(James Saft is a Reuters columnist. The opinions expressed are
his own)
By James Saft
April 5 (Reuters) – So now we will finally get to see if the
stock market can stand on its own two feet.
The Federal Reserve signaled this week that an additional
round of extraordinary help such as quantitative easing is
probably not in our immediate future, and so far risk assets
like stocks are not liking it one little bit.
Minutes from the Fed’s March meeting released on Tuesday
showed a more constructive tone about the economy and,
crucially, revealed that only two members of the policy-setting
open market committee saw the case for more monetary stimulus.
That’s a sharp change from the month before when ‘a number’ of
members believed current conditions could justify additional
easing. That slight chill breeze you felt was from the door
slamming on any move in that direction at the Fed’s April
meeting, implying that only a relapse in the economy will bring
more help.
Risk markets, such as equities, have duly sold off since the
news, as investors made new calculations about how much,
exactly, they trust the strength of the economic recovery.
“Equities have been in a temporary sweet spot where
investors have been factoring in a self-sustaining U.S. economic
recovery while also anticipating the imminent institution of
QE3. This is a contradiction. If the economy were indeed as
strong as they say, we wouldn’t need QE3,” Charlie Minter of
fund manager Comstock Partners wrote in a note to clients.
We are clearly past that sweet spot.
There are two significant questions for markets if in fact
the Federal Reserve is not going to be lending any more aid.
The first, about the strength of the economy, is significant
but in some ways self-limiting. If the recovery disappoints, the
Fed will be that much more likely to twist the yield curve or
buy more bonds. This is what is known as a put option, and it is
firmly in place. Equity holders invest at least in part based on
faith that the Fed had decided not to let them lose (too much)
money.
The implications of this mind-set for how capital is
allocated are troubling. Just look at Groupon, which was able to
pull off a massive IPO despite a fragile business plan and, as
has later been shown, inadequate corporate controls. That kind
of thing happens far more often when people think they are
playing with backing from the house.
STRENGTHS AND WEAKNESSES
The second issue is how well equity markets will be able to
get along in the absence of Fed support? What happens if we
simply inch along, suffering low growth while households and
governments slowly repair their balance sheets?
In the absence of further Federal Reserve easing you have to
ask yourself: do I want to buy equities at an all-time peak of
earnings as a share of GDP? Really a similar question can be
asked of all riskier corporate assets. It is unclear how
earnings will be sustained given poor wage growth and the need
to save. Data last week showed that U.S. consumer spending rose
a better-than-expected 0.8 percent in February even as earnings
only increased by 0.2 percent. Consumers found the money by
cutting back on a luxury: savings, which fell to 3.7 percent,
the lowest level in 30 months. If your milk cow is producing
more in milk than she consumes in nutrition you have a
sustainability problem, although one which seems pleasant as
long as it lasts.
Market reliance on the promise of accommodative policy is
both a measure of the success of the Fed’s policy and an
illustration of its inherent, and central, weakness. The Fed has
helped the economy by floating asset prices higher on a sea of
liquidity. That’s made people feel better and spend more. It has
also transferred some money from savers, who lose out on
interest, to borrowers, who are probably more likely to
circulate the extra cash then are their lenders.
The weakness, sadly, is that the accommodation so often
produces more of the kinds of mal-investment that makes the
booms almost equally as destructive, on a long-term view, as the
busts. If the Fed didn’t ease after the Long-term Capital
Management debacle the dotcom bubble wouldn’t have been as bad,
and if it hadn’t eased as much after the dotcom bust then the
housing bubble wouldn’t have grown so distended.
And, as just the removal of the promise of more Fed aid has
walloped the market, imagine what might happen if they actually
began to liquidate their portfolio? The market and the Fed may
have cornered each other, leaving neither party an obvious route
of escape.
(Editing by James Dalgleish)
(At the time of publication, Reuters columnist James Saft did
not own any direct investments in securities mentioned in this
article. He may be an owner indirectly as an investor in a fund.
For previous columns by James Saft, click on
)
