In almost every respect, adhering to a policy of low rates, employing quantitative easing, deliberately stimulating asset prices, ignoring the consequences of bubbles breaking, and displaying a complete refusal to learn from experience has left Fed policy as a large net negative to the production of a healthy, stable economy with strong employment.~ Jeremy Grantham
So the Fed went ahead with more quantitative easing and the market did yet another happy dance. Strike up the band. We’re in for another round of musical chairs. The meth clinic is open. The roulette tables are full. (Pssst … Ben says bet on black. You can’t lose.)
Those in favour of QE, where the Fed prints money to buy U.S. Treasuries, say that Mr. Bernanke and company did the right thing. They’re just buying time for the economy to recover by supporting asset prices as we recover from the housing collapse – which many submit was caused by the same loose monetary policy. The textbook trade is “Don’t fight the Fed.” Buy stocks and commodities, especially gold. Short the U.S. dollar. Got it.
That’s definitely the trade that’s been working for the past 18 months. It’s almost the same trade that worked from 1995-2000 and from 2003-2007. You’ll notice a couple of calendar pages missing there. Those are the ones we don’t like to talk about. You know, the ones where the Fed’s asset bubbles popped and the wealth effect was painfully reversed. Talk about collateral damage.
Jeremy Grantham on QE Collateral Damage
Well, a few people are talking about those pages. Friday's Food for Thought comes from Jeremy Grantham, co-founder and chief investment strategist of GMO. He writes a quarterly newsletter that’s on my must-read list. Last week, he released a Halloween-themed missive entitled Night of the Living Fed. If you haven’t had a chance to read it, I highly recommend it. If you don’t have time, I’ll hit a couple of the key points for you here.
As you likely already know, Mr. Grantham is not a fan of the Fed’s money-printing policy. His main complaints are that engineered low interest rates create moral hazard, asset bubbles, and the inevitable crashes that go with them. Further, they don’t offer any real help for the economy, except for the temporary wealth effect of rising stock prices. Here are some of the examples of collateral damage he cites:
- Wealth is transferred from savers to banks and corporations.
- Less income for retirees and more profit opportunities for the financial industry as hedge funds can leverage cheaply and banks can borrow from the government at near-zero rates and pay higher bonuses.
- Rising asset prices create the illusion of growth and increasing profit margins.
- Artificially high asset prices become bubbles that pop, causing a rapid return to fair value, and then some.
- Asset price manipulation leads to distorted market pricing, which leads to faulty assumptions by endowments and pension funds, which leads to pension shortfalls. Most are pricing in 8% annual returns, which have not materialized.
- Asset bubbles lead governments to make faulty assumptions about tax revenues, which leads to budget shortfalls.
- “This whole era has been artificially favorable to marginal companies and leveraged companies, partly at the expense of conservative, un-leveraged blue chips.”
- Bailouts have meant that blue chip companies have lost opportunities to pick up the assets of failed companies at bargain prices.
- QE amounts to currency manipulation by the U.S. and causes other countries to respond in kind.
- Commodities bubbles form as the U.S. dollar dives.
- Consumption drops as mid- to lower-income families struggle with food and energy inflation.
- Engineered higher asset prices change “the normal workings of capitalism and the market.”
In short Mr. Grantham asserts that “QE2 is merely the last desperate step of an ineffective plan to stimulate the economy through higher asset prices regardless of any future costs.”
Where to Invest?
Since he manages money for a living, Mr. Grantham offers a few ideas on where you might want to put your money in such an environment:
- Quality U.S. companies that are still cheap in a generally overpriced market.
- Moderately overweight emerging market stocks.
- Moderately underweight the balance of global equities.
- Heavily underweight lower quality U.S. companies.
- Carry extra cash reserves for a volatitle market with insecure fundamentals.
- For the very long term (20 years) overweight resources, particularly if they have a sharp decline.
In terms of how to fix the problems created by the Fed, he offers the same conclusion I often reach when I toss these issues around: “It would all have been so much easier to prevent than to cure.”
How Much Is Enough?
As I read through the letter, a few thoughts occurred to me:
- It’s easy to see how biflation has become a factor here, and why we haven’t really heard of it before the last decade or so. We haven’t seen this type of blatant market manipulation before either. Interest rate engineering has led to the simultaneous rise in commodities and fixed income prices.
- How much is enough? What if this round of QE isn’t any more effective than the last? What if, like the easy money policies of the past 15 years, it only creates another bubble, which in turn means more bullets spent from a gun whose chamber is quickly emptying?
- Where do you draw the line on market manipulation? Apparently, buying Treasuries is OK. How about corporate bonds? What about SPDRs? S&P futures? Maybe some Apple (OTC:APPL) or Ford (NYSE:F)? Never mind General Motors (NYSE:GM). We’re already knee-deep in that pile of … well, you get the picture.
- If, as Mr. Grantham suspects, this approach “will be totally discredited”, I wonder why it has taken so long. We’ve seen the bubbles. We’ve lived through the crashes. Why aren’t more of us jumping from the merry-go-round, or at least calling for it to stop? Am I the only one who’s dizzy and more than a little nauseated?
- Maybe more of us haven’t jumped off the ride because we love the highs too much. Who wants to see the markets tank? But I’m afraid this “fix it now; worry about the implications later” cycle has got to stop at some point and I wonder what that will look like.
- Investors are positively giddy today as markets scream higher. Will they feel the same if asset prices continue to rise, and take the prices of gasoline and food with them?
A couple of weeks ago, I asked whether the Fed could save the day, and submitted that stocks could rise quite a bit in the wake of QE2. As I write this after the close on Thursday, the Dow is up 219 points, the TSX is up 207, and gold is up $54. It’s a good day for the bulls, and a sad day for free market capitalism.