Curtains for Monetary Policy?

In this article I argue that we may be reaching an end game for monetary policy. As economies continue to sputter and the central banks continue to pursue extraordinary measures, the question should be raised: What are we accomplishing? And, at what long-term cost?

There is little doubt the Federal Reserve's quantitative easing policy has helped bolster asset prices, especially prices for bonds, equity and houses. The U.S. stock markets sit around record highs, treasury yields are near record lows, and interest rates on mortgages are near record lows. These factors have created a "wealth effect" in which owners of these assets feel better off.

The question is: Does this asset appreciation mean we reach an "escape velocity" for the economy or does it set us up for greater volatility (ie. another burst bubble)?

Time will prove the fairest judge of this debate. But for now, maybe the biggest long lasting impact of recent monetary policy has been in the area of academia. Through Mr. Bernanke's tinkering we are learning about the limitations of monetary policy. It is becoming apparent that monetary policy has a direct impact on asset prices but the impact on labor markets and consumer spending is more indirect, and potentially dominated by other factors. Similar to a whip, Bernanke applies force to one end with the expectation of a "crack" at the other end.  Will the monetary force used to lift asset prices result in a Bernanke-Jones whip-like economic snap or a Bernanke-Tube Man violation?

The declining velocity of money and slowing growth in the money supply suggest more of a tube man blowing hot hair than Indiana Jones getting the treasure (and girl). Slowing velocity and slowing monetary base growth equals slowing nominal GDP. In other words, inflation risk is declining and deflation risk is increasing, supported by weak gold prices and TIPS.

Recent economic releases continue to paint a mixed economic picture. Consumer spending appears weakening, with cash-register sales declining 0.4% in March. Consumer sentiment fell to the lowest level in nine months. Retailers are actually cutting jobs. The reasons for this weakness are varied, including rising healthcare costs consuming more of a family's budget, rising income taxes, falling mortgage refinancing activity as rates have been at a prolonged nadir, and federal sequestration.

The recent weakness in bank earnings, and the nearing end of lowering loan-loss reserves to bolster earnings, may provide a clearer picture of the strength of the economy. In an ultra low long-term rate environment it is challenging for financial companies to produce acceptable returns. Even more concerning, a research article by Robert C. Merton highlights that due to explicit and implicit government guarantees bank earnings face a "doubly convex" curve, masking the real risk to banks' earnings when the economy worsens and increasing economic volatility. So what seems like satisfactory risk controls in a normal environment can quickly deteriorate into a crisis during an economic downturn.

Central banks are raising the stakes in their battle to drive economic growth, a notion that should cause more skepticism. Most recently, Japan's central bank has committed to expand its balance sheet through asset purchases at the rate of 1% of GDP each month, potentially doubling the base money within two years. This policy is expected to continue for as long as necessary. All of this to offset a naturally deflationary environment caused by an aging population and a relatively inflexible economy. Are central banks lifting us to a recovery or simply holding on as more weight is added to a recession scenario?

Rising prices are not a major contributor with most commodity prices flat to down, including major influences like gasoline and food. Countries that have traditionally relied on commodity exports have been experiencing weakness, including Canada and Chile. In fact, with a consumer debt level to disposable income at a record level of 165% and oil revenue $6 billion below expectations, there is growing concern in Canada that the economy will continue to weaken.

In an environment in which some have characterized as a "no bad news" environment for markets, there is a deep fundamental belief that the monetary policy can cure all. In a perverse way, bad labor market statistics actually encourage the markets because the likelihood of the Fed extending its easing stance increases. Great for the asset markets but maybe not as much so for the economy, especially when growing risks of price destabilization, either inflationary or deflationary, are considered

The markets continue to skip down the path paved by the Bernanke-the-wizard's dollars. Take away that dollar-covered curtain and the picture is down right scary.

Economic Growth of 4% in 2013?

