A Funny Thing Happened On the Way to Economic Armageddon

by Scott Coyler, CEO Advisor Asset Management

Reprinted with the permission of Advisors Asset Management


by John Berzellini

In his most recent blog article, “A Funny Thing Happened On the Way to Economic Armageddon” Scott Colyer, CEO Advisor Asset Management; reminds us of three absolute truths; Death,Taxes and Don’t Fight the Fed.

We may not be able to do anything about death and taxes, but let’s make sure our portfolio manager isn’t picking fights we can’t win!

A Funny Thing Happened On The Way To Economic Armageddon…

by Scott Colyer On October 03, 2012 | Categories: Featured, Market Commentary, U.S. Economy

After the recent announcement by the U.S. Federal Reserve (Fed) that they would begin to engage in what has been deemed “QE3,” there has been a lot of skepticism that such a plan could actually work. The Fed is attempting to carry out their dual mandate of price stability and full employment by engaging in a new round of asset purchasing targeted at the mortgage market. Public support of Bernanke seems to be waning as even some sitting Fed governors are publicly dissing the plan. Congressional support of the Fed is also being tested by those worried that the Fed is monetizing U.S. Treasury debt to a degree that will debase the U.S. dollar leading to inflation.

Many pundits are making media appearances denouncing the potential healing power of Quantitative Easing. The latest version follows three bond buying binges by the Fed (QE 1, QE2, Twist) where the Fed has given its unending promise to buy agency mortgage-backed securities monthly until they see the recovery in full swing. Furthermore, they have extended their zero-interest rate guidance until at least 2015 and promised to continue the stimulus until things get much better. We note that potentially the most important part of the Fed’s new moves is the commitment to keep policy “kitchen-sinked” well into the next recovery cycle. Yes, we believe we are now in uncharted territory.

We have not seen this type of “Mighty Banker” mentality since the days of Paul Volcker in the 1980s. You may remember that Volcker’s challenge was to break the back of inflation, which he did by raising the Fed funds rate to 20%. Do you think that rattled a few cages in Congress? Absolutely! Farmers, who were suffering because of high equipment costs and low grain prices, were rolling their tractors to Washington D.C. in protest. Mr. Volcker was looked at by many as a lunatic bent on ruining the United States by imposing usurious interest rates on a very sick U.S. economy. He was appointed Fed Chairman by Jimmy Carter in 1979 and spent the first three years systematically tightening monetary policy well beyond any measures that had ever been used before. He was re-appointed by Ronald Regan who was elected as President in 1980 and began to install a number of fiscal repairs designed to restore growth to the U.S. economy.

It was not until 1982, when the interest rate peaked on the 10-year Treasury note at 15%, that things began to look better. Unemployment peaked over 11% and the equity and bond markets began one of the longest bull markets in history. Volcker was pictured as a villain on Time Magazine’s March 1982 cover. Faith in the Fed was at an all-time low, yet the Fed was feeding the economy just the medicine that was needed to cure the patient. When it was darkest and popular to hate the Fed, history shows us we should have embraced their resolve.

In many ways, Ben Bernanke is fighting the same fight that Volcker did, except in reverse. Instead of fighting inflation, he is fighting deflation. Bernanke is using his lifetime of studying economic theory, with a focus on the Great Depression, to maneuver the tough conditions we now face. Like Volcker, he has been forced “off the reservation” to places we have not been before in modern days. Also, like Volcker, his medicine just might work. Nobody is saying it; nobody is supporting it; as most pundits are lining themselves up on the “I told you so” side of the street.

We are truly in a time of great anxiety. There has never been a time in modern history when global monetary policy has been this easy. From Washington D.C. to London and from Tokyo to Shanghai, monetary policy is incredibly stimulative. What happens if this actually works? Monetary policy is an incredibly powerful force and can produce some powerful results. With the Fed promising as much easing as is needed to obtain the desired result, should investors buy-in or run for the hills?

The empirical evidence does not favor those who “fight the Fed.” I was always taught that there are three absolute truths that one should accept without reservation. Those are: death, taxes and “don’t fight the Fed!” Because we are in unchartered territory, many people have found themselves doing just that. The Fed is trying to lower interest rates to provide additional cash to people and companies who refinance debt. They are trying to restore confidence by elevating stock and housing prices. A confident consumer is a spending consumer. A growing economy spreads jobs and profits to all of its participants.

Yet, even with the entire stimulus, cash is being drained from equity markets and jammed into U.S. Treasuries, banks and bond funds at a time where returns offered in those areas are at all-time lows. What gives? Could the Fed have it wrong? In our opinion, highly unlikely! Let’s look at what is happening not just here in the United States but globally as well. Equity prices are almost back to levels we saw in 2007. The valuation of equities is very attractive even at today’s levels. Housing prices have bounced as low home prices and record-low mortgage rates have caused the housing affordability index to hit record highs. Could the masses be wrong? Could record cash hoards and bond fund inflows be the wrong move? Most likely it is. History has shown us that when the masses all get parked on one side of a market, the likely winners will be those on the opposite side. If that logic holds here, those cash hoards and bond fund groupies will actually provide the cannon fodder for a prolonged equity market and commodity market run.

Remember, the Fed is producing currency and injecting it into the economy by way of asset purchases. That cash has been initially hoarded but will likely be re-deployed to other asset classes as returns are needed on that capital and returns in non-risk assets are non-existent. As fear dissipates, the velocity of the movement of capital will likely accelerate. Yes, the risk of a melt-up increases. The Fed has the tools and the resolve and they have shown they are not afraid to use it. They have told you what they want and they will keep printing until they get it.

We believe the key here is to get in front of the Fed. For bond fund managers, it might be trying to own what the Fed will be buying. For the normal investor who understands the Fed is trying to create growth, employment and, yes, inflation, they may favor assets where the income streams will likely increase with the rate of inflation. For a demographic generation that is starved for income, we suggest buying income-producing assets that others, in search of income, will come to want and need. They will pay-up for them as their alternatives are disappearing and the Fed has dashed hopes of higher rates any time soon.

We think the same strategy should be deployed to global markets as well. As of the writing of this article, people who fought the European Central Bank (ECB) are suffering as well. All Euro-country equity markets are now positive for the year, except Portugal. Yes, even Greece is up double digits for the year. Ireland seems solidly on its way to recovery. Yes, we hear the “Chicken Littles” tweeting a daily prophecy of death to Europe’s economy and its bonds and equities. Yet, it seems the louder they squawk, the higher the markets move. Another case of don’t fight the ECB (Fed)? We think so.

China is just beginning a huge monetary-easing program. Latin American countries are looking to weaken their currency values that have risen against the dollar. Their competitiveness is being challenged by the Fed’s actions. Japan just upped its asset purchase by 10 trillion yen. The race is on. Should an investor bet against a global easing? That’s hardly a wise course to pursue, in our opinion.

We conclude that fighting the Fed is not a wise move now, just like at any time in the past. Even though Chairman Bernanke is going places where the Fed has not gone before, the outcome is likely to be what they are shooting for. If they don’t get it, they will keep trying. Sooner or later they will achieve their intended target. We believe the risk is in resisting the Fed and staying parked in places that might suffer during a re-emergence of growth and at least some inflation. Finally, if you believe that there are significant opportunities on a more global basis, the same advice applies. Yes, “don’t fight the Fed” is still the rule.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com