It’s hard to know what to make of this week’s record Dow performance except to say, “Don’t fight the Fed.” More than four years after the peak of the financial crisis, quantitative easing—the Federal Reserve strategy of buying up assets like bonds and mortgage-backed securities in order to goose the economy – is still going strong, and so is the market. The Fed is on track to purchase $85 billion worth of assets each month for the rest of this year, and “QE3” as this third round of Fed ammo is called may last even longer than that, given the latest jobs report. The Fed has said it won’t let off the monetary gas until unemployment is at 6.5%. April’s jobs numbers were better than expected, bringing the rate down to 7.5%, but most of the growth was in low wage sectors like retail and tourism. What’s more, most of the incoming economic indicators for the second quarter of the year – like factory orders, consumer spending, corporate profit margins, and GDP growth – will likely be weaker than in the first. If the economy remains sluggish, the Fed will remain active.
But what’s bad for the real economy is—or at least has been–good for stocks. As I’ve explained before, the disconnect between underlying economic data and record stock prices is largely down to the Fed and its firepower. It’s worth noting that each round of QE has slightly less of an effect on the markets than the one before. But even people like PIMCO’s Bill Gross, who has publicly fretted for over a year about the bubble making effects of QE, are advising clients to take advantage of the Fed’s largesse and stay in equities for the time being, before gradually reducing riskier positions throughout the year. (Gross has a coffee mug on his desk that reads, “Don’t fight the Fed – but Be Afraid.”)
But how afraid should we be? And how soon? That’s the magic question. Almost no investor I know thinks that the Fed hasn’t played a large if not definitive factor in the record Dow numbers. After all, when the return on a T-bill is basically flat, and a return on European sovereign debt is negative, where else can you put your money but in a good blue chip stock paying a 3% dividend. But at some point, everyone knows the music will stop. Then, the risks are myriad – stock bubbles may burst, the Fed’s exit from QE3 could become messy, inflation could rise sharply, or we could see some kind of systemic financial instability.
Personally, I’m not too worried about inflation right now (although I write this post from Germany, where everyone around me is). Wages have been flat for four years, and no one expects to get a raise anytime soon. The workforce participation rate is as low as it has been since women began entering the workplace in full force in the 1980s. I don’t worry about inflation – I worry about the U.S. being Japan. I also worry about bubbles, but not a massive crash. I think that there are certain stocks, mainly blue chip multinationals with flush balance sheets, that are essentially self-funded entities that hedge risks across dozens of countries and are therefore are relatively safe bets. If they suffer as part of a large market correction, they’ll rebound. But I think there are risks in other asset classes – namely high-yield corporate debt and commercial real estate – that are worth looking at closely.
The smart macro-economists at Bank of America/Merrill Lynch recently put out a report called “Easy Fed policy – Too much of a good thing?” that’s worth reading, because it separates those risks out in detail, and parses how they might effect the overall financial system. The bad news, according to BofA/ML, is that corporate junk bond lending is on the rise and approaching 2006-07 levels. Those companies have a higher tendency to default. And more investors are exposed to them than in the past through exchange-traded funds, which have doubled their holdings of indexed bonds since 2009. The report also notes that commercial real estate lending is on the rise — and a very savvy investor source of mine is worried about that issue as well, noting that lending standards in commercial real estate have dropped precipitously to 2006-07 levels, and that spliced and diced commercial real estate securities are surging as well.
What does all that mean to the average investor? At this point not much, in part because (as the BofA/ML report points out) many things in the underlying financial system have improved since the financial crisis: Banks are better capitalized, both corporations and households have improved their balance sheets, and a general sense of wariness about the future makes mass risk taking along the lines of a housing boom or dot-com run-up unlikely. All this helps mitigate systemic risk of the kind that led to the 2008 financial crisis.
But it’s worth remembering that when there’s a disconnect between the real economy and the markets, it never lasts forever. Ultimately, if stocks are to stay up, corporate profits and consumer spending have to improve as well. And those factors are ultimately buoyed by real economic growth – not the Fed.