Thursday, September 4, 2014

The Fallacy Of Central Bank Stimulus

by Kevin Flynn


  • Growth rates during the era of quantitative easing.
  • The fixation of investor sentiment with central bank stimulus.
  • Equity markets correct on the ends of business cycles, not on a few rate hikes.

"There are no new eras - excesses are never permanent." - Bob Farrell

Many readers will recognize the above observation as rule #3 from Bob Farrell's Ten Rules of Investing. Farrell is a bona fide Wall Street Legend who actually studied under Graham and Dodd at Columbia, yet was famed for decades as Merrill Lynch's technical analyst.

I bring up the rule because of my conclusion that the market is in the grip of another New Era, in this case the Era of Invincible Stimulus.

Each era of excess eventually coalesces around a guiding principle that is thought to reduce investing to a simple process of buying the dips. The late Sixties and early Seventies had the Nifty Fifty; in more recent times, the late 1990s had the original New Thing, the Era of the Invincible Internet. It was followed in short order by the Era of the Invincible Housing Machine.

Here are some recent headlines from the Era of Invincible Stimulus:

Japan GDP Slump Stirs Stimulus Talk (Wall Street Journal (WSJ), 8/13/14)

European Data Stoke Stimulus Hopes (WSJ: 9/2/2014)

Hong Kong Shares Rally on Stimulus Hopes (WSJ: 8/13/2014)

Copper Rises on Hopes for China Stimulus (WSJ: 8/22/2014)

The United States stock market is, for once, not the current poster child for this belief. That honor goes to the China and Hong Kong markets, where weak data these days means more stimulus, and good data means the stimulus is working. Ergo, all news is good news (a state we are familiar enough with over here).

I haven't the space to deconstruct each stimulus program around the globe. What I can do is cite some U.S. data that should be revealing: from the end of 2002 through the end of 2007, the compound annual growth rate of nominal GDP in the US was 5.75%. From the middle of 2009 through the middle of 2014, the era of QE (a.k.a. The Era of Invincible Stimulus), that nominal rate was 3.84%. The annualized rates since the beginning of QE-2 and QE-3 are 3.89% and 3.63%, respectively. That period includes the Big Bad Winter Quarter of 2014, so I'll throw the data a bone and accept that by the end of the current quarter, the rate might move up past 3.7% and back to 3.8%.

It's very difficult to conclude that QE has made any difference at all in the growth rate in the last two years, at least not without resorting to counterfactual speculation. About half of the difference in the growth rates between the two five-year periods of 2002-2007 and 2009-2014 can be attributed to inflation, which (using the Fed's preferred PCE indicator) ran about 100 basis points a year higher in the earlier period. The reason I'm using nominal GDP data because QE is a monetary phenomenon: One would expect QE effects to show up more strongly in nominal, monetary-only GDP data rather than inflation-adjusted ("real") numbers.

Aye, but here's the rub, as summed up in a MarketWatch column from London on why one should invest in Europe (the short answer being stimulus): "We will probably never have any clear-cut evidence whether QE helped the U.K. or U.S. economies, but both have recovered far faster than Europe has done...Sooner or later, the ECB will act. The one thing we know for sure about QE is that it boosts asset prices, and the stock market in particular. Even if the economy still flat-lines, equities should do well." (emphasis added).

Indeed, over that 2003-2007 five-year period, the S&P 500 advanced a total of 66.9%, for a compound growth rate of 11%. Over the five years from mid-2009 to mid-2014, the S&P advanced nearly double the previous amount, 113.2%, for a growth rate of 16.4%, nearly 50% higher. In short, the monetary inflation we expected from QE made its way into the financial economy instead of the real one.

I will return to that point, but this is a good place to stop and consider that the stated intentions of the central banks is to stimulate the real economy with quantitative easing, rather than the financial one. I don't want to pretend that the central bankers are naive or seem so myself - a rising stock market is certainly one of the hoped-for transmission methods for goals such as restoring animal spirits and loosening the credit reins. The problem under consideration is two-fold: the effects of additional central bank stimulus on both the real economies they are responsible for, and on the financial markets they inhabit.

I also want to make it plain that I am not proposing a blanket repudiation of quantitative easing or monetary easing. What I am proposing as fallacy is one, the notion of quantitative easing as anodyne against all ills and in every wind; two, the financial market belief that asset prices cannot fall so long as there is stimulus. The latter is acting as if the central banks have solved the business cycle: simply print more money, and there will never be any contraction.

