In September over three evening I presented a trio of lectures regarding why financial pricing has been exuberant as compared to a slow growth economy. The videos of the slow growth economy discussion can be found HERE. And why the exuberant pricing is linked HERE. The third evening was a discussion of the current investment dilemma especially for Baby Boomers with the need for asset accumulation and investment income in these extended financial markets. The video of that discussion was not preserved but I provide the power point outlines here:
A decade has passed since the onset of the Great Recession.
The economic policy response has been Keynesian in the extreme. Fiscal policy, which is debt-financed spending, caused government debt outstanding to double over that time period from $10 Trillion in 2007 to $20 trillion in 2017. Shockingly, it took 217 years to accumulate the first $10 trillion of debt and then only a decade to add another ten trillion.
Monetary policy was also pushed to an extreme, first to reduce policy rates to near zero, which had never been done before, and thereafter to purchase a targeted amount of assets, irrespective of the prices paid. To the extent monetary policy leads to higher private spending levels it is via generating debt-financed spending which supposedly is enticed by the lower costs of borrowing. Regrettably, relatively little of that occurred.
The Keynesian medication to cure the economic ills of the Great Recession was applied in the extreme. It left us with the side-effect of higher levels of debt and hence high debt service relative to income. Less was left over to spend on goods and services, which should have given rise to the next round of income generation. Also, the higher government debt load caused higher taxes to service the interest. About half of the interest was lost to our income stream as it was, and is being paid to foreign owners of US government debt.
This by itself would slow economic growth but the malaise was further accentuated by the ongoing deficit in the balance of trade with the rest of the world. These imbalances during the Great Recession decade ran at approximately -3% per year for goods and services.
Taking all this into account, the fabled fiscal “multiplier” of spending from a dollar of borrowed money has seemingly dwindled from the theoretical textbook version of 5 times the original borrowed and spent amount to less than 1.
As a result, over the decade of the Great Recession, a dollar borrowed and spent by the government generated less than a dollar of total spending and income. The consequence is that we piled on more debt than income to support it, year-by-year during the Great Recession and continue to do so. The US is now at the highest historic debt to income ratio both for government debt alone as well as for combined government and private debt to income.
So for all that extreme debt accumulation, relatively little translated into additional spending that would propel the economy forward and create jobs. The economy’s growth rate was sub-normal at 2% or less — which became known as the “New Normal” when compared to the US historic norm of a 3% to 3.5% growth rate in real terms.
This leads us to the question of the Great Disconnect Series. How did this slow growing economy generate elevated financial prices? It defies the common sense notion that the prices paid in financial markets will reflect the economic environment as it sets a general tone for the growth of corporate earnings and the risks that financial contracts will not be satisfied.
There is a linkage of financial asset pricing in this scenario but it is not the usual story of expansionary fiscal and monetary policy accelerating the economy’s growth rate and causing private parties to assign higher values to stocks and other assets.
In this Great Recession the ultra-expansionary monetary policy impacts were quite different. First, the banking system was still rebuilding its capital (net worth) from Great Recession losses and it was not much of a factor in ramping up bank lending.
Given that, the Fed sought to transmit lending to the private sector via capital markets. This needed to be powered home without a banking sector multiplier by setting quantitative amounts of liquidity to be injected into the capital markets. That is, the Fed buying provided the cash to bid up the prices of virtually all assets prices in global capital markets helped by an unanticipated foreign central bank multiplier that worked in the following way.
When a central bank engages in a large scale asset purchase program, which now goes by the name Quantitative Ease (QE), it typically purchases its own country’s bonds which are paid for by its currency. It is important to note, that those bonds are purchased on the secondary markets (not from the government) but from existing private owners of debt. The sellers are typically investment managers for large financial institutions and that is the key to understand what follows.
The private investment managers were enticed to sell government bonds to the central bank at a gain and the higher market price drives market yields downward. Now with cash in hand, the investment manager is in search of a replacement asset. Typically, the manager seeks other assets in the same asset category which is domestic bonds that indeed expanded rapidly as a result of the demand for like-kind substitutes. But when market prices are bid upward and market yields fall dramatically as they did, the managers begin to seek other categories of replacement assets with greater yield or total return prospects.
