Economic & Market Commentary, November 2010

The anticipation and introduction of a new round of quantitative easing (QE) by the Federal Reserve spawned the recent simultaneous increase in the stock market and the decline in the dollar. The announced purchase of $600 billion in US Treasuries through June of next year is in addition to the $250 billion the Fed planned to buy to replace maturing mortgage-backed securities currently on its books. The Fed is implementing QE2, not to defend the integrity of the financial system, but to spur economic activity and to protect the economy from suffering the effects of deflation.

The Fed sees slowing economic growth, weakening housing data and a soft labor market. The inventory rebuild that began late last year appears to have run its course. Consumers have been restrained in their spending, and businesses have been reluctant to hire. The US consumer has historically driven the global economy. No longer. As of June, 2010, household debt was $13.5 billion. That is 2.2% less than a year ago. Because household debt has historically risen between 5 and 15% a year, to see it go down by any percentage is significant.

There were many reasons why consumers increased their debt during the last business cycle. US housing prices had never sustained a decline since World War II. Consumers gained confidence that the increasing value of their homes was permanent. Excessively low interest rates and weak credit standards enabled a confident consumer to front-load consumption by additional borrowing. We all recall how this drove prices up further, at least until the collapse.

There are a few ways to reduce debt burdens. One way, of course, is to reduce debt. Another way is to increase incomes. And the last way is to increase asset prices. Currently, debt is coming down and suppressing consumption. State and local governments are reducing jobs by 30,000 a month. Without a significant increase in private sector employment, there will not be enough jobs to absorb new entrants into the workforce, let alone reductions in state and municipal employees. With continued high unemployment, it appears that incomes will not be rising any time soon. Households have two main assets: housing – almost 30% and equities – almost 25%. It looks like, on average, housing prices could decline another 10%. Fed Chairman Ben Bernanke said in the Washington Post 11/4/2010: “And higher stock prices will boost consumer wealth and help increase confidence, which will also spur spending.” QE2 is an attempt to create a “wealth” effect by increasing equity prices. Will improved consumer confidence from a rising stock market lead to spending and an improved economy?

We normally think that stock prices increase with a growing economy. It seems counterintuitive that a rising stock market will drive GDP. Consumers incorrectly assumed that rising home prices represented permanent wealth creation and felt sufficiently confident to spend some of that wealth. Will they be induced to make that mistake again if the Fed enables speculation in the stock market? Serious investors understand that the price of a stock represents a claim on a long-term stream of cash flows. An artificially high price merely changes the distribution of returns, not the underlying cash flows. A higher price now means lower future returns.

It seems difficult to imagine how QE2 (or QE3 or 4 or…) will have a meaningfully positive effect on the economy. Yet, it may create a short-term speculative appetite for risky assets. Key things to watch for are dollar weakness and consumer confidence. Both may give a short-term boost to the stock market.