The End of the Synthetic Economy

The US Federal Reserve’s aggressive stimulus program was a last resort initiated five years ago in the wake of the 2008 financial crisis to save the global financial system from collapse. Not just the Fed but central banks around the world took to pumping trillions of dollars into their economies.

The result has been to stabilize the system in the US, but it has reaped the unintended consequence of keeping firms artificially alive that should have been dead from bad business decisions. Think of these inherently weak firms as “corporate zombies.” It also created bubbles in various asset markets.

Moreover, during this period of Federal Reserve stimulus, US gross domestic product (GDP) growth has been tepid,  income inequality grew, labor participation fell, business investment slowed, and consumer demand was the weakest in the post World War II era.

We probably now face a period of imbalance, marked by either inflation or deflation. As such, investors should keep a balanced portfolio in the event of either scenario. In particular, high-quality energy utilities can protect your wealth if inflation’s insidious cousin, deflation, rears its ugly head.

For months, economists far and wide have debated whether the US economy has entered a permanent period of low growth and what would happen when the Federal Reserve ended its unprecedented stimulus program. Would these inflated assets and companies start to fail one-by-one as the artificial support of stimulus is removed, and as such, would the US economy fall into a recession, or worse, a deflationary period akin to a second depression?

This publication has devoted a considerable amount of attention to the topic of inflation, because we believe this is a key long-term trend. However, the precursor of growth needs to be in evidence for an inflation trend to occur. And with the Federal Reserve’s move in December to reduce its stimulus program by $10 billion beginning in January, reducing its asset purchases from $85 to $75 billion, the issue of growth is now again at the fore. The question on everyone’s minds is will growth be enough to support the US economy in the absence of stimulus?

Guessing at Growth

Federal Reserve Chief Ben Bernanke, in his comments this week, argued that there has been enough improvement in the economy, “to modestly reduce the pace of [Fed} asset purchases.” The Fed slightly increased its economic forecast, raising its expectations for GDP to 2.9 percent to 3.2 percent growth next year from a prior rate of 2.9 percent to 3.1 percent. The central bank also sees a lower unemployment rate of 6.3 percent to 6.6 percent, from 6.4 percent to 6.8 percent.

But one Fed member, Eric Rosengren of the Boston Federal Reserve, formally dissented against the taper decision. He felt that unemployment was still too high and inflation was still too low to begin pulling back on stimulus. And in press statements this week, bond guru Bill Gross of PIMCO said, “It’s true that all asset prices are artificially priced and we have to be concerned about that as we move forward. What asset prices need basically is a real economy that grows at 2 percent to 3 percent for an extended period of time, and we haven’t seen that yet.”

Of course, what’s most worrying is that no one really knows if the growth will be there next year, given the size and scope of the stimulus and wind down, and the inconsistency in GDP growth per quarter and in corporate earnings reporting (even as other economic indicators have improved).

According to Factset, as of Dec. 13, “the percentage of companies issuing negative EPS guidance to date for the fourth quarter is 89 percent (94 out of 106). This percentage is well above the 5-year average of 63 percent.”

Larry Summers recently argued that the US may have entered a period of secular or economic stagnation (low growth), a theory first proposed during the Great Depression that blames inadequate capital investing for hindering full deployment of labor and other economic resources. Economist Robert Skidelsky confirms that low growth today may be the result of the fact that the average prospective return on new investment in the United States has fallen below any feasible reduction in the Federal Reserve’s benchmark interest rate.

“We may be in a permanent liquidity trap, in which nominal interest rates cannot fall below zero, but the expected rate of return to investment remains negative. Unconventional monetary policies like quantitative easing may inflate a new generation of asset bubbles, but the underlying problem, negative returns to new investment, will not have been solved by the time the next crash comes,” Skidelsky argues in a recent paper.

Other economists assert that the Federal Reserve may be tapering its stimulus because the central bank recognizes that it’s not achieving any meaningful impact on the economy (it’s in a liquidity trap), because the incessant flow of stimulus dollars is not substantially spurring more hiring or lending. Further, the pullback may also have been an acknowledgement that the stimulus is having a corrosive effect on markets by creating asset bubbles.

But what’s most disconcerting is that the velocity of money has plummeted, which means that the huge amounts of money that has been printed by the Fed really hasn’t been used, if at all, though consistent with the tepid recovery (see chart below).

