From John Goltermann of Obermeyer Asset Management [13](pdf format [14])
The Experimental Economy
On the heels of last Thursday’s Fed announcement, there has been much commentary on the whys and wherefores of a new quantitative easing (the so-called QE3). Rather than re-hashing well-covered ground, I want to instead discuss the potential effects and unintended consequences of this policy and how it may impact the investment landscape going forward.
Suffice it to say that the Fed had its reasons. QE3 evidences a belief in the so-called “wealth-effect” – the idea that one will spend more if he/she feels wealthier – and the Fed also believes it can contain any negative consequences. However, others would argue that it’s another shot across the bow of our foreign lenders that we are willing to engage full-out in a currency war as this policy clearly weakens the U.S. dollar. Because the Fed has embarked on a path with little historical precedent – where a central bank has signaled the intent to expand its balance sheet as much as it needs to – we are all now part of an experimental economy.
Leading up to the announcement, weak U.S. economic data had kept rates low and the bond market strong, while also lifting the share prices of income-oriented investments such as dividend stocks, REITS and MLPs (which are generally preferred by reluctant risk takers). Residential real estate also continued to bottom bounce, but a recent rally in bank equities signaled that bank balance sheets had begun to improve. This all by itself could have caused the credit environment to loosen a bit without quantitative easing, which could have easily led to increasing real estate prices, creating a self-perpetuating positive feedback loop. Of course, the Fed may know something we don’t know.
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Remember: In 2007, declining share prices of bank equities revealed a problem in the credit environment and presaged the crash of real estate and stock prices, and the recession of 2008- 2009 (see chart below). Today’s increasing bank equity prices could in fact signal the reverse – rising confidence and improved overall risk appetite.
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What is hard to know, however, is how much consumer, business and investment confidence will materialize while we have 1) a highly interventionist central bank, 2) a government that tries to cajole and regulate economic incentives, 3) a lack of clarity on future policy and 4) a price discovery process that has been corrupted by interest rate manipulation.
Ironically, the weak data has juiced commodity prices and gold more strongly than the stock market as a whole because many participants (correctly) positioned themselves for a quantitative easing announcement, which they got on September 13th. As the hope and hype of the iPhone 5 launch occupied the bulk of financial media air time leading up to the Fed meeting, materials, energy and precious metals stocks had been quietly outperforming by a wide margin because a tough economy means an activist Fed.
Although QE3 and a relatively quiet period for euro-headlines have bolstered investor confidence, this has been offset somewhat by recent unrest in the Middle East, vitriolic political rhetoric domestically, and a still-unaddressed fiscal cliff. The end result: many investors continue to sit on their hands while riskier assets rally.
Interestingly, while U.S. GDP muddles along at a sub-2.0% growth rate and while Europe enters a recession, oil prices have held firm at around $100/barrel, copper prices have stayed elevated at $3.85/lb. and the CRB (Commodity Research Bureau) Index is above pre-2008-crash levels (see chart on following page). To us, this signals that 1) it is not the U.S. and European economies that will drive future commodity prices, and 2) when speculators get a whiff of quantitative easing, their first reaction will be to bid up the prices of key commodities in order to hedge themselves. Unfortunately, this latter behavior feeds into the supply chain and hurts those who spend larger percentages of their income on food and fuels. It is for this reason that quantitative easing may simply amp up the level of speculation in the financial system and hurt the middle class instead of juicing the real economy. It could also increase income disparity, which itself weakens the economy, presenting the Fed with the ongoing dilemma of policy ineffectiveness.
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While it’s not clear that the Fed can do anything about long-term unemployment, it’s not shy about trying. The Fed has been highly accommodative for twenty years, but unemployment is far higher now than it was at any time during the past two decades. Going forward, the Fed’s stance risks its credibility with its foreign lenders. This is a caution that seems to have been thrown to the wind.
This time, the quantitative easing experiment commits the Fed to buying $40 billion of mortgage-backed securities per month (it didn’t say which securities), a strategy that moves the U.S. economy further away from being market-based, towards one that is centrally planned out of Washington. In addition to judging potential investments based on their fundamental merits and prices (and what the prices imply about others’ assumptions), investors must now also factor in political motivations and central bankers’ economic theories when they decide on their risk allocations (which are the good risks and which are the bad).
