, and expecting a different result.
Growth overseas continues to be very weak. Japan is suffering from the demographics of an aging population that is intent on saving more, not spending more. The lower yields go, the more Japanese are inclined to save to make up for the lack of return on their investments. Moreover, a slowdown in China is affecting business in Japan, one of its biggest trading partners. Europe is divided between a north, which is struggling to maintain positive growth rates, and a south which is, by any other name, in a depression. Spanish unemployment still hovers near 20%, Greece’s economy is still shrinking, and all southern tier banks are burdened with defaulted loans that nobody has the nerve to write down to their true value, thus putting off the day of reckoning for the financial system. Finally, South America’s largest economy, Brazil, has moved from boom to bust by the collapse of oil and commodity prices, and a financial scandal that is threatening to bring down the government of president Dilma Rousseff.
Persistent doses of QE in Japan and Europe have not lifted those economies out of their lethargy, but may have only staved off recession (a victory in its own way). China has encouraged (and perhaps mandated) borrowing at all levels, which has been a form of QE. And yet, Chinese growth rates are now slipping from the high single digit rates they enjoyed for the past 35 years.
The U.S., on the other hand, seems a paragon of strength compared to the rest of the world. Our unemployment rate is less than 6% after many months of positive job creation. GDP growth has shown low, but consistently positive, growth for eight quarters in a row. But even in the U.S. the fact that investors cheered when annualized Q1 GDP was revised up to a mere 0.8% underscore how low expectations for growth have become–this is a level that would have invoked worries over a recession prior to 2007!
Monetary policy has gotten desperate enough that the idea of “helicopter money” is being seriously discussed as a possible next step to stimulus. Helicopter money was first theorized by Milton Friedman as he discussed the transmission of monetary policy to Main Street. He fancifully envisioned a point at which traditional monetary policy became ineffective, because borrowers were so highly leveraged they could not, or would not, borrow even more, regardless of how low interest rates might be. Friedman postulated that the alternative at that point would be to drop “free money” from helicopters on the public, who would scoop it up and start spending it, thus resulting in the desired kick to economic growth. In practice, implementation of helicopter money would take some indirect form, such as a tax cut or tax rebate checks (tried by the Bush administration in 2008). Some countries in Europe are experimenting with basic minimum income programs, whereby the state would guarantee a minimum income for every household, which is another form of helicopter money. Fortunately, these ideas are far from being implemented at the moment, and financial markets must cope with the divergence of monetary policies now on the horizon.
Global central bank policy is at a crossroads. Weaker countries dare not stop QE for fear of short-circuiting what stimulus they are able to generate. The U.S. Fed, on the other hand, is moving away from the extreme policies of the 2008-16 era. Having instituted one rate hike in December 2015, Chairwoman Yellen has been clearly telegraphing to the markets that another rate hike is on the way this summer. Fortunately, in our opinion, she has so far rejected the idea of negative interest rates. The Fed has concluded that monetary policy has reached the limit of its effectiveness, and that the economy is strong enough to grow without extraordinary rescue efforts. Yellen is also keenly aware that further easy money policy can have side effects also. She has in the past commented on the possibility of QE exacerbating speculative excesses in the asset markets, a remarkable admission from this ivory tower crowd.
The Fed also suspects that its ZIRP is negatively affecting entities that depend on higher interest rates for their viability. Life insurance companies, for instance, must earn enough to pay claims, and fund annuity payments for many years into the future. Pension plans (including Social Security) must pay incomes for decades to come, and to the extent they cannot earn enough to cover these liabilities, they will have to mandate higher contributions today, or hope to be bailed out by taxpayers tomorrow. These are just two examples of how QE and ZIRP have hurt savers for the benefit of borrowers, and underscores a critical problem with QE: savers feel they must save more to make up for the paltry yields they’re being forced to accept, reducing demand. The Fed knows it must lean toward raising rates and begin to reduce the imbalance between the two.
If monetary policy has reached its practical limits, what stimulus can we count on to rescue the economy from the deflationary forces that are keeping growth in check? A possible answer to this question was eloquently put forth by Mohamed El-Erian, the former CEO of PIMCO and current chief economic adviser to Allianz. He describes policies of the last seven years as akin to driving on a road that comes to a T-junction, where you must turn one way or the other, representing the choices soon to be faced by policymakers. You can transition to one of two alternatives, but you cannot stay on the road you’re on, that is, artificially suppressed interest rates and artificially supported asset prices. One alternative is good—it is a hand-off from central banks to a broader more holistic political response. This would include fiscal policy taking a primary role for stimulus in the form of traditional spending on infrastructure, research and development, and even higher military spending. A long-term solution, if it happens, releases a tidal wave of cash from the sidelines, particularly from corporate balance sheets. Cash that has been used defensively (mergers, share buybacks) can be used offensively (to invest in growth and expansion).
