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Don't fight the Fed (and the ECB and the Banco Central do Brasil and the People's Bank of China) is good advice most of the time--here's why it won't work out quite so well in 2012
01/24/2012 8:30 am EST
Not always, of course, since the Fed itself can get overwhelmed by a global financial crisis here or a euro debt crisis there that can lead to a situation where the real economy doesn’t respond to the Fed’s monetary prodding.
But the saying is true frequently enough so that aligning your investment strategy with Federal Reserve policy makes sense most of the time.
So what about when it isn’t just the Federal Reserve that’s lowering interest rates and pumping money into U.S. economy, but the European Central Bank pursuing the same course in Europe, and the Banco Central do Brasil in Brazil, and, just beginning but accelerating, the People’s Bank of China in China?
Is this flood of cash enough, by itself, to push stocks higher in 2012—no matter what the real global economy is doing? Traders and investors have started 2012 by answering that question with an emphatic Yes. January’s rally in U.S., European, and emerging market stocks is based on a belief that the huge wave of cash that the world’s central banks have unleashed—or are about to unleash—on global economies will send stock markets higher and set economies to growing faster.
Let me give you two reasons why the global version of Don’t fight the Fed won’t work out quite as well as the current optimism suggests this time around. I can see two problems. One is called Pushing on a String. The second is called Inflating Asset Bubbles.
If the world’s central banks can’t pull off a global rescue this time, it won’t be because they haven’t tried. They’re thrown a lot of money—I mean A LOT of money at the global economy.
For the week ended January 18, 2012, the Fed’s balance sheet stood at $2.96 trillion. That’s up $488 billion from the week ended January 19, 2011. The increase is substantially due to the Fed’s purchase of $576 billion in Treasuries. (The Fed bought Treasuries while selling mortgage-backed securities resulting in the $488 billion net increase.) That’s $488 billion in cash created by the Fed and pumped into the $14.7 trillion U.S. economy in the last year.
In my book $488 billion is a lot of money but it is less than the Fed’s $600 billion of buying of Treasuries as a result of the second program of quantitative easing (QE2) announced in November 2010 or the $1.4 trillion in purchases of mortgage-backed securities and Treasuries in the first quantitative easing that began in 2008.
Officially the European Central Bank has steadfastly refused to follow in the Fed’s footsteps and pursue its own program of quantitative easing. But that doesn’t mean the ECB hasn’t been pumping money into European economies under some other name. Because of its program of buying Italian, Spanish and other stressed sovereign debt and because of the loans that the central bank has extended to European banks—most recently 489 billion euros ($629 billion) in three-year loans in December 2011—the assets on the European Central Bank’s balance sheet have climbed to 2.68 trillion euros ($3.4 trillion) in the week that ended on January 13 from 1.89 trillion euros in June 2011.
The European Central Bank has been creating money at a pace that leaves the U.S. Federal Reserve in the dust.
Of course, not all this bond buying by the European Central Bank results in additions to the money supply. The bank works to cancel out additions to the money supply from buying bonds by issuing bonds that it sells to European banks—a process called sterilization. When a bank buys one of those bonds or otherwise parks money with the central bank, it withdraws money from the markets.
There’s a limit to how much bond buying the European Central bank can sterilize. The Netherland’s banking group Rabobank calculates that the central bank can mop up about 300 billion euros—and that at the rate of bond buying the bank has conducted since August, it will hit that limit some time in January. Add in the huge bank lending in December and a second likely round of three-year loans to banks from the central bank in late February or early March and investors are looking at a de facto program of quantitative easing despite all the protests from European Central Bank president Mario Draghi.
In Brazil money supply growth dropped in the first half of 2011 as the Banco Central do Brasil raised interest rates and tightened monetary policy to fight inflation that threatened to overwhelm the 6.5% top of the bank’s target range. Growth in the money supply that had raced to 17.6% year-to-year growth in January 2011 and to 18.5% in February gradually slowed to a low of 11.5% in November. But the bank reversed policy in August and it now looks like, with the typical lag, money supply growth is headed up again. It hit 12% year-to-year in December 2011.
