March is madness when it comes to college hoops. It's the best time of the year for basketball fans, especially if your blood runs Carolina blue, like mine. Go Tar Heels! We socialize with friends, consume a few libations, scream, yell and fist pump for our favorite teams - in other words, regress a little, or a lot. I undoubtedly regressed last Thursday evening watching UNC fall to Wisconsin.
As March comes to a close, madness of a different sort continues to swell in financial markets, fostered by a Federal Reserve that insists on regressing into a silly game of word play when communicating its monetary policy intentions. Following the Fed's most recent two-day meeting, it decided to drop the word "patient" from its formal statement, which had previously replaced the words "considerable time." Both had been used to explain when it would begin to raise short-term interest rates from the crisis level of near zero. In her post-meeting press conference, Fed Chair Yellen provided further clarification of what this omission meant by saying that the Fed would not be "impatient" when it came to raising interest rates just because it was no longer going to be patient.
What did patient mean? I don't think the Fed had any idea. What does impatient mean? Again, the Fed doesn't have a clue, because its blunt monetary policy tools have had a negligible impact on the real economy for some time. Therefore, it doesn't know when, or if, its mandate of full employment and a rate of inflation that approaches 2% will be achieved. These word games are mere stall tactics.
At this point, it is blatantly obvious that Yellen's primary goal is to placate financial markets in hopes that the performance of the real economy catches up with the performance of those markets with which the Fed has intervened. This is why, during her press conference, Yellen felt it necessary to qualify the Fed's position that it would not be "impatient" in raising interest rates, fearing that the omission of the word "patient" might trigger a negative reaction from the stock market. Surging stock and bond prices are the Fed's primary accomplishment, akin to a passing grade on a final exam that it knows it has cheated on, because these prices are far from legitimate representations of the macroeconomic fundamentals that support them.
At the same time, the Fed knows that it must eventually raise interest rates from near-zero and withdraw the excess liquidity in order to show that its policies have been effective in nurturing a self-sustaining economic expansion. It also fears still being at the crisis level of near-zero concurrent with the next downturn in the business cycle. This would raise serious questions about the efficacy of its policies and leave it with no fire power to combat a future contraction in economic activity.
Therefore, we are likely to remain embroiled in ambiguity and double-talk from the Fed for some time in its effort to maintain current policy, so as to buoy financial assets, while also suggesting that policy will soon normalize under the guise it has been effective.
At the root of this monetary madness, which the Fed has spread around the developed world like an airborne virus, is the belief that a dramatic increase in the money supply in combination with a zero percent interest rate policy (ZIRP) creates jobs and leads to a healthy rate of inflation. I do not see the connection. If the surplus of credit (money) that the Fed created had been used for productive investment, rather than financial investment, then a case could be made. It was not.
It is true that monthly job gains averaged 260,000 last year, which was the best year for payroll growth since 1999, but this had nothing to do with monetary policy. Many economists have extrapolated this faster rate of payroll growth into a forecast for accelerating rates of economic growth in 2015, further emboldening proponents of the Fed's policies. The National Association for Business Economics (NABE) is now expecting the economy to grow 3.1% this year. The flaw in this projection is that the majority of the additional job gains last year were likely the result of many of the 1.3 million workers who had been receiving extended unemployment benefits reentering the workforce. The benefits ended at the end of 2013. These workers were forced to take whatever low-paying, part-time work they could find to replace the lost income from the expired benefit. This is why income has not risen commensurate with the gains in employment. The reality is that this economy would have created just as many jobs, if left to its own devices, as it has with six years of extraordinarily loose monetary policy.
There was good reason to increase the supply of money in the financial system through quantitative easing and lowering interest rates to near-zero following the financial crisis. It was the ignition needed to start the engine of economic growth, but not the fuel. It spurred renewed confidence in the financial system by halting the deflationary spiral in financial asset prices. That was good policy. Now that confidence has become complacency, while the fuel has turned into fumes. Maintaining this policy for six years has created false incentives that have actually slowed the recovery rather than help to accelerate it.
If lowering interest rates to near-zero and increasing the money supply was stimulating economic activity, then we would be seeing an increase in capital spending by now. This is the type of productive investment that leads to high-paying jobs. Instead, according to FactSet, capital expenditures for companies in the S&P 500 (NYSEARCA:SPY) are expected to fall by 3.4% in 2015. While the majority of this expected decline is due to the energy sector, growth in capital spending has been abysmal ever since the recovery began.
