With the election results this past week, comes the likelihood of a political stalemate as Republican gains create mixed control of the political process. It does not however, alter the economic landscape which we now face. Charting a course through the landmines in front of us, given the lack of consensus, will require strong leadership from the administration, as well as leaders of both houses. On top of this challenge, we have the Federal Reserve embarking on a grand experiment with quantitative easing. Whether monetary policy has any ability to affect economic growth is a question mark, but the Fed clearly feels that they need to do something.
What a difference a few days make. Last week, we had united Democratic control of both the presidency and Congress. Today we are again divided, with the House under clear Republican control and the Senate pretty much split. We also had a hearty debate over the future of Fed policy, but no clear definition of what they had in store. Now, we have an announced program of additional quantitative easing to the tune of $75 billion per month for the next 9 months, or $600 billion in sum.
The markets are reacting positively to all of this news, moving higher since the Fed’s announcement. We think caution is the most prudent reaction, because in truth, no one from the Fed to Mr. Obama to Mr. Boehner knows what this will all mean. Mr. Obama was out in force Monday, warning that if voters elected a Republican congress that his initiatives would be compromised. We can argue which initiatives since little was being done on a policy front, but the message this morning is much more conciliatory and one focused on joint resolution toward solving the countries problems. If stalemate is the direction of fiscal policy, we should expect more of the kind of stagnant growth we have had for the past year. We are still in the early stages of the deleveraging process, and risk appetite is low. A divided government is unlikely to push through anything new to change the landscape. Although we might be better off without new Cash for Clunkers or First Time Homebuyers program. Regarding Bush tax cuts, maybe we see a compromise with the threshold raised to $500,000. But not exactly game changing policy. Job creation initiatives, while critically important for the country are likely to be uninspired and not far reaching in their effect. On the positive side, at least for high net worth investors, the redistribution of wealth focus of administration policies will likely be stymied. Growing the pie has always been a better means toward a solution rather than arguing about how big the pieces should be. Make no mistake, redistribution is long overdue, and will still be an issue, but it will be much more difficult to achieve.
One initiative, which has to date been completely ineffective, but is of critical importance to the economy, is dealing with the foreclosure crisis. Foreclosures threaten the housing market in many ways including the ability of homeowners to service their debt, the ability for title to be transferred cleanly, and the ongoing solvency of lenders. This is a mess of colossal proportions which needs clear leadership on the part of legislators to help untangle. This mess needs to be untangled not just for the benefit of the banks, but for the millions of underwater borrowers. A huge percentage of homeowners are faced with mortgage balances in excess of their home value. These homeowners are frozen in place. They can’t take new jobs, they can’t move to a new home, they’re stuck. The chart below, from the San Francisco Fed, shows the share of mortgages with principal balances in excess of the home value. It will no doubt take time, and significant political will, but unlocking the housing market will be a crucial step toward restoring balance in the economy.
On the QE2 front, who knows? Certainly arguments can be made supporting the need for additional liquidity in the economy. They can also be made that additional liquidity is likely to do more harm than good. Paul Tudor Jones II did a study that suggested that QE2 was largely a waste of time, and that we would be far better served more aggressively pursuing a fair currency valuation with China. Obviously, the problem with that is the Fed can’t do anything about China; they can only print more dollars. We can only hope that the dollars being printed can find some velocity when they hit the market rather than languishing on the banks’ and corporations’ balance sheets. Mr. Bernanke noted in a speech the other day that the Fed is concerned with the levels of unemployment and inflation. He explained, “The Federal Reserve’s objectives – its dual mandate, set by Congress – are to promote a high level of employment and low, stable inflation. Unfortunately, the job market remains quite weak; the national unemployment rate is nearly 10 percent.” Consequently, the Fed decided further support was needed. He further went on to explain that in purchasing longer terms securities as the Fed did in 2008 and 2009, the Fed’s goal is to produce lower long term borrowing rates. In doing so, the Fed hopes to produce lower mortgage rates, which in theory, would make housing more affordable. Mr. Bernanke has declared the QE2 moves already a success because “This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action.” There are, obviously, flaws to this logic, most prominently in the different circumstances between the economic environment prior to the Fed’s previous bout of QE and now. Then, the markets were frozen, and the lack of liquidity threatened to push the financial markets into complete chaos. But, as can be seen from the chart below much of that liquidity never made it to the broad economy, rather it sits as excess reserves on the balance sheets of the banking system.
Of the $1.7 trillion the Fed added to the system, $1 trillion is resting quietly. Why then should we expect a different fate for the additional $600 billion the Fed has planned. As I mentioned, in the previous experience the Fed was dealing with a liquidity crisis stemming from a collapse in confidence about credit quality. The confidence issues are arguably still with us, but as can be seen, liquidity is not the problem. Consequently, the positive stimulus to the economy is likely going to be muted.
OK, there is a lot to hope for in the fed’s actions, unfortunately most of it is for limited damage rather than potential upside. There are several candidates for potential damage through the Fed’s action. First, that it creates a weaker dollar. A weaker dollar is a mixed blessing. On one hand, it makes American goods and services more attractive overseas, which stimulates US growth at the expense of our trading partners. On the other hand, it lowers our standard of living by lowering the purchasing power of the dollar. Perhaps more importantly however, is the question of against whose currency are we devaluing. Japan and the UK are pursuing similar tactics to try and weaken their currencies, China has all but declared their peg is here to stay, which leaves the Euro. The dollar has depreciated against the Euro by over 10% in the past few months as QE has been debated. While this may be good for US exports, it is disastrous for the debt burdened PIIGS nations. Ireland in particular is grappling with a loss of export competitiveness, and its austerity plans are doomed to failure if export growth suffers.
Any significant improvement in the currency problem with China will take courage and leadership from the administration. Let’s hope that the wakeup call of a disastrous showing at the midterm elections will focus the administration on action rather than rhetoric.
From an investment standpoint, I think this means caution is key. Equities will move with the economy, which should be lackluster at best. Interest rates will probably not move much, while the dollar should remain weak. Well diversified portfolios emphasizing growth areas like technology, emerging markets, even Germany will be likely winners. Look for more upward pressure on precious metals, as well as commodities in general. We have been in a risk on mode since the start of September, and we may be due for a correction.
But, as I said early on, no one including the Fed knows what all this means, so stay light on your feet.