And then, of course, there’s China. The story in that economy mirrors that in Brazil—with a delay of about nine to twelve months. China reversed its policy of fighting inflation by raising the bank reserve requirements—possible now that inflation has fallen to a 4.1% annual rate in China—but it hasn’t yet moved to cut actual interest rates as Brazil started to do in August 2011. With economic growth continuing to slow in China, economists (and the stock market) anticipate the People’s Bank of China will cut interest rates in June or July.
The lack of an actual interest rate cut hasn’t, however, kept growth in the money supply from starting to trend upwards again. In December the M2 money supply grew at a 13.6% annual rate, well above the 12.9% economists had expected. (In addition, it looks like Beijing has given banks permission to increase their new bank lending. New loans in December totaled 640.5 billion yuan ($101 billion), again well ahead of economists’ projections.)
The goal of all this global monetary stimulus is to first, generate faster economic growth, and second, to prop up the financial markets. Which goal comes first and which second varies widely from economy to economy. The U.S. Federal Reserve seems to put growth ahead of financial markets. In China the People’s Bank is sending very clear signals, in a way that the Fed isn’t, that stocks have fallen far enough. In Europe, the goal is to stabilize financial markets with the hope that economic growth will follow.
The way it’s supposed to work is that the promise of support for the financial markets expressed in terms of lower interest rates and looser monetary policy will work to stabilize the financial markets and then stimulate the economy—with money flowing into the real economy from those more confident financial markets too.
But it doesn’t always work like that. And two of the major ways it doesn’t work are in operation right now. These two problems will determine exactly how all the money that the world’s central banks at throwing at the global economy will work through the global economy over the next nine to 12 months.
First, there’s Pushing on a String.
Sometimes, like now in Europe, the financial markets are so fearful that they aren’t willing to put the money sent their way by the central bank to work. Instead they just leave it on deposit at the central bank. That’s what happened in the early and middle stages of the Federal Reserve’s programs of quantitative easing (and what is only now showing signs of turning into new lending) and what is happening now in Europe. European banks aren’t putting much of the money they’ve borrowed from the European Central Bank to work in either the financial markets or the real economy. European banks may have borrowed 489 billion euros in December but last week the amount banks have on deposit with the European Central Bank rose to a new record at 528 billion euros ($628 billion) even though deposits at the ECB are earning just 0.25% right now and inflation in the EuroZone is running at a 2.7% annual rate (as of December.) Banks are really, really afraid of lending this money to anyone, even each other, and even for as short a period as overnight.
The good news is that the huge infusion of cash from the European Central Bank has reduced fears that Europe’s banks are going to hit a financing crisis in January. The 489 billion euros European banks borrowed in December will meet 63% of the banks’ refinancing needs in 2012, Goldman Sachs calculates. The next round of loans scheduled for late February or early March should put Europe’s banks within reach of their refinancing needs for the year. (There’s more good news from European banks. The region’s banks have to submit a plan by the end of the month for how they will reach the capital ratios required by the European Banking Authority by June. It looks like only one or two significant banks will face a problem presenting a credible plan by that deadline.)
Crisis averted. Well, banking crisis averted anyway.
You’ll note that if banks are stockpiling cash at the European Central Bank, they aren’t using it to buy the sovereign debt of Italy and Spain—that’s a job that still seems to fall to the central bank—and they sure aren’t lending it to create growth in the EuroZone economy. The banking crisis may have moved from a boil to a simmer but this “solution” hasn’t addressed the sovereign debt crisis. That just looks set to return with its same old energy when the gathering recession makes it impossible for Italy, Spain, and France to meet their targets for reducing their budget deficits without more spending cuts. And, of course, there’s still Greece, which is likely to see whatever deal it strikes with its bondholders go up in smoke when a deep recession in Greece makes it clear that even a 60% reduction in what Greece owes isn’t enough to bring Greek debt down to sustainable levels.
The net financing needs of Italy add Spain are actually comparatively low in January. February is a much stiffer test. I think the odds are that Europe—and with it the world financial markets—will swing back to fear—and the risk-off trade—from current optimism—and the risk-on trade—sometime in February or March.
