France's 9-11 should remind investors that the world sits atop a precarious geopolitical perch. Madmen with guns have the ability to wreak enormous damage on the fabric of society, which in turn places the stability of markets at risk.
Last week's tragic events in Paris are likely to impose significantly greater security costs on Western societies while leading them to question the open borders that feed immigration and trade, two keys to the future economic growth that will be necessary to dig out of the deepening debt hole they have dug themselves.
Depending on the response, jihadists could win a bigger victory than they imagine if Western governments surrender to their worst fears…
What the Fed Hasn't Learned About Keynes
Markets ran in a parallel universe while events unfolded in France during the week. That universe was one in which central bankers continued to act as the puppeteers and stock market investors jigged and jagged as former tenured economics professors yanked the strings. If the first full trading week of the year was any indication of things to come, investors are in for a wild ride in 2015. The January 7 release of the minutes of the December FOMC meeting led to a bout of frenzied buying that ended four straight days of selling going back to December 30.
While there was little of note in the minutes, markets took the absence of any warnings of imminent rate increases as permission to pile back into stocks despite further oil price declines and more bad economic news from Europe, China and Japan.
Then, on January 8, Chicago Fed President Charles Evans, who would probably never raise interest rates again if he had his way, declared that an interest rate hike would be "catastrophic" – he actually used that word, "catastrophic" – because "official" inflation was running at only about 1.5% rather than at the Fed's 2% target.
One has to wonder what qualifies an individual to become a Fed governor. Perhaps it is a belief in the ability of a group of academics to micromanage the most complex economy that has ever existed in the history of mankind. Or perhaps it is the ability to ignore the fact that the Fed has rarely if ever accurately forecasted the path of the economy or any of its key components such as GDP growth or inflation.
Certainly it must include the ability to forget that only a decade ago the Fed led the economy down precisely the same path it is leading it down today when it left interest rates too low for too long, allowing a housing bubble to form that nearly destroyed the global economy. Whatever Mr. Evans' credentials and those of his colleagues, their performance demonstrates beyond a shadow of a doubt that they are uniquely unqualified for the task at hand, are far behind the curve, have no clue what is happening in the real world in terms of the market bubbles that have formed, and are leading us straight to another crisis.
We don't need cowards with guns who call themselves jihadists to destroy us. Central bankers are doing the job on their own. As John Maynard Keynes wrote, "there is no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction and does it in a manner which not man in a million is able to diagnose."
He learned that, by the way, from a terrorist – Lenin. If the jihadists really want to destroy the West, they should stop reading the Quran and start studying The General Theory of Employment, Interest and Money. Stock market investors haven't figured out what's going on yet, however, so they are only too happy to follow Mrs. Yellen & Co. over the cliff while Wall Street strategists who are paid to lie are urging them to pile in for what they think is going to be another year of gains. If the market is to go up, it will do so in the face of a global economic slowdown, plunging commodity prices, a highly deflationary dollar rally, and increasing geopolitical risks. Unless you are a trader who is in a position to get out of your positions quickly or someone who has hedged your positions against a sharp correction or a bear market, you are playing with fire.
By the Numbers
Last week, the Dow Jones Industrial Average lost 96 points or 0.5% to close at 17,737.37 while the S&P 500 dropped 13 points or 0.65% to end the week at 2,044.81. The Nasdaq Composite Index, which seems hell-bent on breaking its Internet Bubble era record in the Social Media era, shed 23 points to 4704.47. The most sustainable market moves came in bonds where the yield on the benchmark 10-year Treasury dropped below 2% to close at 1.975%. The yield curve is continuing to flatten, a sure sign that the U.S. economy is likely to struggle in the year ahead.
The government may be churning out strong GDP numbers, but those numbers are statistical manipulations that belie underlying weakness in demand, a growing inequality gap, trumped-up corporate earnings, and the ever-increasing weight of public and private sector debt that is suffocating growth.
As low as bond yields are in the U.S., they are virtually microscopic in the rest of the world. Most of Europe's short-term yields (2-5 years) have moved into negative territory while Germany's 10-year yields closed the week at 0.49%. Spanish and Italian yields finished at 1.71% and 1.87%, respectively. In Japan, where the sun is the only thing that is rising, 10-year yields are down to 0.26%. A 1.975% U.S. 10-year yield looks rich in comparison and will continue to draw buyers until it is driven much lower.
Even a BRIC nation like Brazil, which has serious problems, has a 10-year yield of only 4.17%. This is the outcome of Ben Bernanke's and now Janet Yellen's unprecedented experiment in monetary policy to drive down interest rates to the point where the only thing investors can do with their money is lose it by investing it in risk assets.
That leaves the S&P 500 with a total capitalization-to-GDP ratio of almost 2.0x the mean (1.27 versus a mean of 0.65) and a Shiller/CAPE P/E ratio of 27x versus a mean of 16.6x against the backdrop of a flattening yield curve and a Fed likely to start raising short interest rates by the middle of the year (and if it doesn't, what does that say about the state of the economy?).
The Fed is in a straitjacket of its own creation. The December jobs report showed that the economy keeps creating 250,000 jobs a month and that the unemployment rate is now down to 5.6% (just 0.3% away from the Fed's 2015 year-end target of 5.3%) while U6, the all-in rate, fell to 11.2%. Of course, these numbers were flattered by a further drop in the labor participation rate to 62.7%, the lowest since 1977, but Fed policy can do nothing about that.
Obviously the numbers have not yet seen an impact from job losses in the oil and gas sector, but they will come soon enough. Originally the Fed had set 6.5% as the target at which it would start considering raising rates, but who are we to quibble? One disappointing statistic was a 0.2% drop in average hourly earnings as income inequality continues to widen.
Central Banks Can't Pilot a Smooth Landing
The refusal of the Fed to begin normalizing interest rates suggests either that it truly believes it can micromanage the economy to a smooth landing (which experience dictates it cannot) or it is terrified (as Charles Evans suggested) about the effects of higher rates on the economy.
With respect to the latter point, the economy can likely sustain 100-200 basis points of higher rates without much negative effect. Markets, however, are another matter. If stock markets are going to skyrocket every time the Fed hints at a delay in raising rates, as it did in mid-December and again last week, one has to wonder how hard it will sell off when the fateful day finally arrives and the Fed announces its first 25 basis point hike in the Fed funds rate. Despite all the brave talk by the Happy Faces on CNBC that such a move would indicate economic recovery and confidence in the future on the part of the Fed, stock market investors could well interpret the news as a sign that the party is over.
With stocks trading at levels only seen before prior market crashes, this may be what Mr. Evans was really trying to say when he said that an interest rate increase would be "catastrophic." But it is time for the Fed to stop protecting the stock market from itself and let free markets reign.
There may, after all, be some smart jihadist out there who understand what Keynes (and Lenin) were saying and are enjoying watching us destroy ourselves. Maybe their attacks only accentuate the real war that we are waging on ourselves.
About the Author
Prominent money manager. Has built top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.