“If the crisis has a single lesson, it is that the too-big-to-fail problem must be solved” Ben Bernanke. September 2, 1010
“It is unconscionable that the fate of the world economy should be so closely tied to the fortunes of a relatively small number of giant financial firms. If we achieve nothing else in the wake of the crisis, we must ensure that we never again face such a situation.” Ben Bernanke. March 20, 2010
Unconscionable or not, the statistics released by the Fed in December speak for themselves: $3.3 trillion (at its peak) in emergency lending to primarily large financial firms. As for Mr. Bernanke’s March 2010 epiphany, at the same time he was decrying ‘too-big-to-fail’ the Fed’s emergency TAF program was dolling out more than $3.5 billion to U.S. banks and the Fed’s emergency TALF scheme was kicking out billions more to numerous LLC’s. Remember, these and other activities were taking place when the Fed was supposedly focused on an exit strategy (from unprecedented monetary interventions), and Bernanke was giving a speech entitled “The Economics of Happiness”. In this speech Mr. Bernanke claimed, rather prematurely, that with regards to the 1930s, the ‘lesson has been learned”.
Suffice to say, the only lesson that has been learned/confirmed is that Bernanke and company have no intentions of ever seriously dealing with the overly interconnected, overly complex, and moral hazard laden circus that is the U.S. financial system. Rather, as 2011 begins the Fed is still making massive interventions into supposedly free markets, the Fed’s balance sheet is still chalk full of toxic assets, and Bernanke is still not ruling out the possibility of QE3. When does the madness stop Mr. Bernanke? When, if ever, does the Fed get down to the difficult business of busting up a financial system that remains, according to your words, the preeminent threat to America?
Before looking into the crystal ball, one quote from an unlikely source highlights just how reckless and obvious the Federal Reserve’s actions have become:
“When Germany, a country that knows a thing or two about the dangers of inflation, warns us to think again, maybe it's time for Chairman Bernanke to cease and desist. We don't want temporary, artificial economic growth bought at the expense of permanently higher inflation which will erode the value of our incomes and our savings.”
The above quote was spoken by one Sarah Palin…
2011 – An Artificial Recovery Is Still A Recovery
Against the backdrop of minimal job creation and the inability of policy makers to remove any of their extraordinary stimulus measures, Mr. Bernanke actually had the audacity to contend that QE2 was ‘already working’ because it helped raise stock prices. Have we not learned that outsized increases in asset prices are unwelcome - that the booms they engender inexorably lead to gigantic busts? As for the debt side of the equation, with the U.S. consumer showing only faint signs of increasing their appetite for debt, leading the charge is the U.S. government, which, according to the Treasury, in fiscal 2010 accrued more than $2 trillion in net liabilities. The U.S. government, by all accounts, is set to embark upon more years of unrepentant borrowing.
In other words, not unlike previous episodes of ‘recovery’, today’s U.S. revival is being supported by cheap money, rising asset prices, and staggering increases in debt. This sorry state of affairs – wherein policy makers are focused solely on short-term growth objectives – comes after decades of dysfunction. Specifically, and as covered in this year’s Wish List (download preview), increases in debt and asset prices beyond gains in wages have produced an insatiable U.S. appetite for imported goods, and this has created a hysterical policy paradox (on the one hand, failing to direct resources at supporting unsustainable consumption would ensure a sharper economic downturn, while on the other efforts to spur short-term consumption is unproductive in that it reduces the focus on strategic investment and saving). A ready example of this predicament can be seen in the trillions already spent trying to stop much needed financial market corrections (which would have negatively impacted short-term consumption and debt accumulation) versus the meager amount ($586 billion) spent by China making things and investing in technology. Today China is overtaking Japan in R&D spending and trying to slow down its overly successful stimulus activities, while the U.S. is still directing massive resources at trying to fix its broken consumption model.
