QE Can Only End One Way
This article was written by Adam English and originally published at OutsiderClub.com
Here we are, at the last day of a year that has defied all the odds.
The Dow and S&P 500 have posted out-sized gains in spite of what can generously be called tepid economic growth.
The regional governors and economists over at the Fed are undoubtedly enjoying the afterglow of their resounding success with the latest tapering announcement a couple weeks ago.
Investors, banks, and policymakers are most likely enjoying their holiday vacations while planning what to do with the fat bonus checks that are en route.
Of course, the disenfranchised poor are worse off than ever. Millions just lost their only source of money for food, and millions more are stuck in a downward spiral of debt traps and part-time work.
But these downtrodden masses don’t have any money to pour into the markets to boost gains. To the market and policymakers, they were only included when it came time to package self-enriching schemes in populist rhetoric.
Tomorrow, it’ll be time to start thinking about the next set of yearly returns, and none of the big players are worried.
Next year promises more of the same in their eyes. The Easy Money Battle of 2013 was won.
Unfortunately, many of them don’t see that it was a Pyrrhic victory. The cost is already too high to succeed in the end.
A Terrible Record
Clearly, the temptation in the market is to take the latest Fed announcement and ensuing rally as a call to double down on wildly bullish sentiment as 2014 starts.
I have little doubt that we’ll see this shaken out of the market sometime in the first half of next year. When you take a look at the Fed’s record on tapering announcements, it doesn’t look good.
By my count it has one win, one tie, and five losses.
The first mention of winding down QE programs came back on May 22nd. Hints of a reduction in stimulus measures in the Federal Open Market Committee (FOMC) minutes caused an immediate 1% drop in the Dow and a volatility spike.
On June 19th, there were no taper hints. Ben learned his lesson. However, the markets still knew it was imminent. The Dow closed down 1.3% while the S&P 500 fell 1.4%.
July’s announcement caused a 0.7% drop for the Dow and another volatility spike.
September was an aberration and a virtual tie because the government shutdown distracted everyone.
October saw no date set for a taper. There was some volatility and a slight dip in the markets for the afternoon.
Then on December 18th, the November FOMC minutes were released, causing a 290-point gain in the Dow and exuberant front-page headlines.
It’s clear the Fed’s record is pretty abysmal, filled with fumbles and confusion. But the trend appears to suggest that the markets have made peace with the idea. At least on the surface.
So what changed over time?
The overall tone of the statements and Bernanke’s remarks suggests that the Fed is still very “dovish” and willing to err on the side of caution. That helped, but it isn’t enough on its own.
In reality, the folks at the Fed spent the last half-year scratching their heads trying to figure out how to make a taper palatable to the markets. The result was a massive concession in how the taper would proceed.
The Fed now intends to hold interest rates at historic lows past the point when the unemployment rate falls to 6%. This is a large adjustment — over 1% lower than in earlier statements.
The flow of easy money into corporations has been extended through most — if not all — of 2014.
Wall Street could take or leave the $10 billion per month trimmed from bond purchases as long as the virtually free money guaranteed by low interest rates keeps flowing with no real end in sight.
Corporate Cash Cow
The rate banks pay on overnight loans, or the federal funds rate, was at 4.5% in late 2007. As the recession bit into the economy, it was slashed to 0.25% and has stayed there ever since.
Long-term rates quickly followed suit and fell from over 5% in 2007 to record lows near 1.5% in the second half of 2012. Since the beginning of 2013, 10-year Treasuries have crept back to 3%, still well below normal levels.
Corporations capitalized on the low interest rates by issuing $18.2 trillion of bonds worldwide since 2008. Currently outstanding corporate debt has risen over 50% to $9.6 trillion over the same period.
Many of these loans were simply created to push corporate debt obligations out as far as possible. Instead of using them to create growth, it just delays loans from maturing until 2017, 2018, or 2019.
Interest paid by U.S. businesses peaked in 2007 at $2.83 trillion, and then it fell sharply to $1.34 trillion in 2011, the last year data is available from the St. Louis Fed.
At the end of the recession in 2009, companies listed on the S&P 500 paid roughly $4 a share in interest per quarter. Now, they are paying around $1.50 a share in interest on average.
These dramatically lowered interest rates account for an estimated 50% of total profit growth, not including indirect savings from lower leasing or rental costs.
Stock buybacks using debt-fueled funding have also been very popular and have provided quick boosts to stock prices and created earnings per share increases that are not based on growth or performance.
In fact, earnings have tripled since 2000, back when the economy was in far better shape.
The Fed has created a massive boom for corporate America through historically cheap debt and that is what the markets wanted to keep most of all. The Fed capitulated and the markets rejoiced.
Meanwhile, the EBITDA margin (earnings before interest, tax, depreciation, and amortization divided by total revenue) operating profitability peaked at 25.6% in late 2007 and recently fell below 20%.
Of course, this can’t possibly last in perpetuity. Debt will become more expensive, and payments will eat into profit margins.
We have not seen the last time the Fed will disappoint markets, create a volatility spike, and ultimately drive losses for investors.
Still On Shaky Ground
Going forward, the Fed and anyone in the market have a handful of things to remember that should temper the irrational exuberance we’re seeing in the market.
First, Fed policy is overly dependent on creating artificially high asset prices to alter economic behavior for investors and companies. The economy has not substantially improved enough to subsist on meaningful corporate growth, consumer spending, or housing sales.
Secondly, the impact of easy money through abnormally low interest rates is hard to quantify, especially in the short-term. Bullish markets that overextend their gains on very uncertain stimulus will inevitably see very disruptive corrections.
Finally, the Fed is not the only central bank that is actively pushing asset prices higher and fighting to maintain economic and financial stability. China, Japan, and Europe are all using extraordinary measures to intervene.
If any of these major economies see demand that is too weak, experience corporate or bank liquidity and credit crunches, or fail to juggle sovereign debt, the domestic economy will take the full brunt of the blow.
The Fed has fully deployed all of its tools to spur growth while expanding its balance sheet by about $4 trillion with little real effect. Economists put the total return for the Fed’s intervention as low as 0.25% of GDP.
As we close the books on 2013 with large gains for the markets and on a high-note for the Fed, we know what to expect for now. The Fed will have to continue pushing you to put your wealth into the market, and the big players will keep holding the rallying market hostage as they rake in massive profits.
However, the cost has been too high. The Fed may push the day of reckoning well into 2014 or beyond, but there is no way around the correction and burden it will place on us all.