Ben Bernanke announced yesterday that the Federal Reserve (Fed) sees improvement in the economy and that if (and this is a big if) improvement continues, the Fed will begin tapering (not stopping and certainly not reversing) its bond-buying program known as quantitative easing or QE3. The reaction: stocks down more than a percent in the one-and-a-half hours of trading that occurred in our markets after his statement; bond yields up from 2.19 percent on the ten-year Treasury to 2.44 percent as I am currently writing; global markets down 2.5 percent; and finally our markets are about to open down another percent or so. Imagine what would have occurred if he hadn’t said “if.”
First let me state what should be obvious to our clients: Any time the market acts in such a way we are concerned and we will take what measures we believe to be prudent to protect our clients. Many of the recent moves we have made have been in anticipation of interest rates rising and should help. If that is all you wish to know then you certainly have my blessing to stop reading and go about your day. If on the other hand you are a bit more curious, please read further.
Two big questions hit me as Bernanke spoke. The first is, “What does the Fed know about the economy that we do not?” Their forecast was much brighter than it was just in March. Since their meeting in March GDP came in at a full percent lower than expectations, China’s economy has slowed dramatically. Just last week the IMF warned U.S. policy makers that we are at risk. Interest rates have risen dramatically, and one would think that could throw some cold water on the housing recovery, which has been the one bright spot in the entire global economic picture. How in the world does all of that equal a better outlook?
The second question is, “Does this market reaction make sense?” I often downplay the real impact of the Fed on long-term stock returns because ultimately it is about actual company earnings, and what impact does the Fed actually have on the earnings of any given company? The fascination with the Fed is overblown. However, the impact of Fed decisions is actually part of the CFA (Chartered Financial Analyst) curriculum. The real impact has to do with what Fed policy says about the economy, and more importantly to investors, what it says about the future of the economy. The textbook reaction to the Fed tightening monetary policy, usually by raising interest rates but in this case meaning they may buy fewer bonds, is supposed to depend on where we are in the economic cycle. If they raise rates during a boom because they are worried about the economy overheating, then the market should sell off as the Fed is trying to slow the economy which logically will lower company earnings. On the other hand if they raise rates (or in this case reduce QE) after having lowered rates in order to stimulate the economy out of a recession it is actually positive for stocks because this means that the Fed sees the economy getting better, and that should lead to better earnings. At least that is what the textbook says.
Of course, since 2008 nothing has really been textbook. The fear in the market is that the Fed, and in fairness other central banks around the world, has inflated asset prices and potentially caused another bubble after the two big bubbles last decade. It is possible that is true of some assets; gold and precious metals and bank stocks come to mind immediately. Everyone knows about gold, and the current earnings of big banks are almost all Fed-created as they are given money for free and loan it out at 3.5 to 4 percent. That will not last forever, though their shareholders seem to think it will. The rest of the market, however, does not look to be in a bubble. This concern seems overdone to us.
This leads to an important question: Why hasn’t all of this easy money, not just here but globally, led to actual economic growth? The answer can be found in “Abenomics” third arrow. For those who have not followed Japan, their Prime Minister Shinzo Abe has undertaken an aggressive economic policy – coined Abenomics – that consists of three arrows. The first two are aggressive fiscal stimulus and monetary stimulus, and these are the two that get all the attention. Spending and printing money is easy and popular for governments worldwide. The third arrow, however, is probably the long-term key to success: regulatory reform. It was a key ingredient to the Regan and Thatcher formula that stimulated global growth in the 1980’s and 1990’s and that made Bill Clinton declare the end of big government. It is the missing ingredient today. In Europe, for example, all the money printing in the world will not cause Spanish or Italian business owners to increase hiring, because they know that hiring an employee in their country is a relationship that is more legally binding than marriage and more expensive to dissolve. Starting a business today in the United States is more costly than in most of Europe. No amount of free money changes that fact. It has been the lack of the third arrow that has kept the global economy from recovering and made all the money printing largely for naught.
So, does the Fed really see improvement, or have they just come to the recognition that what they are doing isn’t working and they have to stop it sometime? Bernanke is out at the end of his term; Obama made that clear when he said that he had “stayed longer than he should have.” Regardless, Bernanke probably does not wish to leave the Fed before they at least begin some form of an exit strategy. The days of QE may be numbered even if that “if” Bernanke made in his statement doesn’t come to be. That may be what has the market going against the textbook response.
Chuck Osborne, CFA