QE AND ITS APOLOGISTS / JOHN MAULDIN OUTSIDE THE BOX NEWSLETTER

QE and Its Apologists

My friend Tom Bentley sends me political rants every day and then attaches an article from someone. Today’s is from Brian Wesbury, a brilliant economist who packs a thoughtful free-market punch. I mention Tom because I want to also pass on you the note he sent me this morning, introducing Brian. Here’s an excerpt (and Tom’s full note appears below, as a preface to Brian’s piece):

As we continue to suffer under the blizzard of bullshit about everything put out by both sides, and hugely amplified by the media, it’s nice to find a feel-good piece that takes us back to the basics. Much of what Brian writes in the first part are things you have heard from me before. Markets are inherently cyclical and inherently volatile, but they do self-correct before inflicting massive damage.

Now you put government in the mix, it zigs when it should have zagged, and all hell breaks loose. Think of it as an airplane in a storm – it bounces around, people grab their air-sickness bags, then the plane lands and all is fine. Now let’s assume the hand of God intervenes and grabs a wing of the plane in an effort to stop the shaking – the wing will break off, and the plane will start it’s death spiral. Think of mark-to-market accounting rules that Brian describes below as the built-in clasp on the wing, then the regulators refused to let go when the banks hit turbulence.

Seriously good economic news has gotten to be something of an outside-the-box commodity, but that’s what Tom and Brian have for us today.

I find myself in a literally freezing Sonoma Valley. Thank goodness the weather app gave me a heads-up, as most of the attendees at this gathering came expecting “California weather.” I am listening to a few of the people who will also be at my conference make private presentations. Powerful. Has me excited.

Technology has bitten me and I am having to do this intro on my iPad keyboard, typing with one finger. First-world problem. Thinking back 25 years, my choices then would have forced me to be at my office, wielding a pen and yellow pad, and then I’d fax the thing off on my big old clunky fax machine. (Or, if I was on the road, I’d have to pay a king’s ransom to fax.) So I like where we’re going with these technologies. In 10-15 years what we’re doing today will seem so last-century – we forget how fast things are changing, and for the better. It’s no wonder that businesses that “get it” are seeing earnings grow. Those that don’t get it get left behind – creative destruction.

Sidebar: There is going to be more creative destruction in the next decade or two than in all of last century. We are going to have to be able to absorb new ideas and technologies and keep on moving and growing. And do it all over again the next year or even the next month.

It will be the most exhilarating time in history for entrepreneurs and businesses that get it. And difficult for all of us, because central banks and governments will present us with “issues” that will require of us even more creativity – but that’s what free markets and nimble managers are good at.

Lots of moving parts, which will require you to work more and to focus better. Most of us will need an extensive network and trusted sources to help us keep up.

Have a great week. We will talk about inflation and central banks this weekend. I hope to add to your understanding of how it all fits together.

Your trying to put all the puzzle pieces in place analyst,

John Mauldin, Editor

 
Tom Bentley’s introduction:

Brian at his best

As we continue to suffer under the blizzard of bullshit about everything put out by both sides, and hugely amplified by the media, it’s nice to find a feel-good piece that takes us back to the basics. Much of what Brian writes in the first part are things you have heard from me before. Markets are inherently cyclical and inherently volatile, but they do self-correct before inflicting massive damage. Now you put government in the mix, it zigs when it should have zagged, and all hell breaks loose. Think of it as an airplane in a storm – it bounces around, people grab their air-sickness bags, then the plane lands and all is fine. Now let’s assume the hand of God intervenes and grabs a wing of the plane in an effort to stop the shaking – the wing will break off, and the plane will start it’s death spiral. Think of mark-to-market accounting rules that Brian describes below as the built-in clasp on the wing, then the regulators refused to let go when the banks hit turbulence.

During the Obama years, government loved to take credit for putting out a fire that government had started, but truth lies elsewhere. It’s now becoming apparent that our private sector is as strong as it ever was, and still able to kick ass everywhere if we just let it. American business has the secret sauce, and no other country has been able to challenge us at the leading edge (they do kick our ass in the old stuff, like steel and cars). Absorb this: "Corporate earnings are rising rapidly, too, and the S&P 500 is now trading at roughly 17.5 times 2018 expected earnings. This is not a bubble, not even close. Earnings are up because technology is booming in a more politically-friendly environment for capitalism. And while it is hard to see productivity rising in the overall macro data, it is clear that profits and margins are up because productivity is rising rapidly in the private sector.” That last point is important, and will make my friend John smile. Three sectors have been a drag on productivity – housing, education, and medical care – and they have been masking all the gains elsewhere. Even then, medical productivity is way up if we judge by longer, healthier lives, but we have no way to capture the value of that in national aggregates. Keep in mind, part of the reason profits are booming is that the overseas share has been increasing, which explains why profits and stock prices have been able to grow much faster than GDP.

