The Frankenstein Economy

Eric St-Cyr, Clover Asset Management

Over the next few weeks, I will be publishing a series of columns that I hope will help investors understand what will be the global economic drivers for the next 10 years. I will discuss their effects on our lives and how to profit from the changes ahead through a series of 10 investment themes. So far we discussed the growth of the world population and the situation of the global debt.  

If you remember your high school economic’s 101 you will recall that there is also a natural cycle to the economy. Periods of expansion are followed by periods of contraction. During the expansion new corporate leaders are born and during the contraction the weakest links disappear, paving the way for new innovations and future expansion.  

In 1818, Mary Shelley wrote the novel Frankenstein. Everyone is familiar with the story: Dr. Frankenstein defies the law of nature and brings back to life a creature made from a dead corpse. If you have ever had the chance to read the original it is an extremely sad story where the monster vagabonds from place to place in search of a purpose. From the great recession of 2008 emerged a new Dr. Frankenstein, in the person of Dr. Bernanke. Like Victor, the good doctor in the novel, Dr. Bernanke took it upon himself to resuscitate the economy with the unnatural injection of monetary easing. The effects were similar; the economy came back from the dead but without a soul. So weak that it vagabonds, barely escaping recession year after year.  

I am of the view that the Federal Reserve and the US government should have not intervened as aggressively in the natural cycle of the economy. Bankrupted financial institutions should have been nationalised, fixed and brought back to the market in a similar way as was done for General Motors. The weakest links would have perished, replaced by more dynamic and innovative corporations. 

Whatever happens it is now past and we will never know for sure if the path that was taken was the best one at the time. The question now becomes what is ahead of us? Before we answer this question lets review how the Fed has revived the economy over the last five years. 

First, the monetary base has increased drastically since 2009, moving from US$800 billion to $2.9 trillion, an increase of more then 350 per cent. During the same period we also saw the Monetary supply (M2) increase by 55 per cent. Any economic books written over the last 100 years would tell you that such an increase in liquidity should produce massive inflation. However, over the last four years, inflation was nowhere to be seen.  

The lack of inflation since 2009 can be attributed to many factors, the most important being the refusal from the banking system to lend to corporations and individuals, refusing to increase the velocity of capital. Coming out of the financial crisis of 2008, the banks had to fix their balance sheets and accumulated as much capital as they could to do so. After four years spent licking their wounds we would expect the banks to now be more aggressive, however they seem to show little confidence in the economic situation going forward. To be truthful, the poor unemployment situation the US has been facing since the financial did not contribute to an environment where lending could flourish easily. As the economy struggles to recreate the jobs lost during the great recession it is difficult for any financial institution to consider consumer lending as an appealing proposition. However, the economy is producing jobs, slowly but surely, and the situation is gradually getting better. Should we then be expecting more lending and inflation going forward? 

The answer is in the hand of Dr. Bernanke. We see two possible scenarios from this point. Under scenario 1 the Fed reduces the accommodative stance taken five years ago. This would send interest rates higher rapidly and would probably trigger a new recession. This recession may annihilate all the benefits brought by the quantitative easing policy to date. Under this scenario stocks and bonds would plummet, cash would be king and the world would enter into a prolonged period of deflation. 

However, as jobs are created and the economy slowly gets better, the Federal Reserve may elect to continue to keep interest low to assure that the economy is on a solid footing. This should lead to higher inflation. Under this scenario bonds would keep their value but present limited upside and stocks should extent their positive returns over the short to mid-term. In time, as inflation start increasing more rapidly, we would expect the Fed to contemplate scenario 1 and again shock the economy and bring it back to square one. 

The market is now addicted to accommodative policy and both scenarios present important down side risk going forward. I am of the view that the Fed will remain accommodative for many more years. We should, therefore, expect to see inflation slowly rising in the coming months. This slow rise in inflation will be beneficial to equity and hurt fixed income. This situation should remain until the Fed removes the punch bowl. We expect at least 18 months more of quantitative easing and, if the situation in Europe or Japan deteriorates, even longer.  

This is not to say that stocks will go up in a straight line. The best method is to apply a tactical asset mix approach to your portfolio, overweighting or underweighting the different asset classes according to a three-month forecast. Personally I use a series of different indicators to forecast the direction of the market. The price of oil, P/E forward and FX directions are examples of quantitative indicators important to our approach. On the qualitative side, I like to see many bullish commentators on CNBC before turning bearish and only when Roubini and Faber become regular on the different shows do I start being bullish again.In conclusion, the Federal Reserve needs to remember that playing God and trying to modify the laws of nature carries important risk. Like Dr. Frankenstein who perished at the hand of the creature he created, Dr. Bernanke will see his creation destroy his legacy. The question now is when?
 

Disclosure: I receive no remuneration from any websites where I am published and do not publish or promote subscriptions to any newsletters. 

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