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A Demon of Our Own Design

The world’s central banks are running scared.  Their attempts to reduce artificial liquidity provision to the financial systems have run into the twin roadblocks of the trade war induced global slowdown, and a freeze-up in the short-term funding markets.  Far from weaning the financial system off the extraordinary rescue efforts of the last eleven years (“quantitative easing” or QE), the world of money has become more dependent than ever on central banks’ liquidity lifeline.  In asking the Fed and its cohorts to bail out borrowers, lenders, and Wall Street, we have created a demon of our own design.

The latest evidence of this codependent relationship came in the final quarter of 2019.  The US short-term funding markets choked up in September, causing interest rates to briefly spike up to 10%.  Trouble in this market, known as the “repurchase” or “repo” market, brought back memories of the dark days of 2008, when this market froze up, starving banks, brokerages, and industrial companies of the short-term financing they’d become addicted to.  The Fed quickly rode to the rescue, pumping more than $400 billion into the banking system in a mere four months (a $1.2 trillion annual rate!). Though the Fed has protested that this was not another QE program, the effects were the same.

The yield curve, which during the summer had been “inverted” (i.e. short-term rates higher than long-term ones) promptly changed shape back to “normal” (short-term rates lower than long-term).  Investors, believing this artificial manipulation of interest rates somehow reflected true reality, cheered.

But the loudest cheers came from the stock market, which over the last decade has become conditioned like Pavlov’s dogs to having the liquidity spigots turned on at the least sign of trouble.  Stocks rose in virtual lockstep with the expansion of Fed liquidity, despite cautious outlooks from the industrial sector and the dampening effects of tariffs. The Fed has become so responsive to Wall Street’s temper tantrums that it is now as if Wall Street controls the Fed, which is of course like the lunatics running the insane asylum.

Thus, the first demon stock investors must confront is that traditional yardsticks of analysis, such as revenues and earnings, no longer seem to matter.  The chart below, from FactSet, underscores the irrelevance of earnings to 2019’s stock rally. The bars represent the estimated (gray) and actual (blue) year-over-year earnings growth of the S&P 500.  What immediately catches the eye are the negative bars for each quarter of 2019. It shows that the first three quarters of last year posted negative earnings growth, with the estimate for the fourth quarter a decline of 1.5%.  If -1.5% is the actual decline for the quarter, it will mark the first time the index has reported four straight quarters of year-over-year earnings declines since 2016. While softening economic data clearly had an impact on company finances, it had no effect on stock prices as the Fed’s liquidity surge eclipsed all other factors.

The Fed’s QE policies have also created a dilemma for the realistic pricing of financial assets.  The decade-long suppression of interest rates near zero has introduced irrational valuations for stock prices.  The traditional approach of using a discount rate (risk-free rate of return) to calculate the present value of a stock’s price has been biased by the extremely low discount rates (i.e. interest rates) in the market.  These artificially low rates have come to be accepted as the norm, now that QE has become the norm, and thus extremely high stock valuations are viewed as normal also.  

High valuations are also bolstered by the twin mantras of FOMO (fear of missing out) and TINA (there is no alternative).  FOMO is best exemplified by the mindless piling into the largest market darlings, regardless of price. Apple, Inc., for example, has more than doubled in price despite a drop in both sales and earnings for 2019, but it continues to attract money simply because it is popular.  In fact, the pillars of the long bull market are standing taller than ever. The top five stocks—Apple, Microsoft, Alphabet (Google), Amazon, and Facebook—now claim a whopping 18% of S&P 500 capitalization, the highest proportion ever.

Low bond and money market yields have investors feeling as if there is no alternative to stocks, and that the only place to obtain adequate returns is in the booming stock market.  This has pushed valuation levels up to, and in some cases beyond, the extremes seen in 1999-2000. Those levels used to be the all-time absurd valuation extremes, until now. The demon of central bank liquidity has caused market valuations to become detached from reality, and imbued investors with a dangerous sense of complacency.

QE policies are designed to force interest rates down, and thus encourage borrowing and consumption.  This they have done, fueling an enormous expansion of debt at the corporate and government levels, smashing all previous records.  Global debt, which comprises borrowings from households, governments and companies, grew by $9 trillion to nearly $250 trillion during 2019, according to the Institute of International Finance.  That puts the global debt-to-GDP ratio at 322%. More than half of this enormous number was accumulated in developed markets, such as the United States and Europe, with China posting a sobering 303% debt-to-GDP ratio.

High debt levels present two problems.  The first is that the interest that must be paid to service this debt is growing at an accelerating rate.  This crowds out money that could be spent on more productive uses, such as infrastructure repair. Even with generationally low interest rates, based on current trends, real net interest costs will more than double over the next decade.

Moreover, these huge pools of money represent refinancing risk.  The jump in repo yields in September were symptomatic of an unwillingness to “roll over” the debts of marginal borrowers.  The Fed had to step in as the lender of last resort, and underscores the shift in lending markets from raising money for capital investment to one which serves to refinance existing debt to stave off default.  If debts are not to be reneged upon, they must be either repaid or somehow refinanced. This refinancing role means that quantity (liquidity) matters more than quality (price, or interest rates). Central banks play a key role in determining liquidity by expanding or shrinking their balance sheets.  Consequently, because this debt is compounding ever higher, more and more liquidity needs to be added to facilitate the refinancing of the world’s debt. Given the unlikelihood the surge in debt over the last ten years can ever be repaid, the implication is that QE policies may be here to stay.

Finally, central bank policies have contributed to the widening gap between rich and poor.  Over the past 10 years, the Fed has engineered an enormous amount of asset price inflation, and over those 10 years:

  • Wealth of the top 1% has soared by $18 trillion to $34 trillion.
  • Wealth of the next 9% has soared by $16 trillion to $39 trillion.
  • Wealth of the 50% to 90%, (the upper middle class) has risen by a more modest $13 trillion to $31 trillion.
  • Finally, the wealth of the bottom half of households has ticked up by $1.4 trillion to $2 trillion, a tiny fraction of the wealth of the 1%.

How has the Fed contributed to this skewed wealth distribution?  QE policies forced rates to near zero and almost eliminated returns on bank savings products. Households own about $10 trillion in these savings products, such as CDs and savings accounts. These types of products are a classic way of saving money at the lower income levels, but this demographic has probably paid the highest price for QE.

The top 10% of the population, of course, has benefited the most from QE since most of the inflation the Fed hoped to create took place in financial assets.  Stocks, bonds, and real estate have had an extraordinary decade of returns, while consumer price inflation has remained low. This has boosted the wealth of those at the top, while traditional CD and bank savers have seen their real (inflation adjusted) returns drop to near zero.  Over the 27 years from 1989 to 2016, income growth of the top 10% (blue slice) expanded, while the bottom 90% (orange and green) actually saw their share of income shrink.

Central banks’ QE policies have annulled tradition investment analysis, encouraged excessive debt creation, and fed the widening gap between rich and poor.  Any one of these phenomenon may prove to be destabilizing for the financial markets, and must be reined in to preclude an abrupt repricing of market prices and economic expectations.  The Fed and its peers can do this by focusing on their core role as inflation managers and lenders of last resort, rather than being viewed as the wizards that can magically paper over all our economic ills.

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