A few predictions for 2013

• Global economic growth of 3.5%, accelerating from 3.2% in 2012 (Source: IMF)
• US economic growth of 2.0%, accelerating to 3.0% in 2014 (Source: IMF)
• US Retail sales growth of 3.4%, with on-line sales growth between 9% to 12% (Source: NFR)

What do these predictions have in common? Like most predictions, they are likely wrong.

How can I be so sure in my "prediction?" Because I believe that price stability is the largest threat to the economy, and therefore 2013 nominal GDP has such a wide potential range that predicting its growth is no better than a game of darts. Following on from my last article, the Federal Reserve has done a masterful job so far at balancing the fundamental deflationary forces in the economy with the inflationary forces of the QE strategy. But, their path is narrowing and their control loosening, in my opinion.

Fundamental deflationary forces are coming from trends like:

1. Technology advancement
2. Excess capital in industries like retail 
3. Mis-allocated capital as banks postpone write-offs of under-performing loans
4. A leveraged consumer based on debt to income
5. Flat real income
6. Rising taxes paid on income, reducing disposable income
7. More controlled government spending, especially in Europe and wind-down of wars

QE is offsetting these deflationary forces by:

1. Raising income after interest expense through lower interest rates
2. Encouraging capital investment by lowering the cost of capital
3. Inflating both financial and tangible asset prices through direct purchases and lower financing

Why do I believe we are teetering on greater price instability, either deflationary or inflationary? There are signs of increased economic volatility based on interest rates, such as a potential "refinancing apocalypse" as rates rise, the economic distress on young workers (and thus potentially lower future consumption) as lower interest rates enabled schools to hike up tuition, signs of a growing housing bubbles in Switzerland and China (where official statistics show that 20% of GDP is made up of unfinished housing stock), Japan painting itself into a corner, and signs that liquidity is finally spreading wider in financial markets.

Hold onto your hats because I believe the markets have been lulled into a feeling of "the Fed has our backs," allowing that silent killer called risk to creep further into our economy, likely producing large price swings in my view. Let us just hope that Mr. Bernanke is as cunning and well-equipped as the Roadrunner when the silent killer of risk sneaks up on investors.

America the Producer?

In my last article I highlighted the following:

1. The Bush-era lower taxes have added a general stimulus to the economy, enabling individuals to purchase more products and services because of a higher after-tax income.
2. The larger government outlays as a percentage of GDP have driven growth rates above what is naturally sustainable in segments like defense and construction; and has enabled a woefully inefficient healthcare industry rife with fraud and over-billing. 
3. The aggressive monetary policies that have fueled falling interest rates have added significant stimulus to the economy, especially in industries requiring debt financing like housing and autos. 

Given my belief that taxes paid per individual continues to go up, government spending per individual decreases, and monetary policies back-off; I do not find retail, defense, construction, housing or autos overly interesting. Although, I concede that monetary policies could keep interest rates low for an extended period and thus investing in housing and autos could prove quite rewarding. I just don't want to try to get into Bernanke's briefcase every time the market falters.

What I do find interesting is an apparent shift in manufacturing between goods produced domestically versus overseas. Due to a number of economic forces, both macro and micro, there is the beginning of a shift towards domestic manufacturing, in my opinion. Numerous individuals have argued this trend recently, highlighted by Charles Fishman in the December edition of The Atlantic. Indeed, after manufacturing output rose 10% in the first quarter of 2012 the trumpets sounded about America's manufacturing resurrection, only to fall flat for the remainder of the year. So this trend is by no means certain and definitely not smooth. With that said, I plan to explore the argument further.

Macro forces pushing a shift away from overseas to more domestic manufacturing include:

• Higher oil prices, increasing shipping costs
• Lower natural gas prices in the US, reducing domestic manufacturing costs
• Rising China wages, which have increased five-fold since 2000 in US dollars
• Slack US labor markets and weakened unions in the US, enabling lower domestic labor costs
• Rising US labor productivity, enabling lower domestic labor costs
• Falling dollar relative to China Yuan, making Chinese products more expensive

In addition to these macro forces, companies are finding numerous hidden costs to separating domestically-based product design and overseas production of their products. Over time, the assembly of products has tended to become needlessly more complex, increasing production costs and offsetting the overseas advantage of lower wage rates. As Mr. Fishman put it, "it was like writing a cookbook without ever cooking."

