- As the ending of the Federal Reserve's easing programs is only months away, spirited exchanges are happening on what the impacts to the markets are likely to be.
- This culminated with an epic fight on CNBC the other day that highlighted the difference of opinions on whether this end will be benign or malignant.
- Given the Fed's history over the past few decades, I am skeptical that the end of their liquidity support of the markets is likely to end well.
There was a spirited but very terse exchange between Rick Santelli and Steve Liesman on CNBC the other day. The topic du jour was the Federal Reserve, what it has or hasn't accomplished with its various easing programs over the past five plus years and what the long-term impacts will be from the unwinding of the Fed's balance sheet which now stands at north of $4 trillion in assets.
To me these are the questions the market will have to answer over the next six months, as the Federal Reserve finishes over five years of its myriad easing programs scheduled by the end of October. Although I find Santelli abrasive and someone who tends to shout over dissent, I do largely agree with his opinion on the Federal Reserve and the impacts of its various programs.
It is hard to find a rational person with knowledge of the financial markets that would say that what the Federal Reserve did initially in its original easing program (AKA, QE1) was absolutely necessary to avoid a financial meltdown that would have resulted in another Great Depression. However, there should be rigorous discussion on whether subsequent easing programs were warranted or beneficial from a long-term perspective.
My own opinion is that the Federal Reserve should have taken off the "training wheels" some time ago. The economy would have taken a short-term hit, but I think we would be much further along in our recovery by taking our lumps earlier in the cycle before the Federal Reserve expanded their balance sheet to such a massive level.
Despite the Fed's intervention, this has been by far the weakest of ten post war recoveries on record. In the previous nine post war recoveries, the economy grew an average of better than 4% annually on a GDP basis for the four years after a recession officially ended. This post war recovery has muddled along at a 2% level over the past five years.
The Fed's largesse has also had some unintended and detrimental impacts. First, it took the heat off Congress and the administration to implement pro-growth policies or to tackle our long-term deficit issues - which will look much worse once interest rates climb to more normalized levels. In addition, the Fed's policies have worsened wealth inequality, as the liquidity has gone into inflating the real estate and stock markets - most of these gains have been accrued by the top 10% of wealth holders. Unfortunately, this liquidity has done little to improve job or economic growth or business confidence.
So, going forward; Do you trust the Fed? There are myriad reasons I do not and I believe rough times are ahead in the market.
A Sordid History:
Ever since Congress - in its infinite wisdom - charged the Federal Reserve with a dual mandate of both targeting full employment and price stability in the late 70s, Fed policies have usually resulted in non-optimal results. These two mandates often conflict with each other and have resulted in some feckless actions and disastrous results. Just a look at the last 15 years illustrates this quite aptly.
In 1999, the Fed came in and provided additional liquidity due to worries around "Y2K". This was a substantial factor in the internet boom of that year and the subsequent bust in the NASDAQ starting in March 2000. Y2K turned out to be the "Global Warming" of the late 90s, a lot of hype but few actual impacts when all was said and done.
Then after the internet bust in the market and 09/11, the Fed again reflated the credit markets to stimulate growth in the resulting shallow recession. This liquidity accelerated the steep rise in housing values that eventually resulted in the subprime crisis - which the Fed called "contained" - that triggered the financial meltdown of 2008. This is hardly a record to believe in.
New Leadership is Always Tested:
The recent history of the Federal Reserve is one where its new chairperson is always tested. Volcker came into a mess created primarily by two of the worse leaders in Federal Reserve history appointed by Jimmy Carter and Richard Nixon, respectfully, which result in the "stagflation" of the late 70s. Chairman Volcker had to ratchet up rates and trigger a significant recession in order to crush this monetary phenomenon. Alan Greenspan was greeted with "Black Monday" two months into the job where the stock market fell more 20% in one day in October 1987. Bernanke walked right into the beginning of the housing crisis and associated meltdown in the financial markets. Will Chairwoman Yellen be lucky enough to avoid the fate of her immediate predecessors? Given the substantial unknowns of unwinding an over $4T balance sheet, color me skeptical.
The recent history of the ending of previous easing programs is hardly encouraging either. After the end of QE1, the market fell over 15% before the Fed came to the rescue with QE2. When QE2 ended, the market again tumbled more than 10% before the cavalry again arrived with the current version of this easing program. Now that overall market multiples are much higher along with the Federal Reserve's balance sheet, will equities avoid their fate after previous easing programs ended?
So, do you still trust the Fed? If so, you should have your normal allocation to equities in your portfolio. For those of us that are skeptical, a higher allocation to cash is warranted. My own cash position is now up to 30%. I also have sold just out of the money calls on most of my growth positions to further mitigate risk and cut volatility within my portfolio. I don't know if the optimists or the pessimists will ultimately win this argument over the end of the Fed's easing programs. I do know I am willing to give up some gains if the market continues to rally in order to be able to sleep at night.