Author: Daniel Beckerman, Beckerman Institutional
Covestor model: Flexible Value
For the first quarter of this year, so far equity markets have performed quite well. This is a striking contrast to last summer when we were fearful of the European debt crisis. If one recalls, over the past several years the European crisis seemed to re-emerge like a bad mold problem. Although the mold seemed to be treated on the surface with temporary solutions, the roots of the problem were deeply imbedded so that it has been a lingering long-term problem.
However, we have seen aggressive action on the part of the European Central Bank which instituted what I would refer to as its own form of quantitative easing. Despite their previously tough talk in regards to the US quantitative easing (Q.E.) program that was instituted in response to the financial crisis, the “ECB” has instituted a bond buying program as well as below market interest rate (three year) loans to European Banks. Some analysts believe that the total of European Central Bank easing will equate to greater than a trillion dollars.
This action seems to fit into a global theme of trading off the risk of a severe economic downturn with the risk of some currency debasement or inflation. An argument commonly made is that not enough action was taken in response to the Great Depression and that led to a prolonged downturn. Our current Federal Reserve Chairman, Ben Bernanke, would likely argue that there was a need for much greater action in the 1930s in terms of lowering interest rates and keeping them low for an extended period and to institute other forms of economic easing. (Low interest rates encourage increased economic activity as cheaper loans tend to lead to increased borrowing and investing).
There is a tradeoff when it comes to these (monetary) policies. If the rates were kept artificially low forever and unlimited easing was available there would be hyperinflation. So Federal Reserve officials have a difficult job in which they have to guess at when to turn on the low interest rate and Q.E. music, and when to turn off the music and begin to raise rates. It is clear in retrospect that the Federal Reserve was late to respond to the downturn in the economy which began in 2007. Therefore it would not be unreasonable to think that there may not be an immediate response to the first signs of inflation.
Historically, the type of monetary policy that we have experienced has been bullish for stocks. It would be reasonable to overweight stocks relative to other asset classes in the current environment. Global policies have also been bullish for bonds. Rates have moved and remained low and accordingly bonds have increased in value. Although there may be very little impetus for rates to move higher in the near term, there is not much room left for bonds to appreciate. Rates on bonds would have to move to an extreme negative number to repeat their extraordinary performance over the past thirty years. In other words bond investors that are not very careful about what types of bonds they own are likely to experience returns that do not even keep up with inflation.
