Gridlock and the Fed

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
November 9, 2010

IN THIS ISSUE:

1. Hello Gridlock!

2. Is Gridlock Really Good for the Stock Market?

3. The Fed on Auto-Pilot

4. Doom for the Dollar?

Introduction

Two major events occurred last week, the effects of which will continue to be felt on into the year 2011 and possibly even longer. The first was the electoral defeat of the Democrats in the mid-term elections, and the other was the decision by the Fed to inject an additional $600 billion into the economy by buying Treasury bonds.

Of course, both events were widely anticipated and reported on by the mainstream and financial press. Fed Chairman Bernanke had already indicated before the election that the Fed was going to buy more Treasuries to pump more liquidity into the economy; the only question was how much. Likewise, political polls had already sealed the fate of Democrats in the House, so the only real news was that they held onto control of the Senate.

As a general rule, I try not to write about issues that have been sufficiently aired out in the press, unless I can help clear up some mis-information going around or bring a different point of view than other news sources. However, because I always point to the importance of politics and how it can affect your pocketbook and investments, I will weigh in on these two issues, and show how they are actually related.

I hope you find this week’s E-Letter to be interesting and informative. As you read, I’m sure you’ll come to the same opinion I have that the next two years are going to be among the most interesting from both political and fiscal policy standpoints in years. With that, let’s delve into the election and the Fed.

Hello, Gridlock!

Last Tuesday’s election definitely changed the balance of power in Washington. With some election results still not known as this is written, the Republicans definitely took control of the House of Representatives and now have at least 46 Senate seats. While not in full control, the Republicans have now regained at least some say as to the direction of legislation and should be able to prevent undesirable laws from being crammed down our throats.

At the same time, the Republicans do not have sufficient numbers to control the final outcome of legislation, especially considering that Obama still holds the power to veto any legislation that he doesn’t like. While Obama has sounded conciliatory in recent statements about the outcome of the election, it remains to be seen if he’ll move to the center like Bill Clinton did. I doubt it. The condition of “gridlock” is widely expected to describe the next two years, where each political party blocks the initiatives of the other.

Democratic control of the Senate also means that Obama’s judicial appointments will continue to be rubber-stamped and sent on to the bench. I look for him to continue to nominate the most liberal judges he can get away with, considering that some of the Senate Democrats are more conservative than others. I suspect that these appointments, along with those of the Supreme Court, will be his most lasting legacy, not the ill-conceived healthcare bill.

Republican gains weren’t limited to the national level. The GOP also won 10 new governorships, thus bringing the number of Republican governors to 29. Perhaps more importantly, the GOP won control of at least 18 additional state legislative chambers in last Tuesday’s election, on top of the gains in Congress. Republicans now control 54 state legislative chambers (House and/or Senate), which gives them considerable power in the upcoming redistricting process. Some say that these state-level gains could lead to GOP control of Congress for the next decade (see Special Articles below).

On the national level, the bottom line is that Democrats lost control of the House and now have a harder time overcoming a filibuster in the Senate. Of course, Obama holds the golden key in the form of veto power, and the Republicans aren’t likely going to be able to drum up enough votes to override a veto. This is why many political analysts think we will experience gridlock – where neither Republicans nor Democrats can advance their agendas.

As a conservative, I welcome the new rhetoric by the Republicans who have been elected. Talk of not raising taxes and reducing spending are always welcome. However, we also know that when last in power, they did not keep a lid on spending and showed they could be just as fiscally irresponsible as any other political party.

Is Gridlock Really Good for the Stock Market?

Back when polls first began to show that the Republicans might score major victories and take over one or both houses of Congress, the conventional wisdom on Wall Street was that gridlock would be good for the stock market. Now that it’s here, many analysts are saying that gridlock will be bad for the markets. So, which is it? Is political gridlock good for the stock market or not?

The answer sometimes depends on what you mean by “gridlock.” A recent study by Sam Stovall, chief investment strategist at Standard & Poor’s Equity Research, provides three levels of political unity: 1) “total unity” where one party is in control of the White House and Congress; 2) “partial gridlock” where one party controls Congress and another the White House; and 3) “total gridlock” where there is a split Congress.

According to Stovall, the S&P 500 has averaged 7.6% returns in the 67 years since 1900 of total unity, while the 32 years of partial gridlock have produced average returns of 6.8%. However, in a total gridlock situation like we have now, the S&P 500 has averaged only a 2% annual gain. That doesn’t sound like a good environment for stocks to me.

If that’s the case, then why did so many on Wall Street sing the praises of gridlock earlier this year? The premise behind gridlock being good for the stock market is the belief that it means that neither the Legislative nor the Executive branches of the government will be able to advance any meaningful legislation that might affect the stock markets. As we have all heard, the markets hate uncertainty, so handing control of Congress and the Presidency to one party or another always presents a risk that legislation will be passed that could negatively affect the stock market.

Gridlock virtually assures that bickering and grandstanding will abound, but very little in the way of legislation. In the current situation, President Obama is likely to veto any new or permanent tax cuts that Congress may pass, and the Republican-controlled House is unlikely to move forward with any new spending or additional stimulus that Obama may champion.

