The Hawks Surrender
They say that there are no atheists in fox holes. Recently it has also become clear there are no monetary hawks in bear markets.
For much of the last decade many conservative market analysts have decried our reliance on monetary stimulus to prop up the economy and the stock market. But in the final months of 2018, in the face of the worst stock market declines in a decade, many of these supposedly pragmatic figures quickly abandoned their convictions. As the markets briefly crossed into bear territory, monetary hawks joined with the doves and President Trump in issuing a full-throated call for the Fed to cancel their planned rate hikes and balance sheet reductions. It appears as if the Fed got the message. Almost overnight, the tone from the Fed softened considerably, causing Wall Street to sound the “all clear.”
During the Obama years, many of these erstwhile hawks appeared to partially share my belief that big deficits were a big problem and that an economy built on a foundation of zero percent interest rates, quantitative easing and deficit spending was not a real economy at all. Donald Trump picked up that message in the 2016 campaign and it rang true to many Americans who were justifiably resentful that the bubbles created by these policies primarily benefited the rich. But now that there is a Republican in the White House (and a whiff of fear on Wall Street), those concerns have vanished faster than a cool summer breeze in Texas.
But let’s be clear, there was nothing normal about the nearly decade long, record-breaking bull run in the S&P 500 that came to a spectacular end this Christmas Eve. (During the run, the S&P more than quadrupled from February 2009, and never retrenched more than the 20%). There was also nothing normal in its spectacular ending. The worst December since 1931 during the Great Depression was capped by the biggest Christmas Eve massacre, delaying the “Santa Claus Rally” until the Fed Grinch had a change of heart.
As it turns out, all the markets wanted for Christmas was a dovish Fed. And when Jerome Powell finally started singing the right tune, the December massacre quickly gave way to a great opening to 2019 in the equity markets. The surge has caused many to think that the worst is behind us. But such a conclusion ignores both the size of the bubble that has formed over the past decade and what real bear markets actually look like.
According to CNBC, on average, the bear markets since World War II have lasted 13 months, with stocks losing an average of 30.4 percent of their value in each episode. (KRooney, CNBC, 12/24/18) With the notable exception of the Black Monday Crash in 1987 (which took just one day to cross into bear territory), these downturns developed over many months, and continued after the 20% threshold was crossed. The two most recent bear markets of this century (not counting the current bear) provide stark illustrations of these tendencies.
After a record surge in the late 1990s, investors finally realized in March of 2000 that companies with no profits or revenues were not good bets. But even with this vital revelation, it took eleven months for the market to fall back from its record high and to cross into a bear territory. After that, stocks trended downward for an additional 18 months, eventually resulting in a 40.3% total decline by late September 2002. All through that bear market, Alan Greenspan’s Federal Reserve pushed back against the declines by slashing interest rates by more than 400 basis points. Without such dramatic stimulus, I believe the losses would have been far worse. The stimulus eventually helped ignite a furious rally that pushed stocks up 90% from September 2002 to October 2007. (The trade-off for truncating a bear market in stocks was creating a housing bubble that resulted in the 2008 financial crisis when it popped.)
Just two months before the Great Recession began in December of 2007, the S&P began declining again. This time it took 10 months for the index to cross into bear market territory. But like the Dotcom episode, the 20% decline was just the beginning. It took another eight months for the selling to finally come to an end with stocks declining a total 56% from the 2007 highs. This time the Fed responded with an even larger dose of stimulus. Fed chairman Bernanke cut the overnight rate by 500 basis points (100 more than 2002). But when zero percent rates were not enough to turn stocks around, the Fed reached for a new tool called quantitative easing. The policy authorized the Fed to buy bonds to inject liquidity directly into the financial markets and essentially push real rates below zero. Under the program, the Fed eventually bought more than $4 trillion in bonds, the vast majority of which still remain on the Fed’s balance sheet. Despite all this, the S&P still lost more than half its value by March 2009.
But the bear market of 2018 began in a much more spectacular fashion than what we saw in 2000 or 2007. We crossed into bear territory in less than two months. Unfortunately, history would suggest that we might have a long way to go before it ends.
The importance of quantitative easing in the previous stock market bubble becomes clear when you overlay market performance with the chronology of the program. The majority of the gains of the 2009-2018 bull market occurred when QE from the Fed was active. From the time the program was launched until it was finally wound down in October 2014, the S&P 500 gained about 195%. In fact, that was the very purpose of QE: To raise asset prices, thereby creating a paper “wealth effect” that would encourage more borrowing and spending and, therefore, create economic growth. And while asset prices rose, and the borrowing and spending certainly occurred, the growth never maintained the 3% targets that most economists expected. Without the QE wind in our sails, the market stalled. From October 2014 until October 2016, the market was up only 3%. Something else was needed to push stocks up. That catalyst arrived in the form of Donald Trump.
Markets believed that the pro-business swamp-draining Trump would transform the economy the way Ronald Reagan had in the 1980s. After the initial post-election euphoria, the Trump tax cuts arrived to provide a fresh dose of short-term fiscal stimulus to offset the withdrawal of monetary stimulus coming from Fed rate hikes. The business tax cuts boosted corporate bottom lines, and funded a new round of share buybacks, while stoking business and consumer confidence. The rally that began on Election Day 2016 added another impressive chapter to the bull market, pushing the S&P up 35% until September 2018. But since government spending actually rose as taxes fell, the tax cuts provided no real economic relief. A larger government needs to drain even more resources from the private sector to operate. So what the government no longer collected in taxes, it had to borrow instead. Not surprisingly, deficits have soared under Trump, a development that appears to have caused no alarm whatsoever among traditional Republican deficit hawks.
