By
Kevin
Flynn
:
We are believers in the power of monetary policy. We are even
bigger believers in the power of the tape. Yet they are both
limited, and reading
the FOMC minutes
-- wh ich we have been reading for more years than we care to
admit-- le ft us with an uneasy feeling. The impression for the
market may have been the ever-tradable lure of more liquidity, but
for us it was one of people slowly running out of options.
Here is the magic language from the minutes that pushed a
declining market back into the green:
Many members judged that additional monetary accommodation
would likely be warranted fairly soon unless incoming
information pointed to a substantial and sustainable
strengthening in the pace of the economic recovery.
In other words, buy stocks because either the economy goes up or
the Fed prints more money. In other words, the Bernanke put is
on.
We were generally supportive of TARP and past quantitative
easing (neither perfect, but nothing ever is) as having bought time
for the economy and providing support to the financial system while
structural adjustments proceeded. Without easier monetary
conditions, banks would still be in the dumpster, along with
credit, housing, the bond market and the financial sector.
As bad as lending conditions still are for housing, for the last
50 years banks have been behaving the same way -- turning a
profitable sector into a credit fad and then drowning it in the
name of market share, management bonuses, takeover avoidance, or
whatever. Once they blow a sector up, nobody wants to hear about
lending to it again for another generation of CEO management, which
runs for about five to 10 years (the last thing that managers
brought in to replace disgraced managers want to do is more of what
got their predecessors sacked). Banks finally got around to blowing
up housing, so now we have a generation of bank executives in place
whose unifying feature is the determination to avoid a housing bust
that won't happen again for another 70 years or so. The Fed can't
do anything about it.
The good news is that most necessary structural adjustments have
either largely taken place or are underway; the U.S. is actually
fairly well-placed relative to the rest of the developed world. The
drawback is that monetary policy really doesn't have much left to
contribute at this point. One of the only two real positives we can
see at this point from further Fed easing is a continued
depreciation of the dollar, which has benefited exports and sparked
a favorable shift in the cost of production to U.S. employment, in
particular manufacturing.
Currency adjustments are both necessary and desirable to
restoring trade equilibrium. We would even argue that the slowness
in adjustment brought about by those exporting countries that
resist currency appreciation has had a beneficial effect on the
U.S. financial system. Stretching out the pace of depreciation
assists an orderly transition, regardless of the motivations of the
exporters (before you explode, we would also add that Chinese
currency manipulation has been excessive and the West has been too
timid in confronting it, to its own detriment).
However, as the past decade has amply demonstrated, there are
real dangers to too much of a good thing. Downward currency spirals
are treacherous once started. We don't see that as an imminent
danger, except under the one circumstance that worries us in
connection with more Fed easing.
The other remaining positive that we believe monetary policy has
in reserve is to provide a cushion after the European dust-up that
may or may not happen. We have no doubt that the much-rumored
Draghi bazooka
could give financial asset prices another three-to-six month boost,
provided it was impressive enough (the current market favorite is
quasi-unlimited sovereign bond-buying by the ECB, under the guise
of improving policy transmission). We also have no doubt that it
would do little else if unaccompanied by important structural
changes.
The euro is in an awkward place right now -- too expensive for
high-cost countries like Greece, Italy and France, too cheap for
the country that has built itself on having a lower-cost
export-oriented economy (i.e., Germany). Ideally the euro should
depreciate, or allow Germany to leave and have its own currency,
since the latter would be dead set against depreciation. Such
solutions are so counter to entrenched political positions, though,
that they could only happen
in extremis
.
Europe cannot cut its way to prosperity. No business can. One
needs some growth to prosper. Germany has money to give, but only
in exchange for austerity and extra-national veto power over
budgets that aren't possible to the domestic politics of their
allies. Even
the Netherlands
is getting fed up. Currency depreciation is a partial solution for
higher-cost production frameworks in countries like France and
Italy, but cannot happen with Germany in the eurozone, while
countries such as Spain, Portugal and Greece need debt write-offs
and
currency depreciation on a scale much greater than the other
high-cost euro countries would want to contemplate.
Mr. Draghi and the ECB could ease short-term funding problems
for the two euro-Godzillas, Spain and Italy, thereby preventing
them from immediately tearing up the eurozone countryside. The
subsequent rise in asset prices would have numerous knock-on
effects, though.
The Germans rightly fear that necessary structural reforms would
be put off by the lack of budgetary pressure. The bond-buying
program would raise asset prices well out of proportion to the
small real effect it would have on the crumbling European
economies, leaving markets vulnerable to an eventual crash and the
ruling European elites more convinced than ever that the financial
markets are run by shysters and promoters, not at all to be trusted
as valid reflections of policy or enforcers of free-market
discipline.
Then again, Germany might completely capitulate and agree to
unlimited check-writing without budgetary input, currency
depreciation, and the periphery governments could agree to write
off their bad debts and let investors take the losses -- including
the ECB. Such drastic reboots, however, only ever seem to happen in
the wake of catastrophes such as war and/or financial collapse.
It's realistically possible to envision such agreements happening
in the near future through calm and rational discussion, but only
so much as it's possible to envision interstellar space travel --
while the breakthrough could happen any day, it's not a betting
favorite.
Looking at the realistic range of European outcomes, an
intelligent wealth manager might want to avoid European securities
like the plague. Looking at the likely consequences of a Draghi
bazooka, though, he or she would do so at the risk of badly
trailing the temporary explosion in asset prices and thereby losing
most of the client base. The fund manager, whose choice is between
being 95% invested and 98% invested, is left with the guessing game
of which sectors to rotate into if Draghi pulls the trigger
(financials, tech, ultra-high beta), or the ones if he doesn't
and/or when the jig is up anyway (telecom, utilities, staples,
ultra-low beta).
The hedge-fund manager is left with the choice of being
event-sensible and significantly trailing the indices -- only 11%
are ahead this year -- or crossing the fingers and drinking the
Kool-Aid. The retail investor is left on the sideline wondering if
anything in the world makes sense to own (if you answered bonds, be
aware that that horse is nearly dead).
We think that Mr. Bernanke and the Fed need to keep one more
decent reserve of dry powder against the day that Europe has its
look into the abyss. If the former has already embarked upon
accommodation as big as the market hopes for, one large enough to
be called QE-3, then it would have little other option left in a
eurozone crisis but the one of writing unlimited blank checks, the
infamous throwing of money from helicopters come to life. That
could
be the seeds of a downward spiral, one that could get ugly when it
came to decision time for the fiscal cliff.
It might not have to work out that way. In central bank
paradise, Mr. Draghi's bazooka would ignite an explosion in
European asset prices that dovetails with an American monetary push
and sends markets to new heights. That finesses the FOMC around a
re-election (Bernanke may be a Republican, but we don't think he
wants any part of a Romney-Ryan reboot) and through an end-around
of the fiscal cliff. A sensible compromise is reached, confidence
is restored, and life goes on at a somewhat better pace, with
plenty of time for sensible people to reach thoughtful, carefully
constructed compromises.
Just because it's never happened before doesn't mean it can't
happen this time. Just because the Fed has never launched
widespread rounds of fresh accommodation with equities already up
fifteen percent on the year doesn't meant it can't happen this
time. Just because the ECB has only to hint at capping yields to
effectively cap them doesn't mean they won't buy bonds in unlimited
quantities. After all, this time is different. Isn't it?
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.
Additional disclosure:
Relevant for holders of [[SPY]], [[QQQ]], [[EWP]], [[VGK]], and
[[EWG]].
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