The Gift of a White Elephant

Written on February 3, 2014

Despite all the uncertainties such as the government shutdown, Syrian uprisings, the debt ceiling crisis and lingering economic aftershocks, 2013 was one of the best years on record for equity investors.  Total return on the S&P 500 was 32%, the highest since 1997 and the 3rd highest since 1970. Small and mid-cap companies did even better, gaining 35% and 39% respectively. Overseas, the EAFE index of larger foreign companies rose 23% as Europe began to recover and Japan was aided by its own very accommodating Central Bank. Unsurprisingly, Wall Street was surprised! Forecasts at the beginning of last year were for tepid returns in the mid-single digits, near where the forecasts are now. Interest rates rose throughout the year, from 1.6% to 3% on the 10-year Treasury, causing the largest loss in bonds (-2%) since 1994. Other disappointments were Emerging Market stocks (-2%) and Commodities (-10%).

Our fearless leader of the Federal Reserve, or “Fed,” Chairman Bernanke is retiring from his post after eight long, tumultuous years. He leaves with our thanks for a recovering economy. Whatever else you think of him (and we’ll get to that), he helped America navigate the worst economic recession since the Great Depression of the 1930’s. He restored liquidity and confidence in the US financial system by providing capital and funding through the TARP and TAG programs, forcing takeovers of Fannie Mae, Freddie Mac, AIG and General Motors and lowering the Fed Funds rate to practically zero to help businesses and consumers repair their balance sheets. However, the Bernanke Fed also used unconventional monetary policy, purported “Quantitative Easing,” (QE) to force rates even lower. The QE program entails buying $85 billion of US Treasuries and mortgage-backed securities from financial institutions each month with money we don’t have. We often use the euphemism “printing money.” This buying pumps money into the US economy and further reduces long-term interest rates. QE has loosened consumers’ and businesses’ purse strings, kept mortgage and interest rates artificially low and bolstered asset prices, notably housing and stocks.

Amazing results from inauspicious beginnings Mr. Chairman, but at what cost? There is no free lunch in investing or monetary policy. Many observers believe QE’s benefits are transitory, benefiting Wall Street but providing little help to the Main Street economy where earnings and jobs originate.  QE purchases also have distorted the price of Treasury securities. What is the real interest rate investors will require when the Fed isn’t there to sweep up 75% of all new issuance as it did last year? Though the Fed has started tapering QE purchases, its balance sheet has expanded $3 trillion since 2007 and is expected to grow another $1 trillion – or 1,000 billion dollars (see chart below)!

Frontpage chart CERBTTAL Index (Federal Reserve)

If the Fed does exit the QE program by the end of this year, how will the bond market react? How will we dig out from under these trillions of dollars of debt? If interest rates rise too fast and the Fed loses money on their investments, then the Fed could have to force its losses on taxpayers through higher taxes or it could print more dollars to cover the losses, thereby causing higher future inflation.

Chairman Bernanke knows all these risks, and so his last move as Fed Chairman was to start us down the path back to normal policy. He announced a reduction in QE purchases and inserted language that the Fed funds rate would remain lower for longer. Markets interpreted the move positively, as affirmation the Fed would remain highly accommodative. Nevertheless, we are in uncharted waters with the Fed’s balance sheet so large. Our new Chairman Janet Yellen has her work cut out for her.

There is an idiom dating back 1,000 years to the Siam Empire about the gift of a white elephant, a symbol of power and prosperity.  It is a magnificent gift, appreciated by the recipient at first until he incurs the cost of feeding and realizes its power to crush him if not handled carefully.  The gift becomes a burden which his owner cannot afford and cannot dispose of.  Ultimately the gifted white elephant leads to his owner’s impoverishment.  Thank you Mr. Bernanke, for your service and for giving us back our economy.  Now, hopefully we can feed the beast.

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