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Central
bankers around the world may be providing a backstop to the financial markets
in much the same way Greenspan did during the "Goldilocks" years,
but when the short-term euphoria wears off, will the
negative repercussions be even more severe? Bernanke's Federal Reserve (Fed)
appears to specifically target equity market appreciation as part of its
offensive in bringing down the unemployment rate; expectations are high:
every time the market sells off, the Fed might simply print more money. We
fear central bankers have overstepped their reach, and the implications of
their actions may be much worse than the anticipated benefits.
To an extent,
the effects of today's monetary policies resemble the "Greenspan
Put" (named after former Fed Chair Alan Greenspan) in the years leading
up to the crisis. Today's central bankers have been quite straight forward in
communicating their stance: they appear willing to step in with evermore
liquidity should the global economy show any signs of further weakness.
Bernanke's Fed has gone even further: the Fed has stated it's
accommodative policies will "remain appropriate for a considerable time
after the economic recovery strengthens". In other words, financial
markets will be awash with liquidity for an extended period, even if we see
signs of a sustainable economic recovery.
At first
glance, this may appear a positive development for investors holding stocks
and other risky assets. After all, Bernanke appears willing to underwrite
your investments over the foreseeable future. Indeed, Bernanke appears to
specifically target equity market appreciation, on many occasions noting one
of the key benefits of quantitative easing (QE) has been to increase stock
prices. Notably, while he believes the Fed's QE policies have had a positive
impact on stock prices, he considers it has not caused increases to inflation
expectations or commodity prices. We disagree, which we elaborate below.
Ultimately, the Fed may have reached too far, bringing risks to economic
stability and elevated levels of volatility; the full implications of its
actions may be somewhat dire down the road.
From the Bank
of Japan and the People's Bank of China to the European Central Bank (ECB),
the Bank of England (BoE) and the Fed, central bankers are either putting
their money where their mouth is (quite literally) or strongly insinuating
that continued, ongoing easing policies are needed to prevent another
significant downturn in global economic activity. While all the excess
printed money may or may not have the desired effect of stimulating the
global economy, the money does find its way somewhere; unfortunately, most
central bankers appear to fail to realize that they simply cannot control
where that money ends up.
Fed Chair
Bernanke's Achilles' heel since the onset of the financial crisis has been
the housing sector. It's no surprise why the Fed bought over a trillion dollars worth of mortgage backed securities (MBS) since
2009: to re-inflate home prices and in so doing, bail out all those
underwater with their mortgages. The problem was, it
didn't work - house prices continued to weaken across the nation, and have
stagnated to this day. Now, the Fed has announced another MBS purchase
program, this time open-ended, under the auspices of "QE3". Do they
believe the time is now ripe for MBS purchases to positively impact the
housing market and thus the economy? Unfortunately, the first MBS purchase
program failed to have its desired effect; we do not foresee how QE3 will be
any better at stimulating house price appreciation.
One of the
things we believe such actions do stimulate are
inflation expectations. Indeed, the jump in market-implied future
inflationary expectations in reaction to the Fed's QE3 decision was quite
remarkable:
In contrast
to Bernanke's views that QE does not cause commodity price appreciation, in
our assessment, much of the freshly printed money only serves to inflate the
value of assets that exhibit the greatest level of monetary sensitivity:
commodities and natural resources. These are essential in the manufacture and
production of goods and services purchased by U.S. consumers on a daily
basis. As such, inflated commodity and resources prices ultimately pressure
consumer price inflation, as the consumer's "everyday basket of
goods" becomes evermore expensive. The ongoing
weakness in the U.S. dollar only serves to compound these inflationary
pressures. A weak dollar, we believe, is part of Bernanke's strategy to
stimulate the U.S. economy through stimulating exports. While we
fundamentally disagree that this is sound monetary policy for the U.S. to
pursue, the inflationary ramifications are clear: the U.S. imports a great
deal from abroad; every time the dollar depreciates against a currency of a
country from which the U.S. imports, the price of those imports rises.
Not only have
the Fed's actions heightened inflationary risks, but we also believe it
implicitly heightens the risk that the Fed gets monetary policy wrong. For instance,
Fed Chair Bernanke believes that the Fed's non-standard policies since 2008
may have helped lower 10-year Treasury yields by over 1.5%1. In so doing, the
Fed has taken away a key metric used to gauge the economy and thus set
appropriate monetary policy: free market interest rates. The Fed has
historically relied on long-term yields, such as the 10-year and 30-year
Treasury yield, as part of its assessment of the overall health of the
economy. In manipulating those same yields, the Fed can no longer rely upon
them to provide valuable information on the health and trajectory of the
economy. In other words, the more the Fed meddles in the market through
non-standard measures, the more the Fed is in the dark regarding the
appropriateness of monetary policy. Such a situation inherently creates an
additional level of uncertainty over the U.S. economy, U.S. monetary policy,
and may continue to underpin weakness in the U.S. dollar.
The vast
amounts of liquidity provided via the Fed's quantitative easing programs
will, at some point, have to be reined in. Whether due to inflationary
pressures or a sustainable recovery, only time will tell, but the need to
rein in liquidity may create massive headaches down the road. Given the
ongoing high level of leverage employed in the economy, such monetary
tightening runs the risk of undermining any economic recovery and potentially
causing it to crash back down, as the likelihood of it negatively affecting
consumer spending is high. With a still-leveraged consumer, rising rates may
be overly painful, dramatically slowing consumer spending and, in turn, the
economy. Such dynamics may have an outsized impact on the U.S. economy, given
consumer spending makes up approximately 70% of U.S. GDP.
All of which
underpins our view that there is a significant risk that the Fed has gotten
monetary policy wrong. We consider the Fed's actions have not only heightened
inflationary risks, but have also inherently created risks to appropriate
monetary policy going forward. Both of which will likely contribute to
ongoing high levels of market volatility over the foreseeable future.
With so many
dynamics yet to be played out globally, and with central bankers becoming evermore active in meddling with economic dynamics around
the world, investors may want to consider preparing for the potential
ramifications of such policies. While we may disagree with the policies being
pursued, central bankers appear to be at least predictable in their
decisions. We believe the currency market provides the most effective way to
position oneself to protect and profit from the implications of such monetary
policies.
In the
current environment, the general equity market seems to be moving on the back
of the next anticipated move of policy makers, and less so on fundamentals,
but company-specific risks remain. With the outlook for the economy still on
tenterhooks, many companies have been missing earnings forecasts. Currencies
don't have this additional layer of risk. As a result, currencies may be the
"cleanest" way of positioning oneself for the next policy move.
Historically, currencies have also exhibited much lower levels of volatility
relative to equities, when no leverage is employed. As such, investors may
want to consider adding a professionally managed basket of currencies to
their existing portfolios.
Axel Merk
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