Trust Policymakers On Asset Markets, But Not Economy

Includes: EEM, GLD, SLV, SPY, VDE
by: Disruptive Investor

The financial crisis, which started in 2007 and was followed by a recession, led to aggressive rate cuts by central bankers in advanced economies and highly expansionary monetary policies. Currently, there is some global economic stability coupled with surging asset markets. In this article, I will discuss the reasons why investors can trust policymakers with respect to stability in asset markets. However, there are reasons to be skeptical about the impact of policymaker action on real economic recovery. Before I come to the main agenda, I would like to emphasize here that I am bullish on equities and other risky classes with a 3-5 year time frame. Over the longer term, risky asset classes might decline as the liquidity support for the market wanes on continued depression in the real economy.

Why Not Trust Policymakers on the Real Economy

To solve any problem, the root cause needs to be determined. One of the primary reasons for the current recession was excessive leverage. Five years after the crisis, this problem has not been solved. I had shown in one of my earlier articles that the real deleveraging is yet to begin.

Investors and readers might argue that the action taken by policymakers is justified in the current scenario. I would agree if it helps the real economy. Unfortunately, expansionary monetary policies have not helped the real economy and have just been an extended bailout for banks and financial institutions. The charts below prove the point I am trying to make. The fed fund rates were cut to near-zero levels in order to boost lending and consumption. However, the private sector banks became risk averse after the crisis and tightened lending standards. Instead of leading money to the consumers, the banks have $1.4 trillion of excess deposit with the Fed. Banks do earn a 0.25% interest on the excess reserves and they find it more beneficial to park money with the Fed than lending it to consumers. At the same time, the overleveraged consumers have also cut back on their spending and leveraging. Therefore, the real objective of near-zero interest rates has not been achieved.

The level of weakness in the real economy is evident from the money velocity chart below. The money velocity is at a fifty year low and has not improved after the financial crisis. Very clearly, real economic activity is sluggish.

Again, readers might argue that the headline unemployment rate has declined to 7.8% suggesting real economic recovery. I would instead suggest readers look at the U6 rate, which is still at 14.4%. This shows that there is a large number of part time jobs created and employers are uncertain about the sustainability of economic recovery. Part-time employment would also keep consumers cautious when it comes to spending. With festive season spending coming at a four-year low, the weakness in the real economy is very evident.

Few more charts that underscore my point on the ineffectiveness of current policies to aid real economic recovery are presented below. Both the charts compare the 11 post-war recessions to give an idea of the extent of recovery in the current recession.

The total change in US employment 60 months after recession peak and the total change in output are the worst when compared to the post-war recessions. There is no doubt that the current recession was the worst since the Great Depression of 1929 and the recovery will take relatively longer. However, had policies been more investment friendly (in terms of business expansion and growth), the recovery would have been more robust. Gross private domestic investment has declined by USD440 billion from 2007 to 2011 and underscores my point of the cautious stance of the private sector in the absence of very favorable policies for private investment. Instead, the policies have focused on bailing out financial institutions and boosting consumption (which might have already peaked out in 2007).

Why Trust Policymakers on Asset Markets

I am of the opinion that the policymakers do understand that expansionary monetary policies will not aid economic growth in times of diminishing impact of debt. The primary reason for continued easy policy would then be - extended bailout of banks and support asset markets at higher levels.

The reason for supporting asset markets at higher levels is very clear; as of September 2012, 33% of the total ($51.9 trillion) US household financial assets were invested in equities. Further, nearly $3.7 trillion of retirement funds were invested in equities.

If asset markets were to decline across the board, the wealth of households and the savings of retirement funds would vanish meaningfully. This can lead to another round of crisis and civil unrest. That would be the last thing policymakers would want in the current scenario.

The impact of equity market fluctuation on retirement assets is shown below. Very clearly, if markets slump, retirement assets would also shrink.

Given this scenario, policymakers will continue with easy money policies in order to support asset markets at higher levels. I had proved in my earlier article that the current policies are "Too Easy" based on shadow interest rates. This trend might continue in the medium to long term. Even if the Fed fund rates trend higher, the real rates (adjusted for inflation), will remain negative suggesting continued easy monetary policy.

Having discussed my trust on policymakers to support asset markets, I would like to caution here that my outlook is for the next 3-5 years based on how resilient the economic activity remains. There will certainly be a time when market participants see no benefit of easy money, except inflation in asset classes. The depressive inflation might follow and end with a deflationary bust. In other words, I expect higher inflation and subsequent deflation in the US. For now, investors can beat inflation and preserve their purchasing power by investing in equities and other risky asset classes.

My standard investment suggestion would be:

SPDR S&P 500 ETF (NYSEARCA:SPY) - It has been proven that beating the index is not an easy task. Therefore, the strategy should be simple -- beat the index or invest in the index. From this perspective, SPY looks interesting. Also, with excess money flowing into risky asset classes, the S&P should trend higher over the next 3-5 years. The ETF provides investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index.

iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) - Global diversification is necessary and exposure to emerging markets is critical. Over the long term, emerging markets will outperform developed markets in terms of equity price appreciation. I had discussed the reasons for the same in one of my earlier articles. The iShares ETF corresponds generally to the price and yield performance, before fees and expenses, of publicly-traded securities in emerging markets, as represented by the MSCI Emerging Markets Index.

SPDR Gold Shares ETF (NYSEARCA:GLD) - Investors can consider exposure to the hard asset for the long term. In the near term, some more correction in the precious metal is entirely likely. However, expansionary monetary policies and artificially low interest rates will trigger long-term upside in the precious metal. The GLD ETF seeks to replicate the performance, net of expenses, of the price of gold bullion.

iShares Silver Trust ETF (NYSEARCA:SLV) - Very similar to the argument for gold, I am also bullish on silver for the long term. Investors can consider exposure to silver through the purchase of physical metal or the ETF, which seeks to reflect the price of silver owned by the trust, less the trust's expenses and liabilities.

Vanguard Energy ETF (NYSEARCA:VDE) - In times of inflation, investors seek refuge in hard assets. Energy as a sector will do well in times of inflation. The ETF seeks to track the performance of a benchmark index that measures the investment return of stocks in the energy sector. With a low expense ratio of 0.19%, the ETF is a good investment option in a sector, which has good upside potential in the long term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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