One reason for the lack of capital spending is that the stock market has not rewarded those companies choosing to invest in their businesses for the long term as much as those companies choosing to return cash to shareholders in the form of stock buybacks and dividends. Many companies have borrowed to do so. With the stock market rising and the cost for corporations to borrow at historical lows, both of which can be attributed to the Fed's policies, corporate executives who are compensated with stock are incentivized to take the short-term view. This practice is not creating jobs, and the only thing that it inflates is stock prices. Both run counter to the Fed's mandate.
Another reason is that corporate executives have been focused on productivity growth in an environment where there's very little revenue growth. This means either cutting costs or reducing capital spending. In a consumption-based economy, revenue growth is a derivative of economic growth, which is a derivative of consumer spending. We can't realize faster rates of consumer spending without income growth, and we have no real income growth. We lack real income growth because the real unemployment rate is much higher than the 5.5% advertised. This is due to the fact that more than six million people are underemployed and untold millions more are not counted as unemployed because they haven't looked for work in the past 30 days.
The aggregate numbers for personal income, indebtedness and net worth all appear to be steadily improving, which should be leading to an increase in the demand for goods and services that results in a higher rate of inflation than the 1.3% core rate recorded last year. Yet the aggregate numbers paint a very misleading picture of the health of our economy. Because the Fed's extraordinarily loose monetary policy has driven financial investment, as opposed to productive investment, the spoils of its policies have not been distributed proportionately. The wealthiest Americans have benefited the most from the Fed's largesse, while the majority of Americans have seen little benefit at all. The implications of this in terms of economic growth are staggering. The wealthy are far more likely to invest their additional income and capital, rather than spend it, whereas the majority of Americans would spend a significant percentage of additional income and capital, if they could obtain it, on goods and services. Spending on goods and services leads to economic growth, while investing in financial markets does not.
Economists still scratch their heads when figures for consumer spending are worse than expected, while figures for personal income are better than expected and there's a supposed windfall from lower gasoline prices. They focus on the aggregate numbers and fail to acknowledge that those realizing the majority of the income gains are not the same ones who do the majority of the spending. As for the windfall from the plunge in gas prices, this is not money saved, but rather money not spent. It is merely the relief of not having to spend more on something that must be bought. Still, most economists are predicting that the savings from lower gas prices in combination with the increased rate of job gains will lead to faster rates of consumer spending in the year ahead. The survey results recorded below by the New York Fed tell a very different story.
Additionally, debt is still a major headwind for demand in the US economy. While hedge funds can borrow billions at near-zero interest rates, the majority of Americans who need to rebuild their balance sheets can't obtain the credit or the historically low borrowing costs that the Fed's monetary policy has created. According to CoreLogic, 10.8% of US homes with a mortgage were still underwater at the end of 2014, which is up from 10.4% at the end of the third quarter of last year. Delinquency rates also remain elevated well above pre-crisis levels for auto loans, mortgages and home equity lines of credit, as can be seen in the chart below. Student loan debt levels and delinquency rates are off the charts.
The Fed has done an excellent job of inflating financial asset prices. It has failed miserably when it comes to creating jobs and a healthy rate of inflation that's driven by wage growth. This failure is due to the incentives its policies created, but also due to a lack of investment-focused fiscal policy initiatives.
The conundrum facing the Fed now is that it has inflated asset prices well beyond what the real economy would otherwise dictate, and now it is planning to unwind the stimulus that fueled the asset price appreciation while expecting economic growth to accelerate. This is like asking Lance Armstrong to win another Tour de France without his performance-enhancing drugs. This is madness.
Emblematic of a market that's clearly detached from economic reality, stock prices still surge on disappointing economic data in hopes that short-term interest rates will remain near zero for longer, and weaken on upbeat reports that portend a rate hike sooner than the market expects. This also is madness. I place the blame for this distortion, and the instability in financial markets that will inevitably result squarely on the Fed.
This is a challenging environment for long-term investors. In the wake of what I believe has been a contraction in economic growth in the first quarter of 2015, which followed a decline in after-tax corporate profits in the fourth quarter of last year, the stock market is still near its all-time highs. Moving forward, corporate profits for the S&P 500 are now expected to decline year-over-year in both the first and second quarter of 2015, yet the stock market indices seem immune to the slightest pullback in price. It seems that we are again at the mercy of the Fed, just as we were at the depths of the financial crisis, but on the other end of the market cycle.
The tug of war between bulls and bears is one of perception and reality. If the perception that the Fed has created in financial markets is able to lift up the economic reality on the ground, then it will be vindicated. If that perception is a false one, as I believe it to be, then it will evaporate like a mist as the Fed gradually withdraws its monetary policy largesse.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Clients of Fuller Asset Management may hold positions in the securities mentioned in this article. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.