The Big Picture
“We as central bankers need not be concerned if collapsing financial asset bubble does not threaten to impair the real economy…” -Alan Greenspan Dec. 5, 1996.
The above quote from the former Federal Reserve (Fed) chairman on the sharp market decline in 1987 known as Black Monday. Oh how the times have changed! We just witnessed a Fed flip-flop within a few short weeks. Was it that the economic data clearly changed? Or was it that the market experienced one of its worst corrections in several years! If you have been following my rants, the data has not materially changed.
Last year saw a marked return of volatility in the markets. The S&P 500 experienced two significant market corrections beginning in February through April and October through the present. We are still roughly 5% below the market highs of September of last year. If you would like to know what caused the return of volatility; look no further than who is clearly still driving the boat,… the Fed.
Have a Plan and a Process!
From the Trenches
“When government tries to rearrange the economy, legislate morality, or help special interests; the costs come in inefficiency, lack of motivation, and loss of freedom. Government should be a referee, not an active player.”
– Milton Friedman
Bubblenomics is the name being given (or being proposed) to the economic period beginning in the early 1980’s through the present. The proposition is the Fed, as well as other government players, have taken a much more active role in the markets and economy. The beginning of this period commenced with combating the stagflation of the 1970’s. This brought on one of the most lucrative economies and market rallies the world has ever seen. Unfortunately it brought something else as well. Bubbles!
I have been discussing bubbles since the beginning of my career. Bubbles are nothing new! (they go back centuries) I am increasingly convinced that in the present we are in a period perpetuated by inflating bubbles primarily driven by central bank policies. Essentially, the Fed as well as other global central banks, are determined to keep the party going. It seems they will continue no matter the ultimate cost. The Fed has convinced the powers that be that they can navigate this economic-and-market-boat. Unfortunately they may have gone all in on this thinking so a failure would be catastrophic to their credibility as well as their livelihoods.
Now before we get too far into the weeds I am not saying that the U.S. stock market is presently in a bubble. However there are those who believe we are, maybe we call them the “bubbleheads!” At minimum, there are certainly areas that appear to be at bubble valuations. These valuations are being pressed higher with the help of the Fed. If the market believes the Fed “has its back” then what is to stop asset prices from rising to unjustifiable levels? In December of last year, we likely saw an example of what if the Fed backed away.
In every market cycle there are predominant themes or primary factors that drive the economy and markets. Post the 2008 financial crisis one theme is the Fed premium! Or the extra value in the markets being supported by Fed policies.
Bottom line: Stimulus from Central Banks has been a primary driver of this economic cycle. When economic historians look back on this period of time there will very likely be a chapter dedicated to central banks and their very hands-on relationship with financial markets.
“They’re [the Fed] keeping rates down so that everything else doesn’t go down.”
-President Donald Trump, Sept. 5, 2016 while campaigning in Ohio.
The current President understands this well. While campaigning he was a bit critical of the Fed’s long stance of low interest rates and easy policy. At present, he very much understands that the Fed increasing rates and tightening policy runs a strong risk of slowing the economy. No sitting President wants an economy to slow. Especially if an election is approaching!
Interest rates, or the cost of money, are very correlated to economic growth. Nobody wants to take the punch bowl away. However any party that goes on too long results in a markedly worse hangover!
So good news or bad news?
The Good News… The Fed has announced it will cease its tightening policy (i.e. increasing interest rates) for the time being and this is being reflected in the stock market rally witnessed this year. Lower rates and looser policy is supportive for rising asset prices. While last year the Fed was determined to tighten policy (see my post Chicken or Egg from October) they seem to have changed their mind quite quickly. Did market prices change their mind? It certainly appears that was the case…
The Bad News… How long can a central bank driven stimulus economy continue? Clearly longer than many would have guessed! And what are the long-term implications? Possibly a bad hangover! This has been a debate for some time. We have no precedent for the level of stimulus that has been administered over the past 10 years. This is the reason that many investors have felt uneasy about this economic cycle. As well as those still crying foul! Central banks have changed the rules. Understanding the implications are critical to long-term investment success.