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Policy Priority: Stocks. Even If It Leads To Stagflation.

Policy Priority: Stocks. Even If It Leads To Stagflation.

The Federal Reserve, after all, has only one basic instrument as far as economic management is concerned – managing the supply of money and liquidity. Asked to do too much – for example, to accommodate misguided fiscal policies, to deal with structural imbalances, or to square continuously hypothetical circles of stability, growth, and full employment – it will inevitably fall short. If in the process of trying it loses sight of its basic responsibility for price stability, a matter that is within its range of influence, then those other goals will be beyond reach.” 

Paul Volcker, Former Federal Reserve Chairman, 2013

“Though the stock market is massively larger than it was in our early years, today’s active participants are neither more emotionally stable nor better taught than when I was in school. For whatever reasons, markets now exhibit far more casino-like behavior than they did when I was young. The casino now resides in many homes and daily tempts the occupants…..Money,  has trumped morality.”

Warren Buffett 

“Major nations are now officially in recession, suggesting that interest rates should be reduced according to the Keynesian playbook. But inflation is showing signs of rising again, mandating the opposite. These are a rerun of the conditions which discredited Keynesianism in the 1970s, leading to a common description of something that was to statist economists impossible: stagflation.”

Alasdair Mcleod

As Volcker predicted in 2013, inflation would return if policy deviated from a core inflation objective. What has become obvious, although never stated, is that policy has switched its priority, de facto, to the stock market, and inflation has returned in a major way. Meanwhile, investors have been adapting to record stock market speculation and “casino-like behavior” induced by the policy change and its ever-growing intensity.

The chart below shows clearly that ever since the Fed was freed from the gold standard in the early 1970s that the stock market has deviated ever more widely from the long-term exponential fit, with an ultimately upward bias, and now to by far the largest deviation in history.

The record stock market bubble has not been achieved just by improving economic growth, or even higher overall earnings growth. Both have lagged far behind. Policy has focused on a range of mechanisms that directly target the policy objective, the stock market. The driving elements have been debt growth, and more recently liquidity management, and easing financial conditions. So far, they have all worked wonders regarding the new policy objective.

Have we found the promised land? Or are we so far beyond sustainable that the prospect of mean reversion has become terrifying?

Liquidity

The chart below shows how closely US equities tracks liquidity.

Financial conditions

“The total cumulative easing over the past four months ranks as one of the most significant periods of relaxing financial conditions since at least 1982:” @bespokeinvest

Typically, this kind of stimulus only happens when the stock market and economy is in distress. This time the opposite is the case. Policy is simply piling it on.

 

Massive debt stimulus

What should not be surprising is that non-productive debt does not create lasting  economic growth. Since 1977, the 10-year average GDP growth rate has steadily declined as debt increased. Thus, using the historical growth trend of GDP, the increase in debt will lead to even slower economic growth rates in the future.

“Dear Uncle Sam, a nice return on investment? 5 Years Debt: $22T to $34T GDP: $21T to $28T”

 

 

Not only has the debt grown significantly, but international holdings have declined. The demands on debt refinancing are escalating rapidly. Almost certainly the Fed will have to return to buying Treasuries again before too long. At the margin that will be stimulative too!

The economic momentum is nowhere to be seen in the company earnings momentum either. 2024 Earnings concensus has actually declined during the record rally since November!

 

It is worth repeating. The stock market now seems to respond mainly to deficit spending, financial conditions,  and liquidity management. Earnings or long term GDP growth no longer seem to matter.

Can the stock market and debt growth continue to be levitated by an ever smaller economic and earnings base?

The silence is deafening.

The blue line is how people think economic cycles work, and then the red line just comes along and steamrolls that view.

The scale of the yellow filler just keeps getting bigger. Nothing stops this train. Exponential debt growth is a necessary component.

Growth may be enough to avoid a recession for now but the recovery will likely be weak and need continued support.

Yet inflation looks to have bottomed already.

Even before commodity prices have recovered and the private sector has had much if any recovery. The CPI diffusion index is rising again.

Setting up a clash between inflation and the stock market longer term.

The fed will have to choose between supporting both the record debt refinancing and the stock market on the one hand, and addressing inflation on the other hand. Essentially, the choice has already been made, it becomes almost impossible to turn back, so expect inflation to return over time. The bond market has already been weak this year despite the never ending expectations of interest rate cuts.

This is shaping up as a stagflationary debt trap.

While investors always celebrate the first half of a bubble, a huge challenge awaits investors. Managing accounts, without destructive drawdowns, is already a major long term issue, particularly for retirement investors. The gap between the stock market relative to economic and earnings growth has never been wider.

It is crucial that passive investors realize that standard investment methodologies carry very substantial risks on the other side of the current bubble. How do you maximize the bubble through all it’s phases and come out ahead?

Best Investor Standards solves that problem.

Summary

The current departure of the stock market from a normal evolution is clear and unprecedented. It is even a worldwide phenomena. As Japan has recently gone into recession, the Nikkei has finally made a new 35 year high!

Germany is also in the worst recession it has been in for decades, but unusually it also has rallied to new highs.

The US market is now more correlated to deficit spending and liquidity than to earnings or sales and has also just made new highs on the weakest period of leading economic indicators for 40 years.

The Fed thought they were tightening policy, but fiscal policy changed all that. Fed Chair Powell used to talk about being remembered as Paul Volcker. Now he realizes that he is more likely destined for the Arthur Burns category.

Investors have forgotten the lesson of the 1970s.

Investors have forgotten that equity markets can have zero real returns for decades.

Stagflation is a major risk for equities and it’s easy to miss. Why? Because Keynesian policy on steroids initially produces the opposite short term results as described above. So far that is the experience that market participants seem to believe is permanent. However, the inevitable 1970s experience is likely on its way and just a matter of time.

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Chris Belchamber is an IRMAA Certified Planner

Medicare’s IRMAA impacts every retirement plan. Learning how to mitigate it is available via IRMAA Certified Planners designation.

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