Unprecedented and unconventional are the two words that have driven risk assets higher since March 2009. An unfortunate ancillary development is that these two words have probably become the two most overused words in the English language. A quick look at Google searches including the word ‘unprecedented’ reveals a major spike starting in 2008. The trillion dollar question is whether 2008 was really ‘unprecedented’ or was it part and parcel of free capital markets? Financial crises of the magnitude experienced during 2008 are typically separated by enough time so that the current participants forget the past. Despite the reality created by generational amnesia, financial crises are a common and necessary part of the creative destruction function of capitalism. Like the flora that rises from the ashes of a forest fire, new businesses and opportunities arise from crisis…unless that process is short circuited by unprecedented and unconventional policy.
This is not to say that the policies enacted by the world’s central banks were unnecessary – in fact, these policies were needed to manage the deleveraging process. However, as every doctor knows, remedies almost always have side effects and very often the disease can become immune to even the strongest antibiotic. The world economy may have reached this point.
An essential part of central bank policy is managing expectations, also known in central bank speak as the communication channel. The purpose of this channel is convincing the public and corporations that the policy will work. Leveraging the invisible hand is crucial to the success of any policy, especially during financial crises. At the heart of all monetary policy is confidence – confidence that the economy will improve, confidence that inflation will be controlled and confidence that the power of the central bank will not be corrupted by politics. If a central bank loses that confidence its policies face the very real risk of failure.
Since 2009, the financial markets have risen on hope, belief and confidence. Hope that monetary policy will stem the crisis. Belief that the policies will work to improve the economy. And confidence that in the event of a failed policy something more can be done. Each time the financial markets or economy swooned, buyers stepped in, hoping their confidence in the belief of a central bank put was not misplaced. Given this pattern, the US Federal Reserve’s recently announcement of open ended QE should have been a resounding success. No longer would market participants and businesses need to hope the Fed would be there – this should have been much needed certainty in an increasingly uncertain environment. So what went wrong, why hasn’t the Mother of All Bubbles emerged?
Three words..hope, belief and confidence. By announcing QE infinity the Fed has short circuited the process that has allowed mediocre economic data to propel US stocks to levels not seen since 2007. Now when the economy or markets swoon there is no longer hope for Fed action, in essence the Fed put is dissolving. The process that has driven risk assets higher may indeed be reversing. If the reversal in market psychology fully develops it means that bad news is …bad news…oh the humanity!
For investors the loss of confidence in monetary policy has profound implications. Asset prices will once again be allowed to reflect investor perceptions of underlying fundamentals. Prices will once again resume their role as the signal of supply and demand balance. The business cycle actually matters again, so investors better dust off those economics text books and decide whether or not the Fiscal Cliff, European Debt Crisis, or an Asian economic slowdown are going to result in a global recession. For our part, we believe that the global economy has been severely damaged by the multiple looming fiscal issues.
The US Fiscal Cliff is probably the largest obstacle to global growth. Whether a global recession is in the cards is wholly dependent on the resolution of the cliff. Even if corporate earnings remain stable, market participants are increasingly unwilling to pay higher and higher multiples for those earnings. When the S&P 500 reached a high in April 2011, investors were willing to pay 16x earnings on the hope, belief and confidence that the economy would improve. The most recent S&P 500 high was met with a P/E ratio of 14.94…and this was with unlimited, unconventional and unprecedented monetary policy.
All hope is not lost, but we are concerned with the recent increase in corporate layoffs. Whether the layoffs are blamed on the Fiscal Cliff or Europe, the decision implies a long term negative view on the global economy. Moreover, some corporations are moth-balling factories – an even more permanent sign of a slowing global economy. We have used the dual time frames of 1938 and 1982 to analyze the current economic environment.
In 1938, FDR decided to balance the budget and the US economy faltered giving birth to the term recession . While in 1982, the US economy emerged from a Federal Reserve induced recession and the financial markets began 20+ year bull market. We have hoped and believed that the Fiscal Cliff could be avoided, but recent corporate actions has eroded our confidence and consequently we are now more biased toward the 1938 outcome.
In our view, any move higher in risk assets will need to be driven by fiscal policy. Investors need a new catalyst to hope, believe and be confident that the economy will improve. Absent a new catalyst, the drivers of the risk-on rally could face the same fate as the dinosaurs.