Last week, the Dow closed within 100 points of its all-time closing high which seems fitting for a week which saw the Fed Chairman insist in his Congressional testimony that he saw "no sign of a bubble in equities." Bernanke also claimed in his prepared remarks to the Senate banking committee that "in the current economic environment, the benefits of asset purchases are clear."
Observable Harm, Phantom Benefits
This is indicative of a larger phenomenon which is increasingly pervasive in the marketplace: investors, commentators, and analysts alike exhibit an overwhelming tendency to downplay the adverse side effects of the Fed's post-crisis policies while simultaneously exaggerating the efficaciousness of those policies in terms of stabilizing the economy. This is especially disturbing given that the risks the Fed has created are readily observable and in some cases quantifiable, while the economic benefits remain rather nebulous and are often expressed only in terms of what might have happened if the policies had not been implemented.
For instance, while multiple academic studies have confirmed the efficaciousness of asset purchases for pressuring long-term interest rates, Bernanke had the following to say about QE's effect on the broader economy last year at Jackson Hole:
While there is substantial evidence that the Federal Reserve's asset purchases have lowered longer-term yields and eased broader financial conditions, obtaining precise estimates of the effects of these operations on the broader economy is inherently difficult, as the counterfactual --how the economy would have performed in the absence of the Federal Reserve's actions-- cannot be directly observed.
As the Chairman observed, the only way to estimate the benefits of the Fed's policies on the broader economy is to make assumptions about (essentially) the very thing that is being estimated:
If we are willing to take as a working assumption that the effects of easier financial conditions on the economy are similar to those observed historically, then econometric models can be used to estimate the effects of LSAPs on the economy.
In sum then, we do not (indeed we cannot) know the extent to which post-crisis Fed policy has benefited the overall economy. Contrary to popular opinion, there is no way to definitively say that without the bold actions taken by the Fed, we would be in far worse shape than we are currently.
We can however, readily observe how these policies have contributed to the run up in stocks and the rally in fixed income -- we have recently witnessed record low yields, record high corporate issuance, and record high (in nominal terms) equity prices. One might argue that these phenomena are themselves indicative of the economic support the Fed has provided. Without a commensurate improvement in the broad economy however, the rally in equities and fixed income is evidence of nothing more than the existence of asset bubbles.
Note also that one asset bubble (fixed income) is reinforcing the other (equities) as corporations borrow money to fund stock buybacks. As I noted previously, when it is cheaper to borrow money than to pay dividends, corporations will simply issue bonds and use the proceeds to repurchase shares. In other words, companies will use leverage to increase earnings and in the process they will boost equity prices with their share repurchases.
As simple as it is to observe the effect the Fed's policies have had on inflating asset prices, it is equally simple to quantify some of the associated risks. For instance, it is widely acknowledged that by driving down rates, the Fed has induced investors to take on more duration risk in their quest for yield as real short-term rates on many investments are now negative. The risk here is quantifiable; one can calculate the capital losses than will accumulate in a portfolio of long-term bonds for a given rise in interest rates. Here is Bernanke himself on the issue from a speech delivered in San Francisco last Friday:
Of course, [some] risks may very well be mutually reinforcing: Taking on duration risk is one way investors may reach for yield, and the losses resulting from a sharp rise in longer-term rates will be greater if investors have done so.
The irony of course is that it is the Fed which has taken on the greatest amount of duration risk (the Fed owns 30% of outstanding 10-year equivalents) and is thus the most exposed to a sudden increase in rates.
Perhaps the economy would be in far worse shape were it not for the Fed's intervention but since we cannot know, all we can do is analyze the current state of economic affairs. To this end, it's worth revisiting some of the issues I have raised over the past several months.
First, recall that back on December 13 I noted that according to an S&P report, U.S. corporations deferred $175 billion in capital expenditures from 2009-2011 and in the third quarter of 2012, business investment posted a sequential decline for the first time since the depths of the crisis. I called the capital expenditure drought the "biggest threat" to stocks, bonds, and GDP growth. Furthermore, I said that subdued capex decreases long term sustainability and competitiveness, restrains the country's economic output, and gives investors a false impression of corporations' financial well being. In light of these considerations, consider the following graphic from Goldman which shows the rate of growth in business investment during recessions and recoveries:
The blue shaded area represents the range of business investment growth rates during recessions and recoveries dating back more than half a century. The dotted line towards the bottom of the shaded area represents the average rate of business investment growth during those recessions and recoveries. The solid line at the bottom of the chart is the rate of business investment growth from the fourth quarter of 2007 to the fourth quarter of 2012. Put simply, this is the weakest post-recession environment for business spending in sixty three years. Reuters ran a story on February 22 entitled "U.S. Companies Plan to Spend, A Boost for the Economy." The total expected increase in capex during 2013: a whopping 1.3% based on available guidance.
It is also worth mentioning that, as predicted, the surge in personal income and the concurrent increase in the savings rate during December was an illusion created by the uncertainty surrounding the fiscal cliff. Here is what I said about the issue on January 31:
Witness...the dramatic rise in the personal savings rate in December (6.5% of disposable income compared to 4.1% in November). That's the highest rate since May of 2009 when the Dow was sitting at around 8,500. Now obviously this was attributable to the concurrent surge in personal incomes but equally obvious is the fact that the personal income surge was simply attributable to special dividends and other disbursements being pulled forward to avoid higher taxes in 2013.
The figures for January were released last Friday and sure enough, personal income fell 3.6% in January from December, the biggest monthly decline in two decades and the personal saving rate was just 2.4% in January, an epic decline from December's celebrated 6.4% reading and the lowest rate since the crisis:
Readers might also recall from a previous piece of mine that around the first of February, there were 9 insider sales for every 1 insider buy. According to TrimTabs Charles Biderman, the rate of insider selling to buying is now 50-1. This of course, does not contradict corporate share buybacks, as the money used to fund those repurchases is either sitting on the balance sheet earning next to nothing in terms of interest, or, as noted above, is simply borrowed at a lower rate than what it costs to pay dividends. Apparently, company executives are approving share repurchases and debt sales to fund those repurchases even as they sell their own shares.
A Suspension of Disbelief
Ultimately, investors should note the absurdity in what the Fed is asking them to believe: the entirely observable asset bubbles and quantifiable risks presented by those bubbles simply do not exist and even if they do, they do not represent a large enough threat to the financial system to outweigh the unobservable and unquantifiable economic benefits produced by the Fed's policies. In short, the idea is that somehow, real, perceivable systemic risks do not outweigh hypothetical (perhaps even imaginary) economic benefits.
Even for those who do not accept the prevailing ideology there seems to be a general reluctance to pull money from stocks, bonds, and money market funds. The logic behind this hesitation goes something like this: "I understand that this is not sustainable, but I have to put my money somewhere and after all, if I hadn't had my money in stocks or bonds, I would have missed the huge rally in both."
There are two points to make here, both of which I have made before but the continuation of the run up in equities and the resiliency of the fixed income rally proves that they bear repeating. First, the S&P 500 (SPY) is down 27%, 48%, and 84% when adjusted for inflation, priced in Swiss francs, and priced in gold value respectively since 2007. So there clearly were better places to park cash. Second, even the Fed Chairman himself recognizes that anyone (like the Fed itself) caught holding a portfolio full of long-term bonds (TLT) (LQD) bought at the height of the fixed income bubble is going to suffer mightily when rates begin to rise. In this environment, investors should do themselves a favor and remember that the best thing one can do is to "sell high" -- if there is any justice, it's not going to get much higher than this.