Wednesday, April 30, 2014

Implications Of Weak Growth For Financial Assets And Monetary Policy

My economic forecasting prowess has been vindicated by the awful first quarter GDP growth data, which show that the economy is on the brink of recession. I have been saying since October that the economy is at risk of both deflation and recession. I have based my pessimistic outlook on the decline in money growth and inflation over the past two years, and on the Fed’s perverse decision to further reduce monetary stimulus in the face of subpar growth and inflation.

What does this depressing growth scenario mean for financial assets? It is bullish for both stocks and bonds, and bearish for inflation hedges like precious metals.

Implications for Bonds: Bullish
Low growth is bullish for bonds because it removes the risk of accelerating growth,  delays further the possibility of higher short-term interest rates, and anchors inflation expectations at their current low level. The big bond selloff has already occurred, during 2013, when the 10-year yield doubled from 1.5% to 3%. This year, bond yields have fallen back to 2.65%. I don’t like bonds because they yield nothing, but I don’t see the  “inevitable bursting of the bond bubble” happening any time soon.

Implications for Stocks: Bullish
Low bond yields are bullish for equities. Stated differently, high bond PE ratios support high stock PE ratios. (Today, the bond PE is 38x and the stock PE is 19x.) This relationship is captured by the equity risk premium, which compares the demanded return premium for stocks over bonds. On Friday, Aswath Damodaran at NYU will publish his calculation of the ERP for the first of the month. For April 1st, he calculated the ERP at 5.15%, which is on the high end of the range since 1961 (the range is roughly 2% to 6.5%). This means that you are being paid a historically high premium for owning equities.

The ERP is elevated despite high PE multiples because bond yields are so low. Skeptics say that the ERP depends upon strong earnings growth and abnormally low interest rates. The are wrong about earnings growth: the ERP does not reflect or depend upon strong forward earnings growth. They are right about interest rates, but rates are abnormally low because inflation is at a 50-year low. The 1Q14 growth data suggest that rates will remain abnormally low for some time.

Implications for Metals: Bearish
Precious metal prices should move in accordance with inflation expectations, and indeed both inflation expectations and metals prices have been declining since 2012. The current growth and inflation outlook suggests that metals prices will continue to decline until the Fed can get a grip on money growth.

Implications For Monetary Policy: Nothing

The 1Q14 growth numbers represent a victory for the doves and a defeat for the hawks. Once again, the hawks have been shown to have a complete misunderstanding of the Fed’s current monetary stance, which is contractionary, not stimulative. Once again, the doves have been proven correct: tapering at this point in the cycle is insane. This might give Yellen the ammunition she needs to reverse the decline in money growth, but history suggests that she, like Bernanke, will fail. For the Fed to do a complete 360 will require negative growth and higher unemployment, both of which are likely. Then we might see a policy rethink.

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