As we noted in our recent precious metals commentary, investors now expect the Federal Reserve to begin reducing its economic stimulus programme at some point in the next few months. This expected reduction in asset purchases, which is being referred to as “tapering”, and whether or not the Fed actually follows through on it largely depends on one question. Can the US economy really stand on its own two feet without support from the central bank?
Our view is that it cannot and this article examines why that is the case and why talk of “tapering” is just talk.
Evidence that the US economy is still in poor health
What follows is some evidence that the US economy is still in poor health.
- The labour force participation rate is currently 63.4%. The last time there were so few people in the workforce was in 1979 when America was experiencing an oil crisis.
- The employment-to-population ratio for adults age 25 to 54 is still 4.5 percentage points less than its pre-recession average.
- Job growth at small businesses is now at about half the level it was at the beginning of the year.
- The BLS reported that in Q1 labor costs fell by 4.3%.
- Wages as a percentage of GDP are hovering near an all-time record low.
- It takes the average unemployed worker two-thirds of a year to find a new job.
- The US is tightening fiscal policy by 3.2% of GDP this year, the biggest squeeze in half a century.
- Thus far consumers have dealt with the burden of higher taxes by reducing their savings rate, which is now at just 2.5% nationally.
- The burden of taxes, rules, regulations and red tape means that the percentage of Americans who are self-employed is now at the lowest level ever recorded.
- Consumer credit is at the highest level ever recorded and is growing at a frightening pace as millions of Americans resort to going into debt to make ends meet.
- 47.8 million Americans (15% of the country) are receiving food stamps.
- The May 2013 ISM manufacturing report came in well below expectations at 49 (a number below 50 indicates contraction), the lowest since the depths of the crisis in mid-2009. New orders also fell sharply to 48.8 on weak foreign demand.
- The inventory to sales ratio has hit a level not seen since 2009, meaning that there is a lot of inventory sitting out there that people are not buying.
- Industrial production (output at factories, mines and utilities) is broadly flat, as are retail sales.
- The number of commercial and industrial loans made by commercial banks has been steadily declining since the middle of 2012.
- Money velocity continues to plunge indicating that deflation remains a real threat, and inflation remains in a downtrend.
The news isn’t all bad by any means, in fact, the private sector has made excellent progress both in terms of balance sheet repair and efficiency improvements. However, without stimulus from the fed in the form of QE and ZIRP we can be confident that the US economy would be staring into the jaws of a serious recession or even depression.
Our view is that the talk of tapering was designed to take the heat out of the equity markets (as well as other frothy markets). Evidence for this comes from both the Federal Advisor Council, which advises the Fed on markets, and from Ben Bernanke himself.
Minutes from the latest Federal Advisor Council meeting reveal that they group is growing increasingly concerned about the side-effects of QE and ZIRP. Not only are these policies fueling new asset bubbles, they are pushing pension funds underwater on their liabilities.
In his testimony to Congress on 22 May, Fed chairman Ben Bernanke also emphasized his concerns, that “very low interest rates, if maintained too long, could undermine financial stability”.
Evidence of the asset bubble that’s already forming in US real estate was highlighted in a recent article by Alhambra Investment Partners: “This morning the Wall Street Journal was kind enough to highlight the rising level of house flipping. In some markets, particularly California, flipping is already back to bubble levels. Indeed, the most flipped markets are the very markets, including Florida, where the first housing bubble was most apparent. Investors never learn, or at least the distortions by monetary doves prove just too irresistible for fallible human desires like greed and the allure of get-rich-quick.”
Talk of tapering was needed to counter what Alan Greenspan termed “irrational exuberance” and does not actually reflect the view of Fed officials. Evidence of this comes from the recent comment of two of the Feds most ardent supporters of QE, namely Boston Fed President Eric Rosengren and head of Chicago Fed Charles Evans.
Market participants need to keep in mind that what the Fed says it may or may not do is almost as effective a policy tool as actually doing it. In other words the Feds job is as much about managing expectations as implementing policy.
Ben Bernanke knows that to attempt an exit from QE prematurely would be a big mistake. However, he must balance the need for continued stimulus with the need to avoid another market crash – at least until he can hand over the reins to the next Fed chairman (or woman) – and there are plenty of markets that could be the epicentre of such a crisis.
The bottom line, to quote Alhambra Investment Partners again, is that “The case for economic improvement as the primary reason for slowing down QE would be far more convincing with actual improvement, or at least a hint of inflation”.
So what does all this mean for investors? Well, given that QE and ZIRP look set to remain part of the economic and financial landscape for the foreseeable future, it seems likely that US equities will continue to have the wind at their back. However, investors should continue to focus on the highest quality companies, and they should expect increased volatility as time progresses.