We’d been saying all through 2012 and 2013 that we felt as long as the Federal Reserve kept printing money by the tens of billions every month, stocks would continue to rise. All we can say is that when you’re right, you’re right; although we must admit that even we’ve been surprised by the kind of numbers posted by all the major stock indices in 2013.
Based on the underlying conditions in the economy, though, it’s not obvious that these gains in the stock market are justified. Unemployment is still persistently high, GDP has been stuck in neutral for several years and businesses are very skeptical of the political environment. So why is it that the stock market seems to be telling a much rosier story? As we’ve written many times, the answer is found in Fed policies – i.e. QE1, QE2, QE3 and Operation Twist.
These policies have now swollen the Fed’s balance sheet (their portfolio of bonds they’ve been buying) to over $4 trillion. In addition, much of the money that they’ve created to make these purchases is now sitting in bank accounts at the Fed as “excess reserves”. Banks are required to keep a certain percentage of their deposits and capital on hand. These reserves are in the form of cash in their vault to manage their day to day customer transactions and at their account at the Fed used for such things as check clearing. Any amount that they hold above their statutory limit is called an excess reserve. Historically, those excess reserves have been near zero. Today total excess reserves stand just over $2 trillion.
Traditionally when a bank would find itself with excess reserves, they would lend them to another bank that needed them – typically to make commercial loans. The Fed sets the rate that the banks can charge each other (Fed Funds rate). Regardless of what that rate was, it was better than zero, which is what they’d get leaving them as reserves. In 2008 this relationship changed. The Fed Funds rate was basically set to zero and the Federal Reserve started paying banks interest on their excess reserves.
This has created the unprecedented situation where it is more profitable for banks to sit on their reserves and not lend to each other. This is why we’ve not seen an increase in inflation even though the Fed has increased the money supply by trillions of dollars. Those dollars are stuck in accounts at the Fed.
Throughout the recovery, government officials have been critical of the banking sector for not doing enough to stimulate growth by making loans. But here we are with this perverse policy that runs contrary to the publicly stated goals of the government. So what’s going on? The real policy objective here is twofold. First, the Fed wants to drive all interest rates down to make debt more affordable for everyone. Secondly, they need to finance unprecedented levels of deficit spending.
Both of these objectives have been met but now the government needs to find a way out as the accumulated balances reach unmanageable levels. Policy makers announced in December that they would begin the process of winding down these programs. The first such change was to reduce their bond buying from $85 billion per month to $75 billion per month – a mere drop in the bucket. It’s expected that they will announce a further reduction to $65 billion per month in January.
The pace of this exit strategy will be crucial to both stock performance and investment yields in 2014. The San Francisco Fed President was quoted as saying that the Fed will likely continue on a path of gradual, measured reductions in bond purchases assuming the economy tracks modest improvements. That is likely to mean $10 billion steps until they are out of the bond buying business. That being said, the Fed is likely to keep paying interest on excess bank reserves and maintaining a near zero Fed Funds rate.
Assuming a best case scenario where the Fed’s exit strategy unfolds as planned, investors will face many challenges. Through all the QE programs, the Fed has created a significant bubble in the bond market. It’s hard to say where rates should be without the government’s interventions but longer term bonds are likely going to get hit hard through this process. So looking to higher yields in this market is a fool’s game until rates eventually find their natural levels. Who knows how long that will take? It could be two or more years.
With the Fed still firmly in control of short-term rates, it’s unlikely we’ll see any meaningful yields on short-term bonds over the next couple of years. Once you factor in inflation, those returns could even be negative in real terms.
While neither of these events is new for the bond market, investors have found solace in the stock market. Double digit returns have made up for the lack of yield in bonds and given investors a sense of progress. Looking towards 2014 and 2015, questions remain on how stocks will fare without the government’s support. Earnings and valuations are called into question in the face of higher rates.
Corporate earnings are already beginning to trickle in and they aren’t great. Investors are wondering if soft earnings will justify more stock gains. If interest rates negatively affect GDP, earnings will come under even more pressure. By a variety of measures, stocks are already pretty expensive. The S&P 500 currently trades at about 16 times earnings which is already above the recent historical average of 13.
We see little reason for stock prices to continue their previous two year gains into 2014. Historically, when stocks reach their tops, trading gets choppy. We think that will be the case this year. But when all is said and done, our guess is that we’ll finish the 2014 with single digit returns. Half of that will probably be in the form of dividends.
Our best case for support this year in the stock market is the fact that there still remains nowhere else to go. That’s not much in the way of confidence but it is the reality. The Fed is still going to run the show until the QE’s end and they successfully unwind a substantial part of their $4 trillion portfolio.