The Fed’s Stimulus Never Achieved Escape Velocity

When the Fed withdraws its stimulus the question is what if anything will spur banks and companies (with trillions on their balance sheet) to hire and lend. And certainly the velocity of money is a key indicator for inflation. According to the quantity theory of money, if the quantity of money goes up, then inflation  goes up, as long as real GDP growth and what is called the velocity of money (the amount of times you use money) is held constant. But both real GDP growth and the velocity of money has been at all time lows.

Another interpretation of the Federal Reserve’s pullback may be a variation of a Shock Therapy strategy economists use, the sudden release of price and currency controls, withdrawal of state subsidies, and immediate trade liberalization within a country to spur economic activity. However, the risks in this strategy is that stimulus support is removed too quickly and the private sector is either too slow or not ready to supplant the government’s support, causing a deflationary environment.

Neoliberal shock therapy is very controversial, with its proponents arguing that it helped to end economic crises, stabilize economies and pave the way for growth, while its critics (such as economist Joseph Stiglitz) believing that it helped deepen them and created unnecessary social suffering.

A deflationary spiral is a situation where price decreases lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in prices.

Because reductions in general price levels are called “deflation,” a deflationary spiral is when reductions in prices cause a vicious cycle, where a problem exacerbates its own cause. If that sounds familiar, it’s because the Great Depression was regarded by some as a deflationary spiral.

In fact, we believe there will be a critical point in the Federal Reserve’s bond buying program next year when it will become clear whether the US economy has turned the corner and achieved sustainable growth  or “escape velocity,” as economists and Wall Street bankers have been in the habit of saying, and can supplant Fed stimulus reductions.

Crossing the $45 Billion Mark

There will be a critical point in the next year when the economy can go either of two ways: high growth or a slip back into recession. It all depends on the Federal Reserve’s timing on winding down its stimulus program. Economists predict the Fed is likely to reduce its bond purchases in $10 billion increments over the next 7 meetings before ending the program in December 2014.

The period to watch is when the Fed’s bond buying program is reduced to $45 billion, the level that was held until December 2012 as part of its Operation Twist, which involved selling $45 billion a month of short-term Treasuries to fund the purchase of long-term bonds. Before the Fed nearly doubled the stimulus program last year, your correspondent (who studied the Great Depression and wrote an economics thesis at Georgetown University on the subject) was becoming increasingly alarmed at the various deflationary signals that were appearing.

During this period, growth in GDP had been stalling, while the output gap had been widening. Meanwhile, Europe had already been suffering from an economic contraction. Additionally, oil and gold were losing value, and US industrial activity was declining. And sales at economic bellwethers such as Wal-Mart Stores Inc (NYSE: WMT) and McDonalds Corp (NYSE: MCD) had disappointed investors. Furthermore, large investors were considering shorting high-yield bonds and the government’s sequestration seemed sure to stifle growth in economic activity.

But just as it seemed the world was about to fall apart, the stimulus resulting from the Fed’s $85 billion per month bond-purchasing program, which includes both mortgage-backed securities and Treasuries, began to be felt in the real economy. The impact of the increased stimulus seemed to result in improved US GDP and employment numbers. All was seemingly going well. Economists breathed a sigh of relief, believing that perhaps Mr. Bernanke’s untested approach to a balance sheet recession was the right course. Central bankers from Europe to Japan followed his lead.

However, in reviewing this summer’s selloff in US equities and emerging markets currencies that was prompted by the hint of a reduction in stimulus, some of my earlier concerns had come back to the fore.

Consumer demand still remains weak, despite improvement over the last few months. The problem continues to be the crisis-battered American consumer.  “In the 22 quarters since early 2008, real personal-consumption expenditure, which accounts for about 70 percent of US GDP, has grown at an average annual rate of just 1.1 percent, easily the weakest period of consumer demand in the post-World War II era. That is the main reason why the post-2008 recovery in GDP and employment has been the most anemic on record,” according to a paper by Stephen Roach, former chief economist at Morgan Stanley and Yale lecturer.

When the Fed draws down to $45 billion, investors are advised to evaluate various economic indicators such as the output gap, GDP, consumer demand, industrial and business activity, as well as the unemployment numbers. If the US economy does prove to have turned the corner by the end of 2014, and growth is on a tear, that’s when the potential start of inflation is at its greatest. As the price level increases, more companies can pass on their costs.

As we note above, the electric utility industry typically does well in a deflationary environment, because these firms provide relative certainty of cash flows and high dividends.