Thursday, May 23, 2013 - Premature Punch Bowl Withdrawal

Premature Punch Bowl Withdrawal

by Sinclair Noe

DOW – 12 = 15,294
SPX – 4 = 1650
NAS – 3 = 3459
10 YR YLD un = 2.02%
OIL + .01 = 94.29
GOLD + 21.80 = 1392.50
SILV + .36 = 22.73

Yesterday, Fed Chairman Bernanke delivered testimony before the Joint Economic Council and then the minutes from the most recent FOMC meeting were released. The Fed policymakers seem concerned about bubbles. Stock markets have been hanging out near record highs, the S&P is up about 15% year to date. Look back to earlier this year. The boring stocks led us higher. Your mega-cap, super-safe, dividend-paying names were the stocks to own. These stodgy companies sprinted higher for weeks. Safe became the new speculative.

Next, the rally broadened. First, it was short squeezes. Then, the rally focused on the more cyclical names. Energy stocks have found a second wind. Small-caps were. Technology names began pushing the market higher. Bloomberg reports that the most indebted US companies are rallying more than any time in almost four years compared with the rest of the market.

The bulls argue that stocks will keep going up,even if the Fed takes away the QE punchbowl; the argument is that there are record corporate profits. But then we have to ask why there are record corporate profits. The answer is the Fed's accommodative monetary policy. The Fed is effectively subsidizing earnings by providing cheap credit for the federal government. Government spending replaces paychecks as a source of income for consumers to consume. Corporations cut wages and operate lean and mean, and they report record profits. The top line, revenue, has been weak but it hasn't collapsed because the government has been providing just enough to keep the economy moving. The government provides income to citizens and they are still consuming.

Beyond that, corporations benefit from extremely low interest rates, which allows companies to refinance debt and pocket the difference. Or, in the case of Apple, they can borrow at extremely low rates, pass out the cash as dividends, and it's still cheaper than repatriating profits from offshore and paying the taxes. The debt to equity ratio for S&P 500 companies is now 57% above historical averages.

The Fed's accommodative monetary policy has allowed income to be detached from employment. Corporate America has been slowly and surely eroding its own customer base and the government has been picking up the slack with social safety nets. At the end of the day, a safety net is a stopgap measure, not a permanent solution. Without more jobs, without real income, the equity markets will eventually revert to lower valuations.

And so yesterday, Chairman Bernanke continued to beg for fiscal policy, or at least fiscal policy that doesn't embrace austerity. Bernanke has to be worried about the imbalances and he is aware the lesson the Great Depression taught many is that the principal symptom of internal economic imbalance was unemployment; a big enough problem to create a grand market failure. The equilibrium that economies find routinely is one where aggregate demand and output are not enough to ensure that the available labor force is working; that's why the Fed has a mandate of maximum employment, not just a target of 6.5% unemployment. The idea is to ensure internal balance by having the government increase spending, thereby boosting demand, which in turn, increases output, which means more jobs. It's a virtuous cycle. Except it isn't working quite like planned.

Apple is parking money offshore; same with GE, Starbucks, Google, and almost all of the big multinationals. Somewhere along the way, the idea of an economy that maximizes aggregate utility has given way to maximizing profits for a small minority who possess capital. And the idea of the government safety net being utilized to provide capital to increase consumer spending and crank up the virtuous cycle, well that is running into a brick wall in the form of austerity.

The pace, depth and breadth of the stock market rally is certainly not justified by economic fundamentals alone. Investors continue to buy because they are in a desperate search for returns in a low-return world and feel that cheap money will keep them 'whole' if they invest in risky assets, such as stocks.

Yesterday, Bernanke was asked a question that suggested the Fed's super loose, accommodative monetary policy might be creating asset bubbles, which might end very badly. Bernanke responded that “there's no risk free strategy right now.” And that risk is not restricted to the stock market. His all-consuming concern right now must be to avoid the kind of bond market carnage that was created in 1994 when the Fed raised rates unexpectedly, and I suspect that the debate within the FOMC is becoming much more heated with regard to how to achieve some scaling back of asset purchases without causing a similar bond market rout.

Bernanke started yesterday's testimony with prepared remarks by pronouncing: "a premature tightening of monetary policy could lead interest rates to rise temporarily, but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further." It seemed a clear signal that the Fed would continue QE to infinity and beyond.

Then, in the Q&A session, he commented that the Fed could cut the pace of asset purchases "in the next few meetings." It seemed a complete about face.

So, we're back to watching the Fed's targets for inflation and unemployment. There are good economic arguments for inflation to become extremely sticky to the downside at these low levels; just over 1 percent. We'll keep an eye on the next few jobs reports, where good news could be bad news. Also, keep a look at global unemployment numbers. In 14 out of the 35 advanced economies covered by the IMF’s World Economic Outlook dated April 2013, the unemployment rate in 2012 was at its highest since 2007. In terms of jobs, in many countries the crisis is intensifying, not retreating.

The problem is not just that the incidence of unemployment is uneven across the advanced countries. It is also that it is extremely uneven across age groups, or more importantly, generations. The generation that has entered the labor force over the last five years is the hardest hit. These numbers are important because they represent systemic failure in labor, and the Fed can't operate in a vacuum with its monetary policy. It would be strange to see the Fed tightening, while the ECB is loosening. If you want to create problematic global imbalances, all it will take is a gear-shift by the US Federal Reserve and the inevitable dollar surge that follows. Remember that it was the Volcker Fed that set off Latin America's defaults in the early 1980s. It was the mighty dollar that set off Mexico's Tequila crisis, and then the East Asian tiger economies, chain-reaction in the 1990s.

Foreigners have pumped more than $8 trillion dollars into the emerging markets of the BRICS. European banks have lent another $4.4 trillion to the BRICS. If the Fed tightens, the dollar soars, the BRICS freeze, the defaults follow.

I'm not sure what the possible exit plan is for the Fed, maybe for now, it's nothing more than jawboning, trying to gauge the possible responses. So, there is widespread, deep-seated cynicism about the ability of democratic governments, once engaged in stimulus, to change course in the future. Ending stimulus has never been a problem; in fact, the historical record shows that it almost always ends too soon. What needs to happen before we start talking about ending stimulus is a good strong look at fiscal policy; the kind of policy that allows corporations to shovel profits offshore, and erode their long-term customer base in pursuit of short-term profits.

Global corporations have no allegiance to any country; their only objective is to make as much money as possible — and play off one country against another to keep their taxes down and subsidies up, thereby shifting more of the tax burden to ordinary people whose wages are already shrinking because companies are playing workers off against each other.

The total corporate contribution to federal revenue, including employers' share of payroll taxes, has dwindled from 32 percent in 1950 to about 17 percent today. Employer contributions to payroll taxes make the unfairness of the tax code slightly less unfair, but the trend is still clear and dramatic: Corporations are paying a lot less than they used to.

So, Tim Cook of Apple went before the Senate this week and explained the problem, and the problem isn't Apple; it's our tax laws. Apple is only doing what the laws allow. Apple and the other big companies are trying to lower their tax bill, and you would probably do the same thing if you were as big as Apple, and had a fiduciary duty to your shareholders. The problem is the laws allow them to keep billions offshore, which does nothing to create jobs in this country, which does nothing to repair infrastructure, which does nothing to create aggregate demand, which does nothing to crank up the virtuous cycle; which instead puts us on a downward spiral. When you hear outrage about the IRS scandal, don't get distracted; the real scandal shouldn't be whether some low-level IRS employees were taking shortcuts; the real scandal; the multi-trillion dollar scandal was on full display this week.