In our Market Commentary from last August (NO TAPER in September), we made the case that the Fed would delay its decision to taper at its upcoming meeting in September. The basis for our position was not the Fed’s ongoing concern about the labor market, but rather the evidence of disinflationary pressures across the economy. The Fed, we reminded you, is charged with pursuing policies that not only maximize employment, but that also promote price stability. And based on its preferred measures of inflation, the Fed would be unwilling to begin the taper process until it saw more data supporting the consensus opinion that the recent disinflation was transitory.
While we turned out to be right about the deferral of the taper, we also argued that the Fed’s assessment of “inflation” was flawed. Not only does the Fed essentially disregard the prices of food and energy (which disproportionately affects low- and moderate-income consumers), but the central bank also fails to consider asset price inflation. Virtually everyone agrees that the Fed’s easy-money policies have directly contributed to a huge rebound in stocks and housing prices. In fact, aggregate household net worth has increased by $25 trillion to over $80 trillion (an all-time high) since the first quarter of 2009. But the Fed’s goal was not simply to make rich people more rich (which they did). Rather, they are operating under the misguided assumption that higher asset prices will, by some miracle of trickle-down economics, lead to plentiful jobs and higher incomes for the masses.
The Fed’s current policy mistakes are eerily reminiscent of the ones made by Chairman Greenspan in the early 2000’s. Following the implosion of technology stocks in 2000-2001, Greenspan kept the Fed Funds rate at 2% or lower for the following three years. Low interest rates, along with a deterioration in mortgage underwriting standards, led to huge increases in housing prices. We all know how that turned out. The only thing that makes it worse this time is that Chairman Bernanke made no attempt to veil his strategy. He came right out and told us (fairly regularly) that he was targeting stock prices as a way to generate better economic growth. We found those comments troublesome then, and we still find them troublesome today. In our view, the Fed has no business influencing stock prices.
So now we find ourselves in the familiar position of advocating for an end to QE while still believing that the Fed may not follow through with its plan to end QE by the end of the year. Why? Because the Fed’s preferred gauges of inflation suggest that inflation remains too low. Sure, there has been some scattered evidence of modest inflationary pressures. There was an article in the May 4th edition of The Wall Street Journal (“Wage Pressure Begins to Build”, by Theo Francis) that talks about isolated cases of wage increases by specific companies operating in specific industries. But does anyone really think wage inflation is going to get out of control with the labor participation rate at its lowest level in decades? If the price of labor goes up, the supply will quickly go up too as workers re-enter the labor force. These new entrants will keep a ceiling on wage increases.
Our worry is that, notwithstanding the massive increase in stock prices over the past five years, a large contingent of individual investors have become extremely distrustful of the stock market. This lack of confidence is related to a belief that the game is rigged. In my most recent book, Restoring Our American Dream, I argue that it is imperative that we reconnect culpability and consequence. We have to ensure that the average investor has faith that the cards are not stacked against him or her. To this end, we applaud Attorney General Holder for his ongoing prosecution of those responsible for misleading investors prior to the financial crisis (http://www.usatoday.com/story/news/nation/2014/05/05/holder-banks-investigation-jail/8716959/). However, the work doesn’t end there. We also must get off this incessant treadmill of inflating asset prices as a way to stimulate economic growth. These successive booms and busts do not project the market stability that individual investors so desperately seek.
The Fed’s unwillingness to extricate itself from the markets is a very worrisome trend that has had devastating outcomes in the not-too-distant past. Effectively, the central bank is attempting to induce inflation in the broader economy by boosting asset prices by tens of trillions of dollars. Nothing very positive can come out of this experiment. The best case is that baby boomers, wary of the stock market, will have to accept much smaller returns going forward if and when they begin to embrace stocks again. The worst case scenario is that another bubble will burst. Either way, we don’t believe the Fed’s continued meddling will end well.
One last unrelated thought. Remember our comments on Greece and other EU sovereign debt disasters? We warned about the contagion to the other European banks that held Greek, Italian, or Portuguese debt. As those holdings fell in price, they would impair the capital ratios of the holders. Add Russia to the list of problem countries. French bank Societe Generale saw a 13% decline in quarterly profits from a write-down on its Russian business. The economic slowdown caused by increased trade embargoes will have a significant effect across the continent, and will be a drag for the US as well.
We remain invested but defensive. There are plenty of landmines still lurking out there. Stick with quality, and don’t swing for the fences.