Roach Motel Monetary Policy
While we continue to observe some noise and dispersion in various month-to-month economic reports, the growth courses of production, consumption, sales, income and new order activity remain relatively indistinguishable from what we observed at the start of the past two recessions. The chart below presents the Chicago Fed National Activity Index (3 month average), the CFNAI Diffusion Index (the percentage of respondents reporting improvement in conditions, less those reporting deterioration, plus half of those reporting unchanged conditions), and the year-over-year growth rates of new orders for capital goods excluding aircraft, real personal consumption, real retail and food service sales, and real personal income. All values are scaled in order to compare them on a single axis.
Strong leading indicators such as the CFNAI and the Philly Fed Index have been weak for many months, and the deterioration in new orders has moved from a slowing of growth to outright contraction in recent months. In the order of events, a slowing in real sales, personal income, and personal consumption expenditure typically follows – these are called coincident indicators. These growth rates generally only weaken materially once a recession is in progress, and reach their highest correlation with recession about 6-months into the downturn. That’s what we’ve begun to observe over the past few months, adding to our impression that the U.S. joined a global (developed economy) recession during the third quarter of this year. The most lagging set of economic indicators includes employment measures, where I’ve frequently noted that the year-over-year growth rate of payroll employment lags the year-over-year growth rate of real consumption with a lag of about 5 months. As a result, the year-over-year growth rate in payroll employment reaches its highest correlation with recession nearly a year after a recession has started – another way of saying that it is among the last indicators to examine for confirmation of an economic downturn.
All of that said, our concern about recession emphatically is not what drives our concern about the stock market here. In early March, our measures of prospective return/risk moved to the lowest 1% of historical data based on a broad ensemble of indicators and consistent evidence of market weakness following similar conditions in numerous subsets of historical data. Those conditions remain largely in place today.
There’s no question that massive fiscal and monetary interventions have played havoc with the time-lag between unfavorable conditions and unfavorable outcomes in recent years, which prompted us back in April to introduce various restrictions to our hedging criteria (see below). Still, present conditions remain strongly negative on our estimates. Meanwhile, the stock market is not “running away” – at best, these interventions have allowed the market to churn at elevated levels. Only a month ago, the S&P 500 Index was below its level of March 2012, when our estimates shifted to the most negative 1% of the data, and was within about 11% of its April 2010 levels, which is the last time that our present ensemble approach would have encouraged a significant exposure to market risk. Notably, as of last week, an upward spike in long-term Treasury yields took market conditions to an overvalued, overbought, overbullish, rising yields syndrome – which has tended to be anathema to the stock market, even prior to the more limited downward bouts of recent years.
Beyond that, a natural question is – if recession concerns don’t factor into our present defensiveness in the first place, why should we be concerned about recession at all, and devote so much analysis to this issue in the weekly comments? The first answer is that the foundation of this particular cyclical bull market has rested on the continuation of massive fiscal and monetary interventions, and a new recession would stretch those interventions to untenable limits (and to some extent already have), which should be of concern regardless of one’s stock market views. The second answer is that much of Wall Street’s overbullish sentiment, as well as its “valuation” case for stocks, rests on the continuation of record high profit margins that are largely an artifact of extreme government deficits and depressed personal savings (see Too Little To Lock In). A contraction in sales, coupled with a contraction in profit margins – which is what we presently expect – is likely to devastate the “forward operating earnings” case for stocks, and I continue to expect Wall Street to be blindsided by this fairly predictable outcome (as it was in 2001-2002, as it was in 2008-2009).
The distortions we presently observe in the economy will have significant long-term costs, but it is entirely naïve to believe that these costs should be evident precisely at the point where the wildest distortions are taking place. Federal deficits presently support about 10% of economic activity, and the primary driver of improvement in the unemployment rate has not been job creation but a plunge in labor participation, as millions of workers drop out of the labor force. In a post-credit crisis environment, and particularly with Europe’s sovereign debt in question, it should be no surprise that the world has been willing to accumulate U.S. currency and Treasury debt at near-zero interest rates. That makes debt seem benign and money creation seem without consequence. But it is absurd to point at that happy short-term outcome and dance under the illusion that escalating debt won’t matter in the longer term, or that massive money creation will be easily reversed, or that strong inflation will be avoided if it is not reversed.
