Managing Structural Economic Change and the Financial Markets

The second quarter of 2013 was particularly challenging for investors. The last two months, in particular, were impacted by the market turbulence which emerged from concerns that the Federal Reserve Bank would change its current low interest rate policy. The current policy of maintaining low interest rates was intended to support economic growth in the United States by making credit more affordable. They have done this through what is known as their quantitative easing program, which is essentially buying bonds with money that does not exist until they create it. While the historical data does not necessarily support the belief, many investors, nonetheless, associate increasing interest rates with poorer stock market performance. The prospect of a change in interest rate policy created additional uncertainty and a shift in investor sentiment from the irrational exuberance equity investors had during the first two months of the year to more anxious concerns as to the sustainability the equity markets.

What may well be a more fundamental issue, however, is that bond investors also seized upon the prospective change in the Federal Reserve Banks policy and started exiting from bonds. Trim Tabs, an investment research firm, says that investors liquidated over $60 billion from bond mutual funds and exchange traded funds in June. If this is true, that would be the single-largest monthly redemption in history. Some commentators are calling this the end of a 30 year bull market in bonds.

This drove interest rates higher causing losses for traditionally bond investments. Bonds have traditionally, and historically, been considered conservative investments. With bonds as well as stock losing value, this left very few “safe harbors” for refuge from this storm. Cash is one option that some investors will flee to, and an allocation to some percentage allocation to cash is certainly warranted as a prudent allocation strategy. However, with dollars being created without backing by anything other than the “full faith and credit” of a government that does not appear to be capable of operating in a solvent manner, it is doubtful that this is the safe refuge it might appear to be. Moreover, cash offers very little in investment return. While cash is a valuable component of an investment strategy, just as with any other asset, having too much of it has its own hazards.

In my view, while there are many economically sound justifications for higher interest rates to exist, the markets have severely over-reacted to the prospect of a policy change in the Federal Reserve Bank. Having listened to Ben Bernanke’s entire speech, I heard him say that depending upon economic conditions the Federal Reserve Bank would adjust its policy. If the economy was doing well the Federal Reserve would gradually reduce the $85 billion per month of bonds it is buying to keep interest rates low. If the economy is not doing so well, it would continue its policy, and if conditions warranted, it would even increase the amount. From what I can see, given economic conditions, the Federal Reserve Bank seems more likely than not to continue its policy longer than expected. While there can be other factors than the Federal Reserve Bank affecting interest rates, it appears to me that investors have over-reacted toward the downside during the last few months, just as they over-reacted to the upside in equity markets during the first two months of the year. These last few months of stock and bond market behavior appear to be more panicked emotional reactions of market traders rather than the economically sound reasoning of longer-term investors.

In my analysis, I would be surprised to see the Federal Reserve Bank make any significant change in the near future. The consequences for doing so would be too severe in its impact on our anemically growing economy. Were they to change their policy and allow interest rates to rise, the most recent market response to these prospects suggests that at least the initial market response would be decline in both the stock and bond markets. The result would be a further damper on economic growth because of what economist call the “wealth effect” When account values go up, people are more willing to spend and consume. When account values go down the reverse is true which results in slower economic growth. Additionally, the housing market plays a very big role in the strength of our economy. With the housing market appearing to be in the recovery stage, higher mortgage rates, resulting from a change in Federal Reserve Bank policy, could quickly kill the housing recovery, again stalling economic growth. The other important factor is that when interest rates rise, the debt servicing liabilities of the U.S. government and municipalities also start to increase. At present, the servicing of the existing debt is not financially sustainable, even given historically low interest rates. Consequently, taken together, it does not seem likely that we will see a change in Federal Reserve Bank policy anytime soon. An unknown, however, is how much control the Federal Reserve Bank really has left in capping interest rates. There have been reports of Central Banks throughout the world selling their holding of U.S. Treasury bonds. This would put additional pressure on interest rates to rise.

Overall the global economic system is drowning in debt. Were it not for the heavy debt loads that are being carried, the underlying latent economic vigor would look promising. The real challenge to policy makers is how to manage an unwinding and restructuring of that debt. This must be done in the context of continuing demands for financial resources. The real danger is having the management of this process get out of control and become a collapse rather that a slower burn process. If there is a systemic economic collapse the trajectory of where events will lead is unknown. At this point, while I do see economic turbulence ahead, I do not place a high probability on a general overall economic meltdown, at least in the near future.