The question from the audience to the Saturday afternoon, February 2, panel at the MoneyShow in Orlando was direct: How did we think the coming mess in Washington—the battle in March, April and May over the mandatory budget cuts called sequestration, over a continuing resolution to fund the federal government, and over another increase in the debt ceiling—would affect the financial markets?
The gasp of surprise was theatrically audible at my answer: I don’t think it will have any effect, I said. My response wasn’t intended for shock value. I really do think the markets aren’t likely to move much in response to whatever Congress and the President do or don’t do over the next few months. I don’t think that’s because the U.S. deficit isn’t important or because the U.S. budget isn’t a mess, or because Washington can’t tank the real U.S. economy.
I just don’t think that the market is going to go down on bad news from Washington. Whatever the fears of individual investors about our economic and financial future—and I think those fears are totally justified—the big money that dominates the financial markets has decided to rest its faith in the actions of the world’s central banks.
If things go wrong in Washington—and I find it hard to imagine that they won’t—central banks will ride to the rescue again, this belief goes. Even though further expansion of the balance sheets at the Federal Reserve or the European Central Bank might seem like insanely bad monetary policy, Wall Street is convinced that central banks don’t have any other choice. Faced with declining asset prices because of stupidity in Washington, Ben Bernanke at the Federal Reserve and Mario Draghi at the European Central Bank will throw more money at the markets in a globalized version of the Greenspan put that encouraged the risky financial behavior that led to the global financial crisis of 2007.
This time we’ve got a global put and it’s safe to stay long the market in global financial assets, the markets are saying, because central banks will bail out the markets if anything goes wrong.
On the surface of it, this belief by a majority of the world’s big money players seems hard to understand. After all, we’ve already witnessed an almost unimaginable increase in the balance sheets of the Federal Reserve and the European Central Bank. The Federal Reserve’s balance sheet hit $2.92 trillion on January 10, 2013. That’s roughly $2.5 trillion higher than the $488 billion of January 19, 2011. The European Central Bank’s balance sheet hit a high of $4.15 trillion in June 2012. That was an increase from $2.98 trillion.
Now most discussion about the huge balance sheets at the Federal Reserve and the European Central Bank has focused on the distortions to the financial markets that these balances represent—for example, the Fed is the Treasury market for many maturities because it has been buying in such large amounts and for so long. The question has been when will these central banks start reducing the size of their balance sheets. If they don’t start taking out some of the money they’ve poured in the markets, they risk another asset bubble or a jump in inflation whenever growth picks up in the United States or returns in Europe. The last set of minutes from the Federal Reserve Open Market Committee indicates that the members of the committee have talked about ending the current program of buying $85 billion a month in Treasuries and mortgage-backed securities by the end of 2013 or even earlier. For it’s part the European Central Bank has slightly reduced its balance sheet in the last six months.
In the long term reducing the balance sheets of these two central banks is indeed an imperative. And in the long term the appropriate worries are whether the banks will be able to sell the assets they’ve bought in the financial markets back to the financial markets without either depressing prices of those assets or sending interest rates climbing to levels that hurt the real economies in their respective jurisdictions.
But in the short term the financial markets have a point. The two central banks have flooded the markets with cash by buying assets for their balance sheets in order to prop up the value of financial assets—home prices in the United States and sovereign debt prices in Europe—because that looked like the best tool available to them for countering the lingering effects of the global financial crisis and getting economies in the United States and Europe growing again.
With the recovery in the United States proving remarkably tepid—in the fourth quarter the U.S. economy actually contracted by 0.1% due to a decline in government spending—and with much of Europe in recession or near recession, it’s hard to imagine that the Fed or the ECB will simply walk away from the trillions they’ve put into this strategy and say, “Sunk cost. No use throwing more money into those strategies.”
From this perspective the inability of the governments in Washington—and Athens, Rome, Lisbon, London, Madrid, etc.—to come up with plans to stimulate their economies isn’t just a abdication of responsibility for putting in place fiscal policies that would address current economic woes, but also a guarantee that central bank balance sheets will continue to expand. If Washington is committed to gridlock and can’t even manage to agree on a budget for the federal government, that just pushes more responsibility for the economy onto the Fed.
If the one thing that the financial markets really fear is the end of central bank stimulus, the political dysfunction in Washington makes that end less likely. I doubt that financial markets will rally on the prospects of a shut down of the federal government because Congress can’t pass either a budget or another continuing resolution. But I think the financial markets are perfectly capable of holding their ground in the spring spending cuts/budget/debt ceiling mess because the mess guarantees that the Federal Reserve will keep pumping money into the financial markets.
The odds that the financial markets will sail through the spending cuts/budget/debt ceiling mess of this spring of spending and taxation also get a boost from the recently completed fiscal cliff episode. That example of Keystone Kops government didn’t tank the financial markets despite all the worry and warnings. You can argue that the relatively happy ending—from a market perspective—doesn’t necessarily mean that the next crisis will have similarly little effect. But at least part of Wall Street’s current lack of worry about a spring debacle in Washington is a result of the sky not falling in December.
And finally I think the odds that a spring debacle in Washington won’t matter much to the financial markets gets a boost, oddly enough, from the extremely low approval ratings scored by Congress. Congress averaged an approval rating of 15 in 2012, according to Gallup’s polls. (Surveys by Public Policy Polling show Congress trailing cockroaches in the approval ratings.) With that kind of ranking, nobody, of course expects Congress to do anything but the stupid thing. But I think that contempt for government also blends into a belief that whatever government may or may not do isn’t very important. And that works to lessen worries over the spring spending cuts/budget/debt ceiling mess.
The market’s faith in central banks is touching but it leaves me uncomfortable. In the last decade, central banks have certainly demonstrated that they aren’t infallible and that their policies aren’t all powerful. Betting that the global central bank put will bail out the market seems a relatively risky bet given recent history.
And I’m made even more uncomfortable by the realization that a continuation of this rally in the face of the coming deadlines in Washington depends on sentiment. It’s not that the financial markets know that the Federal Reserve and the European Central Bank will support asset prices at current levels or better. (And it is actually important that we don’t know what price level would activate the central bank put.) The rally depends on a belief by traders and investors that central bank policies mitigate—or even eliminate—downside risk in the March-April time frame. Once again I’m looking at a market that could go up on sentiment and that I believe will go up on sentiment—if I’m reading sentiment correctly and if current sentiment doesn’t shift. But where sentiment, and not fundamentals, is clearly the basis of this stage in the rally.
I’d sure like to have a more solid foundation than that for betting on this rally to continue. I just don’t think that I’m going to get one in the near term.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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