“Our destiny is frequently met in the very paths we take to avoid it.”
– Jean de la Fontaine
We are all products of our experiences. Sometimes in life we, or someone around us, make a mistake whose consequences are so painful we promise we will “never do that again.” Too often in those circumstances we end up making all new and sometimes bigger mistakes. George W. Bush believed that his father made a mistake when he did not take out Saddam Hussein in the first Gulf War when we had most of the free world by our side. Determined not to make that same mistake, he made all new ones.
Similarly, Ben Bernanke came into the job of Chairman of the Federal Reserve (Fed) largely by his reputation as a scholar of the Great Depression, and specifically all the mistakes that were made by the Fed during that period. He is determined not to make those same mistakes, and as a result he is making all new ones. For those who need some catching-up: the Fed has announced a third round of quantitative easing (QE3). So-called quantitative easing occurs when the Fed purchases bonds, usually Treasury bonds, but this time they will also purchase mortgaged backed securities, in the open market in an attempt to lower longer-term interest rates.
I will get into why I believe this is a mistake and what it means for investors, but first I think it is important to understand why the Fed is doing this now. They are pursuing the strongest measures they have taken thus far since the beginning of the financial crisis because things are not just failing to improve fast enough; things are getting worse. Unemployment came out last week and the headline number seems encouraging. It dropped to 8.1 percent vs. the previous reading of 8.3 percent. However, when one digs into the numbers, that entire decrease is caused by people giving up and leaving the workforce. As Mortimer Zuckerman, chairman and editor in chief of US News and World Report, recently pointed out, when one adds the eight million Americans who have given up and dropped out of the workforce to the scores of people in the category the government calls “underutilized labor,” the real unemployment rate is closer to 19 percent.
On top of this we have the discouraging report from the Census Bureau: 46.2 million Americans now live in poverty, which represents 15 percent of our population. This number was actually down from last year but not in a statistically meaningful amount, so for all intents and purposes it has remained constant. However, median incomes fell by 1.5 percent in real terms.
As we reported earlier, GDP growth, while still positive, is slowing. Manufacturing activity is slowing dramatically. The numbers of people actually out of work are rising. Incomes are dropping. This is no longer a weak recovery. We are in an economic downturn. We will let the academics decide if it qualifies as a new recession, but regardless of titles things are now getting worse, not better.
This is why the Fed is so eager to take action and why their action is so extreme. I believe they are making a mistake. The Fed has tried quantitative easing twice before (two and a half times before if you count the “Twist” program) and thus far they are 0 – 2 (or 0 – 2.5) in actually helping the economy. It did not work before and there is little reason to believe it will work now. To put it simply, interest rates are already at record lows, making them even lower is not going to change anything. That is not the same as saying the former rounds of quantitative easing did not have an impact. They led to strong, although temporary, rallies in the stock market and in commodities.
Here is our scenario of what happens with QE3: The economic activity does not change at all. No consumer or business person is currently sitting on the sidelines because they thought interest rates were too high. None of the real issues – declining incomes, high unemployment, regulatory uncertainty, unrest in the Middle East, the recession in Europe, etc. – have gone away. We do not see how this will help in any real economic sense. In fact it will most likely cause prices at the pump and prices at the grocery store to rise, as its forbearers did. So we will likely end up with a scenario where incomes keep dropping while the prices on things we need to survive day in and day out continue to rise. In other words, we believe QE3 will make things worse in the real economy.
When we put on our investor hat this becomes a difficult environment in which to make decisions. On one hand, everything in the real world is getting worse. On the other hand, cliché’s exist for a reason and “don’t fight the Fed” is a long-time Wall Street cliché. Over the next several days we will be reviewing opportunities to potentially increase market exposure, but we still believe it is prudent to be cautious. All the short-term traders are as happy as can be that they got their wish for QE3. Soon, however, companies will begin reporting third quarter earnings, and all the data points to very painful numbers. The question is, what trumps what? Market momentum and easy money vs. economic slowdown and depressed earnings. In the long run actual results have always mattered, and while that has not been the case this year we still believe it is the most prudent path.
Ben Bernanke is doing everything in his power to avoid the past mistakes that took a bad situation in the early 1930’s and turned it into a Great Depression. Unfortunately in his effort to avoid that destiny he may very well have put us on the road to it. One thing is certain, he is not making the same old mistakes; he is making brand new ones.
Chuck Osborne, CFA
Managing Director