Amidst all that success, the failure lobby is still hard at work: "The sad thing about the story that QE saved the economy is that it undermines faith in free markets.” I explained a few days ago that monetary economics is one step away from voodoo, and the world would be much further ahead if the gold standard were still the norm. But that genie is never going back in her bottle, so we have to live with the modern-day version of children running with scissors (shoutout to Patsy for that one), which is Big Government types and the sycophants they appoint to the Federal Reserve getting seduced by their newfound powers. “Give a mouse a cookie, he’s gonna want a glass of milk…."

QE and Its Apologists

By Brian S. Wesbury, Chief Economist; Robert Stein, CFA, Dep. Chief Economist; and Strider Elass, Economist, First Trust Advisors LP

 

On March 9, 2018, the bull market in U.S. stocks will celebrate its ninth anniversary. And, what we find most amazing is how few people truly understand it. To this day, in spite of massive increases in corporate earnings, many still think the market is one big “sugar high” – a bubble built on a sea of Quantitative Easing and government spending.

While passing mention is given to earnings (because they are impossible to ignore), conventional wisdom has clung to the mistaken story that QE, TARP, and government spending saved the economy from the abyss back in 2008-09.

A review of the facts shows the narrative that “Wall Street” – meaning capitalism and free markets – failed and government came to the rescue is simply not true.

Wall Street was not the driving force behind subprime mortgages. In his fabulous book, Hidden in Plain Sight, Peter Wallison showed that by 2008 Fannie Mae, Freddie Mac and other government programs had sponsored 76% of all subprime debt – not “Wall Street.” Everyone was playing with rattlesnakes and government was telling them it was OK to do so. But, when the snakes started biting, government blamed the private sector, capitalism and free markets.

At the same time, Wall Street did not cause the market and economy to collapse; it was overly strict mark-to-market accounting. Yes, leverage in the financial system was high, but mark-to-market accounting forced banks to write down many performing assets to illiquid market prices that had zero relationship to true value. Mark-to-market destroyed capital.

QE started in September 2008, TARP in October 2008, but the market didn’t bottom until March 9, 2009, five months later. On that day in March, former U.S. Representative Barney Frank, of all people, promised to hold a hearing with the accounting board and SEC to force a change to the ill-advised accounting rule. The rule was changed and the stock market reversed course, with a return to economic growth not far behind.

Yes, the Fed did QE and, yes, the stock market went up while bond yields fell, but correlation is not causation. Stock markets fell after QE started, and rose after QE ended. Bond yields often rose during QE, fell when the Fed wasn’t buying, and have increased since the Fed tapered and ended QE.

A preponderance of QE ended up as “excess reserves” in the banking system, which means it never turned into real money growth. That’s why inflation never took off. Long-term bond yields fell, but this wasn’t because the Fed was buying. Bond yields fell because the Fed promised to hold short-term rates down for a very long time. And as long-term rates are just a series of short-term rates, long term rates were pushed lower as well.

We know this is a very short explanation of what happened, but we bring it up because there are many who are now trying to use the stock market “correction” to revisit the wrongly-held narrative that the economy is one big QE-driven bubble. Or, they use the correction to cover their past support of QE and TARP. If the unwinding of QE actually hurts, then they can argue that QE helped in the first place.

So, they argue that rising bond yields are due to the Fed now selling bonds. But the Fed began its QE-unwind strategy months ago, and sticking to its plans hasn’t changed a thing.

The key inflection point for bond yields wasn’t when the Fed announced the unwinding of QE; it was Election Day 2016, when the 10-year yield ended the day at 1.9% while assuming the status quo, which meant more years of Plow Horse growth ahead. Since then, we’ve seen a series of policy changes, including tax cuts and deregulation, which have raised expectations for economic growth and inflation. As a result, yields have moved up.

Corporate earnings are rising rapidly, too, and the S&P 500 is now trading at roughly 17.5 times 2018 expected earnings. This is not a bubble, not even close. Earnings are up because technology is booming in a more politically-friendly environment for capitalism. And while it is hard to see productivity rising in the overall macro data, it is clear that profits and margins are up because productivity is rising rapidly in the private sector.

The sad thing about the story that QE saved the economy is that it undermines faith in free markets. Those who argue that unwinding QE is hurting the economy are, in unwitting fashion, supporting the view that capitalism is fragile, prone to bubbles and mistakes, and in need of government’s guiding hand. This argument is now being made by both those who believe in big government and those who supposedly believe in free markets. No wonder investors are confused and fearful.

The good news is that QE did not lift the economy. Markets, technology and innovation did. And this realization is the key to understanding why unwinding QE is not a threat to the bull market.