At the end of August, the Federal Reserve met in Jackson Hole, Wyoming for its annual confab and investors hung on every word uttered by the former tenured economics professors comprising the committee to destroy the global economy. There were strong hints from Fed Chair Janet Yellen and Vice Chair Stanley Fischer that they want to raise rates in the near future, but they have broken such promises before. (This “will-she-won’t-she” romantic comedy is really getting old.)
The worst thing the Fed could do is keep interest rates low; instead, it should announce that it will start raising rates by 25 basis points each quarter until the Fed Funds rate reaches 2% and then urge Congress to act on meaningful tax reform and fiscal stimulus that are the only policies that will help minorities and all Americans. And then this nation should embark on meaningful civic and economic education for all of its children (and even the adults) to insure that they understand how economies work – which is not by increasing entitlements and reducing the cost of money to the point where it has no value.
When you look deep into Fed policy, all that stares back is a black hole. And the hole keeps getting deeper and deeper. While it went largely unnoticed at this meeting, the Fed also made some very disturbing noises about its plans to deal with the next recession.
These plans are unconstitutional and dangerous.
And they’re the next step in a quiet revolution that’s already being waged by central banks worldwide.
Here’s the most disturbing thing central banks are doing right now (and how it can hurt you)…
The Fed May Be Going Shopping – for Something It Has No Right to Buy
Acknowledging that it will not be in a position to lower interest rates by 300-500 basis points as in past recessions, the Fed is paving the way for the next generation of quantitative easing. Some believe the Fed is hinting that it may add corporate bonds to its shopping list the next time it has to bail out the economy and markets. While that would likely violate the Constitution, which vests Congress with the right “To borrow Money on the credit of the United States” (Article I, Sec. 8), the Federal Reserve has shown little regard for any limitations on its powers and Congress is asleep at the wheel.
Buying corporate bonds would be just one more in a series of policy blunders that destroyed global bond markets. Fed purchases of corporate bonds would further reduce market liquidity and distort free market pricing mechanisms (if the latter can even be said to exist anymore). While I have no doubt that we could see the Fed further expand its balance sheet, I am equally confident that further balance sheet expansion will do little to promote economic growth.
On a larger scale, central banks have already been on an illegal shopping spree for quite some time.
And it’s creating a radical change in the investment landscape.
Right now, central banks, sovereign wealth funds, and certain regulated institutions are buying assets without regard to whether they are fairly priced or generate reasonable returns. I would also include corporations buying back record levels of stock in this category since they are driven by different motivations than investors seeking returns. The fact that some central banks are large owners of stocks (Swiss National Bank) and ETFs (The Bank of Japan) tells you that something is seriously awry. Rather than acting as lenders of last resort, these central banks are meddling in stock markets and inflating the value of companies to dangerous levels. While these buyers can hold these stocks indefinitely, they are driven by different motivations than traditional investors seeking an attractive risk-adjusted return on their capital.
This is a profound change in the investment landscape that requires new thinking from investors.
Stock purchases by central banks in particular deserve more attention than they receive in the media. They are nothing short of lunacy. There is no good reason why a central bank should own stocks. That is not what central banks were created to do. Central banks are supposed to act as lenders of last resort, not prop up stock prices. It’s troubling enough that they are monetizing massive amounts of government and now corporate debt in a global Ponzi scheme that is destroying the world’s fixed income markets. Buying stocks is beyond the pale.
This May Mean The End of Post-World-War-II Capitalism
With central banks owning $25 trillion of financial assets and sovereign wealth funds owning countless trillions more, it is time to ask whether post-World War II capitalism is morphing into a new phase. These non-economic actors have different motivations than traditional investors who buy assets in order to earn a profit over a reasonable period of time. Central banks are buying stocks and bonds in order to monetize government debt and keep afloat the immoral Ponzi schemes required to finance massive entitlement promises to their constituents. Sovereign wealth funds are looking for places to park their cash for extremely long periods of time and often focus on assets with trophy or strategic value. But the most important thing these two types of buyers have in common is that they don’t have to sell, which means that their ownership can inflate asset values for prolonged periods of time. This destroys the price discovery mechanism that markets are supposed to provide. And without price discovery, markets cease to allocate capital efficiently.
This remains one of the most baffling investment climates that my generation has experienced. Central bank policies are distorting markets to the point where they no longer function as reliable indicia of the economy or the value of individual securities. The more than $13 trillion of global bonds (today I read that the number is $16 trillion – who can keep track?) yielding below zero signal systemic distress, yet most investors and mainstream commentators and the financial media continue to shrug it off. I beseech the readers of this publication not to shrug it off. Negative interest rates and their causes are symptoms of serious problems at the heart of the global financial system. Negative interest rates effectively allow governments to confiscate capital; they steal from the future to pay for promises that never should have been made and can never be kept. They are another form of default. As my friend David Rosenberg writes: “So we know full well that the central banks want inflation – it is the easiest way to default on the global debt-to-GDP ratio without having to write anything down and generate real losses.” Markets may appear to be sound, but that is an illusion; they are broken. A combination of regulatory and monetary policy errors are draining liquidity, distorting pricing, and impairing the ability of the system to react to stress. Markets are more fragile today than they were on the cusp of the 2008 financial crisis; governments and companies are more leveraged; and the geopolitical landscape is dangerously unstable. Investors are ignoring these warning signs at their peril.
Lulled to Sleep
What is an investor to do in such an environment? The first mission should be to defend against losses. Cash may yield nothing but it is still an important tool for managing risk and positioning to take advantage of future market dislocations. I believe in the adage that many investors make 80% of their money in 20% of the time. That is certainly the history of the credit markets, where most of the money is made after the market crashes; the rest of the time, the risk-adjusted returns are extremely unattractive (like today). The human compulsion to act is the enemy of good investing; that is particularly true when markets are overvalued like they are today. Rather than feeling they are missing out on the current rally, which has no relation to fundamentals, investors should not be reluctant to hold cash, avoid losses, and wait for better opportunities to buy assets at reasonable values. You can read about my cash recommendations here.
One of the symptoms of severe market distortions resulting from ceaseless central bank interventions is artificially low market volatility. On August 23, The Wall Street Journal reported that stock market volatility over the last 30 days was the lowest in 20 years. See Figure 1 above. Factors contributing to this phenomenon include massive stock purchases by some central banks and the sharp reduction of market exposure in Europe after the Brexit vote. Markets are complex systems. Much like earthquake zones, they need to release pressure in order to prevent pressures from building up and unleashing larger fractures. Markets have been unusually quiet since the financial crisis. While human beings tend to assume that present conditions will persist indefinitely, there is abundant evidence that current conditions are unsustainable. I believe volatility is significantly undervalued just as bonds and stocks are grossly overvalued. Future adjustments are unlikely to be gentle.