The ability of reflationary policy to mute the worst risks of debt deflation has been a source of enormous frustration for stock market bears ever since the 2008 collapse. Yes, the initial moderate rally out of the S&P500’s black hole was perhaps not so surprising in 2009. Bombed-out stock markets can always manage some sort of rally. But the ability of the rally to continue through 2010, and then 2011, and now 2012 has been quite vexing and painful for bearish investors.
Indeed, the entire post-2008 market phase has now produced an era of consistently poor performance for hedge funds. Recent data, for example, shows that an incredible 90% of hedge funds are underperforming the S&P500 through mid-September.
Will the pain continue?
Sentiment readings indicate that fears about the global economy dominated hedge fund thinking as early as 2005. And rightly so. It was clear early on that the first reflationary policy wave, which followed the technology bust of 2000, was doing nothing more than inflating a housing bubble. The return to reality in the 2007-2008 debt bust was a kind of victory for short-sellers — but the nightmare started all over again in 2009. Incredibly, even the EU crisis of late 2011 was not enough to hold global stock markets down, as the policy of monetary rescue once again powered financial asset prices higher.
One of the more clever tactics of the U.S. Federal Reserve as it gingerly moved towards its third big reflationary program this year (QE3, the third round of quantitative easing), was to let other policymakers move first. Not only did the Fed hold its fire while Europe experimented for nearly twelve months with various forms of crisis intervention, but the Fed also let other policy solutions bubble up to the surface (e.g., nominal GDP targeting), which added thematic pressure at the margin. As each month passed since last Autumn, the Fed kept repeating its claim that it could do more if the data did not improve.
This left observers mystified, given that the economic data and especially employment numbers did not, in fact, improve. Certainly, as many skeptics believed, the Fed would not move right before the election, would it?
Bernanke may or may not be an avid chess player, but he certainly understands the concept of zugzwang (actually, Bernanke recounts trying to play chess against Ken Rogoff and regretting the experience.) As the next round of global reflationary policy moved into its endgame, Bernanke likely earned the biggest bang not by moving first, but by moving last.
This lent an element of surprise to the action, and the new policy is still being digested by markets. Various research houses, for example, continue to calculate the size of QE3, with Goldman’s most recent estimate coming in at $1.2 to $2.0 trillion. Moreover, other Fed members in their public remarks have followed up the QE3 announcement with aggressive dovish viewpoints. In particular Narayana Kocherlakota has insisted that the unemployment problem is a battle that must be won.
Now, however, just over a month from the Fed’s QE announcement, the mood has darkened in global markets. There’s a sense that the latest round of QE is already in position to fail (an issue I addressed in August: When Quantitative Easing Finally Fails). This conclusion seems premature.
Accordingly, let’s first take a look at three key markets, gold, oil, and the dollar, which have already had a chance to respond to QE3. And in Part II of this analysis, we will take a closer look at the stock market and some of the reasons why the pan-OECD reflationary policy, from Japan to the EU and the U.S., must have elevating stocks to new all-time (nominal) highs as its central aim over the next year.
More to the point: If OECD policy makers do in fact lose stock markets as the main transmission mechanism for reflationary policy, then trouble of a very serious nature will make itself known in the biggest way imaginable since the 2008 crisis began.
This summer bore witness to a rather tedious, politicized discussion about the resurrection of the gold standard. But one can argue now that the idea of a gold standard is outdated. Why? The reason is simple: gold, over the past ten years, has already handily and beautifully served its balancing function to the end of growth and the manic attempt of governments to fight industrial decline.
Moreover, “debate” of the kind seen recently between high profile investors such as Warren Buffet and Ray Dalio further illustrates that the discussion of gold remains trapped in identity politics. It is as though mere association with gold confers all sorts of meaning. But none of this actually pertains to gold’s new role, here in the 'era of no growth'.
Interestingly, Paul Krugman has done some of the best (and politics-free) commentary on gold in the past year; I highlighted his views in last Autumn’s essay Gold and Economic Decline. I remain in agreement that the poor prospect for economic growth, rather than inflation from ‘money-printing’, has been the primary driver of gold for the past decade. Gold has, accordingly, outperformed nearly every other asset – especially stocks and real estate – and for good reason. Krugman wrote:
For this is essentially a “real” story about gold, in which the price has risen because expected returns on other investments have fallen; it is not, repeat not, a story about inflation expectations. Not only are surging gold prices not a sign of severe inflation just around the corner, they’re actually the result of a persistently depressed economy stuck in a liquidity trap — an economy that basically faces the threat of Japanese-style deflation, not Weimar-style inflation.
While many participants continue to use gold as a call option on future inflation risk – and from a resource and food standpoint, there is substantial inflation risk – the launch of QE3 more pointedly confirms the failure of Western economies to produce growth. It's for this reason that gold should prove to be more sensitive to reflationary policy than industrial commodities over the next year.
Did oil prices collapse this year due to the complex financialization of oil, as some predicted? No.
