Central banks have created a new kind of bubble that is far more complex than technology stocks in 2000, or house prices in 2006/7. Those were hard enough for most investors, but now separating out what is real or fake, what the central banks can do and where their limits are, is no easy task. It requires constant attention and analysis.
Not much seems “normal” anymore. For sure, central bank policies have changed dramatically since 2008/09. For a time the new policies were called “temporary” or “unconventional”. However, more than 6 years later, those words are no longer used. So what is it exactly that central banks are really doing? Just this last week it became increasingly obvious.
It used to be that higher stock prices were connected to stronger earnings. However, central banks have now decided that weak economies need massive liquidity injections, which directly or indirectly get channeled into stock markets and create higher stock prices. Strong growth in earnings and the economy are no longer needed in order to generate high stock prices.
Unfortunately, it turns out that the quack medicine of liquidity doesn’t have much, if any, impact on real earnings or the economy. After massive injections of liquidity for years, neither Japan, the US, or Europe have responded positively with anything like a self-sustaining economy.
Remarkably, central banks are trying to ignore this now obvious conclusion. Instead, what they have learnt is that while stock markets remain elevated they can deflect most of the criticism for their policy failure. So now we find equity markets disconnected from both earnings and the economy, and central banks becoming increasingly desperate to prolong what is increasingly becoming an illusion. Normal market price behavior cannot be allowed to conflict with what central banks “deem” appropriate as was explicitly stated this week by NY Federal Reserve President Dudley.
Dudley may have felt rushed into his statement following the headline NFP jobs numbers released last Friday, which dismantled the last main holdout for the economic growth narrative. Without some belief in sustainable job growth, there is no offset to other overwhelmingly weak data. The US stock markets had been closed on Friday when the dreadful NFP jobs report had been released, and were clearly going to open with a big fall on Monday.
The Federal Reserve is now so sensitive about a falling stock market that something had to be done immediately to contain the downside price action. NY Fed President William Dudley made sure his urgent message was published before the market even opened on Monday.
The statement included this remarkable sentence:
“At the end of the day, we will move short-term interest rates to generate the set of financial market conditions that we deem is most consistent with our employment and inflation objectives.”
New York Fed President William Dudley
If you have still been wondering whether the Federal Reserve has been manipulating markets even after QE ended last year, wonder no more. Dudley has even gone a step further. The Federal Reserve has now explicitly claimed that “generating the set of financial market conditions” is just a part of its dual mandate on employment and inflation.
This raises so many questions:
Do markets reflect economic conditions? Or do manipulated prices help achieve economic objectives?
If “market conditions” are generated by central banks, what feedback remains about the effectiveness of their policies? What signals do manipulated prices give, if any?
Is the value of pension and household assets now to be set by whatever “we deem”?
Given the Federal Reserve’s tragic forecasting record, and obvious flaws in their economic models, should it not be a prerequisite to improve in these areas first before taking on any more ambitious tasks?
So much nonsense. The Federal Reserve is taking ever greater risks with its credibility as it shows its extreme sensitivity and concern every time the US stock market dips. Its statements, actions and justifications are becoming ever more extraordinary as the fundamentals supporting the stock market continue to deteriorate.
The list is long and growing. Declining corporate revenues this year. Rapidly falling earnings expectations. GAAP earnings already in decline. As shown below, Q4 2014 GAAP earnings were the lowest since 2012, and comparable with 2007 levels. Also calendar year 2014 GAAP earnings were lower than 2013, and 2015 may show a second consecutive annual decline!
Furthermore, the recent “improvement” in the NFP jobs report this year also needs to be put in context. As shown below, on 2 very key metrics the employment market is nowhere close to a real recovery. Compare current levels with 2007 levels.
In effect the central banks are now managing the markets on a daily basis to keep the stock markets elevated for as long as possible. Increasingly, without the fundamentals supporting the markets there comes a point of diminishing returns from their efforts.
The fear of failure is rising, and this is why the interest rate rises are becoming increasingly unlikely. The talk is all predicated on developing economic growth, however, beneath the media headlines it is nowhere to be found. However, the growth illusion is an important part of the stock market levitation. This is why the Federal Reserve is always talking about the interest rate rises that never come. It is part of the required narrative.
Investors need to take great care with the markets at this time. Short term performance is always good to see, but the risks are sufficiently high that an adaptive but durable investment process that can handle the current complexity and fallout may be far more important.