Farr: Risk Is Back On!
Stocks are stronger today due largely to renewed hopes of additional central bank accommodation in the U.S. and Europe.
In the U.S., an article in today's Wall Street Journalby my friend Jon Hilsenrath speculated that the Fed is getting closer to considering additional action designed to stimulate the economy. This action could come in the form of more asset purchases, which would bring long-term interest rates down even lower than they already are.
The most obvious Fed response might be to extend Operation Twist, which is the Fed's $400 billion program scheduled to end this month. The goal of Operation Twist has been to reduce long-term interest rates by selling short-term bond holdings and using the proceeds to purchase longer-term bonds.
Given the widening in spreads between mortgage rates and 10-year Treasuries, we would guess that the Fed's focus going forward would be the purchase of more mortgage-backed securities. Lower mortgage rates would both support housing prices and allow many homeowners to refinance and save on their monthly payments. The Fed might also consider making future interest rate increases contingent upon targets in the unemployment and/or inflation rates.
Whatever their ultimate decision might be, it is clear that the probability of additional action has increased following Friday's weak employment report and the bad stock market reaction to that report.
In Europe, the ECB decided this morning to leave interest rates unchanged at 1%. However, ECB President Mario Draghialso said that the central bank stands ready to add more stimulus if necessary.
We would guess that this stimulus would come in the form of either an interest rate cut or the provision of more liquidity for the continent's banks through either the extension of the Long-term Refinancing Operations (LTRO) or outright bond purchases. As a reminder, the LTRO offered banks three-year loans at very low rates. The program, which was announced in late 2011, was very successful in two ways. First, the cheap money was instrumental in fighting off a developing liquidity crisis at the banks. And secondly, the loans were successful in stabilizing the market for sovereign debt as the banks used the low-interest rate loans to buy much higher-yielding sovereign debt.
Today's stock market action provides a perfect example of markets that have become addicted to short-term band-aids. Time and time again, markets have swooned as the effectiveness of central bank initiatives decreases, only to rally on the prospect of additional stimulus measures. It should be pretty clear by now that none of these central bank actions represent a long-term solution to the problem of over-indebtedness in the developed world. In fact, most of these central bank initiatives either delay or exacerbate the inevitable.
In the US, it is clear that massive amounts of liquidity in the banking system have not led to a proportionate increase in either the provision of new loans or the willingness to borrow. In our view, consumer debt levels remain too high and the consumer must go through a lengthy process of deleveraging. Lowering interest rates in an attempt to encourage the assumption of even more debt is not a solution to this problem. On the commercial side, businesses appear unwilling to borrow, invest and hire for reasons other than the cost of borrowing. The uncertainty surrounding future tax rates and healthcare costs is likely the much bigger issue.
These fiscal issues must be addressed by government, and it is unlikely we will get close to any solutions before the November elections.
In Europe, the problem is similar. The southern European countries need to go through a long-term process of austerity and deleveraging. The LTRO, which was Europe's version of the TARP program in the US, was successful in warding off a crisis, but it did not represent a solution to the problem. The difference between the LTRO and the TARP was that the TARP represented an injection of capital into the banking system in the US. The LTRO simply added more debt to the banking system in Europe, which was used to buy the debt in troubled European economies. The answer to the problem of too much debt is not likely to be more debt. Rather, the banks must be recapitalized at some point, and the issue of competitiveness and living within one's means must be addressed in Europe.
Our main point is that the developed world is in for a long period of slow growth, regardless of all this central bank drama. The best investors can do in this environment is to add to positions in high-quality companies when anxiety levels are running high. However, the notion that central banks can or will discover a painless way out of the mess we have created is dangerous. So again we say: "Don't rejoice, but don't despair." The road ahead is positive but problematic.
Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.