The other road is not so sanguine. On it, politicians do not step up. Central banks are stilling willing to do something, though their policies become less effective. Even lower, perhaps negative, interest rates may be in store for the U.S. Asset prices start moving back down to match weak fundamentals, and illiquidity (lack of buyers in a declining market) means that falling prices overshoot and pull asset prices down further.
El-Erian rates the probabilities of either path as roughly equal, and guessed that somewhere in the next three years we’ll face this decision. Of course, higher government spending efforts will run headlong into anti-deficit hawks not only in the U.S., but in foreign governments also. Conversely, if electorates sense they are faced with a T-junction” type of choice, we might see a tidal wave of liberal, free-spending political parties take power. Today’s popularity of Bernie Sanders may be evidence of what we can expect in the future if monetary policy’s efficacy is indeed grinding to a halt.
There is no assurance that policymakers will recognize the need to choose a path at the T-junction before a crisis hits. In the current myopic and acrimonious political atmosphere the odds of a far sighted, collaborative solution seem low. But like the crashed Black Hawks in Somalia on that ill-fated mission in 1993, central banks are surrounded by risks. The risks of slow growth, the risk of recession overseas, and a frustrated electorate that is spawning a worrying rise of anti-immigration and anti-trade factions. With evidence mounting that the waning effectiveness of monetary policy may signal the approach of a T-junction, new approaches to managing the economy must be considered. We can only hope that some brave, forward-thinking reinforcements are on the way.
Stock and Bonds: Do What the Fed Says and Nobody Gets Hurt
Stocks and bonds are being held hostage by questions over the effectiveness of central bank policies. In Europe and Japan, stock markets are in decidedly bearish trends, despite large dollops of QE. These market patterns are just the opposite seen when QE first gained popularity as a solution the growth problem, and when there was also less evidence of its effects. Today’s weak foreign markets underscore the creeping uncertainty over QE’s ability to deliver more than a short-term shot in the arm.
The U.S. market continues to be the most attractive globally. Domestic yields are low, but still positive, whereas in Europe and Japan they trade in negative territory. Stocks in the U.S. are free of the European problems of a depressed south, and an influx of unwanted refugees. They also are free of the Japanese problems of highly protected industries such as farming and retailing.
But US markets do face the hurdle of higher interest rates this summer. Having been among the biggest beneficiaries of QE, Wall Street also stands to feel the effects of its reversal. It would be naïve to claim that Wall Street has not been one of the major beneficiaries of QE, as low interest rates pushed investors out of safe harbor fixed-income securities and into higher returning, riskier equities.
Lower interest rates also shrank the risk-free rate of return (typically T-Bills) which helped justify higher price/earnings ratios for stocks. This is evident in the valuation chart below, which is a composite average of four valuation indicators published by Doug Short (http://www.advisorperspectives.com/dshort/). This measure is slowly dropping from the recent peak of May 2015. Indeed, the anemic rate of earnings growth over the last year is starting to take its toll on stock prices, now that US markets can no longer count on QE to lift prices.
Finally, the cost of borrowing to speculate on margin had been brought to historic lows by Fed policy, driving total margin on the New York Stock Exchange to peaks that surpassed those of 1999-2000 and 2007-08. The latest margin level is up a few percent month-over-month, reversing the early 2016 trend, but well off its record high in April of last year. As the Fed raises interest rates, margin costs may increase slightly, but the biggest risk shown by this measure is that investors are still heavily leveraged. The quick drop and subsequent rebound in early 2016 has emboldened investors to buy the dips and disregard the high leverage in the system.
While many pundits have sounded the “all clear” for the markets after the swift rebound from the January swoon, we believe it would be unwise to take the current rally for granted. The ongoing earnings recession makes stock valuations still look expensive. Investors are taking notice of this, and as a result, markets have not made a new high in over a year.
Despite positive breadth measures, the bullish achievement of reaching a new 52-week high remains elusive. The pattern of stalling at previous highs is becoming more obvious now that the end of QE is about 18 months past.
Moreover, the Fed’s commitment to normalizing monetary policy means not only higher rates, but the removal of liquidity from the markets. This is a subtle difference of terms, but a major difference in practice. At a time when every asset class from junk bonds to blue chip stocks is dependent on positive cash flow from investors, its constraint will lead to corrections unless offset by positive fundamental improvements.
Finally, political uncertainty may cause investors to withdraw from the market, further reducing demand for equities. Whether it’s a dissatisfaction with the current front runners Trump and Clinton, or the possibility of a third party spoiler, the election is likely to keep a cloud over the market until the morning of November 9th.