Take Your Medicine Away

Anyone who has young children (or has had in the last 20 years) is likely to have faced the dilemma of just how often you should use the miracle of Calpol.  I know parents who agonise over the rights and wrongs of giving medicine on request from a child.  In a way, we parents are our own worst enemy.  We say things like “this will make it better”, when we know it will do nothing of the sort – it will simply make you feel better whilst your body finds other ways of fixing whatever is ailing you.  In the child’s mind, however, it becomes crucial in future to feel better, irrespective of what is wrong.

I can’t help but think there is an awful lot of this in the market’s reaction to both of the last two FOMC meetings.  What do we know now that we didn’t know at 7:29pm on Wednesday?

We know that the Fed sees less downside risks to the US economy than at its last meeting.  We know that the Fed now believes that US GDP growth will be higher and unemployment lower than it did at its last meeting.  We know that if the US economy pans out the way the committee believes it will, then the Fed will reduce monthly bond purchases later this year, and will stop buying altogether by the middle of next year.  We know that the vast majority of the committee believes that the first increase in the Fed Funds Rate will not happen until 2015.

This is unequivocally good news.  QE is like Calpol – it has made the process of re-adjustment to bank and personal balance sheets less painful; but it wasn’t the cure.  The cure involved more saving, less spending, a re-adjustment of asset values, and a refocus on efficiency.  The patient is healing – but he appears to be petrified about how he is going to feel once Papa Ben takes the Calpol away.  Well, to carry on the analogy – he is just going to have to be a big boy and accept it, because he doesn’t need it anymore.

Largely lost in the melee over the last 24 hours has been stronger than expected data covering UK retail sales, UK mortgage lending, French manufacturing activity and the Philly Fed manufacturing survey.  The only counterpoint has been a slightly weaker Chinese PMI reading from HSBC.

We would not for one minute suggest that investors should ignore the ending of QE and the normalisation of monetary policy – rather, just put it into perspective.  No one believed that QE could last for ever, and everyone knew that government bonds would need to return a positive real yield eventually.  Similarly, equities would eventually have to be faced with a relative valuation test from bonds that legitimately asked what was the right price to pay for equity.

It is popular now to talk of a “1994 moment”.  We have been talking about this for a lot longer.  Admittedly, because we thought we would get here before now – but here we are all the same.  This is the 1994 moment.  This is the point where you have to look at every equity you own on its merit and decide what price you are willing to pay for that future stream of cashflows against a rising opportunity cost in the form of bonds.  Therefore, the deliverability of cash flows and price you pay will determine how good the returns from here are. If 1995, 1996 and 1997 are any guide, there is plenty of upside if you get it right.

It may be that Wednesday did mark the proper bursting of one bubble.  The Fed has given a timeline to stop growing, and then shrink, its balance sheet.  Over the period concerned, it would appear to have very little concern over the outlook for inflation.  If the QE experiment completes without a material shift in inflation expectations, then the great “currency debasement scandal” will have been shown to be a non-event.  So what price gold, then?  With minimal intrinsic economic value, the metal’s price has no natural floor.  It is supposed to be a store of value; but if you are convinced that tomorrow you can buy it cheaper than today then that property has gone in the short term.  The gold price got hammered post the FOMC meeting.  It is difficult to see what utility a buyer is going to get for the foreseeable future.