Let history be the guide
The Fed’s unprecedented steps to insert itself into markets
What does the rise of the ISIS terrorist state in the Middle East have to do with the Federal Reserve’s interest rate decisions or global economic health? There’s more of a connection than most might think. History can be a guide.
For the past five years, I have been invited to attend the Strategic Investment Conference, where some of the best and brightest global thinkers convene to share their insights on the state of our global economy and geopolitical environment. This spring, there was considerable focus on the Fed and how other central banks across the globe have taken unprecedented steps to insert themselves into the markets.
Most of us know that our central bankers are typically charged with two mandates: employment and inflation. On the inflation front, we haven’t seen much to worry about. In the middle of 2013, when the Fed began its policy of quantitative easing, which culminated by injecting $85 billion a month into the economy, we saw typical monetary policy turned upside down. When core inflation reached a 50-year low and interest rates fell while bond prices rose, keen market observers knew that something was “up.”
History suggests that when governments start printing their fiat currency a stampede of inflation can certainly occur. We know Germany in the 1920s had inflation so severe it undermined the country’s post-World War I democracy and paved the way for the rise of fascism, Hitler and the Nazis. Argentina is currently dealing with severe inflationary shock, which last year reached more than 40 percent annually – the highest since 1991.
Yet, in the United States, we have a seeming reversal of the stagflation era of the late 1970s and early 1980s. Instead of high unemployment, high inflation and high interest rates, we have moderate unemployment, significant underemployment and negligible inflation with near-zero interest rates. This is unprecedented territory and takes us to what appears to be a third unspoken mandate for the Fed: the growing business of providing security and stability for the marketplace. What began as the great bank bailout in the fall of 2008 has become an addiction and the seemingly unsaid obligation of providing market stability.
One of the unintended consequences of this trend is that the markets have gotten a free pass, thus far. While markets seem stable for now, the Fed’s psychological attempt to create a rising tide of wealth deserves scrutiny. Clearly, the Fed hasn’t gotten the maximum bang for its buck since it has barely nudged the needle on the velocity of money, and deflation has become as much of a risk as inflation.
If we continue into the realm of negative interest rates (15 countries at the time of this writing), market distortion will escalate the challenge of deciphering the pure calculus of equity prices.
In his presentation at SIC, noted economist Lacy H. Hunt, of Hoisington Investment Management, said he believes we are in a protracted period of compression and deceleration. This may explain why U.S. bond yields remain the highest in the world and why the Fed may have boxed itself in: They may want to raise interest rates but fear if they are raised too fast, it could create unwelcome market instability.
A few other panels and discussions at SIC demonstrated why strategic investing requires an understanding of trends minimally covered in the mainstream media:
• Hedge fund manager Kyle Bass, the investor who made a fortune betting against subprime lending, talked of his quest to drive down health care costs in general – particularly prescription drug prices – through his activist stance on drug patents. He believes that political choices, such as banning competitive drug prices for Medicare Part D, have artificially driven up costs, and is on a mission to do something about it. My guess is that he is also “short” on the pharmaceutical sector.
• Peter Diamandis, chairman of the XPRIZE Foundation, connected to the problem-solving skills of video gamers, a massive influx of alternative energy sources coming on line, and a global Internet connectivity boom to predict that the future could look much better and different than today. Surprisingly, he foresees abundant cheap and clean energy and collected collaboration will together solve the world's problems
• One of the security presentations considered the historical roots of how economic chaos leads to radical political movements. The historical connection and murderous intent of ISIS and the Nazis is uncomfortably close. ISIS was not created solely in a social/political vacuum in the Middle East. The stagnating economies in Western Europe have created a generational opportunity gap and have become a fertile recruiting ground for radical organizations like ISIS. In 2014, Spain recorded a 55 percent unemployment rate for people aged 25 and younger.
Can you imagine what would happen in the United States under similar circumstances? Inflation or deflation would be the least of our worries.
Tom Sedoric, managing director-investments of the Sedoric Group of Wells Fargo Advisors in Portsmouth, can be reached at 603-430-8000 or thesedoricgroup.com.