Without legislative interference, some expect the stock market to heat up again, just like back in the 1990s. In fact, I think that much of the sentiment that longed for gridlock comes from those who fondly recall the late 1990s as the halcyon days of stock market gains. However, that was then and this is now. The market and the economy are very different now than they were in the late 1990s. Here are just a few ways:

No new emerging industry like the technology bubble is coming of age. Sure, there’s a lot of talk about alternative energy, but this is more government-driven than market-driven.
Two strikes (bear markets) and investors are out. There is a ton of money on the sidelines that may never come back into the markets, gridlock or not.
A more activist Fed. Remember in the ‘90s when Greenspan mentioned “irrational exuberance” and was politely laughed off? The Fed and the Treasury have now discovered new powers and have actually used them. Don’t expect a repeat of bumbling Uncle Alan this time around.
The economy isn’t booming. In fact, it’s doing just the opposite. In the 1990s, the economy was screaming and unemployment was at historically low levels. Help wanted signs were everywhere and consumer credit was expanding. That’s definitely not the case today.
The “wealth effect” from stock market gains also helped to generate higher federal tax revenues and budget surpluses. Today, the “unemployment effect” is resulting in less tax revenue, greater spending for unemployment benefits and record budget deficits.
Finally, we don’t have the same regulatory environment today as we did in the 1990s. If you recall, many of the profits of the 1990s were based on questionable accounting practices that came to light during the bear market of 2000–2002. Enron, WorldCom and Global Crossing stand out as examples of this period of lax regulatory oversight of corporate financial statements. The passage of Sarbanes-Oxley Act substantially changed the playing field that exists today.

Add into this mixture a Congress that can’t get anything done because of gridlock and a Fed that is virtually out of bullets, and you have a recipe for potential trouble. The bottom line is that whether there’s political unity or not, it’s important to be going in the right direction. Unity does little good when the policies make the situation worse, which many voters feel has happened over the last two years.

Perhaps “total gridlock” will be beneficial in this case IF it allows for the free exchange of more ideas among our elected representatives. Of course, given the partisan bickering that is the norm in Washington, I’m not holding my breath on that one.

The Fed on Auto-Pilot

Did you happen to catch the debate in Congress in regard to the $600 billion of Treasury bonds to be purchased by the Fed? Didn’t see it? Of course you didn’t, because there was no such debate. The Federal Reserve Board of Governors decided to take the action on their own, without any Congressional action whatsoever.

Typically, government programs to stimulate the economy come in the form of legislation that injects government funds into the economy through infrastructure projects, make-work programs, funding jobs that might have otherwise been cut, etc., etc. All of these are known as fiscal policies and require Congressional action.

Monetary policy, on the other hand, is the realm of the Federal Reserve and can be in the form of adjustments to bank reserve requirements, various short-term interest rates and “quantitative easing” (QE), which is the policy most recently in the news. In a nutshell, quantitative easing involves increasing the money supply in order to stimulate the economy.

You may recall that from December 2008 to March 2010, the Fed engaged in quantitative easing when they bought about $1.7 trillion worth of mortgage-backed securities and Treasury bonds. The most recent round of quantitative easing just announced by the Fed will involve only Treasury securities. The primary goals of QE are:

To increase lending by buying Treasury securities from banks. This essentially replaces a bond with cash on the banks’ balance sheets, thus giving them more power to loan money to businesses with the hope of stimulating the economy;
QE can also help to reduce the cost of borrowing by having a downward pressure on interest rates. It works like this – when Treasury bonds are purchased, the price usually goes up and the yield goes down. This, in turn, can lead to an overall reduction in interest rates across the economy; and
A final goal of QE is to make other investments such as stocks more attractive to investors. The hope is that when the yields on debt instruments fall, investors seek out other options such as equities. This demand can put upward pressure on prices and make the stock market move higher.

All of the goals above are laudable, but I think there are a couple of problems with the Fed’s course of action. First, the Fed doesn’t have money laying around that it can use for purchasing $600 billion worth of Treasury bonds. Instead, the money is created for the purpose of buying the bonds. In today’s parlance, we say that the Fed has cranked up the printing presses.

Anytime the Fed does this, there is a fear that inflation will eventually come home to roost. This is especially true if proceeds from printing money are used to pay down the national debt, a process known as “monetizing” the debt. Relating this to Economics 101, when you have more money chasing the same number of goods, inflation usually results. I share the concern of many prominent economists that the Fed’s printing press could lead to some major long-term economic challenges.

Another problem with the Fed’s decision to buy Treasuries is that it assumes banks aren’t lending money because they don’t have enough to lend. I dispelled that myth in my September 14 E-Letter. The problem with the banks loaning money to small businesses is not that they don’t have money to lend, but that there is very little demand for such loans and it’s harder to qualify if they do apply. The Fed can’t solve either of these problems by just creating a larger supply of money to borrow.

Small business owners are uncertain about their future, especially in light of: 1) the rising costs of ObamaCare now becoming more clear; 2) the question of whether the Bush tax cuts will expire or be extended beyond 2010; and 3) suppressed demand for goods and services brought about by the weak economy and high unemployment.

