While the U.S. midterm elections dominated the news cycles, the result (Republican House/Democratic Senate) was no surprise and had been predicted by markets for the prior two months. For now, it appears there will be little attempt to use increased government spending as a stimulus for growth. We believe that likelihood played into the Federal Reserve's decision to attempt a second round of monetary stimulus in the form of quantitative easing (QE2). The size of the program, $600 billion, exceeded the expectations of most analysts and sparked a global rally in stocks and commodities following the announcement. Perhaps more interesting than the announcement itself was the Ben Bernanke editorial published the next day in the Washington Post. In the piece Mr. Bernanke (the Chairman of the Federal Reserve) explained the reasoning behind the decision. In his view the Fed had to act because unemployment remains higher and inflation continues to trend lower than what the Fed perceives as optimal. We did find Mr Bernanke's logic rather curious particularly where he notes that, in anticipation of easing by the Fed "stock prices rose and interest rates fell" which would result in a "virtuous circle, (that) will further support economic expansion".
In our view- he has the process backwards. The fundamental relationship, over the longer term, is simple: stock prices and financial markets will rise when economies expand and companies increase profitability. So we doubt that merely inflating the value of financial assets will significantly expand economic growth. Mr. Bernanke is looking to stimulate demand for capital investment through lower interest rates, however interest rates are already at historic lows. Is someone out there really waiting for rates to dip below 4% before they buy a home? We think QE2 will more likely provide temporary juice to commodities and perhaps equities with little long term benefit but at a big cost- continued weakness in the dollar.
Here is an updated version of the graph we published last month that showed the contrasting performance of the dollar since the Fed indicated it would again start easing. To further illustrate the divide, we have added a commodities index.
Sometimes excessive easing by the Fed can have negative unintended consequences. There is little doubt Fed efforts to keep interest rates low in the 2002-2005 period contributed to the housing bubble. We doubt that many view the results of that as a "virtuous circle ... support(ing) economic expansion". More like a trapdoor to one of Dante's Circles of Hell. Many Asian countries fear the Fed's action will result in unwanted appreciation in their currencies and/or housing markets (just because the dollars are printed in the US, doesn't mean they stay in the US). The decision to move ahead with QE2 also gives the dangerous impression that an 'independent' Federal Reserve is in fact succumbing to political pressure.
We remain moderately optimistic on economic performance and we think economic data has been positive over the last month. The October jobs report proved better than expected with an increase of 159,000 jobs. Private sector employment has grown every month this year although this has been somewhat offset by government layoffs at the state and municipal level. Corporate profits continue to be strong and it is not unreasonable to believe that without another shock, we could see decent economic growth in 2011. For the possible source of such a shock we look across the Atlantic where the fiscal difficulties of the periphery nations have popped up again, this time in Ireland. The graph below (courtesy of tradingeconomics.com) shows the interest rate on an Irish government 10 year bond over the last decade. The yields have now spiked higher than they were during the earlier Greek crisis.
This indicates that investors have significant doubts about the ability of the Irish government to continue financing their deficits. The Wall Street Journal recently had a lengthy article detailing how the Irish government's decision to bail out their banks had resulted in this crushing ($50,000 per household) debt. It appears that markets are trying to force Europe to bail out the Irish as they did the Greeks. If this happens, you can be sure that Portugal and Spain will be next on the list and the success of the effort to limit the contagion will be the most important factor in the global economy.
As always we appreciate your comments and feedback. If you have financial planning needs, we welcome the opportunity to meet with you.