We have already accumulated enough government debt to place a broad range of current and future government services under a cloud. Given that most of the publicly held U.S. government debt is of short maturity, there is no way of inflating away its real value over time, because interest rates would adjust at each rollover of that debt. In the event that the sheer size of the U.S. debt results in a loss of confidence (which is a 5-10 year proposition, though not yet a present one), there is no reason that we could not expect the same short-term funding strains that many European countries are facing in fits and starts today.
Meanwhile, last week, Ben Bernanke announced that the current “Twist” program (where the Fed buys long-term Treasuries and sells an equal amount of shorter-dated Treasuries) will be replaced with outright “unsterilized” bond purchases. In doing so, Ben Bernanke has put the economy on course to choke down 27 cents of monetary base for every dollar of nominal GDP by the end of next year – in an economy where even the slightest normalization to interest rates of just 2% would require the monetary base to be cut to just 9 cents per dollar of GDP to avoid inflationary outcomes. The chart below is a reminder of where we are already.
Understand that Fed policy now requires interest rates to remain near zero indefinitely, because competition from non-zero interest rates would reduce the willingness to hold zero-interest currency, provoking inflationary outcomes unless the monetary base was quickly reduced. Given an economy perpetually at the edge of recession, so far, so good. But as interest rates essentially measure the value that an economy places on time, Ben Bernanke's message to the U.S. economy is clear: time is worthless.
Monetary policy has become a roach motel – easy enough to get into, but impossible to exit. Bernanke seems pleased to note that inflation presently remains low, but why shouldn’t it? In a structurally weak economy, velocity drops in exact proportion to new monetary base, with zero effect on real output or inflation. The problem is that Bernanke seems incapable of running thought experiments. Suppose the economy eventually strengthens at some point past 2013. At that point, the Fed would have to sell nearly $3 trillion of U.S. debt into public hands in order to reabsorb the money creation he claims “is only a temporary matter.” These sales would add to the stock of U.S. debt already held by the public, very likely while a significant government deficit is still in place. Such a sale would be, by two orders of magnitude, the largest monetary tightening in U.S. history. Is that possible to achieve without disruption? I doubt it.
So instead, the Fed must rely on the economy remaining weak indefinitely, so it will never be forced to materially contract its balance sheet. To normalize the Fed’s balance sheet without contraction and get from 27 cents back to 9 cents of base money per dollar of GDP without rapid inflation, we would require over 22 years of suppressed interest rates below 2%, assuming GDP growth at a 5% nominal rate. Indeed, Japan is on course for precisely that outcome, having tied its fate 13 years ago to Bernanke’s experimental prescription (stumbling along at real GDP growth of less than 1% annually since then). Bernanke now sees fit to inject the same bad medicine into the veins of the U.S. economy. Of course, a tripling in the consumer price index would also do the job of bringing the monetary base back from 27 cents to 9 cents per dollar of nominal GDP. One wonders which of these options Bernanke anticipates. Psychotic.
Big picture – my perspective remains unchanged: the long-term viability of the global economy is being increasingly wrecked by short-sighted policies focused on avoiding short-term economic adjustments, and at bottom, on avoiding the restructuring of unserviceable sovereign, mortgage and financial debt. Yet only that restructuring is capable of unchaining the economy from reckless past misallocations; only that restructuring is capable of unleashing robust new demand that would form the basis for sustainable economic activity and job creation. You either pull the bad tooth, or you provide every kind of pain killer and symptom reliever, and let the problem rot indefinitely.
From an investment perspective, we know that the impact of quantitative easing both in the U.S. and abroad has generally been limited to a rally in stocks toward the highs of the prior 6-month period, in some cases moving as high as the monthly Bollinger band (2 standard deviations above the 20-month average). Given that the S&P 500 is within a few percent of its highs, and that conditions have already established an overvalued, overbought, overbullish, rising-yields conformation, much of the “benefit” of QE on stocks appears already priced in, as it has been since October when Bernanke effectively announced the present policy. The downside risk overwhelms the upside potential, in my view, but we can’t confidently rule out some amount of upside potential – which would still seem dependent on the avoidance of negative economic surprises.