The Fed’s quantitative easing policy will be “disastrous,” according to Jim Bianco, but prices for riskier assets will rise over the near term as a result. In remarks last week, Bianco, the head of the Chicago-based economic research firm that bears his name, also gave the US economy a near-failing grade of C-, and warned that inflation will be “problematic.”
Assessing Fed policy and its effects on the economy and the markets was the subject of a talk Bianco gave last Wednesday at a lunch sponsored by the Boston Security Analyst Society.
“Fed policy will produce the worst possible outcome,” he said. “It will make rich people richer, because rich people own stocks, and they will go up. And it will make a poor people poorer, because it is not going to create jobs and they are going to pay higher gasoline prices.”
Let’s review Bianco’s forecast for the economy and inflation and how he believes the Fed’s policies will affect markets.
A weak economy
Bianco called himself an “old-school” economist who believes in leading, coincident and lagging indicators. He cited several such indicators to justify his weak forecast for the US economy.
The economy is not in or heading toward a recession, he said, despite warnings from the Economic Cycle Research Institute (ECRI). But he said that firm’s leading indicator – as well as the Chicago Fed National Activity index – both forecast GDP growth of approximately 2.5%. Bloomberg is estimating 1.8% GDP growth in the third quarter and only 2% for the fourth quarter.
Bianco said economists have been consistently downgrading their Q3 and Q4 GDP forecasts, as well as forecasts for sub-components such as industrial production and payroll.
Operating earnings for the S&P 500 were down approximately 1% in Q2, he said, and Q3 is expected to be negative as well. Forecasts for Q4 are falling rapidly, Bianco said, although some analysts are forecasting a rebound.
On the revenue side, there was 1% growth in Q2 and forecasts call for negative growth in Q3, he said. That would be ominous, according to Bianco, because every time quarterly S&P 500 revenues have shrunk, a recession has followed shortly thereafter. That follows naturally, since approximately $11 trillion of our $16 trillion economy comes from the sales of S&P 500 companies. Without growth in that component, it’s unlikely the overall economy will grow, Bianco said.
Looming inflation
Bianco cited a number of statements by Fed Chairman Bernanke showing that the Fed intends to target 2% inflation, based on the personal consumption expenditure (PCE) index. Bianco noted, though, that the basis for that target, according to Bernanke, is that it represents a consensus of other central banks.
Paul Krugman, who Bianco called the most influential economist in the US, has called for a higher inflation target. Bernanke’s response was that would impair the Fed’s credibility, which has been earned by maintaining low and stable inflation for the last 30 years.
For economists, the relevant question is if inflation will deviate from 2% and, if it does, what response the Fed will adopt, according to Bianco.
Although inflation is currently near that target, expectations are for higher inflation. The 10-year Treasury-TIPS breakeven rate was a 2.64% the Friday before Bianco spoke, which is the highest that measure has been in the last decade, according to Bianco. Another measure is the five-year, five-year forward rate, which measures inflation expectations over a five-year period, five years from now. This figure has spiked to nearly 3%, as high as it has been in several years.
“The market is telling us when you are going to get well in excess of 3%,” Bianco said.
Another inflation-forecasting measure is the Philadelphia Federal Reserve survey of economists, but Bianco said that survey has not been updated since the Fed announced its latest round of quantitative easing.
During the question-and-answer period, Bianco was asked how inflation could occur in a weak economy – characterized by high unemployment, falling median income and an output gap in production. He said it would be “cost-push” inflation, because quantitative easing would drive up the price of commodities, such as oil, which – together with food – represent nearly a quarter of the CPI.
In addition, escalating rental rates – driven by fears of home ownership – would drive up the housing component of the inflation measure. Bianco said housing represents over 20% of the CPI.
The US can have rising inflation and high unemployment, as it did in the 1980s when both measures were at or near double-digits, Bianco said.
Disastrous quantitative easing
Bianco said he is part of the consensus, when it comes to the Fed’s recently announced policy of ongoing quantitative easing: It will matter for the market, but it will do nothing for the economy.
“The Fed is boldly moving forward with a failed policy, and everybody is happy about it,” he said.
But the Fed’s policy is predicated on a wealth effect, and Bianco doesn’t believe the desired result will ensue.
By buying bonds, the Fed will depress interest rates, incenting investors to buy other fixed-income securities. As rates on those bonds are pushed down, investors will move into successively riskier assets, from corporate bonds to high-yield bonds to high-quality stocks to low-quality stocks. Indeed, investors could buy futures on crude oil, which would produce the cost-push inflation Bianco predicted.
Bernanke has also said consumers’ confidence will grow and with that consumption. But, Bianco said, “that is absolutely not happening.”
In order for consumer confidence to rise, Bianco said, two things must occur. First, wealth – particularly in the stock market – must surpass its previous peak. But the S&P peaked at 1,560 in October of 2007, and it is still below that level.
Moreover, that growth must be viewed as permanent. That’s why the housing boom had a wealth effect; consumers perceived it as permanent growth. But consumers do not perceive the current increase in equity prices as permanent, Bianco argued, citing the fact that money has been flowing out of equity mutual funds over the last several years.
Bianco said the Fed is effectively betting that wealth in the stock market will “trickle down” into the real economy. “That is why I think it is ultimately going to be a disastrous policy,” he said.
A note on Europe
Bianco said that European central bankers are making the same bet by expanding their balance sheets. But Europe, he said, is stuck in a never-ending cycle of failed policies. European central bankers have responded to the crisis there by announcing aggressive measures; markets have reacted positively to those announcements, with lower borrowing rates; but those lower rates have caused central bankers to back off their policy commitments, which has restarted the cycle.
Europe will be in crisis for “the rest of our careers,” Bianco said. A resolution can come only from a fiscal union or from dissolving the euro and going back to legacy currencies. The former scenario is politically unlikely, he said, and the latter would be an “unmitigated disaster” for financial institutions.
One path that has promise is for economies to pursue austerity, something that Keynesian economists such as Paul Krugman have opposed. Ireland, Bianco said, endured 18 months of austerity beginning early last year. By cutting back painfully on government spending, it was able to lower its borrowing rate to the point that it may now be fiscally self-sufficient.
Implications for US markets
Markets for riskier assets are going to rally, Bianco said.
“They're going to rally at least through the spring,” he said. “They are going to rally on the basis of the Fed action, not necessarily on the basis of the economy getting better.”
Expect a steeper curve, higher interest rates and higher stock prices, Bianco said.
One potential threat investors should discount is the fiscal cliff, according to Bianco. He cited a number of surveys showing that the looming government spending cuts and tax increases were the biggest worry among fund managers. But other surveys show an overwhelming majority of fund managers expect broad fiscal reform in 2013. There is even a bill in Congress now – expected to pass – to extend deadlines for six months, he said.
“Nothing is going to happen on January 1,” he said.
The fiscal cliff has been over-hyped because the financial industry employs an army of consultants to help them understand Washington policy decisions. Those consultants have an incentive to identify some factor – perceived or real – to rally around, and it is now the fiscal cliff.
If you’re looking for one more positive signal from the market, it is the fact that the odds of Obama being reelected are now approximately two-to-one. Bianco said that, since 1992, there has been a near-perfect correlation between the S&P 500 and the popularity of the incumbent president, regardless of party.
“Obama is a risk-on asset,” Bianco said.
Read more articles by Robert Huebscher
