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Although the U.S. stock
market continues to hit new nominal highs on a nearly daily basis, the U.S.
economy bumps along at a lackluster pace. This disconnect has been achieved
by a massive Fed experiment in monetary stimulation. Through the combination
of seemingly endless maintenance of zero interest rates and the injection of
some $1trillion a year of synthetic money into fixed-income markets, the Fed
is hoping that the boom it is creating on Wall Street will lead to a boom on
Main Street. In reality, this a very dangerous economic gamble of enormously
high stakes. As we have seen in the recent past, financial bubbles can
leave catastrophe in their wake.
In October 2013,
Professor Robert Schiller, the renowned Yale economist, was awarded a Nobel
Prize together with two others for research into asset bubbles and resulting
values. In a recent interview in the German newspaper, Der Spiegel, he
said, "I am not yet sounding the alarm. But in many countries stock
exchanges are at a high level and prices have risen
sharply in some property markets. That could end badly. I am most worried
about the boom in the U.S. stock market. Also because our economy is still
weak and vulnerable."
However, there are many
in the financial establishment who disagree with the professor, including,
most interestingly, Professor Karl Case, the co-creator of the famous
Case-Shiller Home Price Index. Most markets either believe that current share
prices are fully justified by corporate metrics or they believe the Fed has
expertise, and the ability, to prevent an ugly sell-off if things turn out
badly. This debate has become the defining conversation as we head into the
end of the year.
However, those who
believe that QE will produce positive results to compensate for the risks are
finding their position to be increasingly difficult to defend. At the
International Monetary Fund's November annual conference in Washington, Mr.
David Wilcox, reputed to be one of the Fed's most important economic
advisors, offered insight into some problems facing QE. In essence, he
maintained that the Fed's QE-3 program is producing only very limited results
in terms of U.S. economic growth. At the same time, he seemed to hint that
unlimited QE could create serious financial market distortions.
Many market observers,
including myself, think that the Fed's open-ended QE program has been a
massively expensive failure. As a result, market watchers have become
increasingly eager for the program to be wound down, and many do not
understand the Fed's reluctance to taper its monthly bond purchases.
Although many of the more
open-minded members of the Fed's Open Market Committee may have lost faith in
the ability of QE to deliver tangible gains in the real economy, they have
also shown some concern that a diminishing of QE could trigger stock and bond
market turmoil. There can be little doubt that such an outcome could usher in
a new round of recession. In other words the "good" that the Fed
sees in QE may merely be the prevention of a potentially worse reality.
A majority of investors
have seemed to convince themselves that QE has become an unneeded crutch that
the Fed will be more than happy to abandon by the end of next year. Many
believe that such an outcome will place limited downward pressure on stocks,
bonds and real estate. These views are Pollyannish in the extreme. The recent
sell-off in the bond market should attest to that. On the other hand, some
investors, including some aggressive hedge funds, seem to be operating under
the belief that QE will not be ended any time soon, if ever. They have even
borrowed massively to invest on booming financial markets that stand already
at record highs. Today, total New York Stock Exchange margin debt stands at
$412 billion, an all-time record.
The disagreements of the
investing public are of little weight in comparison to the opinions of the
FOMC members themselves (such is the world we have created). The key point
for 2014 is how many voting members of the new Yellen-led FOMC will follow
her down the Keynesian cul-de-sac. Should a majority of the FOMC feel forced,
in the national interest, to vote against an expansion of the Bernanke-era
stimulus policies (which we believe Ms. Yellen is sure to propose), financial
markets could be in for a severe shock.
Those who wish to continue
equity investing in face of this risk might be well-advised to ensure they
have adequate hedging policies in place. Investors in both equities and bonds
must question how the Fed can coax a market into a continued boom in a manner
disconnected from economic reality.
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John Browne is a
Senior Economic Consultant to Euro Pacific Capital. Opinions expressed are
those of the writer, and may or may not reflect those held by Euro Pacific
Capital, or its CEO, Peter Schiff.
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