In terms of stimulating demand to boost an economy that remains stuck in the doldrums there are two types of policy levers that can be pulled: fiscal policy levers and monetary policy levers. Fiscal policy refers to the use of government taxes and government spending to shift the aggregate demand curve to the right. Monetary policy of course, refers to the use of money and credit to alter less than desirable economic outcomes.
In America today, both policy levers seem to be broken and this does not bode well for the economy if one is, like Keynes, skeptical of the economy's ability to self adjust without government intervention. The implications of this for the stock market have become abundantly clear over the course of the past six weeks as the uncertainty surrounding fiscal policy and the diminishing returns of monetary policy took their toll on third quarter business sentiment causing revenue growth to slip for many of America's largest companies and occasioning a wave of outlook cuts.
2013 is a big year for the Keynesians. If lawmakers fail to craft prudent fiscal policy and if the Fed's actions fail to boost asset prices, sentiment may sour on heavy-handed market intervention. It could be however, that October was just a particularly bad month. A less than spectacular earnings season coincided with the introduction of QE3 to make it appear as though monetary policy isn't working and on top of it all, there was no progress on fiscal policy ahead of the election.
Perhaps then, this is a temporary hiccup on the way to a prosperous 2013 wherein the Fed's monthly asset purchases and a grand fiscal bargain bolster demand, jump start the economy and, by extension, juice equity prices. Here is some valuable perspective on the issue of stumbling fiscal and monetary policy and what it means for the market from some of the folks at Goldman Sachs.
Goldman's Chairman Jim O'Neil is optimistic about the medium term prospects for the market -- it's the short term he seems concerned about. In the latest insallment of his "Viewpoints" series, O'Neil notes that the October ISM was encouraging and that jobless claims continue to fall with the "underlying trend of continuing claims [at its] lowest level since mid-2008."
Like Jamie Dimon, O'Neil sees the fiscal cliff as the biggest obstacle, noting that the post-election Washington looks quite a bit like the pre-election Washington and if the past is any indication, this likely isn't a good thing in terms of the prospects for compromise. Interestingly, O'Neil also directs a bit of stinging criticism at Republicans reminiscent of Jim Cramer's "Tell The GOP The War Was Lost" bit from Street Signs last week. From O'Neil:
"...while it seems to have escaped the minds of some Republican Party figures, the electorate hardly endorsed their more aggressive views on matters, and one might think that some of their grandees and others with an eye to the future might take the results as a signal that they need to change."
In light of the fractious environment, O'Neil sees a market shock as a necessary precondition to a congressional bargain, noting that
"... without a sense of drama, Congress is not likely to come up with a credible deal."
This seems to be O'Neil's way of putting a positive spin on what he calls two "worrying" developments in the S&P 500 charts:
"... a quick glance at the S&P charts suggested to me a pattern forming not dissimilar to the one formed in the early Summer of 2012, or more worryingly, that of the Summer of 2011, i.e. the spot price and its 21-day moving average had dropped below the 50-day."
In O'Neil's view, this appears to be a sign that the market is headed lower in the short term, a development which he apparently believes will be just the shot in the arm Congress needs to strike a deal. It's not necessarily a good thing that Washington needs a market collapse to force policymakers to do their jobs.
Meanwhile, on the monetary policy side of the equation, O'Neil's colleagues at Goldman released a rather interesting bit on the effect the Fed's policies have had on refinancings. Surprisingly, the results haven't been as dramatic as one might have anticipated. Goldman notes that the correlation between loans on which the rate is 100 basis points or more above the prevailing rate (so called "in-the-money" loans) and loan repayments has completely broken down and offers the following chart as evidence:
Source: Goldman Sachs via ZeroHedge
Goldman offers both supply side and demand side explanations for this phenomenon with the demand side suggestions being the most disturbing:
"One possibility is that many borrowers are not aware of how much the market rate has declined. Another possibility is that borrowers may think that lending standards are so tight today that they would be denied of refinancing, or that the process would be too much an ordeal."
If either of the above alternatives are at fault, it represents a complete and utter failure of the Fed to convey to the public exactly what is going on and what the aims of its policies are. This is analogous the ECB's broken monetary policy transmission channel. Recall that the ECB's policy rates are not translating to lower rates in the periphery as borrowing costs in troubled countries are dictated more by sovereign spreads than by monetary policy. The situation here is similar.
Note the size of the discrepancy in the chart above. For years, the correlation between in-the-money loans and prepayments was very strong. From the outset of QE1, this relationship has virtually ceased to exist. What Goldman's analysis suggests is that the dramatic nature of this divergence is not likely due to stricter lending standards. It is due to the Fed's inability to create the outcomes they want to create using the tools at their disposal. Once again, a broken policy lever.
What we are witnessing is a failure of both monetary and fiscal policy simultaneously. Given that these are the only two policy levers we have at our disposal in terms of remedying constrained aggregate demand, investors should ask themselves how far this recovery, and by extension, how far a stock market rally predicated upon the economic recovery, can possibly run. Investors should remain cautious, move to cash or gold (GLD), and stay short the broad market (SPY) (QQQ).