During today's Buttonwood Gathering, held by The Economist in New York City, David Einhorn made headlines by reiterating his strong opposition to the Fed's ultra-loose policy:
I think we have passed the point where incremental easing of Federal policy actually acts as a headwind to the economy and is actually slowing down our recovery, and I am alarmed by the reflexive groupthink of the leaders which is if we want a stronger economy, we need lower rates, we need more QE and other such measures.
By now, many in the investment community are familiar with Einhorn's "jelly-donut" analogy, whereby one or two is fine, but 36 of them will make everyone sick. The concept is that low interest rates and a round of QE may have added a much-needed jolt to the economy back in 2009, but the continuance of these crisis policies is actually having a profoundly negative effect on the economy.
Let's breakdown the argument:
By now, investors have become accustomed to hearing or reading the words, "transitory inflation" in Bernanke's addresses. In reality, we've seen national gas prices between $3 and $4 since QE2, significant inflation in food prices, and soaring gold prices; hardly transient.
Lower rates drive up the cost of commodities: oil and food. And money that is spent on oil is sent out of the country to the Mideast and it doesn't help, and takes out income from people's pockets that could otherwise be spent on other goods.
The following chart illustrates the undeniable correlation between equities (the Fed's target asset market) and national gasoline prices:
The takeaway from this chart is that as a direct consequence of propping up equities, which is supposed to create a wealth effect and induce consumption, consumers are forced to pay more at the pump and at least some of the wealth effect is negated.
Low Interest Rates Actually Prevent Consumption
The next concept is that although the prevailing idea amongst economists is that a ZIRP policy lowers the opportunity cost of spending money, and thereby induces profligate spending, the reality is that consumers are actually hoarding more cash. Armed with the knowledge that rates are going to "remain exceptionally low until at least mid-2015," Einhorn believes that Americans know they need to save more in order to built a big enough nest-egg for later since they're not earning anything (in real terms) on their deposits or bond holdings.
The second is that not being able to earn a safe return on savings, is causing people to hoard savings rather than consume. In other words if I know I am going to earn 3% in the bank I can spend that income and I can have visibility towards that, but if I know I'm going to earn zero in the bank, in order to figure out how much I need to save for retirement I need to save a much bigger number. Which means I can't spend much now, I need to save more now, to build up those savings for retirement.
If I am already retired and I am on fixed income, my income has now really gone down and I have to hoard money so I can spread it out thinner over a longer part of my life. So by denying individuals savings or interest on income on their savings, it is causing hoarding which is driving down consumption which is hurting the economy.
I completely agree with Einhorn here, especially regarding retired individuals. If this sort of policy was temporary, and conveyed to Americans as being so, then consumers would take advantage of low rates by consuming more, refinancing, etc. Of course, this is exactly what happened during QE1, given the freshness and size of the policy. The effects were clearly diminished in QE2, essentially non-existent with Operation Twist (which didn't expand the Fed balance sheet), and are likely to be absolutely nil in QE3.
However, people know these policies are not temporary. Individuals are shifting their plans to align with the reality that they can't look forward to interest rates that are meaningfully higher than the rate of inflation - at least not anytime soon. As a result, this "new-normal" is causing Americans to build to savings as they would in a period of normal interest rates.
The Creation Of Tail-Risk
Finally, Einhorn argues that given the public's discomfort with such unprecedented policies, the Fed has driven up the perception (and possibly reality) of tail-risk, which has in-turn driven down P/E multiples and added a jolt to the price of insurance hedges:
We've opened up enormous tail risks of what happens if the Fed loses control, what happens if the Treasury loses control and these scare people and drive up risk premiums, and drive down P/E multiples and make companies defer long-term investments in the country because they are worried about significant tail risks these very aggressive policies are creating.
Hard to disagree with this. Clearly, market participants, the general public, and executives are worried about the kinds of threats this policy could potentially have; runaway inflation, dollar collapse, treasury bubble and its subsequent collapse etc.
Back in April, Gallup announced that the percentage of Americans who own stocks fell to the lowest level in eleven years. The figure, 54%, is far lower than the 65% registered in 2007. Of course, over that time the stock market has doubled, yet retail investors aren't buying it.
Many investors and most economists are allergic to the conclusion that the Fed's policies could very well be hurting the economy. After all, economic models illustrate that lower rates induce higher rates of investment, more employment, more consumption etc. Models even account for "liquidity traps," whereby the demand curve becomes inelastic and drops in interest rates barely improve economic conditions.
The Fed's response to this inelasticity of demand going forward will be "unconventional" monetary policy. Over the next few years, we'll likely be given GDP targeting (we've already seen inflationary targeting), continued LSAP (large-scale asset purchases) in new varieties, perhaps even talk of negative nominal interest rates. None of it will make much of a difference, and Einhorn makes a strong case that it will actually harm the actual economy.
No one can with certainty say that current policy will fail or succeed, but given the weakness in the U.S. GDP growth rate over the past three years (3%, 1.7%, ~2% est.), it doesn't appear that the "vibrant" economy the Fed is looking for is coming anytime soon.
My view has been that the credit cycle will have to reset before we see typical GDP growth and unemployment levels. Specifically, we'll need to reach the point where credit relative to GDP is at a sustainable, healthy level. Knowing where exactly that level is, of course, extremely difficult.
From an investment standpoint, Einhorn makes an extremely compelling case for owning physical gold long term. I've been bullish on gold's long-term prospects for all the well-known reasons: currency debasement, tail-risk, Fed balance sheet expansion etc.
For equity investors, it would be far too drastic to sell everything and prepare for collapse. Einhorn is arguing that the Fed is holding the economy back more so than he is that we are in for apocalypse.
Granted, he notes the fact that when we do in fact experience another recession, the monetary and fiscal tools are not going to be there. This is clear, and my feeling is that it will be at that point that we will have to deal with, but pull through a pronounced recession. Running deficits in both recessions and periods of economic prosperity has left us without the proverbial safety net for when another recession does in fact hit the U.S.
In conclusion, the same is true now as it has always been, with one alteration: hold high-quality companies with strong economic moats (who cares if it's a cliché), but hedge tail-risk and the reality of ongoing currency debasement by holding a portion of your wealth in physical gold.