Chairman of the US Fed risks repeating history with his recovery strategy
All economic historians know about the tragic year of 1932. Back then everyone believed that the measures taken by Hoover's administration had beaten the recession of the day. Stock markets and optimism soared.
Fast-forward 78 years to a similar situation being described by Jeremy Grantham, founder/director of GMO, a leading US-based global investment firm.
"The market has had a near record rally, sprinting far past our estimated fair value of 875 for the S&P 500. [Ben] Bernanke [chairman of the US Federal Reserve] is, in fact, begging us to speculate, and is being mean only to conservative investors like pensioners who cannot make a penny on their cash."
As in the days that followed the great Wall Street Crash of 1929, the masters of the universe have taken charge. They have prescribed a massive bailout programme that prevented the complete meltdown of the financial system and engineered a temporary economic recovery. The obvious cost of this bailout has been the unprecedented deterioration of the Federal balance sheet. But Grantham points to the less obvious but perhaps more severe cost incurred by rewarding recklessness and saving the incompetent.
"Weak enterprises, financial and other, were not gobbled up by the stronger, more prudent and more competent natural survivors, and there is a long-term cost in that. So now, Bernanke begs us to speculate, and we are obedient. Despite being hammered down twice in 10 years and getting punished for speculating, we again pick ourselves up off the canvas and get back into the good fight. Such persistence is unprecedented - 20 years for each really painful experience has been the normal recovery time - but Uncles Ben and Alan [Greenspan, former chairman of the US Fed] have treated us so well in these two disasters that, with hindsight, they don't feel so bad after all. Yes, the market is still down a lot in over 10 years and on our data is likely to have a second consecutive very poor decade, but we have had two wonderful recoveries in which the more speculative you were, the more money you made. So why not break the historical rules and try a third time? Perhaps this time it will be lucky."
Given the current state of the US economy and the global markets our friend at GMO is far from optimistic about where the Fed's policy will likely lead us - off the edge of a cliff.
"To do it twice seems like sadism. And for us to play the game once more seems like lining up behind hot stoves and begging, 'Please, can I burn my hand a third time?' Investors used to be more pain averse... The key shift seems to be the confidence we now have in Bernanke's soldiering on with low rates and moral hazard to the bitter end, if necessary, cliff or no cliff. The concept of moral hazard has changed. It used to be a vague expression of intent: 'if anything goes wrong, I will help you if I can'. It seems to have been transmuted into a cast-iron commitment. The Fed seems to be pledging that it will bail us out after every flood. All that is lacking is a rainbow…. This time, the recovery for the total market was 80 per cent in one year, second only to 1932, and the really speculative stocks are almost double the market, as they also were in 1932."
Back in 1932, however, the conditions were different. Grantham believes they were more conducive to such a rally. But he argues that today's excessive market responses have occurred because stocks are far more sensitive to low rates and the Fed's policy than the real economy itself.
The economy is "limping back into action" as it attempts to shake off the excessive mortgage defaults and public debt, he says, but it will face "seven lean years" before the fundamentals get back on the right track. And this calls for a more bearish and boorish approach to investment than the speculative bull being reared on Bernanke's ranch.
"The economy's durability and flexibility is usually undersold by the bears, and I have generally been leery of underestimating its potential. But we can probably agree that the economy is plagued by unusual problems this time. It is therefore perhaps more likely that the economy will recover in fits and starts, and that over several years it will underperform its historical record."
This is why John Sheehan, managing director of Bangkok-based Global Markets Asia, has for some time now seen the 12 months starting from July as both a tricky and crucial time - even a positive outcome is fraught with danger, yet whatever happens over the next year will play a defining role in what path the global economy takes for many years to come.
If both the economic recovery and the drop off in unemployment are slow then Bernanke will keep rates very low, as promised. "In that case," says Grantham, "stocks and general speculation will very probably rise from levels that are already overpriced. And if they do, Bernanke will definitely not be concerned and has told us as much."
Despite many foreign central banks taking sensible, precautionary action against the risks from emerging asset class bubbles, Bernanke has adopted Alan Greenspan's stance of "let the bubbles take care of themselves". He may even doubt their existence, according to Grantham, which is a disturbing perspective given the speculation-fuelled foam bath that lurks around the corner.
On the upside, if the US recovery is strong, sustained and broad then interest rates will likely rise in time to cap the risk from rising bubbles. This, in turn, will leave us the substantially overpriced US market and more moderate global equities and risk premiums to deal with. The market would likely decline, but not disastrously so, says Grantham. "If, however, the economy only limps along, which seems more likely to me, then we run a very real danger of a third dangerous bubble in stocks and in risk-taking in general."
Despite the seemingly obvious financial disaster this would create, Grantham remains convinced that the Fed chief would still refuse to raise interest rates. "Bernanke will do nothing to let the air out gently. His lack of anti-bubble action is pretty much guaranteed."
While the end of such events is notoriously hard to predict, generally speaking the larger the bubble the greater the shock to the economic and financial system when it finally bursts. The key questions are, how can the economy recover from a third seismic shock? And where would the resources to revive the economy come from?
Improving unemployment just might provide a hook from which to hang our hopes from; that, combined with something to dash the speculative spirit. Otherwise history will likely repeat itself without the financial mentalists having learned from their past mistakes.
Looking at the current economic fundamentals, Grantham believes we're facing a clear range of possibilities and these correlate with the "great divergence" referred to by S&P award-winning fund manager Scott Campbell during his recent Bangkok visit - basically an environment where anything that can happen probably will happen.
Those who believe that history repeats or has patterns that emerge over time may be interested in the fact that many of the problems of the "Tragic Year" started in Europe which is also at the heart of the heightened risks and financial shock waves right now. The difficulties that the global economy faced in 2008 were comparable to the scale of those experienced in 1929. And the equity markets' initial reactions until the beginning of last year also were very similar.
Paul Gambles is the managing partner of MBMG Group. He can be contacted at paul@mbmg-international.com.