Reality Number 1: The stock market has had a great run over the past couple of years. Reality Number 2: The U.S. unemployment rate just crossed 6%, reaching the lowest level since the Great Recession.
These realities are objective, proven, quantifiable statements of truth. But are they really true? In other words, are they dependable?
As always, it all comes down to context. It is indeed true that the U.S. economy has made significant progress since the trough of the Great Recession. The automobile industry bailout has, despite a circa $10 billion loss, been successful, as the U.S. car industry is alive and well and millions of jobs have been preserved (by some estimates, the economy would have taken a $40 billion hit had GM gone under, so policymakers made the right economic decision). The bank bailout has certainly worked out, and taxpayers have made a nice profit out of it. The massive post-crisis stimulus package was generally disbursed without much waste (credit goes to Vice President Biden for successfully overseeing its implementation). Even the Affordable Care Act has met the enrollment target necessary to be sustainable over the long run.
But here is where context leads to confusion. Is the growth we have experienced since 2009 satisfactory? Considering the enormous liquidity the Federal Reserve has injected into the economy, the answer is a resounding “no!” We often forget that the Fed’s balance sheet has quintupled – you heard right, it has grown more than five times – since 2008, from $850 billion to $4.4 trillion. During this time, the economy has grown on average somewhere around 2%. Not bad – but certainly not impressive, especially considering the Fed’s accommodative policies and the low starting point following the large correction incurred in 2008-2009.
I wrote in my last column that my generation lacks an important point of reference our elders possess: the Cold War. My peers and I do not – and cannot – tangibly grasp the nuances and emotional effects of symmetric warfare, nuclear proliferation, major adversarial blocks, realpolitik, Mutually Assured Destruction, transformational personalities, etc. In the same way, we cannot fathom inflation levels of 15%, such as those our parents and grandparents experienced in the early 80s. To understand that then-Fed Chairman Paul Volcker raised fed funds rates from 10% – recall they are near zero now! – to 20% is something we can barely digest intellectually and certainly not emotionally. To my generation, monetary policy seems like a piece of cake: keep rates perennially low, then buy government bonds or mortgage obligations, and the stock market will be at record levels, real estate prices will go up, venture capital and private equity money will abound, and corporate America will get financing at ridiculously low rates (recall Verizon raised $60 billion in one go last year). Clearly something has got to give.
Returning from the generational context back to the economic context, we need to recognize that quantitative easing is coming to an end and will thus have a real effect on both the economy and on markets, despite the “Efficient Market Hypothesis” that everything is already priced in (by the way, thanks, Finance Theory, for the ghastly recession you caused). We just have not dealt with a liquidity absorption and withdrawal of this size ever before. Who is to tell how many businesses will stop running once easy money dries up? The Verizons and the Apples will be fine: they have locked in their low rates and immense financing raises. It is small businesses that will hurt the most. If you are complaining about income disparity and the 1% now, just wait a couple of years…
And of course, it is not just our own monetary policy that bears uncertainty. We are inextricably integrated with the global economy. You have heard about Europe being in stagnation as we speak (even Germany’s growth forecasts were reduced to 1.5% a few days ago), but think about the inflation picture: France is running at 0.5%, Italy at -0.2%, i.e. deflation, and the Eurozone overall at 0.4%. All of this is now the case despite a multitude of liquidity injections from the European Central Bank. God forbid Europe enters into a deflationary spiral while Mario Draghi, the President of the ECB, tries to pump liquidity once again. Stock markets will rise temporarily, but that will do very little for the underlying economies. Such circumstances would truly signal the end of monetary policy as the panacea for low growth. In fact, I do not know what solutions Europe would find at that point to pay off its debt obligations absent some groundbreaking innovation.
We might very well be looking at a major deleveraging cycle, one that has been accelerated by Russian-provoked turmoil and that may be exacerbated by the upcoming Greek national elections. If this scenario materializes, the effects will be painful in the United States – and God forbid our own fed fund rates are close to zero at that point.
Did I mention reports show investors are as complacent as they have been in 25 years?
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Stefanos Kasselakis has traded commodities at Goldman Sachs and founded