However, in early 2018 the Fed began its long-discussed plan to “shrink” its balance sheet by selling significant quantities of its bonds so that it would have the flexibility to grow its balance sheet again if the markets needed the support. This could not have come at a worse time, as it meant that the larger deficits created by the tax cuts would have to be funded by private capital markets, thereby crowding out less creditworthy borrowers. It should have surprised no one that the process of selling bonds (called quantitative tightening “QT,” – the opposite of QE stimulus) would put downward pressure on stocks. And as it happens, the beginning of the bear market corresponds almost exactly to the October expansion of the quantitative tightening program from $8 billion to $50 billion per month. As investors then expected the QT program to continue on “automatic pilot”, the concern spread quickly. Fortunately for them, Powell has since pulled the plug on the automatic pilot. This was the spark that has ignited our January rally.
From here, there are two possibilities: Either the Fed continues to raise interest rates and follows through with its planned draw-down of its balance sheet, in which case the country may find itself in a long overdue and deep recession and the market slide continues to…who knows where, (For some thoughts on where market valuations could be in the absence of stimulus, see my November 14th, 2018 commentary The Stock Market Economy) or it capitulates to market and presidential pressure and completely calls off further rate increases and balance sheet draw-downs. And while the latter (dovish) scenario may lead to a near-term relief rally on Wall Street (as we are seeing now), the long-term ramifications are not good. That is especially true since the rate hikes of the past may already guarantee a recession, even if the Fed refrains from any more hikes in the future. Also, simply ending QT will not be enough. The next recession, I believe, and the surge in annual budget deficits that already exceeds 1 trillion, will not only require a return to QE, but on a scale that will exceed QE’s 1, 2, and 3 combined.
However, if the stock market declines while the Fed is still stimulating, as I expect it will, investors around the world may finally realize that the United States may have become a monetary Roach Motel, where monetary stimulus checks in but it can never check out. The economic house of cards that has supported us for a decade will finally be laid bare, and investors may recognize that interest rates will never return to normal and that the size of the Fed’s balance sheet will rise in perpetuity. At that point, America may officially become the world’s largest Banana Republic, but without the bananas. That means a crisis may not just be a garden-variety financial crisis like the one experienced in 2008, but a far more extensive sovereign debt and currency crisis. Confidence in the U.S. dollar could plummet.
So a return to ZIRP and QE will not be a stimulus that revives the economy by creating the illusion of growth, but an overdose that may kill our currency. The developments of the past few weeks, which reveal how little support there is for anything resembling fiscal and monetary discipline, make this scenario all the more possible. In our foxholes, everyone will be praying and no one will actually have the courage to stand up and shoot.
But perhaps the biggest danger facing the American economy is not financial or monetary, but political. If we are currently entering a recession that proves to be even more severe than the last, which I believe we are, Donald Trump and the Republican Party will take the blame. Trump may become the trans-formative president that voters hoped him to be…but in the opposite way that they expected. Trump may accomplish for the Democrats what Jimmy Carter accomplished for Republicans 40 years ago.
Even though Carter did not create the horrible economy of the late 1970s, he nevertheless bore the blame for a recession that was more than a decade in the making. The failure of his policies to turn the economy around paved the way for the conservative Republican backlash that elected Ronald Reagan in 1980. With the exception of the 1964 election, Republican presidential politics in the post War years had been dominated by centrist “Rockefeller Republicans.” As a died-in-the-wool Barry Goldwater conservative, Reagan’s attempt to capture the presidential nomination in 1976 fell far short. But, by 1980, voters correctly concluded that the economic crisis had resulted from leftist policies that had been implemented by both Democrats and Rockefeller Republicans. The backlash permitted a true political shift to the right.
Trump may accomplish the same thing in reverse. When voters go to the polls in 2020, I believe the economy will be in shambles. At that point, the backlash against Republicans will be in full swing. Voters will incorrectly assume that the policies of Trump were actually “right wing,” even though his deficit-busting big-spending approach had nothing to do with true conservatism. Disgust with Trump may allow the unthinkable, the election of a president from the far left of the Democratic Party! What’s worse, this future Kamala Harris or Bernie Sanders will be able to rely on a solidly democratic Congress to push their agenda through. In short order, we could get the full “democratic socialist” recipe: Much higher taxes, much greater regulation on business, universal health care, student loan amnesty, corporate racial and gender quotas, renewable energy requirements, and significant expansion of entitlement spending.
The resulting debt and economic restrictions will finally bring the American economy to its knees, resulting in an inflationary depression unprecedented in our history, but commonplace among other overly indebted nations that have gone down this fatal path. We may have one last opportunity to take back the country in 2024, but if despite their abject failure the socialists retain power, they may never lose it. Then our Founding Fathers’ experiment in self-government and freedom will have finally ended in failure, and the light on Ronald Reagan’s City on a Hill will shine no more.