Bankers to Fed – We Are Concerned About an Unsustainable Bubble

 

fed-reserveThe Federal Advisory Council (FAC), a group of twelve executive-level bankers, consults with and advises the Board of Governors of the Federal Reserve System. One member is chosen by each Reserve Bank to represent that Reserve Bank’s District, and members ordinarily serve three one-year terms. Presently, the following people serve on the FAC:

 

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Joseph L. Hooley, Chairman, President, and CEO of State Street – First District
James P. Gorman, Chairman and CEO of Morgan Stanley – Second District
Bharat B. Masrani, President and CEO of TD Bank – Third District
James E. Rohr, Executive Chairman and former CEO of PNC – Fourth District
Kelly S. King, Chairman and CEO of BB&T – Fifth District
Daryl G. Byrd, President and CEO of IBERIABANK – Sixth District
David W. Nelms, Chairman and CEO of Discover Financial Services – Seventh District
D. Bryan Jordan, Chairman, President, and CEO of First Horizon National Corp. – Eighth District
Patrick J. Donovan, President and COO of Bremer Financial Corp. – Ninth District
Jonathan M. Kemper, Chairman of Commerce Bank, Kansas City Region and Vice Chairman of Commerce Bancshares – Tenth District
Richard W. Evans, Jr., Chairman and CEO of Cullen/Frost Bankers – Eleventh District
J. Michael Shepherd, Chairman and CEO of Bank of the West and BancWest Corp. – Twelfth District

12 Federal Reserve Disctricts

 

Source: Federal Reserve

Records of the Federal Advisory Council’s meetings are typically posted two weeks after each meeting (there are four per year). A record of the May 17, 2013 meeting was just posted on Friday on the Fed’s website. The eight topics of discussion at the meeting were as follows: Current Market Conditions, GSE Reform, the FHA, Too-Big-To-Fail, Stress Tests, Reliance on Models in Regulations, Economic Discussion, and Monetary Policy. While all eight topics would provide for an interesting discussion, it is on the final topic, monetary policy, that I would like to focus.

Slowly but surely, it is becoming more widely accepted and discussed that the Fed plays an incredibly large role in propping up not just the bond market but also the stock market. As well-known fixed income manager Jeffrey Gundlach recently said during a CNBC interview, “Everything begins and ends with quantitative easing.” Bob Doll, Nuveen Asset Management’s Chief Equity Strategist and Senior Portfolio Manager, essentially concurred with Gundlach in a May 2 CNBC interview when answering David Faber’s question, “That’s really what you’re saying, isn’t it, Bob? It’s all about the cheap money?” Doll’s response was simply, “It is.” And he is right. There are still, however, many people who are struggling to face the truth about the stock market’s rise being largely influenced by quantitative easing. If you are in that camp, you most certainly will not like what the Federal Advisory Council had to say at its May 17 meeting. I was even stunned at some of the words that were allowed to be published on the Fed’s website for all investors to read. In particular, this quote stuck out to me:

“There is also concern about the possibility of a breakout of inflation, although current inflation risk is not considered unmanageable, and of an unsustainable bubble in equity and fixed-income markets given current prices [emphasis added].”

Notice the use of the word “bubble.” The financial media, financial advisors, and portfolio managers, as a collective group, have been calling the bond market a bubble for quite some time. So the FAC’s mentioning that possibility is really no surprise. But what is surprising is the FAC’s expressing concern about an equity bubble. Nowadays, it is pretty much impossible to find an analyst or portfolio manager calling the stock market a bubble. It is also quite a rarity to have the words “equity” and “bubble” mentioned in the same breath by leading bankers and to have the Federal Reserve be willing to publish that for everyone to see.

In addition to the Council’s concern about “an unsustainable bubble” in equities and fixed-income markets, it also mentioned that Fed policies have helped increase the prices of equity securities (among other things), that current Fed policy has created systemic financial risks and potential structural problems for banks, and that “uncertainty exists about how markets will reestablish normal valuations when the Fed withdraws from the market [emphasis added].” Moreover, the FAC noted, “It will likely be difficult to unwind policy accommodation, and the end of monetary easing may be painful for consumers and businesses.”