Macro forces paired with fundamental business interests should eventually make for a powerful trend, in my view. Furthermore, the President is also focused on improving the manufacturing capabilities of the country, and thus political interests are aligned with economic trends. Finally, the on-going efforts of the Federal Reserve likely continues to weaken the US dollar over the long-term, adding further support to moving manufacturing back within domestic borders.

So there appears a fairly complete argument driving the growth of domestic manufacturing above GDP growth. The key phrase is "above GDP growth."

The consensus seems to tilt towards healthy GDP growth in 2013, driving favorable earnings growth. The key assumption supporting these views, in my view, is price stability. Given the Federal Reserve's decent track record over the past few years to balancing the deflationary and inflationary forces in the economy (where I have been wrong in my investment thesis), I believe assuming price stability in 2013 is the easy argument. However, changes in fiscal policy and increasing discord within the Federal Reserve may result in more volatile prices going forward. In the next few articles I plan to look into the following topics:

(1) The assumption of price stability
(2) Expected economic growth
(3) Interesting companies likely benefiting from domestic manufacturing

Forget Fiscal Cliff! Can the Economy Grow in Five Years Without Government Stimulus?

I don't know about you, but the hysteria about the fiscal cliff is beginning to really rub me raw. It is not so much the politicians doing their dance. It is instead the distraction from the larger fundamental question of: "What is right for the long-term health of the economy?"

After a big step back, let's consider what deficit spending has meant to the economy.

% of GDP	2000	2012
Total Government Receipts	20.6%	15.8%
Total Government Outlays	18.2%	24.3%

The amount of taxes paid, as a percentage of GDP, has declined almost 5% of GDP to 15.8%. In other words, instead of paying money to the government, individuals have been purchasing goods and services, a stimulant for the economy. Secondly, government outlays have increased over 6% of GDP to 24.3%. A significant stimulant to the economy has been higher government spending, especially in the area of healthcare.

One can argue that these figures suggest more stimulus is needed in order to avoid an economic slowdown. Indeed, there are economists on the left-side of the spectrum advocating up to $2 trillion of additional stimulus spending in order to grow the "denominator," or GDP. The basis of the argument is that cutting the government deficit produces a 1-to-1 reduction in the private surplus, hurting the economy as witnessed in Europe under austerity measures. Yes, we are talking defined formulas for calculating GDP. Also, intuitively it makes sense that slowing government spending or raising taxes will be a drag on the economy, just as the opposite was true during the last decade.

Source: New Economic Perspectives

However, this raises the philosophical question of whether the government should be the main driver of economic growth for an extended period of time. The government can obviously drive growth, but when pursued for a decade how does this type of growth driver pervert private economic activity? President Obama has maintained budget deficits in excess of 7% of GDP during his term in office. While this has helped avoid a more catastrophic depression, I fear it is also increasing systemic risk as companies increasingly rely on both government spending and lower income and capital gains taxes, either directly or indirectly.

Where I respectively disagree is sustainability of these policies. Economists advocating stimulus spending generally argue that by growing GDP through deficits, the economy can reach a self-perpetuating growth rate, at which point the government can remove stimulus spending and on-going growth can then pay down the debt. Based on this theory, you would think after 4 years of historically high deficits the economy would have performed better. In fact, the only period in the last 10 years of fiscal stimulus that has approached "normal" economic activity was the result of an inflating housing bubble that proved short lived. I suppose an ever increasing deficit and increasingly aggressive monetary policy can keep the economy growing, but there may be a diminishing impact on GDP growth as inefficiencies in the economy are allowed to remain.

