Market surge indicates correlation between markets and monetary policy

Dubai: It’s hard to believe but as recently as 2009 the entire balance sheet of the Federal Reserve was less than $1 trillion. Today it is just under $3 trillion, with the Fed buying $85 billion of Treasuries and mortgage-backed securities monthly. At this rate, the balance sheet will grow by more than $1 trillion in 2013 alone.

The Wilshire 5000 index, the broadest measure of US stock market performance, has risen from 8,000 in 2009 to 16,000 today, proving a correlation between monetary policy and market performance. The Fed hopes that pouring money into the economy through bond purchases will stimulate growth and create jobs, but that isn’t how the world works. A significant portion of the money appears to flow into financial assets. You could argue that the Fed’s objective is partially being fulfilled because the balance sheet has tripled, with the market doubling in the last four years, but this monetary expansion hasn’t gotten the US on a strong growth path.

The recent severe sell-off in the US equity market was partially attributed to indications in minutes of the Federal Open Market Committee that the Fed is considering reducing monthly purchases this summer. The inconclusive results of the Italian election also contributed to the decline because Europe’s economic uncertainty intensified. A deep market decline is doubtful as investors who didn’t participate in the rise in the market in January have been waiting for a chance to buy equities at less than peak prices.

The January rally may have been related to the year-end events in Washington. The fiscal cliff was avoided by making most Bush-era tax cuts permanent and reducing some deductions. I didn’t think this deal would be celebrated in the financial markets.

One component of the agreement on taxes surprised me. I’d thought the 2 per cent payroll tax holiday would be phased out slowly, but the termination took effect immediately. I worry that this tax increase takes a bite out of the paychecks of all wage earners and has a negative effect on consumer spending — now at 71 per cent of GDP.

The strong market performance in January also ignored the so-called “sequestering” which was a plan developed in 2011 when Congress and the President couldn’t come to an agreement on cutting the deficit by $1.2 trillion over the next decade. This should have a further dampening effect on the economy and will cause inconveniences as a result of government programs and services cutbacks. The January rally suggested that investors focused mostly on the Fed’s continued purchases of bonds by the Fed. Until that stops, stocks are going up, has been the prevailing reasoning.

The combination of strong market performance together with rising housing prices has had a positive effect on consumer confidence. The question is what will happen to this increased confidence if the stock market consolidates or declines. Current measures of investor optimism reflect a more constructive outlook. While not quite at euphoric levels, investor attitudes have reached a point where corrections have begun in the past. It is just hard to determine what the trigger event will be.

The biggest problems could emanate from service reductions as a result of the sequestration. The current cost of government entitlements and other services needs to be scaled back. However, when you actually consider what reducing expenses entails, it is clear that elected officials will be forced to make hard and unpopular choices. Aside from the possibility that the economy might suffer from higher taxes and less government spending, there is the possible problem of a profit margin squeeze. Profits increased rapidly after the recession troughed in June 2009 as one might expect, but something happened in this cycle that had not happened in the five previous recoveries: profits increased faster than revenues. In a typical cycle sales climb almost exponentially; labor compensation comes next as laid-off workers are hired back and employees who endured the slowdown are rewarded with raises or bonuses. Profits recover less dramatically. Not so this time. Companies used the ample cash on their balance sheets to buy labour-saving capital equipment, enabling profits to grow even faster than sales. That’s one of the reasons the unemployment rate has remained so high. In past cycles it would have dropped to 5 per cent by this time. The rate is now 7.9 per cent.

Substituting capital for labour caused productivity to surge in 2009-10. US profits as a share of national income are at a record of 14 per cent. Profits as a percentage of corporate sales are also at a high of over 9 per cent. Income from foreign operations has contributed to this performance. A recession in Europe this year may reduce the positive influence of this factor.

Another reason for the profitability surge is the low level of interest rates for corporate borrowers. There is no sign that interest rates are going to rise in the near term, though they are not likely to decline from present levels. Wages are the other factor that has a heavy impact on profits. In the 1920s profits were 24 per cent of wages; they declined to 11 per cent by the 1970s. Profits are now back to over 20 per cent of wages. Real wages have made little progress over the past decade and that has contributed to the inequality argument. The growth and compensation in the financial sector has been a factor in the change in the wage/profit relationship, but manufacturing as a share of total profits is increasing and finance is declining, which is an overall positive for the US economy.

My thesis is that a combination of modest revenue growth and increasing costs would put pressure on margins. By increasing their leverage at low interest rates, companies may be able to maintain high margins in spite of cost pressures. Doug Kass of Seabreeze Partners has pointed out that at the start of the current fourth quarter earnings season, the estimate for S&P 500 profits was $25.50. Now with 80% of companies reporting he says $23.50 looks more likely, an 8 per cent shortfall. He further notes that in January 56 companies provided 2013 guidance. The ratio of negative to positive was 45 to 11.

The performance of the market so far this year has largely been a function of monetary expansion, in my opinion, and the low level of interest rates has also had a positive impact on corporate profits. I have maintained that earnings will be disappointing this year, although the evidence on this point is mixed so far. Right now stocks are on their way to deliver another double-digit year for the S&P 500, but if margin pressure appears, then a more modest return is likely.

Byron Wein is Vice Chairman of Blackstone Advisory Partners