Investors Should Be Cautious

By Vincent J. Truglia

Investors need to remain cautious because several developments in the US and around the world imply, at least to this long-in-the-tooth economist, that risks abound. Last week, when the Federal Open Market Committee’s (FOMC) were published, I was too otherwise occupied to write a blog about it.  What I found the most important factor in the long document was that:

A few participants raised the possibility that it might be appropriate to increase the federal funds rate relatively soon. One participant cited evidence that the equilibrium real interest rate had moved higher, and a couple of them noted that some standard policy rules tended to suggest that the federal funds rate should be raised above its effective lower bound before the middle of this year.” 

Higher Rates Coming

That immediately raised red flags.  As my regular readers know, I have advocated raising short-term rates later this year, which is quite different from my position even as late as September 2013.

Auto Sales Are Key

When I examined the growth rate of Personal Consumption Expenditures (PCE) in the initial estimate for 4Q13, about half the growth came from auto-related sales.  That wasn’t a surprise, since the US auto fleet is quite old, with an average fleet age surpassing 11 years, implying that many autos need to be replaced.  However, what worries me about this trend is that auto-financing is now mimicking pre-crisis mortgage activity.  It is now well known that almost anyone can walk into an auto showroom and buy/lease a car despite bad credit, and with little or no down payment.  Sound familiar?  Sub-prime auto securitization is a booming business. I should add that I would not equate mortgage lending with auto-finance, since car repossessions are far easier than foreclosing on a house.  Nonetheless, it does not give me comfort to find that people can now finance their new cars with loans for  as long as 7 years, a far cry from traditional practices, where 3-4 year loans were common, and 5 year loans were an “innovation.”

Housing Will Only Stabilize

Housing will not return to its pre-crisis levels in the US for many, many years.  The reasons are simple.  Young people are saddled with an unprecedented level of student loan debt, implying that they will have to postpone any new home purchases longer than the earlier generation.  More importantly, mortgage-lending practices have reverted to their historical norms, which means sizable down payments, and good credit scores. I should add that in recent years, a significant proportion of existing home sales have been accounted for by investors, who paid cash, requiring no mortgages.

Moderate GDP Growth

On the surface, this appears a somewhat bleak picture.  However, it isn’t.  The Federal government’s role in dragging down GDP growth will slowly be coming to an end.  For instance, in 4Q13, the federal government’s decline in spending resulted in the US economy growing by nearly one full percentage lower than it would have if the federal government — the fiscal crazies in DC — had not caused sharp declines in federal spending.  If we just get the federal government back to a neutral position, there is enough momentum in the economy to keep it growing at 2.5-3.0%. For those who like to read FOMC details, you will find that buried in the document is an important allusion to the fact that growth in the US will be above potential growth for the next few years.  Assuming that is the case, that means inflation caused by full capacity will return sooner than previously anticipated.

The Overall Economy

Housing is slowly stabilizing, albeit at a lower rate than in past recoveries.  Auto sales will continue.  Income growth will remain flat, but since many consumers feel more secure about their employment prospects, consumption should hold up, even if it isn’t growing at the rate we saw in Q4.

Why The Anxiety? 

I refer back to the quote from the FOMC minutes noted above.  The fact that a FEW of the participants raised the possibility that the federal funds rate (the anchor short-term interest rate) may need to be raised before the middle of the year is a WOW statement.

If short-term rates are raised, then we will see all asset prices reset.  The most important of the asset price resettings will be in stock and bond markets worldwide.  EM countries who have been affected by tapering better be prepared for higher short-term US interest rates in the not-too-distant future. Compared to tapering, higher short-term fed fund rates will hit markets like a tornado.

At the same time, since the Federal Reserve is responsible for the US economy, and not for foreign economies, the Fed must and will focus on US national self-interest.  If the Fed doesn’t then the Congress should remove the lot of them.  However, I don’t think that is likely to happen, because I have full faith that the Fed will carry out its mandates regarding the US, and ignore foreign side-effects.

Stanley Fischer As Fed Vice-Chair?

However, I will leave you with the following thought.  I believe Janet Yellen is a highly qualified Fed Chair.  However, I was not impressed by her testimony before Congress.  Twice the committee chair had to ask her to speak up so she could be heard.  Why is that relevant? It’s important because this year she is going to have to deal with a very divided FOMC – appropriately divided, I should add.

I have been wondering why the US called on Stanley Fischer to be the new Fed Vice-Chair.  He’s is eminently qualified, however, there were/are equally eminently qualified full-time US residents who lived through the Great Recession while still residing in the US who could have been nominated.

I see Fischer as the new éminence grise, as they say in French (the powerful advisor behind the throne).  Since Yellen may lack the corralling skills of past Fed Chair’s, Stanley Fischer might be considered to have the gravitas needed to deal with strong and growing opposition to unorthodox Fed policies.  I should add for those who don’t already know it, Fischer was both professor and mentor to both Bernanke and Draghi at MIT.  I see Fischer as their stand-in at the Fed.  Unfortunately, the time for unorthodox monetary policies, at least in the US, is coming to an end.  If Fischer’s role is to try to thwart a reversion back to the historial norm, then I hope other FOMC voting members will see through that ruse, and stand-up to someone who frankly should NOT have been named Fed Vice-Chair.

As always, Clear and Candid.