The recent market declines have been pretty one sided - investors are worried about the impact of fiscal policy on the economy. But what's most interesting about the recent decline is that it comes right on the back of QE3. For many weeks in the late summer it seemed like the only driver of market price was anticipation of QE3. In early September we got the Hilsenrath leak about QE3 and then the official announcement just a week later. The market peaked the day after the FOMC announcement on QE3. Within days many economists were proclaiming Fed policy a huge success as the economic data appeared to validate the market rise and the illusion of the "wealth effect" was in full effect.
Of course, a lot has changed since then. Earnings have been worse than expected, economic data has been tepid at best and the risks to future economic growth have increased. And the primary driver of the fears have been concerns over fiscal policy and the fiscal cliff. It's dangerous to extrapolate broad conclusions from a few months of equity trading, but I think the last few months have been quite telling as worries over fiscal policy have dominated euphoria over monetary policy.
I think this makes perfect sense. Anyone who understands the balance sheet recession knows that fiscal policy has played an inordinately important role in recent years. Viewing the markets through this macro prism and thinking ahead like a chess player made the conclusion rather obvious as the election neared. Would the market experience a relief rally due to the pro-QE3 President winning or would the market sell-off due to the post-election concerns over the fiscal cliff? In a research note several weeks ago at Orcam I described why the election of the President mattered far less than concerns over the fiscal cliff:
…As we've discussed in recent notes, the market is likely to turn to the matters of investment tax treatment and the fiscal cliff as soon as the elections results are digested. Goldman Sachs es mates that the capital gains tax rate is likely to increase to 23.8% under both candidates. And the fiscal cliff is unlikely to be settled before early December when Congress comes back from recess. These are market negatives and will persist through November regardless of who wins tomorrow night.
While the election might reduce some near-term uncertainty, the fiscal cliff is a far larger issue for 2013 than the Presidential election. And the markets will immediately begin to focus on that outcome come Wednesday morning.
What we've seen since the election results proves that the market is far less concerned with monetary policy than it is with fiscal policy. After all, Obama was the pro-monetary policy, pro-QE3 candidate as Romney made it clear he disapproved of the Fed's actions. But the re-election of President Obama resulted in about 6 hours of euphoria over the certainty of continued Fed policy. And as soon as the market realized that fiscal policy was at risk of being tightened the market panicked and has sold off over 4% since the election and 8% since the FOMC's QE3 announcement.
This makes perfect sense. Now, I'm not in the camp that says Fed policy has done nothing. QE1 had a substantial impact on balance sheets and I think the Fed's easing has helped the private sector considerably. But I think the government's continual trillion dollar + deficits have had a far larger impact. Particularly on corporate profits where we can quantify the impact of fiscal policy with relative ease (see our previous analysis for more on this). Austerity and cratering corporate profits (and stock markets) in Europe also confirm this view.
All of this makes me wonder - what if we're finally seeing definitive evidence that the Fed is far less powerful in this environment than many presume? More importantly, will economists and pundits finally begin to give credit where credit is due with regards to the anti-austerity policy in the USA that has helped bolster the economy? Fiscal policy in a balance sheet recession is far more impactful than monetary policy. It's time we all realize it. More importantly, it's imperative that the politicians in Washington realize it and take the necessary steps to stop playing political chicken with the US economy.