- The Federal Reserve has succeeded in stopping the liquidity crisis that gripped markets.
- Flooding the markets with liquidity has led to an asset bubble that benefits the rich and widens the wealth gap.
- It's not the Fed's job to prevent investor losses and prop up zombie companies, this creates a new set of problems that could lead to economic catastrophe.
The Covid-19 crisis has brought a world of economic destruction, Depression-era-sized levels
of unemployment and financial instability. Worried about a financial crisis compounding the
economic breakdown, the Federal Reserve (Fed) and central banks globally responded with an
intervention that far exceeded their response to the Fiscal Crisis of 2008.
In May, we addressed the necessity of the Fed's response in a commentary, "The Fed Put is
Necessary for Markets to Function." Now, I want to address some potential downsides from
this and subsequent actions by the Fed.
Einstein suggested that individuals should strive to add value instead of seeking success. The
Fed has clearly succeeded in stopping the liquidity crisis that gripped the bond market and the
massive declines in both the bond and equity markets. But is it providing value to the majority
of U.S. citizens?
I think not.
At least not yet. The Fed is diligently trying to get people back to work. Fed Chairman Powell
has said he would like to see more inclusive prosperity; meaning an equal distribution of wage
growth across all social categorizations. Unfortunately their game plan tends to benefit the nation's wealthiest individuals, which is economically inefficient. Flowing capital into bonds
drives yields lower. This cuts companies' borrowing costs, and leaves them with more cash to
retain current employees and hire new ones. The hope is that this will help the unemployment rate decline.
The collateral damage is that the wealthy benefit no matter what happens. While the desired
effect is that companies the wealthy own shares in will get a productive labor pool needed to
produce profits, the reality is even if the unemployed aren't hired, the wealthy see asset appreciation in their investment portfolios, which increases their wealth.
There's no other way to put it. The Fed is making the U.S. wealth gap worse.
The wealth gap in the U.S. is a serious issue that affects our nation's productivity by limiting opportunities for some, while favoring others.
In early March, as the equity and fixed-income markets collapsed, the Fed jumped into action
and did everything it could to add liquidity to non-functioning markets.
It cut the federal funds rate to 0% and cut the "discount window" rate 1.5 percentage points to
0.25% It expanded its repo operations by $2 trillion, and returned to the policy of quantitative
easing, to buy $700 billion of U.S. Treasurys and other securities.
Both the equity and fixed-income markets experienced massive rebounds.. The market went
from a price-to-earnings peak to trough, back to previous peak in just four months compared to
the 26-month rebound during the Great Recession.
The Fed's goals are to promote maximum employment, stable prices and moderate long-term
interest rates, not to prop up markets to prevent investor losses But with the Fed's recent announcement that it will keep interest rates at 0% until 2022, can we say they are successful in
achieving their objectives. Apart from stopping the crash, we sure don't have stable prices. We
definitely do not have moderate long-term interest rates and while it may have stopped the unemployment rate from climbing higher, there remains massive unemployment. The one thing
it has done is create an asset bubble.
Among the Fed's many actions over the past three months, it supported companies with no
more than 15,000 workers and gave loans to states. But these actions also include buying
mortgage-backed securities, individual corporate bonds and other financial instruments, such
as exchange-traded funds (ETFs).
So what value have the public received from these moves?
With Treasury bond yields historically low, people flock to riskier assets, which seems to be the
Fed's objective. In fact, the Fed has unapologetically been forcing dollars into riskier assets, like
stocks. Rising prices in risky assets exacerbates the wealth gap by increasing the wealth of
high-income families at the expense of lower-income families. This is because most lower-income people don't own stocks or bonds. As stocks and bond prices go higher, the rich get
richer. So I ask: Is the Fed creating value or will their recent response create an asset bubble
that will lead to greater economic catastrophe?
The Fed had to backstop the markets. But after creating a backstop, a central bank doesn't need
to keep flooding the market with liquidity. The Fed needs to take its foot off the accelerator and
let the markets work by their own devices. The Fed stopped the crash, but it's not the Fed's job
to prop up the markets so that investors don't lose money. This throws the entire risk/return
equation out the window and creates moral hazard.
It's like a rich parent paying off a child's irresponsible debts. The parent has brought the child
to neutral, but it's not the parent's responsibility to keep funding the child's ostentatious lifestyle.
The child now needs to learn to live within his means. And it's important for the market
to do the same thing. But the Fed ignores this and continues to pay for and feed the market's
Throwing money at the problem without discretion increases the market's fragility.
Instead of helping people and bringing back the demand curve, the Fed helps the rich by keeping
poorly-managed companies with too much debt alive, turning them into zombies. If it weren't
for the Fed these companies that should go bankrupt, would go bankrupt. Instead they stay
afloat and kick the can down the road with short-term financing.
Keeping zombie companies alive, which may temporarily avoid layoffs, prevents markets from
breaking out of this volatility cycle. The only way this gets fixed is you have to let the cards fall
where they may. Capitalism demands companies that can't manage their finances should die.
I'm a raging skeptic of both the economy and the market, which is not normal for me.
I'm skeptical because I can't see anything trading on fundamentals. And by propping up these companies to keep everything going, the Fed is creating bigger and bigger problems that won't be good for the economy in the long term.
At Aware Asset Management, we are responding by being more surgical in regards to the risk
in our portfolios. We're not just buying yield. We're buying high quality companies that we
think will survive this type of environment, so cash is extremely important.
To answer the earlier question, the Fed has been doing everything in its power to help markets
and promote economic stability, but at what cost? A widening wealth gap is leading to upheaval
in the land. If the Fed doesn't address its culpability in expanding the wealth gap, it will end up
with more upheaval. Given this downturn is created by an opponent (virus) we have never
seen before, the Fed may need to consider that its playbook doesn’t work in this environment.
The value it provides may not be truly the value we need.
John E. Kaprich, CFA
Aware Asset Management