Oil prices don’t trend along price pathways simply because oil is the subject of financial speculation. Financial speculation can only take prices outside their fundamental price envelope for limited periods of time. And further, did QE3 cause gasoline to zoom to $5.00 a gallon, as many predicted? No, because quantitative easing doesn’t axiomatically cause oil prices to rise. Instead, it drip-feeds broken economies and mutes the devastating effects of debt deflation. QE dampens tail risk and allows the portions of the economy that are able to recover to muddle forward.
The two great forces currently acting on oil prices are, instead, the migration of demand from the OECD to the non-OECD, and the newly-significant higher cost to bring on marginal supply. That’s it. Neither is mysterious or complicated. As I explained in my recent piece, The Repricing of Oil, an odd stability has appeared in the global oil market that constrains oil prices to a range, defined at the lower bound by marginal costs and at the higher bound by exceptionally slow growth in aggregate oil demand.
Fresh QE from the EU, Japan, and the U.S, however, serves to place a harder floor under crude oil. QE and other reflationary policy from the OECD tends to flow more efficiently towards the non-OECD, either boosting or supporting much higher growth rates compared to developed world economies. This keeps annual growth rates of energy consumption plugging along for coal, natural gas, and, of course, oil. Much of this trajectory is not, in fact, dependent on robust world trade. Instead, the core trend in energy demand in the developing world simply comes from population expansion and the industrialization process that has yet to complete.
Do a reduction in world trade and less consumption of Asian goods from buyers in Europe and the U.S. mean that the non-OECD will grow more slowly? Of course. We can see the slowdown already, reflected in the soft pricing for global iron ore and metallurgical coal. But that doesn’t affect the ability of the 5 billion people in the developing world to slog forward with steady demand growth for oil. China and India, even in their slower-growth mode, are growing their oil demand by 4-5% per year. Should the global economy find its footing, oil prices will shoot substantially higher – though not because QE3 repriced oil; but because QE3 will have patched enough holes in the global economy to create new leg of growth.
The year-long rally in the U.S. Dollar Index must certainly have been a consideration for the Fed when deciding on new QE.
Why? Since the 2008/2009 low, U.S. exports have been one of the sturdiest sources of growth for the economy, with exports crossing the $2 trillion mark (in value) for the first time and taking up a larger proportion of GDP. As I explained in The Price of Growth, U.S. exports of coal, agricultural goods, and eventually natural gas represent a supertrend that offsets the portions of the U.S. economy that will have a difficult time recovering. Eventually, manufactured goods will also reappear as an export, owing to North America’s very cheap electricity rates, and U.S. labor costs will likely fall.
But the dollar’s rally on the Index, from 72.00 to 84.00, began to bite into export growth over the past year. It was inevitable that the Fed would eventually have to fight that trend. And fight it they have:
The market correctly anticipated the onset of QE3, of course, and started to break the dollar’s rally in late summer, as bourses positioned themselves for resolutions in Europe (which were positive for the euro currency) and began to react more confidently to weak U.S. data. For now, the year-long rally in the USD is decisively broken.
While it is certainly a stretch to claim that a weaker U.S. dollar will lead to job growth, the opposite, a strong dollar, would certainly lead to tighter monetary conditions. It is strange, moreover, that many of the same economists and financial writers who have for years decried the poor state of U.S. manufacturing and the super-elevated levels of U.S. consumption would either fear or criticize policies to weaken the dollar.
Do U.S. consumers not buy enough goods from abroad? Do U.S. consumers need to reverse the nearly decade-long trend of declining oil consumption via some policy that attempts to drive oil prices downward through a strong dollar? The fact is, the U.S. is already in the process of transitioning – like the rest of the world – to the powergrid. With its road and highway system in decline and with U.S. oil consumption down 15% from decade highs, the U.S. economy has rebounded, using not oil, but natural gas and coal. These are two commodities that, at current rates of economic growth in the U.S., are in fact quite abundant. The U.S. economy does not need a strong dollar.
Contrary to popular belief, the Fed is much less concerned about the rise of gold as a challenge to their authority than many presume. Moreover, the Fed has come through a learning curve about oil. Bernanke understands (and has said) that there is a constraint on supply and that cheap oil is a thing of the past. Bernanke also understands that a price ceiling is largely operative in a time of weak economic growth, as economies will continue to balk at oil prices above $120. Accordingly, given that gold and oil already underwent spectacular price revolutions in the past decade, it can hardly be the concern of the Fed to “control” them now. No such control exists, and the Fed has essentially given up any pretense in this regard. Instead, it’s the U.S. dollar and the U.S. stock market that primarily concern the Fed.
In Part II: Where the Stock Prices are Headed Over the Next Year, we explain why the Fed – and its counterparts in the EU and Japan – cannot afford to lose control of stocks, especially as the global economy appears to be entering a synchronous slowdown. Moreover, just-released data on U.S. exports confirm that the encouraging three-year trend higher is faltering badly. Is it possible also that the Fed acted in anticipation of a new slowdown in the U.S. economy? Despite the controversy and elation over the latest jobs report, there is reason to believe that the U.S. economy may be seeing a four-year cyclical peak. In other words, the same concerns that are now the focus of stock market technicians and historians are also relevant to the U.S. economy.