You might say the current stock market rally began on August 27th at Jackson Hole Wyoming. Fed Chairman Ben Bernanke alerted the markets that inflation wasn’t at a level that was conducive to a healthy economy in the long run.
“Recently, inflation has declined to a level that is slightly below that which the FOMC participants view as most conducive to a healthy economy in the long run.”
Translation, more inflation is needed. The markets initially slid on the news, but that didn’t last long. The markets figured it out and the reflation trade which had begun to languish was put back on. Stocks, bonds, and commodities are all up since that speech giving us one of the best September’s in recent memory.
To reemphasize that more inflation is needed the latest FOMC statement from September reiterated this very same point. Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.
Nothing excites and gets the markets juices flowing again then the prospect for more cheap money. As I wrote recently in “Money Never Sleeps’” when money is created it doesn’t remain idle, it flows to where it is treated best. The Fed is reminding us that it intends to keep rates low for a considerable time. Zero returns have become unpalatable to investors. Prospecting for returns has now become a matter of investment survival.
We’ve tried economic stimulus and that didn’t work. With trillion dollar deficits for as far as the eye can see there doesn’t seem to be the stomach for adding any further stimulus. GDP rates are slowing down to around the 1% level. Job creation is falling and the unemployment rate is rising. Washington politicians are now in a panic mode and are now worried about their own unemployment come this November.
With stimulus off the table this leaves only the Federal Reserve to do the job of bailing out a faltering economy until after the November elections. The current low economic growth rate raises the risk of further weakening and the possibility of dipping into another recession. Given the political paralysis more intervention is needed which leads us back to Mr. Bernanke’s recent speeches. The central bank will have to carry the ball. Bernanke has shifted the debate from worries over economic growth to inflation. So the Fed is prepping the markets for the next injection of monetary steroids.
The markets have begun to salivate in anticipation of trillions of new dollars flowing into financial markets. All asset classes have begun to rise in unison: stocks, bonds, commodities and especially precious metals.
However, the next question is how much will be enough? Apparently, the last $1.7 trillion didn’t do the job. Will $2, $3 or $4 trillion get the job done? If the money is created where will it go? My guess is that it will flow where it always goes first which is the financial system. The last round of monetary injections pulled stocks out of the abyss and turned double-digit losses into double-digit gains for 2009. Maybe we’ll see a repeat performance.
Source: Stockcharts.com
We know from recent experience the last round of newly created money ended up on bank balance sheets. Banks were reluctant to lend and borrowers were reluctant to borrow. Instead of lending, banks played the carry trade preferring to invest in risk free treasuries as they sought to rebuild their impaired balance sheets.
What I believe Bernanke would like to see is another asset bubble, an area that he has plenty of expertise. The last monetary injections inflated the stock market but did very little for the housing market. Before consumers are ready to borrow again they will only do so if they see an improvement in their own balance sheet. Housing prices need to stabilize, stock, bond, and asset prices need to rise. Only when asset prices stabilize and begin rising again will investors/consumers feel secure enough to take on more debt.
The reason banks have been reluctant to lend is that asset prices have been falling. Falling asset prices erode the collateral backing loans. We already know from recent and past history that newly created money first flows into the financial markets. With near zero percent interest rates the Fed is forcing investors to go out on the risk scale. Rates have gotten so low recently that corporations have been able to squeeze concessions from investors forcing bondholders to accept the lowest rates on bonds in more than half a century. Money has been pouring into bond funds as investors eager for yield and safety have been using bond funds as a proxy for money markets. According to Bloomberg, U.S. debt sales in the third quarter have amounted to over 2 billion. Companies from DuPont to Microsoft have borrowed at record low interest rates with very few concessions to institutional bond buyers. Most deals are oversubscribed as bond managers are forced to deploy hundreds of billions of new money flowing into their coffers. Even junk bond spreads have narrowed with private equity firms using the firms they’ve invested in to tap the bond market in order to pay out fat dividends back to their owners.
