In part I of this two part series, I discussed the possible rush for the exits and market volatility in what I saw as a long overdue correction. The violence of the correction and the extremes of volatility that I worried about have now actually appeared.
As I rewrite the introduction of this part II, conventional Wall Street wisdom has now become that the correction and volatility are due to the fear of rising inflation and the rising fear that the Fed will have to raise interest rates even faster than anticipated. In addition, the recent Budget Agreement significantly raises the budget deficit at a time of high resource utilization, certainly a cause for concern about inflation. Demand for new Treasury debt was lackluster at the last auction, and the Fed is now a net seller, not a net buyer of Treasury paper. Thus, traders have pushed interest rates up significantly, and Wall Street has reacted badly. The truth is, the Fed and other major central banks are way behind the curve, having kept policy too easy for too long. The new conventional wisdom, for once, appears to be spot on. And, as I have written previously, the Fed’s fingerprints are all over each and every post-WWII recession; and they will likely be on the next one.
Fed policy has never been as accommodative at this stage of an expansion as it is today. Most real rates of interest (the yield curve less goods and services inflation) are still significantly negative. The reason for the Fed’s continuing accommodative policy is the inflation excuse. As measured by CPI or PCE, it has been too low. The Fed’s target is 2 percent, an annualized level that hasn’t been seen in any month for more than 5 years.
What is magic about 2 percent?
That 2 percent inflation target was set in 1996 and hasn’t been altered for more than 20 years. Meanwhile, the economy has undergone a significant metamorphosis (demographic, competitive, attitudinal, technological…). The inflation target appears to be inappropriate. What is really magic about 2 percent? If the target had more appropriately been moved lower as the economy morphed, to say 1 percent or even 0 percent, then the Fed would have, long ago, moved rates higher and significantly reduced its bloated balance sheet. And, likely, financial markets would not be overvalued.
The Fed chairs
On December 5, 1996, when he uttered those famous words, “irrational exuberance,” then Fed Chair Greenspan was excoriated by the financial media. He quickly backed off and continued accommodative policies. The result was the dot.com bubble.
Bernanke, now infamous for telling us that sub-prime mortgages weren’t an issue just a few months before the financial meltdown, relied on the “wealth effect” to support the economy. The wealth effect occurs when the prices of real and financial assets rise, making the owners of such (usually the more well off) more confident and more willing to spend. The wealth effect has long been considered a much weaker policy tool than deficit spending or tax cuts because the marginal propensity to consumer of the wealthier class is much lower than lower classes in the social strata.
Yet, Bernanke’s Quantitative Easing (QE) was a policy whose ultimate objective was this very “wealth effect.” There were three QEs, the last one coming long after the ’09 financial meltdown was in the rear-view mirror, but clearly Bernanke used this to shore up Wall Street and financial asset prices. In fact, Bernanke penned an op-ed in the New York Times in the immediate aftermath of QE1 stating this.
It also appears that the Janet Yellen Fed has been a Wall Street supporter. She had concerns about market valuations early in her tenure as Fed Chair which began in February, 2014. In July of that year, she said “valuation metrics in some sectors do appear substantially stretched.” At that time, the S&P 500 stood near 1975 and the trailing PE ratio was 18x. In her last press conference, December 13, 2017, she said (incredibly) “…when we look at other indicators of financial stability risks, there is nothing flashing red, or possibly even orange.” Wow! On that date, the S&P 500 was 2663 and the trailing PE ratio was near 23x! But nothing is even flashing orange!
The Jerome Powell Fed
Wall Street originally assumed that Powell would be a clone of Yellen, Bernanke, and Greenspan, and that monetary policy would continue to be accommodative even as the economy operated above potential and as some inflation inevitably appeared in the drum tight labor markets. But, in early February, Wall Street began to change its tune regarding the Powell Fed and now believes that interest rates will rise faster and further. Maybe Powell’s quote from the meetings of the American Finance Association in January, 2017, finally hit home: “It is not the Fed’s job to stop people from losing (or making) money.”
We may now be entering a period where the markets simply don’t automatically rise, a period where monetary returns are much harder to acquire. In such a market, active portfolio management (asset allocation strategies and stock picking) actually matters.
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Fieldstone Financial. www.FieldstoneFinancial.com .
He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee. Robert leads the investment governance program at Fieldstone Financial, is the head of Fieldstone Research www.FieldstoneResearch.com, and is co-portfolio manager of the Fieldstone Financial Fixed Income ETF (FFIU).
Statistics and other information have been compiled from various sources. The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information.