A Fool’s Game

The Dow Jones Industrial Average surpassed 17,000 for the first time in its history last week. The S&P 500 is at an all time high as well. Only the Nasdaq hasn’t surpassed its tech-bubble peak. And its not just the stock market—real estate, high-yield bonds, emerging markets, government debt, fine art—you name an asset and I promise you it’s booming. The latest craze is frontier debt. That is, bonds of dicey governments such as those in sub-Saharan Africa. Credit spreads—the differential in borrowing costs faced by investment-grade and lower-rated firms—are at an all-time low. Overall market volatility has almost never been lower. It looks like the good times are here. Except, they most decidedly are not.

The economic recovery is, in fact, tepid. The US economy is expected to grow a mere 2.1 per cent this year. In the first quarter, it actually shrank by 2.9 per cent. Yes, the unemployment rate has fallen to 6.1 per cent, exactly where it was on the eve of the financial crisis in December 2007. But, as of June 2014, 2.7 per cent of adults who wanted a job were not actively looking for work. Another 3 per cent of the population in working part-time because they can’t find full-time work. Counting the underemployed and the discouraged, the labor market shortfall is 15 per cent. Not that the pre-recession era was all that swell. In December 2007, this shortfall was 12 per cent. 

At $2.1 trillion, corporate profits are higher than ever; accounting for an eighth of US GDP, tying the previous record that was set by the 1942 war economy. The effective corporate tax rate back then was 55 per cent, compared to 20 per cent now. No wonder corporate profits after tax accounted for a tenth of GDP; a new record. Meanwhile, the share of wages and salaries in 2013 was 42.5 per cent; another record low. One could assume that with the going so good for the masters, at least the sky-high equity valuations would be justified. One would be wrong. The Shiller P/E ratio, at 26, is back to pre-recession levels. The forward price/earnings ratio is also back to the pre-crisis bubble years. Amazon, the darling of the stock market, is trading at more than five hundred times its earning per share. The risk premium demanded by investors to compensate them for holding riskier assets is back right down to levels last seen in 2004-2006. Amidst a weak economic recovery, we are witnessing nothing short of a financial boom.

This isn’t quite Tulip mania. Investors—at least the clear-eyed ones—know that assets are overpriced. Yet, they are in no hurry to sell. This is because the financial boom is a foster child of the United States Federal Reserve. And as every child knows, you’d be a fool to fight the Fed. The markets are simply dancing to the Fed’s tune. 

The Fed has followed an extraordinarily accommodative monetary policy for nearly six years. The policy rate has been zero since December 2008. Soon after hitting the zero lower bound (ZLB), the Fed embarked on non-standard measures proposed by Ben Bernanke in 2004. This policy has three components: (1) Forward Guidance: declaration by the Federal Open Market Committee (FOMC) to influence the expectations of market participants; (2) Expanding the Fed’s balance sheet beyond what is required to maintain rates at the ZLB: what’s called Quantitative Easing (QE); and (3) Outright Asset Purchases: intervention in markets of distressed debt and toxic assets to prop up prices in order to prevent banking crises. The Fed’s balance sheet has grown from a few hundred billion dollars to $4.3 trillion. It is now in the process of “tapering”—that is, slowing down the expansion of its balance sheet, which will continue to grow through this fall. Fed officials are mulling what to do with that giant pile in the long run. They reckon they’ll have to keep it. The highly-unusual intervention in various distressed assets, what purists would call “price administration,” has stabilized financial markets. Forward Guidance has been unexpectedly effective. Bernanke’s “taper tantrum” last year prompted a large-scale sell-off of emerging market funds and led to a sharp spike in market volatility generally. The Fed’s clarification calmed the markets and the market response to the actual taper has been quite tame.

BIS figures

Such extraordinary intervention has pushed down the entire yield curve on government bonds, precisely as the Fed intended. Investors’ search of yield has pushed up prices of assets across the board, thereby depressing yields on all assets. The decline of volatility and inflation expectations have increased the risk appetite of investors. The elevated risk appetite of investors has in turn buoyed up demand for lower-rated debt. US firms have increasingly tapped capital markets to exploit record low yields, at a time when many banks have been restricting credit. Gross issuance in the high-yield bond market alone soared to $90 billion per quarter in 2013 from a pre-crisis quarterly average of $30 billion. Since cheap credit has enabled troubled firms to refinance easily, corporate default rates have declined. The depressed default rates have in turn justified tighter credit spreads. Firms are using cheap credit to pay higher dividends, buy back shares and engage in mergers and acquisitions. This has allowed very many troubled firms to look quite dandy. Remarkably, despite the vanishing costs of finance, nonresidential fixed investment by nonfinancial firms is flat; perhaps in light of the economy’s actual prospects. 

It’s clear that the Fed’s bubble economics is causing a major misallocation of capital resources. The notion of price discovery has disappeared from asset and credit markets as prices increasing diverge from fundamentals. Perhaps more importantly, the risk of a major financial bust as the Fed tries to implement an exit from its extraordinarily accommodative monetary policy is getting more and more serious. Based on these considerations, the Bank of International Settlements (BIS) issued a stern warning against delaying policy normalization. Fed Chair Janet Yellen has dismissed such concerns. Krugman is still making fun of bond market vigilantes. The IMF considers the baseline scenario to be a smooth exit. Right, we’ll see about that.

Basically, everyone caught on the floor when the music stops playing is going to pay dearly. This is why smart money has moved into a conservative capital preservation strategy. For instance, the cash component of JP Morgan’s fixed income fund, the world’s largest, is now no less than three-fifths. 

The Fed has painted itself into a corner. There is no smooth exit now. The Fed simply cannot normalize policy without dislocating world markets. And the longer it takes to reverse policy, the worse the dislocation.