Going in Different Directions

Last month I deviated a bit from my usual path in my articles to simply expound on what I’m watching and what I find interesting in the markets and economies around the world. While it was nice to get some positive feedback,it was strongly suggested that I shorten my comments but write more often. Accordingly, my intention is to put together shorter columns monthly. Currently, I’m watching closely to see how the growing economic and policy divergences around the world play out in the markets. I have a feeling things might play out a bit counter intuitively.

Policy Divergences – Who Is Doing What?

After several years of leading the world with massive monetary intervention in our economy, the policy direction in the United States is moving in a sharply different direction from most of the rest of the world, particularly Europe and Japan. The Fed stopped its last quantitative easing in October 2014 and is looking for a time to begin “normalizing” rates by hiking the federal funds rate possibly later this year or next. At the same time, Europe has finally committed to implementing their own quantitative easing (QE) with the planned purchases of over €1,000,000,000,000 worth of bonds. While for Europe the devil will indeed be in the details, the hope is to spur their moribund economies to life and to stave off a systemic deflation. Japan, which has been fighting deflation for decades, ironically further increased their QE on October 31, the same month that the Fed stopped their purchases. On a percentage basis, Japan has already exceeded the Fed’s purchases and is essentially buying all the bonds issued by the government as they monetize their debt. These are indeed unusual times.

Paradox of Quantitative Easing

To reiterate, quantitative easing (QE) is the program employed by central banks where they purchase securities (mostly government bonds) in an attempt to spur economic growth. This strategy has been employed extensively by the U.S. Federal Reserve since the early days of the financial crisis six years ago. However, the actual market impact of the Federal Reserve purchases of roughly $4,000,000,000,000 of bonds seems very counterintuitive to me. The basic math of bonds is that as prices go up, yields go down. Thus, with these massive purchases over the last several years, we would certainly have expected prices to rise and yields to fall. It would simply be the expected result necessary to bring supply and demand into balance.

Interestingly, even though yields are currently near historical lows, most of the decline in yields occurred during the intervals when the Fed was not buying bonds. Surprisingly, the periods of Fed bond buying actually triggered falling pricesand rising yields. That doesn’t seem right at first glance. I would have expected the buying to drive prices up and yields down. What gives?

My Explanation

While the Fed was clearly an enormous buyer, I think the real message the market took to heart was that the Fed was going to make sure the economy was not going to spin further out of control (or into a deflationary recession) thus it was okay to take risks. With that safety net in place, investors willingly took on more risk by selling bonds and moving into stocks. Implicitly, I believe the market was telling us that the economy needed Fed intervention and would not be able to stand on its own. Thus, paradoxically, Fed bond buying led to higher stock prices not bond prices. When the Fed took breaks from their QEs, the markets seemed to grow concerned about the sustainability of the economic recovery without the fed intervention. It was during these times when the Fed was on the sidelines that investors switched back into bonds driving prices up and yields to new record lows.

Can the Fed Unwind the Great Monetary Experiment – Is the Recovery Self-Sustaining?

This trend for interest rates to fall (and prices to rise) when the Fed discontinues their programs seems to still be in place. When their bond purchases ended in October, treasury 10-year notes yielded around 2.35%. By the end of January these rates fell to 1.68%, though have bounced back to around 2% currently. Clearly, the Fed hopes the economy is self-sustaining so they can discontinue all QE programs and normalize interest rates. And, despite the rally in bonds, the stock market has not sold off this time. If stocks can hold up here, perhaps the paradigm is changing and our economic growth can actually continue without Fed intervention.

Will Self-Sustaining U.S. Economic Growth Reward Investors?

Many of the market prognosticators and economists point out that the U.S. is a bastion of strength in a world beset with major economic problems and extreme sluggishness. The truth is that our economic numbers are really quite good, not just in comparison to the rest of the world but also to our own history. While many have bemoaned the subpar recovery from the recession, the key is that it has continued unabated. The unemployment numbers have plummeted to 5.7% (from nearly 10% in 2009) back into the range of most of the last 30 years. We continue to have very low levels of inflation without falling into deflation. Interest rates are at or near all-time lows. Home affordability is about as good as it has ever been. American business is at peak levels of profitability. None of the traditional indicators are signaling any warning signs of a pending recession. It all looks exceptionally good.

(As I write about all these good economic indicators, it is interesting that people just don’t feel that good about things. Perhaps these numbers are either misleading or don’t tell the whole story. Tammy’s article explores the idea of money’s relationship to happiness on an individual level. I wonder about the group level. While the so-called “misery index,” which adds the unemployment rate to the inflation rate, is at the lowest level since the Kennedy administration, many people are still hurting. Perhaps we need new indicators, but alas that might be a topic for another article.)

In any event, the economy appears to truly be in fine shape. If so, one might expect the stock market to do particularly well. I’m not so sure. Paradoxically, economic strength does not always lead to higher prices, especially in a market that has advanced for several years. It all depends on how much economic growth is already priced in to the market. Time will tell, and certainly in the long run which matters to long-term investors, the market will end up going higher as it always has.

Europe Is a Mess – Should Investors Beware?

Europe being “a mess” is debatable but they sure do have problems. As I write this, the new far-left Greek government is in negotiations on its debt arrangement with the rest of the Eurozone. Both sides seem to be playing hardball … it seems to me that the powers-to-be (led by Germany) would like to see Greece leave the Eurocurrency union. While it would be disruptive overall and likely devastating for Greece, it would send a clear message to other countries who might consider not abiding by debt agreements. Of course, the risk for the Eurozone as a whole is that a Greek exit could get out of control with contagion and a possible crisis. In all likelihood, they will do what political leaders usually do and “kick the can down the road”.

Unlike the U.S., the economic situation in many countries in Europe is dire with some countries experiencing unemployment levels as high as 25% and youth unemployment at 50%. Furthermore, prices have actually fallen into deflation territory for more and more countries. Anti-establishment parties, some virulently anti-Euro, have been gaining support. A gradual unraveling of the Eurozone may be happening before our eyes. Even their quantitative easing program is decentralized with individual countries expected to implement nearly 90% and the ECB doing the balance – sure seems like a step away from integration.

While a crisis may be brewing, intuitively it would seem an unwise place to invest. I’m not so sure. Over my years of following markets, the absolute best time to buy is when things look the worst as the late John Templeton said “when there is blood in the streets”. Most disasters and crises are unexpected unlike today in Europe where the risks are on everybody’s radar. Markets actually love expected crises that end up not materializing. In sort of the flip side of the situation in the United States, perhaps current prices reflect an overly dire expectation of the future. We shall see.

Interesting Times

I really love to follow markets and find their behavior fascinating. They so often reflect what is going to happen in the world before we can see it. While the U.S. has been the clear leader both economically and in the markets for the last few years, I wonder how long this will continue. Of course, I have no real idea of how this year and the next few will play out. Fortunately, our investment strategies are not contingent on having to predict anything. Staying disciplined will work as long as the strategy is sound with a long-term focus to meet long-term life goals.