Geopolitical Events – Abroad and Here
Crises around the globe have consumed much of our attention as of late.
These events are important, but we should not lose focus on economic matters at home.
The year is only one-quarter over, but it has already been full of market-moving events, including:
(more than normal)
Devastation in Japan Continued fiscal
deterioration in Europe
Revolt in the Mideast and North Africa has covered most of the alphabet, ranging from (B)ahrain to (Y)emen. Investors and nations worldwide have been jolted into a new reality, unsure what the implications are, much less how to respond. Are we witnessing the beginning of a true democratic movement in the region? Will those cries be stamped out by the extremists and the renewal of tribal conflicts?
It is unlikely these questions will be answerable for some time. Given that the Mideast and North Africa produce over one-third of the world’s liquid fuels, the questions are particularly relevant. Oil markets are tight as there is no excess oil being produced. The price of oil has spiked over 25 percent since mid-February as a result of the unrest, especially due to the civil war in Libya. Fortunately, Libya provides only 2 percent of the world’s oil supply.
On top of this unrest, Japan has been hit with an earthquake, tsunami and, perhaps most importantly, a nuclear disaster. Japan is the world’s third largest producer of nuclear power so the potential fallout from a core meltdown is enormous for that country and its power needs. Japan is also the third largest economy in the world and these domino disasters have had reverberations worldwide. Manufacturing around the globe is being impacted. For example, in mid March, General Motors ordered all non-critical expenditures be put on hold and was temporarily halting production at some facilities in the U.S. and in Europe due to parts shortages from Japan. Is this a hiccup or something much more serious?
At this point, global growth is likely to slow through the spring as manufacturing is taken off line. The rebuilding of Japan should provide a stimulus later in the year and into 2012, both for Japan and for worldwide growth. This disaster may prove to be a watershed moment for Japan, but we firmly believe its citizens have the resources to rebuild.
As for continued fiscal problems in Europe, in March alone, the government debts of Spain, Portugal and Greece were all downgraded. This might have made bigger headlines without the Mideast and Japan on the front page, but it is hard for many U.S. investors to stay focused on Europe as its continual financial crisis resembles a slow train wreck. As someone recently asked me, “Wasn’t Europe’s fiscal crisis in 2010?” Well, yes it was. And in 2009.
Unfortunately, the fiscal crisis is not going away anytime soon. Like our own fiscal problems, European overspending and borrowing will not be fixed with anther bailout in the form of more borrowing. To be fair, one can make the case that Europe is taking its fiscal challenges more seriously than the U.S. is presently. If this is true, it is probably because Europe has been forced to while we have not…yet.
Is the Goosing Laying a Golden Egg? With a few notable exceptions, it is clear our elected officials will not take the necessary steps to get our fiscal house in order until forced to do so. From the market’s perspective, one of the more debated issues is that the Federal Reserve has been pursuing an aggressive easy money policy. This includes the second round of quantitative easing (QE2) and short-term rates maintained near 0 percent since December 2008. With QE2, the Fed is simply buying lots of government bonds ($600 billion) in order to put this cash into the economy in hopes that it will goose the economy.
As Fed Chairman Ben Bernanke said in his November 2010 Washington Post editorial to justify QE2: “And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.” Stock prices have certainly moved up (9 percent) since QE2 was started in November. But so have gold and many other commodities. The Fed is not trying to goose commodity prices upward, but one could make a cause-and-effect connection.
If the Fed wants the credit for higher stock prices, surely it accepts some responsibility for higher commodity prices. The Fed’s easy money policy has many investors scrambling to find inflation hedges, including commodities. Higher commodity prices have many consumers feeling the pinch, primarily due to higher food and gas prices.
Prices are moving up worldwide and it is less-developed countries such as those found in the Mideast that are being hit the hardest. Many governments in this area of the world control the prices of food and energy in order to keep citizens less enraged by bad economic policies, a common strategy for dictatorships. Interestingly, higher food and energy prices appear to be contributing to much of the unrest in this part of the world. Subsidies to citizens must be increased in some fashion or governments must allow price increases to pass through to them.
A second quote of Bernanke comes from his 60 Minutes interview in December 2010, answering critics of QE2 who were concerned about the inflationary impact of so much economic goosing: “We could raise interest rates in 15 minutes if we have to. So, there really is no problem with raising rates, tightening monetary policy, slowing the economy, reducing inflation, at the appropriate time. Now, that time is not now.” This sounds all well and good in theory but in practice there can be unintended consequences which can result in things not going exactly to plan. Often, unintended consequences result from time lags in taking action.
This starts with the Fed recognizing a need to start raising interest rates. Even after recognizing a need for change and implementing the change, the full impact of higher rates slowing unwanted inflation may take up to a year. This job is even more difficult due to the Fed’s inflation goal of 2 percent versus the 1 percent inflation rate present when QE2 started in November. This is a small needle to thread.
Are the Fed’s Two Jobs One Job Too Many? With QE2, The Fed has clearly signaled the significance of its dual mandate of promoting maximum employment while fighting inflation. The importance of this is that these mandates are at times diametrically opposed to one another. If inflation starts to exceed 2 percent on a sustained basis, does the Fed tighten even in the face of weak employment? Our employment problem shows signs of being more structurally based and less influenced by the Fed attempting to lower interest rates or increase stock prices. The long-term unemployment rate remains very high by historical standards.
In addition, the percentage of the population that considers itself as part of the labor force, whether working or not, has dropped dramatically over the past 10 years. Not only are many people not working, they are not even looking for work.
Together, these factors indicate it may be difficult for an easy money policy to have much of an impact on getting people re-employed. Does the Fed’s action guarantee inflation is going to climb upwards? Certainly not. The Fed is only half of the equation.
The second half is the banking system – banks have to make loans in order to expand the money supply; otherwise the money just rests in the banks’ vaults. If the banks do not lend, the Fed is simply pushing on a string. The Fed views the economy as containing enough slack that will allow it to react quickly and bank lending will not grow too fast.
A risk of this strategy, however, is that the Fed’s actions are inflationary while at the same time, it is pushing on a string in terms of generating increased employment. Is that even possible given the Fed’s aggressive actions at flooding the economy with cash? Unfortunately, the answer is yes.
As we build up increasing amounts of debt, that debt has less positive impact on growth and at some point could have a negative impact on growth. The chart “Lower and Lower GDP Growth for a $1 Worth of Increased Debt” shows that for every dollar increase in debt since the 1950’s, the increase in GDP has consistently been less, decade after decade.
Quite simply, we are getting less bang for our buck as we leverage up. More borrowing will likely not fix this either. While consumers have reduced their debt loads either through savings or default, governments at all levels have continued to take on more and more debt. Much of this debt increase now and especially in the future is to fund transfer payments from one group of taxpayers to another. Under QE2, the Fed has been the primary buyer of Treasury debt.
If debt issuance does not result in a faster growing economy on its own, there is skepticism that the Fed’s purchase of the debt will alter that basic equation.
Besides a higher stock market creating a wealth effect, part of the rationale for QE2 was to reduce interest rates to encourage more economic growth. Since QE2 began in November 2010, the interest rate on a five-year Treasury Note has actually increased by one percentage point.
The bond market seems to be saying QE2 may not be the answer to our employment problem.
It has been speculated that the Fed may initiate a third round of quantitative easing when the QE2 expires in June, given continued weak employment. We would add that a QE3 sequel when QE2 is finished may not be a blockbuster hit either. –