2009 was a year of extreme lows and highs, neither of which were correctly anticipated by many. March 9th, 2009 saw the S&P 500 hit 666, only to rebound about 80% from the trough.
The year started with legitimate fears that the banking system would collapse into oblivion. We came within hoursof a complete collapse of the global money market – the source of short-term funding for banks and corporations. When the Primary Reserve Fund, a large money market fund, broke the buck, it sent investors scrambling to redeem money from what were previously thought of as secure investments. Money market funds, the pinnacle of safety, became the victim of a modern day run on the banks. Only explicit government guarantees of money market funds stemmed redemptions.
Had the money market collapsed, banks would have failed and corporations would have been unable to meet payroll. Hundreds of millions (if not billions) of citizens around the world would have been unable to withdraw money from their banks and would not have received a paycheck. Without free-flow of money, consumer spending would have seized and businesses would have failed, resulting in a modern-day economic depression.
Instead of allowing the system to fail, the US Treasury and Federal Reserve stepped in with explicit guarantees, capital infusions and new accounting rules, which changed the game, turning previously dirty banks into polished profit engines.
A new president, a new hope, a wall of liquidity and an inkling of stabilization stopped the drop in confidence. Green shoots, a phrase made popular by Ben Bernanke, grew roots and lifted the market off its back, while skeptics watched from the sidelines. In fact, most market participants were skeptics, and in Q1 and Q2 2009 it became popular to predict the end of the world.
What did markets see that the skeptics didn’t?
First of all, one can argue that markets fell more than justified by fundamentals; much of 2009 was simply a recovery of value that should have never been lost in the first place. Moreover, massive amounts of liquidity supplied by central banks around the world found their way into speculative hands that put the money into the markets.
Much of the market is now indirectly or directly propped up by governments. Consider this: virtually the entire US mortgage market is financed by the US government; the Federal Reserve balance sheet has doubled to support troubled banks; Chinese banks have been ordered to lend, despite country-wide capacity issues.
Also, markets are discounting mechanisms which saw that 6-10 months down the line the massive wall of liquidity and fiscal stimulus would have an impact on economic fundamentals and asset prices. Those that looked forward by several months, and had the capital to risk, made a nice profit over the past several months.
And here we are, 10 months from the March lows. According to many measures, the rate of economic decline has stabilized, and according to other measures the economy may have started to grow during the summer. While some herald an improving economic metrics others point to the 17% real unemployment and argue we are in a depression.
Is this an economic depression?
The degree of error in predicting where we are and where we are going is extraordinarily large. The range of possibilities is a function of the uncertainty behind the timing of policy actions. Generally, there are three policy scenarios that should impact anyone’s outlook:
1. Stimulus is maintained for too long.
2. Stimulus is withdrawn too soon.
3. Stimulus is withdrawn at the perfect time.
History, and Ben Bernanke’s own words, suggest that scenario 1 is most likely. Because the Federal Reserve doesn’t target asset bubbles, it can lean on inflationary measures until consumer prices rise – this can take a while. Despite tame CPI figures, the housing bubble that grew out of the Fed’s easy money policies of the early-mid 2000s is a perfect example of the damage caused by ignoring asset bubbles. However, as an expert on the Great Depression, Ben Bernanke knows the consequences of withdrawing monetary and fiscal stimulus too early, and will be very cautious (too cautious?) when taking away the punch bowl.
Who will drive the recovery?
What happens as a result of overstimulation depends on whether or not the private sector is able to take over the ‘recovery’. So far, much of the stabilization and nascent growth was originated by government spending. If the private sector doesn’t take over, government deficits and debt will continue to explode. History has shown that out-of-control deficits crowd out private investment, raise interest rates and create the highly inflationary incentive for central banks to monetize debt. If left unchecked, exploding budget deficits could result in some combination of government default, currency crisis, hyperinflation and painful austerity measures.
On the other hand, if private sector demand recovers, government deficits will subside but monetary stimulus will be prolonged. In this scenario, another asset bubble is likely to occur somewhere in the world, eventually leading to another bust…and the cycle continues.
What could prevent private sector demand from taking over?
1. Housing, which has stabilized due to government stimulus, resumes its decline.
2. China becomes a massive bubble and busts.
3. Foreign government bond markets start freezing.
Will the markets post double-digit returns regardless?
Given the Federal Reserve’s loose stance, it is possible that we see double-digit nominal returns in 2010, regardless of the condition of the economy. Investors need to understand the difference between real and nominal returns for US stock markets. [Remember, Zimbabwe has had one of the best-performing stock markets in the world, in nominal terms.]
There are various ways to distinguish between nominal and real returns:
1. How is the US market performing in terms of foreign currency?
2. How is the US market performing in terms of gold?
3. How is the US market performing in terms of the cost of living?
On all three measures, real US stock market performance has been far from exhilarating since 2000. Even over the past year, a large part of US stock market gains are explained away by the appreciation of gold and the depreciation of the US dollar.
Recovery or no recovery, if the US market performs well in 2010, it will likely be in nominal terms only.
How long does the nominal charade last?
As long as governments can borrow at virtually zero cost to support ailing economies, nominal stock market returns will continue to be positive. However, when rates on government securities rise, the market will feel the real cost of saving the economy. This will mark a turning point in the recovery.
If private sector demand has not picked up, governments will either need to pay an increasing yield on debt, print money to finance expenditures or cut back on spending. Would the US cut back on fiscal stimulus while real unemployment is at 17%? This is not politically feasible.
History suggests the US will opt for inflation over unemployment. After-all, it took 10 years of inflation during the 1970s before the political will was mustered to fight rising prices. Since politics tends to outweigh economics, this type of response is likely in most countries experiencing government debt problems.
As government yields rise, real asset prices will fall. However, an inflationary response to a frozen government debt market would lift gold prices.
The question is this: when, and to what degree, does all this happen?
Extreme scenarios rarely occur outside of the movies. The non-tail probability is that the world works through a prolonged period of sluggish growth, rising rates, rising inflation, weak real asset returns, and strengthening commodity prices.
The tail-risks tell me to hold gold.
