Our biggest concerns with regard to the Fed’s ultra-loose monetary policy over the past few years have been: 1) its propensity to encourage the assumption of more debt in response to the problem of too much debt; 2) its propensity to cause financial bubbles (at worst) and market dislocations or distortions (at best) through financial repression and moral hazard; and 3) the fact that the Fed has no business opining on and targeting valuation levels for stocks or any other assets. We’ve said repeatedly that the current Fed is simply perpetuating the same asset boom/bust cycle begun by Alan Greenspan and continued by Ben Bernanke and Janet Yellen. So are we on the precipice of another Fed-induced asset-price collapse similar to the technology/internet stock crash and the housing collapse? We don’t think so, for a few different reasons.
- The first reason is that asset prices, though inflated, are not really in bubble territory. Housing affordability has improved dramatically since the throes of the Great Recession due to the drop in housing prices and plummeting mortgage rates. The homeownership rate is back to where it probably should be, and new household formation is finally picking up after years in which people chose to double up or live with their parents rather than buying or renting their own place. With regard to stock prices, we remain troubled by near record-high corporate profit margins, which create the illusion of a market that is cheaper than it really is. As margins revert closer to the long-term average, stock prices may indeed need to come down more to reflect the slowdown in earnings growth. However, the S&P 500 has now retreated about 12% from its all-time highs, with certain sectors like Energy and Materials getting hit much, much more. More importantly, the S&P 500 has now retraced about 17% of its rise from the March, 2009 low to the peak early this year. This has not been a minor pullback. Furthermore, alternative measures of stock valuation suggest that stocks could actually be cheap right now. The most compelling of these arguments is the fact that the yield on the S&P 500 is now in line with the yield on the 10-year Treasury note. During the financial crisis, the S&P 500 yield did surpass the 10-year note for a while, but the situation did not last for too long.
- The second reason we should not see a market collapse is that the economy, although still growing at only the 2.0%-2.5% pace of the past several years, does not appear headed for recession. We could be wrong, but the economic weakness outside the US is not likely to pull us into recession territory. Yes, China is slowing with future growth rates coming in perhaps meaningfully slower than the government’s target of 7%. However, US trade with China is very small relative to GDP, and Europe appears to be pulling itself up by its bootstraps after following the Fed’s playbook of monetary easing. Moreover, it should be remembered that consumer spending makes up almost 70% of GDP. So while weak exports, flat government spending and subdued corporate investment certainly impact the pace of economic growth, the economy generally goes as the consumer goes.
- The third reason we are in pretty good shape relative to past Fed-induced crises is that the banking system in the US has been recapitalized and remains heavily regulated compared to the years prior to the financial crisis. Banks are simply no longer allowed to rapidly grow their balance sheets by making risky bets with borrowed money, especially deposits. In addition, credit losses are running at generational lows, and US banks have a ton of liquidity parked at the Fed and elsewhere, which can serve to both reduce the risk of a liquidity crisis and allow banks to take advantage of opportunities as they arise. In fact, the recapitalization of the banking system, in our view, is perhaps the single-best competitive advantage the US economy has right now over some of the other developed markets (read: Europe).
- Fourth, the consumer, while still heavily indebted, has both reduced his debt and has refinanced other debt using lower fixed rates. This has led to a situation whereby the Household Debt Service Ratio, tracked by the Fed, has fallen dramatically since the financial crisis. Don’t get me wrong, I remain very uncomfortable with the Fed’s encouragement of more debt in response to the problem of too much debt. There is also some evidence of credit bubbles in specific consumer-debt areas like student loans and auto loans. However, a good chunk of the consumer debt that existed prior to the financial crisis has either been charged off or effectively assumed by the Federal government through increases in transfer payments. (Obviously, the US Treasury will have to deal with its own debt problems, but there are solutions to this like addressing the issue of entitlement spending, which would have the additional positive side effect of creating more flexibility to enact short-term fiscal stimulus.) The reduction in the consumer’s debt service burden frees up money that can be spent elsewhere.
- In addition to lower interest rates, the consumer is now and should continue to benefit from a plunge in energy/gas prices. The savings from lower gas prices do not appear to be getting spent as of yet, but they are giving the consumer the ability to pay down some debt and increase retirement savings. We have long believed that the relative lack of retirement savings is a huge intermediate-term problem for the US economy. To the extent that consumers are able to clean up their balance sheets and save more through lower energy expenditures (and lower debt-service costs), this would be hugely beneficial to the long-term health of the consumer-centric economy. Moreover, the prospect of a completely energy-independent United States should have multiple future benefits, including national defense.
- Given the turmoil experienced in the housing sector during the financial crisis, we’ve consistently viewed housing as a vital cog in the US economic wheel. Encouragingly for the future, residential investment as a percentage of GDP remains very depressed (about 3.2% in 2014 compared to the post-WWII average of 4.6%). As housing prices continue to recover, which admittedly is highly dependent on low mortgage rates, we would expect the housing sector to continue to boost economic activity, job growth, consumer spending, consumer confidence and household net worth. At this stage in the housing recovery, the big wildcards are the trends in both credit availability and credit costs (mortgage rates). We would hope that incremental clarity with regard to new banking regulations would eventually lead to wider credit availability. With regard to credit costs, we have long believed that the US economy is not growing strong enough to withstand a dramatic increase in interest rates. Ongoing monetary easing in foreign economies should also put a lid on borrowing costs in the US.
- Another complaint we’ve had about the US economy is weak middle-class income growth and increased income inequality. Unfortunately, not much progress has been made on this front. As noted, we believe the early polling success for Bernie Sanders, an avowed Socialist, and Donald Trump, who advocates both protectionist trade policies and a harder line on illegal aliens, represents concrete evidence of the widening wealth and income gaps. However, for the first time in a while, there does seem to be some very modest evidence that wage growth may be picking up. We attribute the improvement to the consistent job gains and their impact on labor slack in this country. Although it may be much further in the future than most economists think, a tighter job market should lead to better income growth for the middle class.
- And finally, next year we elect a new president for the first time in eight years, and hope springs eternal. We are hopeful the election is not full of vicious negative campaigns and class warfare, but rather hope and optimism for the future. There are clear remedies to some of our economic woes, such as addressing the problem of ballooning entitlement spending, making our corporate tax system more competitive and less complicated, and figuring out a way to repatriate some of the corporate capital trapped overseas. We are hopeful a new candidate will emerge who will give us the truth, rather than campaigns full of empty promises for short-term economic benefits.
So, in summary we ask, has the Fed recklessly inflated asset prices and encouraged excessive debt and speculation for a third time in 20 years in an effort to stimulate growth? No question. But we also must ask, does our current situation even remotely approach the danger created by past Federal Reserves? We think the answer to that question is no. Nobody can effectively time the markets with any degree of precision or consistency. We remain invested, but we continue to favor high-quality, defensive investments. Keep the faith in America; cautious optimism is warranted.