Authored by Michael Pollaro, originally posted at Forbes.com [14],
Central bank credibility is at all-time highs. As a consequence, we suggest, equities are near all-time highs too while gold is scraping multi-year lows. A change though may be in the offing with all three. Not today, nor tomorrow. But perhaps sooner than most think.
Here’s how we see it…
In the context of five plus years of the most unconventional monetary policies the world has ever seen, there is a near universal belief that a group of Keynesian/Monetarist schooled, largely academic economists have got it all figured out; namely, that super-sized, well-orchestrated, easy money policies – zero even negative benchmark interest rates, a smorgasbord of essentially free lending programs and of course mega-size asset purchase programs (QE) – can produce sustainable, economic growth. In other words, central bank credibility and the efficacy of their policies are in the heavens.
No central bank is more revered in this regard than the Federal Reserve. As we discussed here [15], the Federal Reserve, it is said, is “pulling it off.” Because of its heroic, unconventional, all-in easy money policies, the Federal Reserve is said to have “saved” America from an almost certain depression and then, because of its continued easy money policies, is the driving force behind America’s now accelerating economic growth. Just look at the economic numbers, say the pundits. The Federal Reserve’s monetary policies are working. Yes, not as fast as we would like, but going in the right direction. Only one task left – a well-calibrated, data-driven exit from these unconventional policies. The strengthening economy can take it, they say. In fact, the exit should be welcomed because it signals a strong and growing economy, one that will no longer require any Federal Reserve support.
Of course, this is music to U.S. equity market investors and speculators alike, so much so that U.S. equities have become the asset class de jure. You can’t lose, proclaim one investment manager after another. Don’t “fight the Fed,” they say, embrace it.
This unwavering faith in the prowess of central banks is seen with greatest clarity in the Euro zone. Observe the near universal belief that if only the Germans would get out of the way and allow ECB head Mario Draghi [16] to implement a Federal Reserve style, open-ended, sovereign debt based QE program, the Euro zone economy and especially its equity markets would boom. Isn’t that what the recent sell-off in Euro zone equities is saying, post the disappointing news that the ECB has no plans for a such a QE program. To us it’s obvious why so many people think this way. It’s because recent U.S. economic data seems to confirm that the Federal Reserve’s unconventional, all-in easy money policies are working. And if such policies can work in America why not in the Euro zone too?
We reject this unwavering belief in central banks and their policies, outright. As the Austrians teach, easy monetary policies sow the seeds of their own demise. Flooding the economy and financial markets with money (and credit) created out of thin air – thereby distorting interest rates and price signals and, in so doing, creating malinvestments – is no way to create sustainable, economic growth and ever rising equity prices. Sure, at first glance, the malinvestments and attendant booming equity prices look like genuine growth and wealth creation. But they are not. As we explored here [17], they are instead unsustainable bubbles that turn to bust when the growth in those money supply (and credit) footings decelerate; i.e., when the easy money abates.
Today we posit some questions we think every equity investor needs to answer. What if the Austrians are right? What if unconventional, all-in easy money policies do not produce sustainable, economic growth? Contrary to the expectations of nearly everyone, what if the next big event is in fact a bust? What will that mean to the equity markets going forward? And then, what will that say about the credibility of central banks?
Well, if the Austrians are right, as we wrote here [18], given the size of this monetary experiment, one can expect a pretty big swoon in equity prices if not an ugly crash. More important though is the very real possibility that a bust could put a dagger in central bank credibility, severely damaging if not destroying the belief that unconventional, all-in easy money policies can goose the economy and equity markets anywhere near as effectively as in the past. Maybe, in real terms, not at all. Truly a problematic situation the next time central banks step in to “save” us. This we think is especially true if a bust occurs right here in America. Consider this: The former Federal Reserve Chairperson Ben Bernanke [19] (and world renowned expert on the Great Depression) and his closest adviser current Chairperson Janet Yellen [20] birthed the largest, most heralded, monetary support apparatus in world history and it was found unable to produce sustainable, economic growth, unable to float equity prices ever higher. Instead, it did the exact opposite. How many investors/speculators will then put their unswerving faith in any central bank, at least for the foreseeable future? We’re thinking a lot, lot less than today.
The Federal Reserve is in the process of exiting its grand experiment in unconventional monetary policy. QE3, a two plus year asset purchase program that at its peak injected an annualized $1 trillion of monetary fuel directly into the financial markets, has been wound down. What’s more, though “data dependent,” the Federal Reserve is signaling that it will begin raising interest rates in mid-2015. Of course, nearly every economist and nearly every investor expects this plan to work. Yes, a bit of transitional weakness in the financial markets – like we are seeing now – but after that, up and away.
We of course say not so fast. Given the fact that this exit means a further deceleration in the already decelerating trend in the rate of monetary inflation, the risks are growing that the next big move in the economy and the equity market is not up but down. In fact, if the banking system does not step up and fill the monetary inflation void being vacated by the Federal Reserve we think a bust could begin rearing its ugly head sooner than anyone thinks.
Enter gold, the much maligned, near universally hated asset. It’s presently on no one’s radar screen, except maybe the shorts. And why should it be. Thanks to supposed central bank infallibility, economic growth appears to be strengthening and the equity markets are in a major bull run. As James Grant, editor of Grant’s Interest Rate Observer [21] likes to say, gold is the reciprocal of central bank credibility. We agree. Central bank credibility is at a peak, so gold is in the dumps.
Gold wasn’t always in the dumps. It rose right along with equities, indeed outperformed equities, from the 2009 Great Recession bottom – when central banks the world over first began implementing their unconventional monetary policies – straight through to its September 2011 top. The reason we think it did is quite simple. Coming out of the Great Recession, central bank credibility – their ability to “pull us out” of the Recession – was being severely questioned by investors. Thus, a good portion of investor money found its way into gold. That changed in 2011. Underwritten by these same central bank easy money policies, the as yet unresolved malinvestments of the Housing Bubble turn Credit Bust turn Great Recession, which were in the process of a healthy liquidation, were short circuited, while new, yet to be revealed malinvestments (we think the largest being anything in and around financial engineering) were starting to bear fruit. The belief took hold that the heroic policies of these central banks were finally working, finally restoring long term vitality to the economy. Gold then sunk while equities marched ever higher.
So here we are…
In our minds, get that bust in America (or even a real scare playing out in the U.S. financial markets in anticipation of a bust); then, get the near certain response from the Federal Reserve; i.e., another perhaps even bigger round of easy money policies, and maybe investors will be looking to overweight their portfolios with the reciprocal of central bank credibility instead of equities, forthwith.