Indeed the latter point underlines one of the great weaknesses underlying prevailing market beliefs. The explicit sentiment, as represented in the MarketWatch comment above, is that QE must lead to higher asset prices. However, implicit in this notion are two very serious flaws, the first being that asset markets are insensitive to the business cycle. The second, more fundamental (and more serious) flaw is the one implicit in such phenomena as Farrell's rule cited above, the New Economy (i.e., dot-com) and the granddaddy of them all, Tulip Mania: the business cycle has been repealed.

The overwhelming sentiment I see in market commentary from professional and amateur (skilled or not) investor is that the market cannot seriously correct until the Fed seriously raises interest rates. However, that cannot be true unless the two flaws above are eliminated, leading to the unavoidable inference that so long as the Fed does not rates (or only raises them a little), the business cycle cannot end. Stimulus has overturned it. Either that, or for the first time in history, asset prices are now insensitive to the cycle and its declining cash flows. It's a new era.

It's become fashionable these days to talk about recessions as being pure children of the Fed. In other words, they only happen when the Fed crushes the economy with the sledgehammer of much higher rates (I am quoting almost verbatim). Once again, this sentiment presumes that the business cycle can somehow be overturned. It also flies in the face of the evidence of the last two recessions.

The tech bubble did not burst because of rising interest rates. It burst when the country was so ridiculously awash in new telecom gear and South Sea Bubble-style dot-com enterprises that hardly anyone could make money from them anymore. The housing bubble didn't burst either because of higher rates. It's true that at the margin, higher short-term rates made some of the more exotic financial products unprofitable, and higher mortgage rates raised monthly payment levels, but this is akin to complaining that the newest batch of cadavers aren't pretty enough to be vampires. They're still dead.

The financial system began to collapse in 2007 when it ran out of warm bodies to give a mortgage to and early-default rates soared. Like Tulip Mania, both the dot-com bubble and the housing bubble became pyramid-like schemes that crucially depended on the ability to flip purchases to a higher bidder, Such schemes always end the same way - eventually everyone is a seller and no one is a buyer - regardless of the level of interest rates.

One of the biggest problems in political economy is the overwhelming human desire for simplistic, one-size-fits-all policy formulations that can be relied upon in every situation. Cut taxes. Increase spending. Balance the budget. Don't balance the budget. Wear the black sweater today. The truth is that most policy prescriptions only work at certain times and places. The Fed can cause a recession - it certainly did in 1980-1982, and most deliberately so, with short rates approaching 20% (not a typo) - but in most cases, the Fed is simply taking away the last cocktail from an economy that has had more than one too many, and is about to get sick and pass out anyway.

We don't blame ourselves for paying insane prices for money-losing tech stocks, or taking out million-dollar mortgages with $50,000 incomes, or buying and selling derivative products that are indecipherable to mathematicians. No, we blame the Fed for raising rates.

For a good summary of why China cannot stimulate its way out of the business cycle, see this note from Michael Pettis (brought to my attention by John Mauldin). For evidence on why the Fed cannot do it either, read this column again - and see the problem presented by Bill Gross in his monthly commentary.

I had hoped to present a case on the ECB, but have run out of time and space. Of course the ECB might do something to make stock prices go up first - think about tulips, think about dot-coms. Then ask yourself how a crippled economy can only be a win-win of either more stimulus or more GDP, in light of how well it worked in Japan over the last thirty years. Ask yourself why inflation will have to rise in Europe, when the era of QE in the U.S. has experienced an inflation rate 100 basis points lower than the cycle that preceded it. What the EU needs most of all is a much weaker euro - like about 25% lower for a start - and it won't get it without undergoing collapse first. Think about it. You're betting that someone else will buy your tulip.

Central bank stimulus is not an invisible force field against adversity. It may have crept into the popular imagination that way of late, the way investment mantras do, but there is no historical evidence to support it. In the meantime, consider that U.S. domestic valuations are very dangerously high, that the margin for error is dangerously thin, and that investor bearishness is at multi-decade lows. If nothing at all goes wrong, then stocks will continue to rise. But something always does, as Farrell's rule #3 observes. That would bring rule #1 into play: Markets tend to return to the mean.

See the original article >>

No comments:

Post a Comment

Follow Us