- The FED’s “protect the market at all costs” attitude minimizes the risk of a severe bear market but increases the risk for an inflationary environment.
- Trade deficits and low productivity are not good signs for the long-term, no matter the positive data from the labor market.
- Until the focus shifts from central banks to real structural reforms, sluggish GDP growth could easily turn into a recession.
There are more important insights that can be gained by going through the FOMC minutes than by just reading the news about an eventual interest rate increase. An interest rate increase of 0.5% won’t change much. It will give the news something to talk about for two weeks and from then onwards it will be business as usual. Structural risks and what the FED is ready to do or not do in the case of turmoil is what will determine our investing returns.
The Patient Needs Stronger Medicine
The FOMC minutes start with a discussion about the implementation of a monetary framework, clearly stating that since the 2009 crisis, heavier intervention is needed to stabilize the markets and the economy. Before the crisis, a few rate cuts or increases and minimal market asset purchases were enough to reach stability. This can be clearly understood by having a look at the FED’s balance sheet. It increased fivefold from 2009 to 2014.
Figure 1: FED’s total assets. Source: FRED.
For investors, this is important because it tells us that the FED will use all the tools at its disposal to keep the economy and markets stable. This minimizes the risks of a severe bear market as capital injections will be immediate, but it also increases the risks for an inflationary environment.
The Economy & Inflation
The economy shows mixed signs. On one hand it is doing very well with the latest jobless claims data at only 262,000, extending the period below 300,000 to 76 weeks which is the longest since the 1970s. On the other, weak manufacturing data, a trade deficit and growth from consumption alone keep the FED from decisively increasing rates.
The unfortunate thing is that adding jobs is easier than solving structural issues. With low productivity and a trade deficit, it is difficult to expect miracles from the U.S. economy in the long term, which again indicates that some international diversification and inflation protection should be welcome in the long term.
Inflation is still only at 1% indicating that something isn’t working as planned. Low interest rates and lots of cheap capital have spurred investments which increases the supply of goods, sending prices down, not up. Such a situation enables the FED to keep rates low and sustain the economy, but nobody knows how long such a situation will last. The FED is just postponing the reach of the 2% inflation target, which is now set for beyond 2018.
The sluggish GDP growth forecast and an economy relying on easy-to-hire jobs and consumer spending indicates that monetary easing did what it can do and now it is time for something else to step in. Structural reforms, lowering student debt and investing in infrastructure might be reasonable ideas, but until the focus is on monetary policy, the risk is high that this slow growth will turn into a recession.
The Situation in Europe
The European central bank released its policy meeting minutes a day after the FED. Europe is still a few years behind the U.S., asset purchases and direct financing programs are the norm but have no influence on inflation or economic growth. Inflation in the EU zone is at 0.8% while industrial production is contracting and GDP growth is below 1%. For the ECB, the good news is that unemployment has decreased from 10.2% to 10.1% and youth unemployment is “only” at 20%.
Similar data clearly indicates that other actions are necessary for the reach of sustainable economic growth. The terrible unemployment rate signals severe structural issues that cannot be amended by monetary policy. At least the situation in the U.S. looks much better after taking a look at Europe.
Everyone expects miracles from central banks, but those miracles only work for a short while. Hopefully structural reforms will enable future economic growth. Until then, we have two situations on our hands as investors.
- Situation Number 1 – Central banks will intervene at any sign of market and economic weakness with more stimulus, minimizing the risks for long term investments. This means that we can stay long, but we have to be careful to watch for the point in time when the majority of people in the markets understand that monetary policies do not suffice.
- Situation Number 2 – Global economies are not that healthy, especially in Europe. Severe structural reforms are necessary in order to create real growth, not just financially engineered growth.
The primary conclusion then, is that you can stay long and grasp eventual price declines for rebound trades as central banks state that they will do whatever is necessary to keep things stable. In the longer term, as monetary policy is not working, watch out for the moment when somebody yells: “The emperor is naked.”