As I recently pointed out in a Money and Markets’ column, the Federal Reserve’s easy money policies have created a state of stable economic disequilibrium where savers are unfairly punished while risk takers are rewarded with excess returns, and it’s highly likely that this uniquely unusual environment will prevail for quite a while.
Like it or not, the Federal Reserve has become a proactive player in our economic system. Whether it is through direct purchases of government securities (which can easily be resumed at some future date) or some other form of direct or indirect stimulus: This is truly the new normal.
The Fed emphasized its point by recently announcing that the current Zero Interest Rate Policy (known as ZIRP), will likely stay in place into 2017. By pushing out the time frame for the ZIRP, the Federal Reserve is sending a powerful message to the financial community and the world: Don’t underestimate our ability to stay the stimulus course.
|On almost any historical metric, the U.S. equity market is very expensive.|
Unfortunately, from the economic perspective, the most significant impact of monetary stimulus is now on the financial markets and asset prices rather than on economic activity and unemployment. While Federal Reserve intervention five years ago arguably prevented a full-blown economic depression, the reasons behind our very modest economic recovery are now largely beyond the Fed’s control. However, because the Federal Reserve has become a proactive player in the economy, it will continue to focus on the best levers for stimulating economic activity and increasing employment, even though there is no silver bullet.
Whether you see the Fed’s activist policies as a glass half full or half empty depends on your own personality and psychological make-up.
If you are a bull, you’ve probably never met a market you didn’t like. If you have a relatively short memory, stock prices probably look attractive, even compelling. Traditional price-to-earnings ratios, while elevated, are not in the stratosphere. Deficits are shrinking at the federal and state levels. The consumer’s balance sheet is getting better even if real household income isn’t on the rise. U.S. housing is recovering, and in some markets, prices have surpassed the prior peak. America is on the way to energy independence.
With certificates of deposits and bonds yielding next to nothing, equities appear to be the only rational choice. The Fed will continue to hold interest rates extremely low, leaving investors no choice but to buy stocks regardless of the fact that the S&P 500 Index has almost tripled from its spring 2009 lows. QE has undoubtedly worked. And if the economy or markets should backslide, the Fed undoubtedly stands ready to once again ride to the rescue. The Bernanke-Yellen put is firmly in place.
On the other hand, if you are a skeptic who’s a student of market history and you’re more interested in return of capital than return on capital, then there are more than enough issues to cause concern. A policy of near-zero short-term interest rates continues to distort reality with unknown but worrisome long-term consequences. As the Fed begins to unwind its experimental economic policies through tapering, there is no way to draw any legitimate conclusions about the Fed’s ability to end QE without severe financial market consequences.
Fiscal stimulus, in the form of sizable deficits, has propped up the consumer and inflated corporate earnings. This in turns begs the question: What is the right multiple to pay for juiced corporate earnings? Indeed the Shiller cyclically adjusted price-to-earnings ratio is more than 25, a level exceeded only three times before — prior to the 1929, 2000 and 2007 market crashes. On almost any historical metric, the U.S. equity market is very expensive.
There is a growing gap between the financial markets and the real economy. The Fed’s continuing stimulus and suppression of volatility has triggered a resurgence of speculative froth. Margin debt measured as a percentage of GDP recently neared an all-time high. And a recent survey by Investors Intelligence of U.S. investment newsletters found the lowest proportion of bears since the ill-fated year of 1987.
Looking around the globe, Europe remains in disarray. Despite six years of painful structural adjustments, Greece’s government debt-to-GDP ratio currently stands at 157 percent, up from 105 percent in 2008. Germany’s own government debt-to-GDP ratio stands at 81 percent, up from 65 percent in 2008. What’s more, the EU credit rating was recently reduced by S&P, and European unemployment remains stubbornly above 12 percent. As German Chancellor Angela Merkel recently pointed out, Europe has 7 percent of the world’s population, 25 percent of its output, and 50 percent of its social spending.
There are worries about slowing growth in China and economic weakness in emerging markets. The fear is that lower demand from emerging markets will hurt U.S. companies doing business there and, as a result, handicap their future economic prospects. After all, the developing world accounts for 50 percent of global GDP, and it’s expected that 70 percent of global growth will come from the emerging markets over the next few years.
Various other geopolitical risks lurk on the periphery: Bank deposits remain frozen in Cyprus, Catalonia seems to be forging ahead with an independence referendum in 2014, and unrest continues to escalate in Ukraine and Turkey. And all this in a region that remains saddled with deep structural economic issues.
That’s why it’s imperative for investors to maintain a watchful eye on the Fed so you can keep your portfolio out of harm’s way should the Fed’s policies change. Watch this space after the Federal Open Market Committee meets this week.