King And Minack: Thoughts On QE

My friend Cullen Roche recently penned an article discussing the plunge in oil prices and the lack of a subsequent decline in the S&P 500.  To wit:

"If you had told me that oil would fall over 50% in the last 6 months I’d have bet you that the S&P 500 would be down at least 10%+. At a minimum. But that’s not at all what’s happening. Instead, oil has cratered, and the S&P 500 is down a mere 3.5%. The 2008 oil price collapse is a common comparison to what’s presently going on in the oil market, but it’s clearly been different this time."

Cullen is right. It is different this time, at least up until now. One of the key differences between now and 2008 is the global intervention by Central Banks into the financial markets which have alleviated the perception of "risk" in the markets and various financial assets. Those interventions, either actual or verbal, has kept money flowing into the financial markets in search of return above globally suppressed yields on fixed income.

While no one knows how this ends, logic and history both suggest probabilities of a rather negative outcome. However, currently, Central Bank intervention rules the game for now. However, I thought the following points were worth your consideration with respect to the eventual "end game."

Bill King, the editor of the King Report, recently penned an interesting point:

"Some media ran headlines and stories that stated stocks are soaring on optimism about the US economy and the Fed. These should be mutually exclusive dynamics. 

We’ve noted incessantly over the past many months that each time stocks start tumbling on economic or political concern; central bankers rescue stocks with verbal or actual intervention. This makes for an extremely dangerous environment for investors and traders – as evinced by the sharp declines and rallies since July 2014."

"This is how stocks reacted in 1929. However, a big difference then was the Federal Reserve was tightening rates while some NY bankers kept credit loose, effectively running their monetary policy to usurp the Fed. When the DJIA cratered 12.5% in March of 1929, Charlie Mitchell, the CEO of National City Bank and a Director the NY Fed, saved the stock market by providing credit to Wall Street.

One can argue that just like in 1929, some current Fed members, principally those from financial market areas and those that believe in the wealth effect, are running easy monetary policy to boost stock prices.

So many people were buying on margin in 1929 that there were six billion dollars outstanding in brokers’ loans as compared with one billion in 1920… The Federal Reserve Board in Washington took to brooding about this item and got into a lovers’ quarrel with the banks about it. The gentlemen in the capital wanted to raise interest rates to make borrowing a little tougher. However, the banks had no qualms at all about the mountainous speculative tides; they were doing nicely, thanks.

Thus Charles E. Mitchell, president of the National City Bank and a director of the New York Federal Reserve Bank, took a very dramatic step in March when the growing talk of a curb on loans led to a break in the market. As more than eight million shares changed hands in a wave of scare selling, Mitchell announced that his institution stood ready to put out 25 million dollars in call loans"

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One of the myths that prevails on Wall Street is that the Fed has never done anything like this before. That is not exactly true as Ron Chernow in an NY Times op-ed from October 2009 pointed out:

"The stock exchange was a rigged market that made no claims to fairness. Speculators operated more than a hundred “pools” that openly manipulated individual stocks and sometimes bribed financial journalists…

Even as the stock boom captured the national imagination, most Americans sat safely on the sidelines. In a population of 125 million, fewer than two million took a flier in stocks… Those, who questioned the New Era gospel, were ostracized as knaves or fools…

In retrospect, the 1929 crash stands as the dark gateway to the Great Depression, though not its direct cause. In its aftermath, government moved with unwonted vigor to shore up the economy. George Harrison, head of the New York Fed, bought large amounts of government bonds and slashed the rediscount rate…"

Back to Bill King for a moment:

"The SF Fed on the NY Fed doing QE in 1929 and why the Fed now fears normalizing policy:

In the immediate aftermath of the crash, the New York Fed took prompt and decisive action to ease credit conditions. When investors attempted to liquidate their equity holdings, many lenders also called their loans to securities brokers. With the encouragement of officials at the New York Fed, many of these brokers’ loans were taken over by New York banks, who were allowed to borrow freely at the discount window for this purpose. The New York Fed also bought government securities on its account in order to inject reserves into the banking system…

However, this respite from tight money proved to be temporary. After the liquidity crisis had been contained, monetary policy once again resumed a contractionary stance. Throughout 1930, officials at the New York Fed repeatedly proposed that the System buy government securities on the open market, but they were systematically rebuffed. The reasons, other members of the Federal Reserve gave for opposing monetary expansion, are instructive.Several felt that much of the investment undertaken in the previous expansion was fundamentally unsound and that the economy could not recover until it was scrapped.

Others felt that a monetary expansion would only ignite another round of speculative activity, perhaps even in the stock market. In any event, monetary policy remained contractionary; the monetary aggregates fell by 2% to 4%, and long- term real interest rates increased… [Why the Fed fears normalizing policy now.]"

Recently Patrick Commins interviewed the "much-admired straight-talking strategist at Morgan Stanley" Gerard Minack who has recently been discussing the mounting risks in the global economy.

"I think QE has been overrated, but six years of zero rates in the US is going to have an impact.

But for me the most important monetary policy act of the last four years by a mile was [European Central Bank president Mario] Draghi's 'whatever it takes' speech. In the two years before that, every time we hit a soft patch you reintroduced the tail risk of a systemic European banking crisis. And by taking that risk away all of a sudden the market became inured to macro weakness and started this two year re-rating. It was a pure valuation rally. From the late 2011 lows in global equities to early this year the MSCI All Country Index was up 65 per cent. Earnings over the same period were down, so we had a pure P/E-led rally.

My look forward this year is that with the Fed tightening even modestly you bring the curtain down on P/E expansion. It's going to be a poor year for US equities because earnings growth is not that strong; but at least the US has earnings growth. Outside the US you don't, which is a very problematic outlook for this year unless you want to say the world suddenly accelerates, which it may do for a quarter or two because of low oil prices, but beyond that it doesn't look great.

In a way I think we are all turning Japanese. In the 1990s when they first tackled their bubble – and it was world's best-practice bubble, it was spectacular! – initially most analysts, myself included, applauded. It looked like they had let the air out gently without a recession: rates and growth came down and unemployment did not go up.

But the point was that it was the second downturn in '97 that nailed them; only after then did the Japanese 'turn Japanese'.

Now, we've shot a lot of bullets in the global financial crisis and the next downturn I think will reveal most other people are turning Japanese.Unfortunately the one policy that blindingly obviously works is fiscal policy, but it's very unlikely to be doable in the next downturn; in the US due to congressional gridlock, and it will be disabled in Europe because they won't have a centralised fiscal authority.

When the US heads into the next recession it's very likely to enter that recessionwith the lowest short rates, the lowest long rates, the lowest nominal GDP growth, and the lowest CPI it's ever entered recession with. Then you've got a problem! But that's the next downturn. So you're left response-less when you enter the next downturn, with monetary policy that is ineffectual, unconventional monetary policy that's just embroidery, and very close to deflation.

The biggest bubble out there is central bank credibility. If Draghi was a stock he'd be on a P/E of 200! Yellen's on 100. When that bubble pops, all hell will break loose again, and there you really just want to be in cash.

The funny thing is there is a disconnect between what investors are saying and what they are doing. No one thinks all the problems the global financial crisis revealed have been healed. But when you have an equity rally like you've seen for the past four or five years, then everybody has had to participate to some extent.

What you've had are fully invested bears."

Lance Roberts