Why the Fed Loves Anacott Steel (…and, Amazon, and Apple, and Tesla, and Netflix)
“Psst….C-Street. Over here.”
“Who’s there? Sugar High, that you?”
“Keep your voice down. You didn’t hear it from me, but the fix is in. Uncle Gordon wants you to know Blue Horseshoe loves Anacott Steel.”
Remember that infamous line from the 1987 movie “Wall Street?”
In the scene, the young trader Bud Fox passes along a hot stock tip from a mysterious investor by simply repeating the line “Blue Horseshoe loves Anacott Steel.”
Immediately, Anacott Steel’s stock price trades higher as word gets out and investors start buying up shares.
Hollywood sure knows how to tell a good story. And, heck, who wouldn’t have wanted to wake up long shares of Anacott Steel?
But even in Hollywood, every story doesn’t have a fairytale ending. And neither, does real life. Just don’t tell that to Uncle Jerome.
The Fed’s Blind Love For Wall Street
In the Fed’s Ivory Tower, there is only one acceptable reality, Disneyland. So, Blue Horseshoe really loves Anacott Steel; and Amazon, Apple, and Tesla; and Netflix, Walmart and Macy’s; oh, and Carnival and Boeing and American Airlines. And of course, bonds, bonds, and more bonds.
Asset prices are “THE” unspoken tool of monetary policy and can never be allowed to fall in price. Valuation be damned. Risk be damned. Solvency be damned. The consequences would be catastrophic.
Just close your eyes and buy, buy, buy. If you are taking a ride on the Fed’s Magic Carpet, you are probably pretty happy and don’t want to hear from me. You also believe 2+2=5 and call me a pessimist because I insist the answer is 4. I am more like one of the Brothers Grimm; a storyteller whose tales come with a cautionary moral. I may be the boy who cried wolf, but let’s face it, Peter certainly wished someone listened to his last cry for help.
I have long argued that Federal Reserve policies have been, shall we politely say, off the mark. I can even pinpoint the year of my epiphany. It came when Ali G (my nickname for Alan Greenspan–the first Genie of Monetary Policy,) issued those now infamous words, “Irrational Exuberance.”
It was 1996 and the overpriced market reeled at the sacrilege, short-lived though it was. It was in many ways the beginning of the end for restrictive monetary policy, Custer’s Last Stand, a monetary Waterloo. From that point on, the floodgates have been open. Monetary policy has been on a one-way trip to Easy Street: low, lower, and even ultra-low rates;
promises of transparency and predictability that beg for excess risk-taking; and, purchase programs designed to eliminate risk as a metric in valuing asset prices.
Ever since, woe be the Fed Chair who thought or acted otherwise! But at what cost? Although it may not feel this way, policy that is asymmetrically biased towards
accommodation has effectively distorted and destabilized the financial and economic system.
But to what effect?
Massive, Major Global Indebtedness
To begin with, these policies are ostensibly designed to generate growth and prosperity. But look around the world, the lowest ambient interest rates in memory have resulted in decades of anemic growth. What little growth we have seen is just as likely a result of the staggering increase in government debt in virtually every country around the globe; a debt load that has been encouraged and exaggerated by central bank policies.
I received a note from a friend yesterday pointing out that the level of global indebtedness will reach $277 Trillion by year-end, about 365% of global GDP. I will save you all the effort, that equates to about $35,000 per human. I won’t get into it now, but I have long
argued that standard economic theory is wrong when rates drop towards the zero lower bound and asset purchase policies join the monetary stage. I challenge anyone to argue that such economic mediocrity presents a strong argument to the contrary.
At various points in time, the Fed’s stance on monetary policy and the other tools they have implemented to control the economy have caused effective leverage to permeate the system, asset values in a variety of markets to become ever more expensive and disconnected from traditional measures of value, and systematically minimized risk as an element of financial decision-making and capital allocation.
Suppressed, but not eliminated.
As a result, we have seen tech stocks soar to the stratosphere and then collapse; we have seen housing markets giggle in glee before laying waste to the American economy; we have seen sophisticated, leverage strategies run through arcane markets before causing the world to tremble on the brink of collapse. We have seen bubble after bubble grow and burst. And yes, we have seen the Fed ride to rescue declaring that excess risk should never be allowed to ruin a party and challenging anyone willing to think otherwise. Never let a punchbowl run dry.
The Enemy of the Rational
It has gone by various names, moral hazard, the Greenspan, Bernanke and Yellen “puts.” Just close your eyes and drink the Kool-Aid. Based on the impact of their policies, I like to call the Fed the “Enemy of the Rational.”
And yes, based on your stock portfolio and 401K, most of you are probably rolling your eyes. As this electronic stylus is put to the technological papyrus, the footprints of the Powell Fed are everywhere.
Despite one of the worst economic catastrophes in history, equity markets are at or near records in price, and certainly in valuation; the nation’s debt levels are rising at an unprecedented speed at virtually all levels of government and yet rates across the entire yield curve are constrained to remain at record lows; corporate spreads, a measure of the ability to service debt are at historically tight levels (included in this mix are near bankrupt zombie businesses that are, for all intents and purposes bankrupt.)
So, what’s the problem you may ask? The problem is that trying to divorce everything from reality does not seem likely to end well. Unfortunately, I know you can’t defy the laws of physics and pigs definitely can’t fly. Equity valuations are almost twice historical norms and this, even pre-Covid, followed several years of lackluster earnings. Yes, some of this lies in the ever-growing market capitalization of a handful of companies who trade at stratospheric multiples. Unfortunately, valuation metrics are pretty much guaranteed to revert to more traditional levels and the process could well overshoot significantly.
Keep in mind some of the exposures we are looking at. For example, a significant portion of retirement assets are invested in equities. The economic impact would be severe and probably compound the problem. It is the capitalist’s Sword of Damocles
As I noted, interest rates are at historically low levels. Yes, this is due to the economic environment and what the Fed perceives as unacceptably low inflation. And, yes, this plays a role in pushing market levels higher. In fact, the one place the Fed has succeeded in creating inflation is equity prices, but don’t tell them.
Nevertheless, we have been living this story since the first digit of the Millennium changed. In the meantime, we are living on borrowed money and, probably, borrowed time. The risk and consequences of a return to more traditional levels of yield could be catastrophic. At current debt levels, every 1% increase in ambient borrowing costs will increase the Federal deficit by $250 Billion per annum. I expect Treasury borrowing to double in the next decade or so; you can imagine the potential cost. It only gets worse from there. And this is just the Federal debt.
Should you listen to me? Perhaps. Most of you probably love a good horror flick. What I truly believe is that we have done significant damage to our economic superstructure. Is it likely to result in more volatility over the long-term? I think that is guaranteed. Will stock prices drop a lot? At some point, unquestionably. Will the Fed intervene to try to stem the bleeding? For sure. But will it work? That is the question. At some point, the answer will be no. Is the next time the unlucky charm? Possibly. If you look at the Fed’s response to each preceding crisis over the last several decades, the amount of “ammunition” required has increased each time.
The next time will be no different.
My guess is that the next crisis will require the Fed to acquire a sizable portion of the US equity market to stop the hemorrhaging. Will it be enough? Who knows. We have become addicted to Fed heroin and cannot live without it. Let’s hope we have not already killed the patient.