Can the Fed pull off another asset bubble when another asset bubble is what they think is needed to bailout borrowers? I believe they have a window of opportunity to do so again. We are in a subdued period of credit expansion in the private sector. Money is flowing off the sidelines into bonds as most investors are worried about risk and return. If the Fed can channel the newly created dollars into the financial markets and other risky assets they may indeed get another asset bubble. Rising assets lift all boats. If Bernanke can drive up stock prices, and with enough money maybe even real estate, or at least get real estate to stabilize, then lenders and borrowers may get what they want; higher asset prices for borrowers which could encourage them to borrow, and higher collateral value for lenders which would encourage them to make loans.
It’s a tricky game of confidence. However, it is doable. We’re currently in a race to the bottom when it comes to currencies. No country wants a strong currency because many of them rely on exports. Japan has recently intervened in the currency markets. Britain’s leaders are hinting that perhaps another round of QE II could be in the works, and the Europeans could also become reluctant followers. We seem to be back to beggar-thy –neighbor policies. This is I believe the message of the gold markets.
After the November elections it is widely expected that momentum will build to extend all of the Bush tax cuts for 2011. With the presidential election cycle starting up next year it is more likely the tax cuts get extended until after the next presidential elections in 2012. What sitting president is stupid enough to raise taxes in an election year when you are asking voters, including campaign contributors to extend your employment contract for another four years? Gridlock in Washington and the extension of the Bush tax cuts would remove some of the uncertainty that has plagued the financial markets all of this year. This would then provide another impetus for the markets. If timed with Fed quantitative easing the combination could give us just what the Fed wants which is another asset bubble to bailout borrowers and lenders alike.
Given the Fed’s proclivity for money printing and its stated intention to create more inflation where might that money begin to manifest itself? Lets’ begin with the obvious, precious metals. Gold bullion prices are up 20% this year and silver has risen over 30%. As the main currency countries around the globe are pursuing policies to debase their respective currencies, gold and silver will be the main beneficiary. Gold is money and it is assuming its historical role as a store of value. I believe precious metals and precious metal stocks should be at the top of every ones list. In my opinion, precious metal stocks represent a better value at this point in relation to bullion. At ,300 gold and close to silver, miners are leveraged to the price of bullion and should begin to outperform. Another trend we should see continue is miners increasing their dividends, a trend that has begun and should accelerate as the price of bullion and mining margins climb.
The next area that should do well is the commodity space, which would include agriculture, energy, and certain base metals. Tin prices are up 45% this year with Indonesia’s largest mine now going into decline. Rising demand from Asia, the Middle East and other developing nations should also keep energy demand high despite declining trends in OECD countries. Energy is underpriced and has underperformed since the BP spill. Economies can’t grow without energy and we’re not finding enough new deposits to replace what we consume. Deep water oil needs - oil to remain profitable while tar sands oil needs - oil to remain profitable and attract new investment.
Other areas that look attractive are emerging markets where all of the economic growth is occurring and large cap blue-chip multinationals who sell to the same market. Other areas that look good technically are farm machinery, computer storage & peripherals and pharmaceuticals.
Short-term interest rates are zero bound and should remain there for quite some time. As long as all nations reflate at the same time the Fed may be able to pull off another asset bubble, the biggest being the bond market. The bond market remains complacent as bond fund managers are forced to deploy incoming capital at historically low rates and low premiums.
Source: Bloomberg
Money never remains idle and right now it is seeking the highest rate of return. The reflation and risk trade has been put back on and will remain there until inflation and interest rates climb back to 4 and 5 percent respectively. As I wrote in “Money Never Sleeps,” the two most widely held perceptions today have been deflation and a stock market crash. So far, other than a brief few months in 2008 we have had neither. The inflation rate this year should track at around 2.7% and so far the bulls have had the upper hand. Only time will tell if these perceptions are wrong. Put on your prospector hat and grab your pick and shovel it’s time to go mining for the next bubble.