In this way the financial buying power spread to domestic equities, preferred stock, pipelines, REITs, etc. Indeed, the search for substitute assets widened to other countries and their financial assets as barriers to foreign capital flows have been eliminated so those markets are in play. This often makes foreign assets interesting replacement assets for the domestic investment manager.
But there was an unintended consequence to this chain of events.
When foreign capital descends on a capital market it first passes through the currency market and causes the currency of the recipient country to appreciate. This is the new dynamic of domestic monetary policy: it causes the recipient country’s currency and financial prices to appreciate.
You might only imagine the rub for the recipient country. The central bank that engaged in the initial QE drives financial spending to the recipient’s financial markets and caused its currency to appreciate and its bond yields to decline. Basically, the initial country in effect conducted expansionary monetary policy in the recipient country’s capital markets and with a more expensive currency is depressing the recipient’s foreign trade balance. After registering its displeasure and alarm, the central bank of the recipient county then felt the need to take actions to offset the foreign capital inflows.
The recipient central bank response typically has been expansionary monetary policy of their own with the logic of reducing its relatively higher interest rate to remove the incentives for foreign capital to be attracted to its capital markets. This intervention by the recipient country central banks leads to a generalized reduction of global interest rate and the reduction in the interest rate differentials. Some of these yield reductions have been extreme with some central banks pushing the market yield on its governments’ bonds to zero and below.
But to offset the impact of the initiator, the central banks of the recipient countries needed a sizable asset purchase as well.
This dynamic, of the initiator and the offsetting asset purchases of the recipient, has created a “global central bank money supply multiplier” from the originating country to most all recipient countries. The total monetary expansion globally has then become some large multiplier of the original monetary expansion of the initiating country.
If one wanted to consider the Fed’s Quantitative ease to be the first mover, the Fed’s asset accumulation over the decade was $3.5 trillion or 430% from its 2007 base. This is wildly larger than its usual annual increase which was near 4% per annum or perhaps, at most, 50% over a decade.
From that base, the other major central banks expanded in large proportions as compared to normal times so that the total asset accumulation by the major central banks, including the Fed, over the decade was plus $12 trillion or 3.4 times the Fed accumulation alone. If one were to also include the Emerging Market central banks, asset purchases would be even greater and in some instances result in the direct purchase of corporate stock including US shares by other central banks.
This is an obvious change in the landscape of what drives financial asset purchases and higher prices. It has become central bank driven and asset prices are largely independent of the strength of the economy and corporate earnings. It is arguable that stock prices and the economic fortunes had become inversely related: A weak economy caused central banks to drive up asset prices.
A further cause of the Great Disconnect of financial prices from the underlying performance of the economy and corporate earnings has been the financial dynamic of globalism. The US has run a current account deficit since goods markets became open starting in the l980s. This has put a dent into US annual GDP growth as noted above.
Ironically, the US current account deficit has an important flip side. The winners of the trade war are typically Asian and some European countries who tend to save considerably more than they are investing domestically. This leaves them with very large annual US dollar earnings allowing them to use their excess savings to acquire assets in capital markets.
The order of magnitude of this excess savings looking for a home in financial markets is presently running at $1.25 trillion per year and eclipses total US savings of about $700 billion per year. That normally is the pool of domestically generated annual purchasing power for US assets.
So the winners of the trade game are purchasing US assets with the trade spoils, contributing enormously to the Great Disconnect.
Now, financial prices have detached from ordinary standards of how much a private party will pay for a stream of earnings with a given discount rate. More fallout includes raised financial P/E ratios, lowered fixed income and real asset yields from familiar benchmark and financial markets on edge when market prices do not feel normal given the economic circumstances.
Adding to the concern, the Fed has recently announced it will unwind its extraordinary monetary accommodation. If foreign central banks also contract then that would be a legitimate concern. I am doubtful that will all occur. If the Fed is successful in raising interest rates, this will attract foreign capital, run up the dollar and do further damage to the US chronic trade deficit and slow the economy even more than it would just from the higher interest rates alone.
We are more likely heading for a long term adjustment to this excess money printing and asset buying, not by selling the assets from the central bank vaults, but by allowing the economy to grow into the higher currency level. I predict the time frame for that is more likely to be a decade of adjustment ahead. Stay tuned to TheSpellmanReport.com to see how this all rolls out. The videos of this series can be found HERE.