The Fed Reverses its Policy

Yesterday the Federal Reserve announced that it will maintain the size of its $2 trillion+ balance sheet by reinvesting principal repayments into Treasury bonds. It should be understood that the Fed’s decision does not translate into new easing measures. Rather, the reinvestment of principal should be viewed as neutral as it eliminates what otherwise would be a gradual tightening in policy ($10-$20 billion in liquidity leaving the system each month as principal is repaid). However, implicit in the Fed’s action is a commitment to accelerate purchases and grow the portfolio in the future if the economy continues to struggle and/or the risk of deflation increases.

The Fed’s objective with regard to these bond purchases is to reduce longer-term interest rates and therefore stimulate borrowing, investment and consumption. At the forefront of the Fed’s concerns is the housing market, which appeared to have bottomed but has struggled in recent months following the expiration of tax credits. We continue to believe (and the Fed appears to agree) that a stabilization in housing is key to any self-sustaining economic recovery. Therefore, it should not come as a major surprise that the Fed changed course and decided to maintain the size of its portfolio.

Stocks are weaker today as investors digest the implications of the Fed’s actions. While we think the decision to maintain the size of the Fed’s portfolio was largely expected, we also believe that the Fed’s statement may have instilled some fear into the markets. In our view, it is very difficult to read much positive in the first paragraph of the Fed’s statement:

“Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls. Housing starts remain at a depressed level. Bank lending has continued to contract. Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.”

Our consistent message this year has been that the economic recovery, as well as stock prices, have become highly dependent on stimulus. Now that voters in the US have become more concerned with massive budget deficits than the current state of the economy, fiscal stimulus measures may become harder for Congress to enact (especially with elections in November). Even economists as renowned as former Fed Chairman Greenspan are now calling for the repeal of all the Bush tax cuts, not just those given to the rich. Therefore, the onus may fall on the Fed to spark a self-sustaining economic recovery. This means we can probably expect another round of quantitative easing in the future (QE2) if/when economic data continues to deteriorate. Our concern is that the more the Fed does, the more addicted the economy becomes. As rates continue to decline, the economy will again reset to a lower rate environment. At some level, lower interest rates may indeed improve loan demand, bank skittishness and unemployment (although they have not so far). At some level, low mortgage rates should put a floor on housing prices by improving affordability. At some level, low long-term interest rates could cause a rally in stock prices. However, what happens then? What is the end game here? It seems like the Fed lacks a longer-term plan.

The problem with our economy is too much debt. We must therefore go through a process of deleveraging that will inevitably result in sub-par economic growth and pain (yes, pain) along the way. Many of you have already heard me say the following: “The federal government has succeeding in rescuing us from crisis; it should not attempt to rescue us from all consequence.” We believe the Fed is trying to rescue us from all consequence. The answer to an overleveraged consumer is not the encouragement of more debt. The answer to falling asset prices should not be the encouragement of widespread speculation. It appears that the lessons of the very recent past are being ignored to some extent. The Fed must consider the consequences of their actions. What about savers, including retirees, who are earning nothing on their money? What about asset bubbles, which recent history has shown can be created by long periods of low interest rates?

In last week’s Market Commentary we argued that recent weak economic data have argued for a continuation of existing stimulus initiatives (at the very least). We also said that the problem in our economy right now is that everyone (banks, consumers and businesses) appears to be hoarding their money. Therefore, the challenge is to encourage healthy lending, consumption and investment without creating longer-term risks like inflation (including asset bubbles) and over indebtedness. It appears to us that this could best be accomplished by extending the Bush tax cuts and creating new tax incentives to hire and invest. Companies must have more clarity with regard to their costs of doing business in the future, and this includes taxes, healthcare, and regulatory costs. This uncertainty is keeping companies from hiring and investing, and it must be alleviated. At the same time, we believe Congress MUST address the problem of longer-term deficits and the explosion of entitlement spending. And needless to say, tax rates are more than likely to rise in the future due to the massive debt burden we’ve created for future generations. However, that time is not now given the fragility of the economic recovery.

As a final note, it seems troubling to us that stock prices have become so heavily dependent on additional Fed action. Despite a clear deterioration in the economic data over the past few weeks, stocks headed sharply higher in anticipation of additional Fed stimulus. At this stage, we do not believe investors should view bad news as good news any more. So we remain defensive, investing in companies with strong balance sheets, excellent cash flow and defensible market positions.