The Q4-2010 issue of Automated Trader featured an interview with New York based Conquest Capital Group's Managing Partner, Marc H. Malek. In the interview, Marc described Conquest's approach as "systematic with a discretionary overlay". At the time of the interview, Marc outlined his macro view [See "Feeling Queasy?"] detailing the potential folly of maintaining a weak currency, and specifically what it might mean for the US economy. One month on, we felt it was time to catch up with Marc for an update.
Over the past two months, the S&P 500 has risen nearly 13%. These gains have come despite tepid growth and continued underemployment. Although much of the rise can be attributed to dollar weakness and corporate profits, the recent few weeks have been predicated on the announcement of a new round of monetary stimulus, commonly called QE2. We think this optimism will ultimately prove to be misguided.
When economic conditions deteriorate, there are two courses of action available to the government: monetary policy and fiscal policy. Monetary policy comes in the form of reducing interest rates and injecting money into the financial system. These measures are designed to increase the velocity of money and stimulate economic activity by increasing the availability of credit and reducing the attractiveness of cash. Quantitative easing takes this measure to an extreme by depressing Treasury and credit yields such that investors seek other vehicles for their capital and consumers spend.
Although the government has enacted a broad array of stimulus programs, these programs have been largely ineffective. Instead, this recovery has been driven primarily by the monetary policy of the FOMC. In late 2007, the Fed began an aggressive campaign of rate cuts to support the financial markets, particularly the debt market. When the overnight deposit rate reached zero and the financial markets were still not operating properly, the FOMC launched a program of quantitative easing.
While the first round of quantitative easing has succeeded in stabilizing the credit markets, the benefits of these measures have been restricted to banks, credit-worthy individuals, and corporations. Although these entities have purchased goods and reinvested their capital into the equity markets to some extent, the velocity of money has not increased. Personal lending is still at an untenably low level. Instead, investors and institutions are staying in cash or purchasing Treasuries even at these depressed yields.
Corporations are borrowing, but they are hoarding cash and paying dividends rather than producing goods and hiring. They have opted to curtail expansion because they see declining demand for their merchandise and services. Although debt relief and some credit have supported demand thus far, there is a growing percentage of the population that will be unable to consume.
Unemployment has remained near high post-Depression levels for over a year and is abating only nominally. Many potential homeowners still do not have access to credit and many homeowners are underwater in their homes. With little likelihood of ever settling their debts, some homeowners have opted to become delinquent on their mortgages to live rent-free.
As demand deteriorates, corporate profitability will necessarily decline. Inventory accumulation only helps in the short-term but these goods must be sold. The emerging market economies are growing but they face the same conundrum as they rely on exports. Even though China is growing and consuming raw materials at an insatiable rate, it is still a net exporter.
In that vein, we believe that monetary policy has run its course. QE2 will have limited incremental benefit because it will not address the underlying issues in the economy. The glut of liquidity has not tangibly reduced unemployment. The velocity of money has not accelerated. The credit-worthy entities that benefit from low interest rates are already flush with capital, while those who need the credit to consume and drive the economy still do not have access.
Instead, the next step in stimulating economic recovery must be fiscal in nature. This outcome seems less likely as we look ahead. With a mixed Congress now elected, the likelihood of enacting such measures has declined. Absent some sort of fiscal solution, we expect that the global economy will muddle along until it begins to slowly circle the drain.