The entire global economy now clings precariously to one crucial phenomenon.
That is, how much longer can the central banks of the developed world artificially
suppress interest rates at near zero percent?
The violently-negative market reaction to Janet Yellen's comments during her
first press conference was a clear indication of how vulnerable the stock market
is to the eventual reality of rising interest rates. All Ms. Yellen did was
remind investors that the Fed Funds Rate would have to be moved up from zero
percent -- probably beginning in the middle of next year. That was enough to
send the major averages cascading downward faster than you could say the words "flash
trading."
In typical fashion, a cacophony of Wall Street Cheerleaders were quick to
dismiss the negative market reaction by claiming investors misunderstood what
the new Chairperson meant to say; or that the rookie Fed Head simply misspoke.
And, more importantly, these bubble-apologists also were quick to make the
case that even once the Fed eventually gets around to raising interest rates,
it will merely be a sign of economic health -- a move that the equity market
should fully embrace.
The reality is that rising interest rates will soon arrive, either courtesy
of the Fed or through free market forces. And a rising cost of money never
bodes well for the stock market or the economy. This fact will be especially
true this time around because growth -- or the lack thereof -- won't be the
salient issue; but rather it will be the attempt to end the Fed's massive manipulation
of rates. The removal of the Fed's all-encompassing and price-indifferent bid
for Treasury debt will place tremendous upside pressure on rates. And even
if interest rates do not increase, the outcome for investors will be equally
devastating -- I'll explain the simple reason behind that in a minute.
But first let's see if rising interest rates are really all that good for
equities, as Wall Street so desperately wants investors to think.
The 10 Year Note is Spain was trading at the 4% level during October of 2010,
while the benchmark IBEX 35 was trading at 10,900. Yields then surged to 7.7%
by August of 2012. Not because the ECB raised interest rates, but because the
free market deemed its sovereign debt to have come under significant duress.
The IBEX tumbled 35% to 7,040 in less than two years.
It was much the same story In the United States. Interest rates went through
a secular uptrend throughout the 70's and into the early 80's. This time it
was an outbreak of inflation that caused yields to rise. In March of 1971 the
Ten Year Treasury had a yield of 5.5%, while the S&P 500's value was 100.
By January 1982 the benchmark yield soared to 14.8% and the S&P 500 traded
at just 115. During those 11 years the market increased by a total of only
15%, even though consumer price inflation skyrocketed 135%! This means in real
terms investors in U.S. stocks lost over 50% of their purchasing power.
Staying in the U.S., rising rates in 1987 didn't bode well for the market
either. The Ten-Year Note started off in January at 7.01%, and jumped to 10.23%
the month before the Dow crashed 22.6% on October 19th 1987.
It is true that there are brief periods when stocks rise at the onset of rising
rates. However, the reasons why interest rates increase in a significant and
protracted manner are because of rising inflation and/or burgeoning debt levels
-- and that is never healthy for equity values or economic growth.
What will happen to our debt-laden economy once interest rates normalize?
Municipalities will come under great stress, as they try to manage soaring
debt service payments from a tax base that is quickly eroding. Real estate
flippers will be dumping their investment properties, as home prices begin
to tumble once again. Equity market investors will sell shares, as the record
amount of margin debt is forced to be liquidated. All forms of adjustable rate
consumer debt will come under duress, severely hampering discretionary consumption.
Banks' capital will be greatly eroded as their loans, MBS and Treasury holdings
go underwater -- vastly curtailing the amount of new credit available to the
economy. The Fed will be deemed insolvent as its meager capital quickly vanishes.
Interest payments on Federal debt will soar, causing annual deficits to skyrocket
as a percentage of the economy. And, the over $100 trillion market for interest
rate derivatives will go bust. This will be the result of creating an economy
that is completely addicted to debt, asset bubbles, ZIRP and QE for 7 years.
In essence, the entire economy will collapse...perhaps this is the real reason
why the Fed found it expedient to completely remove the numerical unemployment
rate target for when it would begin rising rates. Let's be clear; the Fed is
ending QE not because the economy has reached the inflation and unemployment
goals it set out to achieve, but rather from fear of the monstrous size of
the balance it has created.
But what if interest rates don't rise as a result of the Fed's exit from QE?
If interest rates stay at these record-low levels it will be because the private
market supplanted all of the Fed's purchases at these ridiculously-low yields.
The only reason why that would occur is if the tremendous deflationary forces
unleashed in the wake of the Fed's absence from its support of money supply
growth causes equity and real estate prices to tumble, bringing the economy
along for the ride.
In either case the outcome for investors will be shocking. Market participants
should prepare now for the failed exit of QE. On the other side of this imminent
revelation will be unsurpassed volatility between inflationary and deflationary
forces, which will dwarf those experienced during the credit crisis. Because
of the unprecedented and unsustainable amount of debt outstanding, central
banks now face only two choices: stop printing money and allow a devastating
deflationary cycle to pop the asset bubbles that exist in equities and real
estate; or continue expanding the money supply until hyperinflation eradicates
the middle class and the economy.
Therefore, our Investment outlook remains very cautious. It should be noted
that the S&P 500 is up just 2%, and we are in April. That paltry return
is not worth the risk of being anywhere close to fully invested. In fact, I
believe a trap lies in waiting for long-only investors. An anemic global economy,
a record amount of margin debt and the Fed's tapering of asset purchases will
cause a sharp selloff very soon. To be specific sometime between now and before
summer gets going. We will use that opportunity to get back into the market
at much lower prices.