As we have often emphasized, by keeping interest rates below the actual increase in the cost of living, people are incentivized to consume now instead of later (when they would have to pay a higher price) and to take risks because of the insufficient returns offered on cash and savings vehicles. Policy essentially forces people to borrow from the future and, as we now know, has in turn caused massive capital misallocations as evidenced by the obvious bubbles in tech stocks and housing.
Where Fed policy has succeeded is in enriching many financial services providers (and businesses within the financial service ecosystem) at the expense of savers and retirees. This is why we see real estate prices in New York, London, Aspen and Cap d’Antibes surging while those in Chicago and Cleveland remain lackluster. This is why we see the market prices for Picassos continuing to explode while the automobile industry flatlines. Those who earn $100,000,000 don’t buy proportionately more cars relative to their incomes than those who earn $50,000. Actions have reactions and not all of them are good!
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As we mentioned above, the Fed’s launching of QE signals its belief in the wealth effect. The problem with the wealth effect is that not everyone participates equally, and it doesn’t account for the skewness (pardon the statistics terminology) of wealth. In other words, average wealth might increase, but median wealth decreases because more and more people have lower real incomes while a few people have exponentially increased theirs into the stratosphere, bringing up the average. So long as the cost of living from food, energy and healthcare continues to skyrocket, more people lose their standard of living and unemployment stays high.
One measurement of income disparity is reflected in the chart below:
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Without getting into the mechanics of how the Gini Index is calculated, this chart reflects a dramatic increase in income disparity since 1991. A value of zero reflects a population with equal incomes and a value of one reflects maximum inequality where one person has 100% of the income. I have argued that this has not occurred due to tax policy, but rather due to Fed policy. Since 1991, the Fed has kept short-term interest rates below the increase in the cost of living (see chart below). This, in effect, forces savers to subsidize speculators and has exacerbated the problem. Some have argued that what it has really done is impoverish the people of the United States. I don’t know if I would go that far, but QE3 represents the continuation of a policy that has resulted in increasing income dispersion and high levels of indebtedness.
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Many consumers have made up for their income deficit with new debt, so Fed policy could also largely account for the excessive overall debt levels that caused the entire financial system to become fragile and attempt to adjust itself in 2008. Now, without real income growth or debt expansion potential, households have a limited ability to fuel much growth in the 73% of the GDP that depends on consumer buying. The irony is that the Fed, through QE, has signed us all up for low economic growth rates, which it is using QE to address. We are not sure how that cycle will break.
It’s also questionable whether Fed policy positively impacts the overall employment situation. If you look at the labor force participation rate, you’ll see that it has dropped significantly under a highly accommodative Fed and is currently at the lowest level in thirty years.
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Moreover, enrollment for disability income (SSDI) has skyrocketed since the recession ended in 2009. While certainly not true in every case, disability payments have been substituted for long-term unemployment benefits for some workers who struggle to find employment and drop out of the labor pool. Again, twenty years of an accommodative Fed has seemingly had little positive impact on today’s employment situation.
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The point of all this is that while financial markets celebrate the effects of QE3 and bid up all sorts of asset prices, the wealth effect won’t necessarily benefit everyone equally and may further contribute to an income disparity that acts as a drag on the real economy. This has a self-reinforcing political effect as more and more people are forced to sign up for government benefits as their opportunity set diminishes, as interest rates are kept at zero and as economic growth remains low.
Ultimately, it is not our job to criticize Fed policy but rather to manage assets as best as we can, given how the Fed views the world and what it is likely to do. Our investment process on the equity side is to establish positions in well-managed businesses with good assets that have pricing power, but that can also survive and thrive in a slow-growth environment. It is also important to know that the current Fed policy has special consequences and risks.
One of the unintended consequences of such an accommodative Fed is that it has significantly benefitted the economies of, and terms of trade for, our emerging-market trading partners as it essentially incentivizes investment capital to move abroad in search of its highest and best use. This fuels foreign economic development, infrastructure, education and health care systems – making them more competitive on a global scale. We seek to capitalize on this trend (and protect our clients’ wealth) by owning materials firms, infrastructure firms, financiers that do business in emerging markets, agricultural businesses and brands that are highly coveted outside the U.S. And finally, we strongly believe that precious metals belong in everyone’s portfolio in light of the distinct risks that quantitative easing and a weak dollar bring. To deny these risks and avoid an allocation to precious metals could be extraordinarily risky as the grand experiment continues and the outcome remains uncertain.