So, here we are, a mere thirteen months from the depths of economic despair and I find myself wondering if we learned anything from the experience at all. A year ago the stock market was just recovering from its devilish low of 666 on the S&P 500, the results of the bank stress tests were just coming out, house prices were still falling at double digit rates, the Fed had just embarked on a program of “credit easing” which involved the purchase of copious quantities of mortgages and other securities, the US auto industry was on its deathbed and Geithner was still working out the details of the PPIP.
Now, the stock market is booming, up 8 straight weeks and a whopping 80%+ from the lows, the economic statistics continue to improve, bank profits are nearly back to their pre-crisis peak, house prices have stabilized and inventories have been reduced, the Fed has completed its asset purchases, GM just repaid the portion of our largesse labeled as a loan and Geithner is still working out the details of PPIP as far as I know. (Some things never change.) To what do we owe this wondrous recovery? Is it real? Will it last? The answers are: the Fed or more accurately, inflation; yes, depending on your definition of real; and maybe for longer than a rational person would think.
What has happened over the last year is that Ben Bernanke asked us…no, no he didn’t ask…forced us to take risk. Ben Bernanke’s policies since the beginning of the crisis - a crisis he helped create I might add - amount to little more than theft. He has taken billions of dollars of interest earnings from savers and transferred it to banks and other speculators. With the Fed artificially suppressing interest rates, money market mutual funds and other relatively safe savings vehicles became more of a liability than an asset. Faced with the reality that after taxes and inflation these accounts were sure money losers, investors reduced money market assets from $3.9 trillion at the peak in the week of March 11, 2009 to the current $2.9 trillion.
With the Fed suppressing deposit rates and lending liberally against collateral that no other bank would accept, banks accepted the Fed’s gift of free money and turned it into trading profits. That doesn’t mean we now have a sound banking system; that could have only been accomplished by allowing the poorly managed ones to fail while the prudent ones assumed their assets and liabilities (deposits). What the Fed did instead was create a set of conditions where even Citigroup can turn a profit while waiting for the bad assets that still infect its balance sheet - which thanks to some liberal accounting don’t look all that bad - to cure or be written off over a longer period of time. While they wait for this to happen, they are content to buy Treasuries, use them as collateral to borrow more from the Fed and keep trading. It doesn’t create any long term wealth but it does remove money from the pockets of the retail dupes and put it where it rightly belongs - in the bank bonus pool. By the way, if you are outraged by this the answer isn’t to regulate banker pay; the answer is to take away the Fed’s ability to distort credit markets.
The tsunami of cash unleashed by the Fed over the last 18 months has had an effect on the economy, but I think it is important to remember that activity in and of itself is not the goal - or shouldn’t be the goal - of economic policy. The type of economic activity created matters and based on our recent experience, matters a lot. The Fed created a set of conditions in the late 90s which made it seemingly logical to buy internet companies with no earnings at a price based on the number of eyeballs ogling their webpage. The Fed created a set of conditions in the mid 00s which made it seemingly logical to bet that house prices would never fall. Neither set of conditions was permanent or beneficial. So the Fed has a track record at creating activity, but evidence of them creating useful activity through the wonders of their money manipulations is harder to come by. The amazing thing is that the public keeps falling for their parlor magic tricks, getting sucked into the latest speculative maelstrom as if the previous ones never happened.
I might add that as a group, investment professionals haven’t done much better. Many of the individual investors who got burned in the late 90s would not have participated in the dot com bubble if it hadn’t been for the cheerleading of the analysts and brokers. Portfolio managers, faced with career risk if they didn’t keep up with the markets, were just as susceptible to the siren song of easy money as the general public. And now we are back for round three and hoping that it is different this time. I am reminded of a bumper sticker I saw soon after the dot com bubble burst: “Lord, just give me one more bubble and I promise I won’t blow it this time.”
Investors - and fiduciaries such as myself - face a difficult choice right now. As mentioned above, safe alternatives offer yields that unless we see outright deflation are guaranteed to lose money in real terms. Stocks are rising but cannot be called cheap by any measure and long term bonds appear to be a bubble looking for a sharp object. The Fed has pledged to keep interest rates low for an extended period but we’ve seen that movie before and the ending is ugly and unpredictable. There are any number of potential problems that could derail the economy. China might be a bubble destined to burst with blowback felt worldwide. The minor trade skirmishes we’ve seen since the beginning of the current administration could spin out of control into a full scale Smoot-Hawley like, depression inducing trade war. Commercial real estate could blow a new hole in the bank’s balance sheets. The rising price of raw materials could derail the profit recovery. There are lots of potential pitfalls for investors.
At some point the Fed will have to tighten monetary policy, but even after they start it will take an extraordinarily long time to return policy to anything resembling normal. Even if they were to start selling mortgage backed securities tomorrow it would take years to rid the balance sheet of anything but Treasuries. Yes, they’ve got a few other tricks they can use to tighten policy, but many of them have never been tried and I have some doubts about their efficacy. Assuming Bernanke doesn’t suddenly abandon the Phillips curve mentality that dominates Fed thinking now, it appears to me that monetary policy will be accommodative for a very long time. If that is true, the price of stocks and other assets may still have considerable upside potential.
At this point it is the “other assets” which intrigue me the most. To me, what the Fed is doing is nothing more than inflation. They are printing more money than can be deployed efficiently in the real economy and the excess is finding its way into more speculative activities. I tend to accept the classic definition of inflation which means that it is most easily observed in the value of a country’s currency. There has been a lot of talk about the recent strength of the US dollar but that strength is a mirage based on the exchange rate with the even less desirable Euro. Looking at other measures of the value of the dollar yields a different view. The Canadian dollar has recently reached parity with the US version, the Australian and New Zealand dollars are firm, the Brazilian real is still rising and all of them pale in comparison to the ultimate currency - gold.
I don’t see a lot that has changed since the beginning of the financial crisis. In fact, I don’t see a lot of change since the Fed took us down this very same path after the 2000 recession. If we haven’t changed anything, I don’t see how we can get much different results. It probably won’t be real estate that is the object of everyone’s desires this time but the excess money has to go somewhere. To protect our purchasing power I see no better alternative than commodities, which have always acted as protection against governments that debase the national coin. If I’m right that this is all just an inflationary illusion, gold and other real assets should hold their value. If I’m wrong, the Fed gets it right, third time’s a charm and it really is different this time, then commodities will be in high demand to feed the world economic boom. Either way, I think it is prudent to review your portfolio and do a little reallocation away from the intangible things that have done so well - stocks - and toward the real things that haven’t done as well - commodities.
Disclosure: No positions