Friday, August 13, 2010

The Three Hundred Pound Gorilla in the Room

…Or is it the elephant in the room? No matter. The investment team spent the day last Friday pouring over economic data and a host of other security related issues, only to decide that the outlook remains either “mixed” or “muddled.” Senior Analyst Carl Noble is writing our monthly market review and as of this writing I don’t know which description he will choose. For me the biggest problem is not to decipher what the “weight of the evidence” is telling us about global economic conditions at the moment. It seems clear to me that while we can find a number of positive bullet points in the data, the general conclusion is that the global economy is still weak and that the risks are tilted in the direction of slower rather than faster economic growth. Heck, all we have to do is listen to the gloomy comments from our Fed Chair, Ben Bernanke, to know that we are not yet experiencing the robust economic recovery we all hoped for based on the amount of economic stimulus that has been thrown at the economy. The risk of the U.S. experiencing actual deflation is palpable. Inflation rates are less than 1% and the fear is that any kind of economic slowdown will put us on a path of generally falling prices, an economic condition not seen in the U.S. since the Great Depression. And, the consensus wisdom is that there is little policy makers can do about it since interest rates are already at zero and there is little political appetite for further fiscal stimulus programs.

As an investor, if you believe in the recession/deflation scenario, the best values in world are found right here in good-ole U.S. Treasury securities. Ten-year yields which are hovering around 3% would fall dramatically to new lows. There is no reason to think that “fair” yields wouldn’t be 2% or perhaps much lower on the bonds. You would sell equities on any bounce from here as the “fear trade” would be on and risk assets would get sold in a flight to safety. But the wild-card here is monetary policy. What would Ben Bernanke do if prices were to actually begin falling? He has written several famous papers on the subject of what the Fed could do at the “zero bound,” or zero interest rates. At the moment those investors who are “short” risk assets are terrified that the Fed would come in with a massive Quantitative Easing (QE) program to induce inflation. In the most talked about scenario, the Fed would buy about $1 trillion in bonds to significantly lower the dollar and subsequently create asset inflation in risk assets of all kinds. Those investors who bought bonds in advance of such a QE program would get slaughtered, as would investors who have underweighted risk assets. If the Fed were to come in with a QE program, when would they do it? Could you buy the bonds, wait for the markets to riot, and then safely sell them as the Fed rides to the rescue later in the year?

The Fed is now the “Three Hundred Pound Gorilla” with the power to distort the markets in any number of ways. John Mauldin just mentioned in his e-letter this weekend ( a rumor that the Obama administration is thinking of proposing a new strategy for Fannie and Freddie to forgive the amount of consumer mortgages that are currently under water. And of course, the debate on tax policy is heating up and will have a huge impact on the direction of financial markets heading into the fourth quarter. Oh, and did I mention it is election season again? I’m afraid that lately we are spending a lot more time trying to decipher what Washington will do to us than I would care to admit.