Second, there’s Inflating Asset Bubbles.
Sometimes, and this is the big risk in China now, the money from the central bank goes into financial assets such as real estate or the stock markets rather than into loans that increase the productive capacity of the real economy. In other words, rather than leading to a healthy increase in economic activity, the monetary stimulus produces an asset bubble.
This is the danger that the People’s Bank of China has been trying to tackle—without crashing China’s economy—for more than the last year. The Chinese economy is seriously out of balance with consumer spending accounting for just 35% of so of economic activity. The rest of the economy is built upon productive—and unproductive—investment in fixed assets such as shopping centers, airports, and luxury residential complexes. This investment has been built on cheap money that has been available to good and bad projects alike.
In many ways this frenzy of investment in fixed assets wasn’t too different from the U.S. housing bubble, which too was built on cheap money available without too many questions asked from U.S. mortgage lenders.
But it’s important to recognize the China seems to be on a course to attempt to re-stimulate its economy by loosening its monetary policy before it has washed out any significant part of the excesses of the fixed asset bubble.
Contrast how far prices have fallen in the U.S. against how far they’ve fallen in China. In Tampa, Florida, one of the hardest hit of U.S. cities, home values have dropped by 53% since their peak. That has wiped out $135 billion in wealth in the city.
In China, in contrast, although you can find hard hit sector—prices in the luxury market in Shanghai are down 30% from their peak—on a citywide basis the losses in even the hottest markets are relatively modest. In Wenzhou, a city hit particularly hard by the credit squeeze on smaller companies, for example, prices are down 6.9% from a year earlier as of December.
A 6.9% decline isn’t a shakeout. Or a market reset. Or anything like a deterrent to a renewed asset bubble. And now there’s talk that the government will move soon to remove some of the restrictions on the development sector because the sector has suffered enough.
The re-stimulation of the Chinese economy and the expansion of the money supply that the Chinese government now seems to have begun will indeed produce the kind of stock market rally and economic acceleration that Beijing wants.
In the short run.
In the longer run—say way off in 2013—the People’s Bank risks re-inflating the asset bubble it worked so hard to deflate in 2011 and to make the Chinese economy even more unbalanced and even more dependent on fixed asset investment for its growth.
If you enjoyed the extraordinary volatility of 2011, you should love 2012. I think we’ve got a good chance of seeing the beginning of 2012 rally run for weeks yet, taking the market into really over-extended territory, before it swings back to fear as the euro debt crisis demonstrates that even $1 trillion in lending by the European Central Bank hasn’t fixed the problem. The U.S. Standard & Poor’s has gained 9% from the December 19 mid-month low as of January 20. Let’s say that the rally finally tacks on another 65 points to take its total gain to 15% at 1385 on the S&P 500.
And then we get a return of fear when investors read the fine print in the
Greek deal with bond holders, or when enough bond holders refuse to buy into the deal and trigger credit default swaps on Greek debt, or when a worsening inflation pushes Italy and Spain into larger budget deficits, or when a new French president threatens to blow up France’s partnership in austerity with Germany, or when the International Monetary Fund refuses to flush any more cash away in propping up Greece. Any of that is enough to push the market back into a risk-off mode that would erase the 15% gain from mid-December. A 15% decline at this point wouldn’t be horrendously painful except for investors who piled in at the end of the December-January-maybe February rally.
That correction would be enough to set us up for another 15% rally—and if my Rule of 2 holds a 15% rally in U.S. would be accompanied by a 30% rally in the stocks of China and other emerging markets—when the People’s Bank of China joins the interest rate cut club in June or July or so.
A Chinese rally might be enough to take us all the way through 2012—which would make the second half of 2012 a pretty good six months—before the bills for all this monetary expansion start to come due in 2013.
At some point the Federal Reserve and the European Central Bank will have to start reducing the size of their balance sheets, at some point the U.S. will have to start serious reductions in its own budget deficit, and at some point China will have to face up to another asset bubble.
My bet is that 2013 will be that point. In the meantime, 2012 is shaping up as a very interesting year.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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