“Volatility may be scary, but it is not necessarily bad for long term growth. The Great Moderation of recent decades did nothing to increase the long term growth rate of the United States.”
Ruchir Sharma’s statement in his excellent book “Breakout Nations” sums up the problem of economic policies based on avoiding a recession at all cost. Sharma further states that “nations with the wherewithal to pay for a soft landing out of recession frequently end up sinking in this expensive pillow.” Japan’s two – soon to be three – lost decades illustrates this best. Even though Japan went through the greatest bubble in human history, when the bubble burst there was no pain. “Like falling off Everest without breaking a bone” writes the economist Andy Xie. “There was never a major round of foreclosures or bankruptcies, as the government kept bailing out debtors.”
We have all become Japanese now.
In recent years, the Federal Reserve Banks’s self-imposed goals have been a series of moving targets. When the Lehman bankruptcy first hit the markets in 2008, central banks around the world followed the Fed’s lead in pumping liquidity into a system that was imploding. Once the initial crisis was past, the Fed took an a new mission: avoiding a major recession. After that, its next mission was to avoid a double dip. Next, it became keeping the economy growing at all cost. This it hopes to achieve through asset inflation.
The modern hyperactive Fed is the new Big Nanny. It is here to protect us from the ills of capitalism. The central bank under Greenspan thought it had finally found the twentieth century’s Holy Grail: an economy without down cycles. It was called the Great Moderation. A financial crisis later, Bernanke has taken the world to the logical next step. Call it the Great Manipulation.
To be fair, the Fed has been forced into this role by its dual mandate. Congress wants the Fed to keep inflation under control and at the same time avoid unemployment. What a shock. Congress wants to have its cake and eat it too.
The Great Manipulation.
At the core of Bernanke’s policy is the conviction that a wealth effect will reinvigorate consumption. When feeling materially well off, people start spending again. That, in turn, gets the economic engine going. Based on paper wealth, Americans are encouraged to spend their savings again.
Greenspan also talked about the benefits of the wealth effect. At the time, “wealth” came from high housing prices, greatly encouraged by an aggressive interest rate policy. It did not end very well. Yet, the central bank is back at it again, and then some.
What is new in Bernanke’s era is the extent of the manipulation of asset prices by a few unelected officials. From QE1 to QE2 to whatever number is deemed necessary, the Fed has embarked on a massive manipulation of the bond market, the housing market, the mortgage market and the stock market. THIS is unprecedented in the short history of capitalism.
The Fed has a stated policy of pushing bond prices up. Mortgage rate manipulation is similarly part of the Fed’s known intentions. By buying the long end of the interest rate curve and by taking bad mortgages off banks’ balance sheets, the Fed is actively supporting the mortgage market, and thus the housing market.
Manipulation of the stock market is not as clearly stated. It just happens to be a side effect of well timed policy announcements. A rising stock market is also something Bernanke likes to point to once in a while.
Could it be that the Federal Reserve Bank is pushing major indexes up just before the markets open for the day, or when there is too much selling pressure? One can only wonder. What we do know is that the buying pressure is not coming from retail investors. They are still shying away from what many perceive as a rigged game. Japan, on the other hand, is not shy about supporting stock prices. The central bank of Japan has made it official. In the early 1990’s, investors in Tokyo used to call markets’ magic rebounds as the central bank’s “PKO”, or Price Keeping Operation.
Whatever the level of direct manipulation of the stock market, traders have behaved with Pavlovian predictability to any hint that a central bank is about to make an announcement.
Good news is good news. Bad news is also good news for the market. It triggers a buying spree on the hope of more intervention. Mediocre earnings only affect stocks for a day or two. Then they snap back to previous levels. Even central banks’ inaction no longer triggers a selling frenzy. Traders are too scared to be caught on the short side. Nothing can bring this market down.
Short sellers are licking their wounds. Fundamentals are to be ignored. The Fed will not let you make money speculating against a recovery.
This is working. There is no question central banks have been successful at pumping up assets. Unfortunately, the Great Manipulation has not helped revive the global economy. The wealth effect has not delivered the anticipated economic growth. The US is treading water. Europe is already back in a recession. Asia is facing a hard landing. Many Latin American countries are moving back to the economic policies that have made them the perpetual success stories of tomorrow.
So, with valuations relatively high on peaking earnings margins and slowing economic growth, what can the markets expect next?
The new contrarians point out that markets always climb a wall of worry. Maybe. But it would make more sense if there was a better future on the other side. Take a look. Fiscal consolidation as far as the eye can see is not a recipe for growth. Whatever policies developed countries choose, it will involve dealing with an enormous amount of accumulated debt.
In the aftermath of the 2008 crisis, companies cut costs aggressively, which allowed for a dramatic rebound in corporations’ earnings margins. These reached historic high levels. From here, only top line growth will push companies’ earnings higher.
Indeed, that’s what the markets anticipated in the first months of the year. Remember the 3.5 to 4% GDP growth projections? Economic growth was lifting earnings estimates. But now corporate earnings are projected to be flat. Yet the bulls are still in charge and the stock market is back to its year high. How quickly we forget and move on to the next reason to own stocks.
In spite of the many warnings, optimism is still predominant. From Nouriel Roubini’s prediction of the perfect storm coming in 2013 to Bill Gross’ calling of stocks a Ponzi scheme, a lot of smart people are worried. Traders, on the other hand, are still pushing markets higher. The tyranny of short term performance is just too strong. If markets are going up, one has to be on board.
But missing in today’s bullish view is a clear path to better times. The printing press and short term thinking has kept the prolonged bull market alive. Is it reasonable to believe it will continue without economic growth?
At the end of the day, fundamentals do matter. Unreasonable optimism about small economic bounces do not justify today’s unusually long market rally. Foreign markets are particularly vulnerable to a major correction because they have often moved in tandem with US’ optimism, no matter the deteriorating local economic situations.
Here is the problem: how can anybody seriously envision a real recovery without an attempt to clean up the fiscal mess?
Ironically, today’s markets’ villain, Europe, is ahead of the curve. Government deficits in Euroland add up to less than half that of the US. Germany is pushing the southern European countries to get their fiscal houses in order. Time for gimmicks has come and gone. Structural reforms are needed, and without question,they will be painful.
Greece is in a depression. Spain, Portugal and Italy are struggling to regain financial markets’ confidence. These stories make the headlines. But already Ireland is no longer in the news. Here is why: Ireland’s tough medicine is paying off. Having faced its problems head on, the country can now look forward to rebuilding on a sound basis. If Mrs. Merkel holds firm, the rest of Europe will soon be a much better place to do business. And yes, the euro will survive.
Japan is a totally different story. Having kept their heads in the sand for more than two decades, the Japanese can no longer remember what a rising sun looks like. They have settled for stagnation. To an outside observer, it is mind boggling that with a debt to GDP ratio of more than 200%, the Japanese do not see any political urgency. Curiously, the Japanese yen continues to defy gravity. The mysterious Orient…
Most Asian countries have copied the Japanese export-led economic model. They are now facing a crossroads. Global trade is slowing down. Western countries’ previously insatiable demand is waning. Furthermore, protectionism is showing its ugly head. Either Asian countries rapidly reinvent themselves or a Japanese-style slow decline awaits them.
China’s sharp correction should be a warning. The Shanghai SE is down 20% over the last 12 months and is trading 40% below the peak reached at the end of 2009.