The hazards of conspicuous consumption noted, the expectation that many unsustainable/artificial drivers of growth will, eventually, spark an increase in jobs remains. Howl all you want about how ill-guided U.S. policies are, but if the definition of recovery is quarantined to the idea of growth at any cost there is the potential for short-term success. Quite frankly, given the continued improvement in many of the recent economic statistics and strong advances in many jobs-related stocks, new job creation may be imminent. If so, an extension, albeit unstable, of the ongoing recovery is likely.
This is not to say that the recovery is built to last. After all, remember that all of the 8.1 million U.S. jobs created by rising asset prices and debt from September 2003 to December 2007 quickly vanished during the crisis.
Bears Will Have To Wait!
Along with the improving economic headlines, the problem with being a starving bear is that capital flows and sentiment trends have turned decidedly bullish. We see these trends in the Investor Intelligence and related surveys and complacent readings in the VIX, but also, more anecdotally, by the fact that Abby Joseph Cohen and company are yelling it’s time to “Get Back Into Stocks!” and a jolly Lawrence Kudlow is interviewing a jolly Donald Luskin. Having watched the 1990s mania unfold and the 2003-2007 ‘recovery’ keep rolling along, these episodes of acute optimism have a way of feeding on themselves, often times for longer than common sense would deem possible.
As for those that take a contrarian bent – since no one is bearish now must be the time to be bearish! – this attitude is definitely warranted insofar as a market correction is concerned. However, the sentiment may be misplaced if speculating on an immediate bear market. Quite frankly, in direct contrast to all of the optimism to be found is the fact that equity fund flows have only started to turn positive after more than 7-months of steady outflows. Will, after months of market gains, the average American play the role of sucker once again and return to U.S. equities en masse? There is this possibility.
Finally, beyond the obvious trends sits another, more layered observation in that the world needs the U.S. more than the U.S. needs the rest of the world. As a quick example, the dysfunctional U.S. dollar can catch safe haven flows regardless of its horrendous fundamentals because the Euro is in a more dire state of dysfunction, because China strictly manages its currency, and because numerous countries do not want the dollar to fall (at least not yet). The same story holds for U.S. equities, which if being priced solely on earnings valuation or Fed model view, are attractive compared to other parts of the world.
As for the potential obstacles leading into 2011, they include a more widespread Euro-crisis, a blow-up in China, a global bond market meltdown, a municipal bond crisis, another real estate down-leg, inflationary pressures, a dollar crisis, a commercial real estate crisis, wars, etc. With the possible exception of raging commodity prices – which owe part of their resurgence to Bernanke’s printing press – none of these events is likely to derail the U.S. recovery. Rather, the story is that of U.S. policy makers unleashing waves of stimulus, increasingly risk-enamored investors taking to surf, and global policy makers terrified of rocking the boat. Untenable and dangerous as this situation might seem, unexpected obstacles simply exhume a ‘more of the same!’ response. And while these events may make the next crisis that much larger, they also impart a resolute attitude of recovery that is difficult to ignore.
In an effort to clarify a very complex condition: the U.S. economy will either continue to recover or the financial markets, U.S. dollar, and U.S. government as we know it will completely collapse. This all or nothing outlook is what happens when debt, asset prices, and policy ammunition myopically fixes its gaze on short-term GDP advances…
Conclusions
For the moment the world needs the U.S. more than the U.S. needs the rest of the world. This is what 2011, and beyond, is about. Only when this fact changes or investors reacquire an aversion to risk will the outlook for continued recovery materially change.
In this environment the investment alternatives are few, while the opportunity for speculation is strong. Paying little attention to the latter, the story is that of being extremely selective in equities, weary of mispriced fixed instruments, cognizant of your currency exposures, and maintaining an exposure to precious metals.
As for the dream that one day financial institutions will be stable/strong enough to be broken into smaller pieces, and that these pieces will never again be permitted to hold the Fed and American public ransom, this remains simply a dream. Another year of living dangerously ensures that further obstacles to meaningful reform will be erected in the shadows, and that another financial crisis is preordained.