The budget deficit as a percentage of GDP has been 10.1%, 9.0%, 8.7% and 7.0% for 2009 through 2012, respectively.  To put this in perspective, the largest budget deficits since WWII were a little over 5%, which only happened twice. In 2013, the budget deficit is forecast between 5.5% to 6.0%.

Again, let's review some numbers:

• US Debt Held by Public - $11.5 trillion (~ 75% of GDP)
• US Debt Outstanding - $16.3 trillion (Greater than 100% of GDP)
• Estimated US Debt Outstanding 2016 - $22.8 trillion (~ 150% of GDP)
• Total Liabilities of US Government (Soc Sec, Medicare, Govt pensions) - $86.8 trillion (550% of GDP)

Here is a measure Debt/GDP from other countries:

• Spain - 85%
• Greece - 175%
• UK - 75%
• Italy - 126%
• France - 90%
• Japan - 235%

Why does the US benefit from ultra-low interest rates while other countries with a slightly higher debt-to-GDP have interest rates spike upwards? One of the main reason, in my opinion, is because of the Fed's bond buying. However, the size and strength of the US economy, a focus mostly on public debt, falling debt service payments, and the view of the dollar as a safe currency play important roles. But, the disparity in interest rates has caused some head-scratching. I believe my Sagflation theory helps to explain this issue through the combination of fundamental deflationary forces offset by expansionary monetary policies, both of which are pushing interest rates lower. 

So debt levels have been rising. At what level does the bond market pull back from US debt is very much debatable. I will leave it by stating the obvious, the higher the leverage ratio the less forgiving is the bond market if the economy slows. Stimulative policies that raise the leverage ratio increase the risk of interest rates spiking should the economy slow before the debt can be reduced.

Why I Continue to Remain Bearish

Returning to two points made previously, and adding one more. Since 2000, the following has happened in the economy:

1. Taxes paid, as a percentage of GDP, has declined almost 5% of GDP to 15.8%. 
2. Government outlays have increased over 6% of GDP to 24.3%.
3. Interest rates on 10-Year Treasuries from around 6% to about 1.5%.

The lower taxes have added a general stimulus to the economy, enabling individuals to purchase more products and services because of a higher after-tax income. Given the current battle in Congress it appears as though taxes paid may go up, either through higher rates or lower deductions. Either way, this stimulant is about to reverse and become a drag as after-tax income declines. Luxury sales are likely to soften as taxes on incomes over $1 million potentially go up.

The larger government outlays as a percentage of GDP have driven growth rates above what is naturally sustainable in segments like defense and construction; and has enabled a woefully inefficient healthcare industry rife with fraud and over-billing. The growth rates in these industries likely moderate, although healthcare may prove more resilient given the changes to the healthcare laws.

The falling interest rates have added significant stimulus to the economy, especially in industries requiring debt financing like housing and autos. Not surprisingly, both the housing market and auto industry has enjoyed a lift as the Fed aggressively purchases treasuries and mortgage-backed securities.

The critical question, in my mind, and the one everyone is fighting over is this:

Is the economy structurally efficient for the long-term?

Hard to answer this question, but I think the fundamental deflationary forces, shadowed by excessive bank reserves, hint at over-supply and poor returns in many industries. Structurally the tax code is inefficient and this constant whining from business leaders about "uncertainty" in Washington hints of businesses too closely tied to the government and its policies.  Finally, the rising amount of poorly written regulation as the government reacts to crises is likely having a cooling effect on the economy.

Mr. Bernanke can keep the growth engine bouncing along as the Fed's balance sheet now exceeds $3 trillion, and in many ways he is doing what is necessary to avoid a deflationary death spiral. But, until the government enables the economy to become more efficient I believe we are doomed to Stagflation.


So while the federal government pursues stimulative measures the markets likely respond favorably. These policies could continue throughout President Obama's term in office. However, the exit of these policies becomes riskier as the debt balance rises and the Federal Reserve's balance sheet inflates. For a fundamental analyst, it is tough to swallow any company-specific analysis when the foundation of the economy seems softer and riskier than ever before.