As I was thinking about what level of importance to assign to some of the things the FAC noted during the May 17 meeting, I was reminded of a quote I once came across from a letter Franklin D. Roosevelt wrote to Col. Edward Mandell House on November 21, 1933. In that letter, FDR said, “The real truth of the matter is, as you and I know, that a financial element in the larger centers has owned the Government ever since the days of Andrew Jackson.” It is certainly fascinating to read something like that from a former President of the United States. And from what I have observed over the years, what FDR stated in the letter still holds true today.

Given the powerful role that bankers play in today’s society, the influence they have on policy, and their generally never-ending bullish stance on equities, I find the use of the words, “unsustainable bubble” and “reestablish normal valuations” to be worthy of more attention than normal. I do not ever like to assign undue importance to any one particular indicator, report, or thing that someone has said. In this case, I think investors should think long and hard about why a group of bankers, appointed by the Fed to consult with and advise the Fed on policy, chose to mention (and allowed to be published) the words they did.

Before concluding, there is something I would like to share regarding the idea of “reestablishing normal valuations.” While market pundits debate whether the current trailing-12-month P/E, a cyclically-adjusted P/E, or a forward-looking P/E (using what I think are unrealistically high earnings estimates) are appropriate for determining whether equity indices are cheap, at fair value, or expensive, I think market participants should be focusing on something else. Ask yourself at what level earnings and P/Es would be without a QE-centric financial world. Today’s valuations and earnings levels are simply not sustainable absent a constant rush of easy money. Moreover, ask yourself what bond yields would be at absent the constant flow of QE.

I am of the opinion that there would be both earnings contraction and multiple contraction should it be widely assumed that the Fed were done with QE. This would result from a negative feedback loop that would start with the stock market’s falling. Regarding bonds, I think the initial reaction would be a spike in benchmark yields and a widening of corporate bond spreads. Then, as investors fled equities, there would be downward pressure on benchmark Treasury yields. How corporate bond yields react would be determined by the difference in spread widening and downward pressure on benchmark yields. The Fed, in my opinion, is well aware of this.

As President and CEO of the Federal Reserve Bank of New York, William Dudley, noted in the May 21, 2013 speech “Lessons at the Zero Bound: The Japanese and U.S. Experience,” “there is some risk that market participants could overreact to any move in the process of normalization” and that such responses could “threaten financial stability.” Yes, the Fed is well aware of the important role the stock market plays in the economy and the Fed’s role in propping up the stock market. That is why the Fed will find it very difficult to stop QE for any extended period of time at any point over the coming years. The Fed is essentially trapped. If it continues QE, it will fuel the bubble the FAC expressed concern about. But if it stops, the stock market will fall, and the resulting negative feedback loop will likely send the U.S. economy into recession.

On a final note, the scariest thing that could happen to equity investors would be if the markets started going down despite ongoing QE. At some point, it is bound to happen, especially if valuations keep rising and earnings growth remains lackluster. When that happens, the Fed will lose one of its biggest assets: The widespread belief by market participants that the Fed is all-powerful and will protect equity owners at all costs. For bond investors, I doubt a QE exit will have any notable negative consequences over the subsequent 12 to 18 months. It may take some time for the initial spike higher in yields to be met with sufficient demand from investors rotating out of equities to drive yields lower, but I do think that would eventually happen.

As you sit back and digest everything in this article, keep the following in mind: Investing in today’s financial markets is as tricky a venture as it has ever been. The Federal Reserve’s policies have distorted asset prices to such an extent that it is incredibly difficult to determine what an asset would be worth absent a persistent traditionally unconventional but increasingly conventional easy monetary policy. Spend some serious time thinking about all the different scenarios that could arise over the coming years and how your portfolio would perform in those situations (don’t forget to consider correlations). Then do your best to remain level-headed while executing your financial plan as well as you can.

Good luck on your investing journey.

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