Don't Fight the Fed but Do Worry About the Real Economy
I gave a brief explanation last week to a group of employees here at Phillips and Company on why the recently announced Quantitative Easing policy by the Fed is not inflationary in its primary essence.
I think it's worth discussing here, as I believe alignment around outlook is critical if we want to improve our return capabilities for our clients. I'm going to skip some non-essential details for simplicity sake, so here it goes.
You hear it all the time, "the Fed is printing money". Not really.... If it were, then inflation would be a concern. When the Fed buys back treasury securities (Quantitative Easing) from commercial banks and primary dealers (those authorized to conduct business directly with the Fed) they don't really put more cash into the economy directly.
The Fed operation goes something like this:
The Fed buys back treasury securities from dealers and banks that have set maturities and specific yields. In return the banks basically buy new treasury securities at new rates and maturities. Basically, all that's changing at the bank level is the rate and maturity duration of the treasury securities they own. The concept of a bank holding cash is bogus. They buy something with the money and it's usually a treasury security.
So instead of printing money, the Fed is swapping rate and duration. This is why Bernanke insists his QE2 is not inflationary in and of itself (see his Washington Post Op Ed piece for more http://wapo.st/bpBThf). On Friday, November 5th Ben Bernanke gave a speech at Jacksonville University where he stated:
“What the purchases do… is… if you think of the Fed’s balance sheet, when we buy securities, on the asset side of the balance sheet, we get the Treasury securities, or in the previous episode, mortgage-backed securities. On the liability side of the balance sheet, to balance that, we create reserves in the banking system. Now, what these reserves are is essentially deposits that commercial banks hold with the Fed, so sometimes you hear the Fed is printing money, that’s not really happening, the amount of cash in circulation is not changing. What’s happening is that banks are holding more and more reserves with the Fed. Now the question is what happens as the economy starts to grow quickly and it’s time to pull back the monetary policy accommodation. There are several tools that we have”
What is the Federal Reserve looking to accomplish? If the Fed buys back higher yielding treasury issues and issues lower yielding treasury issues then perhaps banks and primary dealers might choose to lend out more money or buy riskier assets in hopes of better returns. Basically, they are trying to induce investors of treasuries to move up the risk curve into things like business loans, personal loans, real estate loans and stock market purchases. They hope that banks will want a better return than what the Fed can offer, and as a result banks will start to speculate. I emphasize hope.
Here's why: If investors start investing into the economy, especially the stock market, the Fed may be able to stimulate the “Wealth Effect.” According to Karen Dynan and Dean Maki in their study Does Stock Market Wealth matter for Consumption in May 2001, they estimated that an additional dollar of wealth leads households with moderate securities holdings to increase consumption between 5 cents and 15 cents, with the most likely gain in the lower part of this range. (http://bit.ly/ctinqz)
Although speculative, I think the Wealth Effect trade is on and if we see several months of positive returns then we could see a self sustaining cycle of consumption that drives production and investment. This in turn will drive consumption, jobs and income. Shazaam! You now have GDP growth and the Great American Ponzi Scheme is back on.
However there is a problem with this Wealth Effect trade that the Fed is banking on. There is no demand for money, debt, or speculation by the largest segment of job creators, small businesses. Small firms accounted for 65% of the 15 million net new jobs created between 1993 and 2009 (http://bit.ly/5s9XD). Animal Spirits are at the foundation of the Fed Trade and no one really knows if cheap money will drive speculative animal spirits.
On this we will have to wait, watch closely and see.
Some side notes on what else I'm seeing from the Fed Wealth Effect Trade:
Those misinterpreting the inflationary impact of this trade are bidding up many commodities. I don't include gold in this as I think there are other factors that are pushing gold higher beyond the inflation speculation. While QE2 can lead to inflation, the treasury buyback will only directly impact inflation if the demand for higher returns trumps safety.
The real losers of the wealth effect trade are those that live off of interest income of have "cash" in the bank. Let's face it, these rates are going to get worse…if that's possible.
The emerging markets might be the biggest recipient of the speculative trade. If I'm an investor (and I am) I'm buying countries with a growing middle class and less litigation, regulation and taxation. That's not the United States! Unfortunately, if the money inflates the emerging markets for just a few investors then the Wealth Effect is a non-effect.
I hope this clarifies some things for you and explains why Ben Bernanke insists QE2 is not inflationary... It's not, but let's hope it leads to at least a little inflation in the coming year.
My investment themes continue to be:
- Luxury Goods with growing emerging market exposure
- Weak dollar opportunities - exporters
- Select technology - specifically business processing
- Media (Print that is adapting to on-line)
- Rare Earths (again see our Tweets on this)
- Emerging Markets Debt and Equity that is driven by US dollars finding better investment environments
- Mega Cap US companies that are finding great margins with little top line growth, especially exporters.
Tim Phillips, CEO