By: John Browne Monday, December 9, 2013
Although the U.S. stock market continues to hit new nominal highs on a nearly daily basis, the U.S. economy bumps along at a lackluster pace. This disconnect has been achieved by a massive Fed experiment in monetary stimulation. Through the combination of seemingly endless maintenance of zero interest rates and the injection of some $1trillion a year of synthetic money into fixed-income markets, the Fed is hoping that the boom it is creating on Wall Street will lead to a boom on Main Street. In reality, this a very dangerous economic gamble of enormously high stakes. As we have seen in the recent past, financial bubbles can leave catastrophe in their wake.
In October 2013, Professor Robert Schiller, the renowned Yale economist, was awarded a Nobel Prize together with two others for research into asset bubbles and resulting values. In a recent interview in the German newspaper, Der Spiegel, he said, “I am not yet sounding the alarm. But in many countries stock exchanges are at a high level and prices have risen sharply in some property markets. That could end badly. I am most worried about the boom in the U.S. stock market. Also because our economy is still weak and vulnerable.”
However, there are many in the financial establishment who disagree with the professor, including, most interestingly, Professor Karl Case, the co-creator of the famous Case-Shiller Home Price Index. Most markets either believe that current share prices are fully justified by corporate metrics or they believe the Fed has expertise, and the ability, to prevent an ugly sell-off if things turn out badly. This debate has become the defining conversation as we head into the end of the year.
However, those who believe that QE will produce positive results to compensate for the risks are finding their position to be increasingly difficult to defend. At the International Monetary Fund’s November annual conference in Washington, Mr. David Wilcox, reputed to be one of the Fed’s most important economic advisors, offered insight into some problems facing QE. In essence, he maintained that the Fed’s QE-3 program is producing only very limited results in terms of U.S. economic growth. At the same time, he seemed to hint that unlimited QE could create serious financial market distortions.
Many market observers, including myself, think that the Fed’s open-ended QE program has been a massively expensive failure. As a result, market watchers have become increasingly eager for the program to be wound down, and many do not understand the Fed’s reluctance to taper its monthly bond purchases.
Although many of the more open-minded members of the Fed’s Open Market Committee may have lost faith in the ability of QE to deliver tangible gains in the real economy, they have also shown some concern that a diminishing of QE could trigger stock and bond market turmoil. There can be little doubt that such an outcome could usher in a new round of recession. In other words the “good” that the Fed sees in QE may merely be the prevention of a potentially worse reality.
A majority of investors have seemed to convince themselves that QE has become an unneeded crutch that the Fed will be more than happy to abandon by the end of next year. Many believe that such an outcome will place limited downward pressure on stocks, bonds and real estate. These views are Pollyannish in the extreme. The recent sell-off in the bond market should attest to that. On the other hand, some investors, including some aggressive hedge funds, seem to be operating under the belief that QE will not be ended any time soon, if ever. They have even borrowed massively to invest on booming financial markets that stand already at record highs. Today, total New York Stock Exchange margin debt stands at $412 billion, an all-time record.
The disagreements of the investing public are of little weight in comparison to the opinions of the FOMC members themselves (such is the world we have created). The key point for 2014 is how many voting members of the new Yellen-led FOMC will follow her down the Keynesian cul-de-sac. Should a majority of the FOMC feel forced, in the national interest, to vote against an expansion of the Bernanke-era stimulus policies (which we believe Ms. Yellen is sure to propose), financial markets could be in for a severe shock.
Those who wish to continue equity investing in face of this risk might be well-advised to ensure they have adequate hedging policies in place. Investors in both equities and bonds must question how the Fed can coax a market into a continued boom in a manner disconnected from economic reality.
John Browne is a Senior Economic Consultant to Euro Pacific Capital. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.