Tiptoeing Through the Tulips

Stock investors continued to take the path of least resistance today as they digested more data confirming a slow but steady economic recovery. This morning's incoming metrics included a first read on GDP growth in the second quarter, the ADP employment report for July, and the Employment Cost Index. All were deemed "not too hot and not too cold," leading investors to buy stocks at the open. The continued inflow of "Goldilocks" data has confounded those on both sides of the economic fence. Those worried about an inflationary surge sparked by massive amounts of Fed money-printing are simply unable to conjure any evidence of inflationary pressures (at least not within the generally accepted and narrowly defined gauges of inflation). At the same time, those who believe the economy is on the brink of the next recession cannot ignore the steady growth in jobs of about 200K per month. So where does the economy go from here? Where do stock prices go from here?

Simply stated, investors currently see very little reason to meaningfully reduce stock exposure. Notwithstanding a 125 basis-point increase in the 10-year yield over the past year, stocks, generally speaking, appear attractive when considering the still-paltry yields available in the bond market. The bull case for stocks goes something like this: The economic recovery is progressing at a slow but steady pace. Corporate America continues to post earnings increases based more on productivity enhancements than top-line growth. The Fed, which has been priming the pump with steady monthly purchases of $85 billion in bonds, is in no hurry to remove the ultra-accommodative monetary policy that has been forcing investors into riskier assets. Investors are further emboldened by the continued evidence of disinflation rather than inflation, and the Fed's mandate to maintain price stability holds on the downside as well as the upside. Moreover, widespread inflationary pressures are unlikely given relatively high rates of unemployment and low rates of capacity utilization. Given these considerations, stock investors remain emboldened by the Fed's continued support, which they believe limits their downside risk. Attractive upside potential combined with little downside risk equals "BUY!".

But perhaps there is an element missing in this analysis. Seemingly ignored within Bernanke's July 18 testimony to the Senate Banking Committee was a remark about recent interest rate increases. Bernanke said that recent developments in the capital markets were helpful in reducing excessive speculation, but that the tightening in financial conditions (read: increase in interest rates) was "unwelcome." In our view, the increase in rates is more than unwelcome for Bernanke & Co. The Fed spent trillions of dollars buying up assets on the premise that lower interest rates will lead to increased investment, increased consumption, and, yes, higher asset prices. Higher asset prices, in turn, would result in improved confidence and a greater willingness to spend and invest. This virtuous cycle would continue until unemployment reaches an acceptable level, which is the second of the Fed's two mandates.

We cannot argue that the Fed's Quantitative Easing (QE) has not supported the economic recovery. Low interest rates have clearly produced a housing recovery, a surge in stock prices, a remarkable rebound in auto sales, and more jobs than we could have expected without QE. The question that nags us now, then, is this: If lower interest rates produced all these positive economic benefits, why would a sharp reversal in rates not produce the opposite effects? Houses and autos are bought using borrowed money, and the attractiveness of stocks must be weighed against the yields available in the bond market. What's even more troubling is potential damage yet to come. If the mere mention of a "tapering" in asset purchases is enough to produce a 30% increase in long-term interest rates, what will happen when the Fed actually does start to taper. Even worse, what will happen if, God forbid, the Fed starts to sell some of its $3 trillion+ in bonds?

The next few weeks are critical in determining whether or not the economy is on a self-sustaining path. The Fed's deliberate (and highly risky, in our view) attempts to control the level of asset prices carry far-reaching consequences. The easy part is done. Assets have recovered much of the value lost during the financial crisis. Aggregate household net worth is back at an all-time high. Now we must see if the Fed can extricate itself without causing massive market disruptions. Bernanke must be counting his days until his term is over.