Yesterday, the Fed decided to stick to its target date to begin its slow balance sheet shrinkage process. Heading into the meeting, indices continued to reach new highs and investor sentiment had become about as euphoric as we have ever seen despite the Fed warning all year that it was preparing for quantitative tightening. That is interesting because the narrative about the growth of the central banks’ balance sheets was a major factor that had driven many investors into the equity market. The Fed finally appears worried that asset prices are too high, creating systemic risks, but investors refuse to care in a major way even as the Trump legislative agenda becomes quite dubious.
While QE gets the credit for the equity bubble, we strongly suspect that it was corporate stock buybacks that were the real driver. Without them, it would have been impossible to ignore that many publicly traded companies were not growing much organically and had simply engineered EPS growth by levering their balance sheets to shrink outstanding equity. That reality gets lost in the shuffle, even as debt measures in the corporate sector have deteriorated to concerning levels. A slowing in this practice could prove more significant than what the Fed does.
The U.S. economy will be lucky to grow above 2% this year based on what we know now. Nothing new there. Recently released retail sales and industrial production data for August were weak, even adjusting for Harvey. This month’s Equifax fiasco and Irma won’t help, but the economy was not robust before these scourges despite seemingly every pundit proclaiming otherwise. Credit growth in the U.S. had already begun to slow for months and auto sales have likely peaked for the cycle. The post-hurricane rebuild effort will boost some sectors, but hurt others because the money to pay for it has to be diverted from elsewhere.
Central bankers have fostered the myths that they can stop bad things from happening to markets and that QE means higher stock prices. Yet seeing that none of these policies have helped the real economy or boosted inflation, the PhDs are gingerly trying to step back from the emergency measures of the last nine years just to be done with them. The surge in populism globally has to weigh on them because that sentiment is a reflection of the tensions between holders of assets and everyone else. Besides the Fed’s policy transition, the ECB is said to be ready to further reduce its monthly QE effort if only the euro would stop rallying. The BOJ looks to have pulled back already, but it is trying to shroud itself in mystery for political reasons.
The St. Louis Fed released a study recently that conveyed increasing doubt about the positive effects of QE. We could have saved them the trouble if they had merely read our letters for the last ten years. We think that this blinding glimpse of the obvious from that research piece comes close to summing up our own thoughts: “With respect to QE, there are good reasons to be skeptical that it works as advertised, and some economists have made a good case that QE is actually detrimental.” Nice of them to notice!
Of course, the facts that the inflation the monetarists wanted to create (for some insane reason) is nowhere to be found and growth is half of what it was before the last recession should be enough to make this apparent. But why let the empirical evidence get in the way of reaching the conclusion that the medicine has not worked as promised.
“Removing the training wheels” from markets is proving incredibly tough for the monetarists because they can’t hang their hats on clear proof of policy success. They are incredibly afraid of what used to be considered normal levels of stock volatility. The result is a generation of market participants that think a 2% down week or a 10% correction is a big deal. Fragility has been building for years as more stocks end up in the hands of those who have unrealistically low tolerances for losses. High yield bonds have the same problem. Most don’t know what they really own and that is a cardinal sin in investing.
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