The past
eight years provided a phenomenal environment for stocks, bonds, and real
estate due to the tremendous expansion of the Fed’s balance sheet and the
resulting eight year zero interest rate policy.
During that eight year period the world became familiar with terms like
Quantitative Easing (QE) and Operation Twist as the Fed moved into uncharted
waters in both the magnitude and length of its easing programs. What began as an emergency program to rescue
the U.S. and the world from the Global Financial Crisis turned into a longer term
attempt to stimulate growth through the inflation of financial assets; the
theory being that wealthy people would spend more and that wealth would
“trickle down”, and result in economic
growth. As it turned out, it should also
be mentioned, that the Fed alone pretty much carried the economic football as
the budget sequester limited the impact of fiscal policy as the U.S. government
continues to struggle with debt and deficits.
Several
times during the past eight years, sell offs in the stock market were
alleviated or reversed as the Fed “rode to the rescue” with more QE and the
aforementioned Operation Twist. So
powerful were the effects of the Fed’s activity that other major central banks
in Europe and Asia started QE programs of their own. The ECB and BOJ have “upped the ante” by
taking interest rates to negative levels several years out on the yield curve,
and in the case of the BOJ, have even resorted to buying equities through the
ETF market. As a result approximately
$12tn of sovereign debt in Europe and Japan have negative yields and in
addition, the Government Investment Fund of Japan is a top ten shareholder in
the majority of the market capitalization of the Japanese stock market. We don’t know where the Japanese buying of
equities stops or possibly reverses, but it is not healthy to have the national
government interfere in free markets and substitute public for private capital
in the ownership of what should be the nation’s growth engine.
We have
discussed many times how ill advised, to put it mildly, the major central bank
policies are. In essence these policies
distort the relationship between risk and return that is essential for the
efficient pricing of capital. This
causes bad investments to be made and good investments not to be made. Zero and negative interest rates also push
investors into riskier investments than would otherwise be made as they chase
yield. The companies themselves, in the
U.S. and increasingly elsewhere, have been on a “feeding frenzy”, buying stock
back at extremely inflated levels to the detriment of investing in their
businesses. In many cases, compensation
of senior managements is determined by EPS metrics not adjusted for stock
buybacks. Since it is the managements
and boards of companies that authorize and execute these programs, an inherent
conflict of interest exists as managements ”knock” options “into the money”,
thus influencing their own compensation.
With the stock market at or near all-time highs the public is not
focused on this, as the “music is still playing”. But we maintain that the day may come when
the focus of politicians and regulators will be how much money was stripped
from shareholder’s equity of U.S. companies as stock was bought back at
valuations that in more normal times would cause them to want to SELL equity,
not buy!
The rally
that has taken place since the election of Donald Trump comes at a time that
the Fed is (slowly, so far) reversing the zero interest rate policy of the past
eight years. In addition, they are not selling the bonds they bought and are holding
on their balance sheet, but rather are letting the balance sheet “run
off”. Said another way, this is money
printing, i.e., currency debasement, plain and simple. In our view, the market is betting the Trump
promises of tax cuts, deregulation, repatriation, and fiscal stimulus across
defense and infrastructure related industries will outweigh the potential
negatives of possible trade wars and tariffs, a stronger dollar, inflation, and
further rising debt and deficits. To our
way of thinking, and to no surprise to our readers, we believe the market’s positive
reaction thus far will be dead wrong.
The damage
has been done over the last eight years by the Fed’s ill-conceived and
irresponsible zero interest rate policy and unprecedented money printing. Financial assets have been inflated to at or
near the most expensive levels in history.
As the Fed raises rates and tries to normalize, debt will continue to
climb, and in our view, Trump or no Trump, we will not grow our way out of the
problems that exist. Whether we have low
growth and low inflation, or whether we have stagflation remains to be
seen. But either way, when rates
normalize, as they must, the markets will become rational again. In our view, when that happens, both stock
and bond prices will be substantially lower.