Think about it, would you bite off on a big bank loan to expand your business with 9.6% unemployment and possible higher taxes and healthcare costs in the near future? I wouldn’t, and the Fed can’t erase uncertainty with monetary policy. If anything, they can probably only make it worse.

So, if the $600 billion printed up by the Fed is not going to go to loans or capital to build up businesses and hire workers, where will it end up? That’s a good question. Some economists think that this additional liquidity will flow to a new asset bubble like it did into tech market stocks in the 1990s or real estate just a few years ago. By suppressing the return on the safest of assets, the Fed is pushing investors toward more risky assets such as domestic stocks, foreign and emerging market securities and commodities, among others.

If that is the case, then the Fed may be creating the next crisis it will have to deal with in the future. Plus, if the Fed is unsuccessful in mopping up all of this liquidity which, by the way, no one has ever done before in this magnitude, serious inflation could develop. I don’t want to think what might happen if we have a new asset bubble burst while also experiencing significantly higher inflation. It could make the 70’s stagflation look like a cakewalk.

Ironically, the asset class currently getting the most attention as a possible bubble is the bond market, which is the opposite of the Fed’s desire to promote investment in risk assets. I’ll discuss this phenomenon and its implications in more detail in next week’ E-Letter.

Doom for the Dollar?

Another prominent argument in relation to the Fed’s action to buy Treasuries is the effect on the value of the dollar. As you probably already know, the dollar has been in a steady decline since the turn of the 21^stCentury based on the US Dollar Index. A quantitative easing policy like the Fed is pursuing is inherently negative for the dollar. The greater the QE, the worse the effect on the value of the dollar.

Some economists feel that the Fed is unnecessarily debasing the world’s reserve currency. However, a cheaper dollar helps to make US exports look more attractive in the global economy, thus improving the prospects for economic growth. However, this growth doesn’t come without a cost, and that cost is being paid by other countries whose currencies are now higher in relation to the dollar.

Lower interest rates in the US are also driving investors to foreign assets, which also helps to strengthen their currencies in relation to the dollar. This makes their exports more expensive in relation to other countries, especially the US. As these countries adjust their policies to combat the falling dollar, trade conflicts and currency wars could ensue.

The lower dollar is also resulting in a surge in commodities prices (skyrocketing in the case of gold), since all commodities are denominated in US dollars.

As I cautioned last week, it does bother me that virtually everyone around the world is bearish on the US dollar. Last week’s announcement that another $600 billion in QE2 is official was viewed as a near guarantee that the dollar would move lower. Keep in mind, however, that the dollar had already fallen hard in late August, September and October in anticipation of Bernanke’s announcement of QE2 last week.

Conclusions

There are several conclusions that I would like to draw from today’s discussion. First, there’s no guarantee that gridlock will be beneficial for the stock markets over the next two years. The economy is not yet back on its feet and could easily be tipped back to negative territory. While gridlock is usually preferred because nothing can get done, doing nothing in this economic environment could be all that’s needed to fall back into a double-dip recession.

As a result of possible gridlock, another conclusion we can draw is that the Fed is likely to continue to be active in trying to find solutions to our economic doldrums. This will mean that a group of appointed officials will be largely responsible for the well-being of our economic future. If the upcoming round of QE doesn’t work and Bernanke and company go for more, the US could debase the dollar and possibly lose our top credit rating, not to mention rolling out the red carpet for some serious inflation.

Activism on the part of the Fed and the Treasury has concerned me over the course of the credit crisis and subsequent recession. I fear that we’re in for more of the same, especially if Congress and the Obama administration are in gridlock. The Fed has a delicate balancing act on its hands – on the one hand trying to stimulate growth, and on the other not letting inflation heat-up.

The markets have been rising steadily since Bernanke let it be known in late summer that more QE was coming, and stocks got another good pop last week as investors evidently interpreted the $600 billion in QE and the Republican landslide as good news for the market. For better or worse, it’s possible that much of the $600 billion will indirectly end up in the stock market, possibly creating another asset bubble right in front of our eyes. That seems to be the consensus view at this point.

A final conclusion evident from today’s discussion is that there is no quick fix to the global economic woes. Neither the Fed, nor the Treasury nor the US government can enact a silver bullet that will bring back economic prosperity quickly. Republicans have been given another chance to govern as conservatives. However, if they do a repeat performance of the last decade where they showed they could spend money with the best of ‘em, we’re not likely to make much progress toward economic stability.

As I have mentioned numerous times, most analysts I follow tend to think that economic growth will continue to be slow and unemployment high on into 2011 and possibly 2012. That being the case, unless the Republicans get back to their conservative roots, there could be another house cleaning in the 2012 elections with the Republicans on the receiving end of voter discontent.

Warmest regards,

Gary D. Halbert

SPECIAL ARTICLES

Election analysis: A Return to the Norm (very good)
http://www.washingtonpost.com/wp-dyn/content/article/2010/11/04/AR2010110406581.html

GOP gains in governors & legislatures could keep them in power for a decade
http://www.reuters.com/article/idUSN0328435720101103?pageNumber=2