To Infinity and Beyond!

 

 I was going to write a long post on the effects of QE3 to infinity announced by the Fed when I came across an extremely well written piece that describes both the plus side and coming negative side of endless printing on different asset classes. It supports the goal of this blog to examine the macro economic environment to preserve and grow wealth. You can read it here. I have also shown it below:

The Dark Side Of QE: The Next Chapter In Our Story

I am about to tell a story with a very happy beginning and a very sad end. Unfortunately, it happens to be the story we are living in today, but because we are still in the happy part of the story most people cannot see what is coming ahead. I will provide that for you here.

The immediate knee jerk reaction to the Fed's announcement today is that the Fed printing $40 billion per month and pumping it into the banking system is fundamentally strong for every type of asset in the world. Those that graduated from college in 2009 and have only been watching the market for a few years would believe this is a fact.

In essence: buy everything and just keep on buying.

Now that we know we are on the path of QE to infinity it is very important to understand how an endless running stream of new money fundamentally impacts assets differently. You'll notice a repetition of the word fundamentally because for long periods of time assets can move in the opposite direction of their fundamentals. Think of the 100% par value of subprime mortgage tranches in early 2006 or the multi-billion dollar valuation of Pets.com in 1999. Over time assets have a tendency, like gravity, to revert back to their fundamental value. This is what causes booms, busts, opportunity, and disaster.

Before we go any further, let's quickly review how QE actually works. The Fed shows up at the doorstep of primary dealer (the largest) banks with a printed bag full of money and asks them if they can come in and buy some mortgage bonds. The banks agree, hand them the bonds, and take the bag full of cash. The banks now have a new lump sum of money to spend or do with what they like. This is also new money that did not exist in the economy before which is how the money supply is increased. In reality, there are no knocking on doors with bags of money, this process takes place electronically with a few key strokes from either side. The outcome, however, is the same.

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Part 1: The Positive Benefits Of QE (March 2009 - September 2012)

We'll start with mortgage bonds as a completely separate conversation because the Fed has targeted this one asset as their choice of purchase. Mortgage bonds and mortgage rates will have an obvious fundamental advantage to the Fed purchasing them every single month. If the Fed decided they were only going to purchase blue Honda Accord cars every month, it would have a positive fundamental impact on the price of those cars.

The QE process of mortgage bond purchases has the immediate impact of lowering mortgage rates (a new larger buyer of mortgages in the market - higher demand equals lower rates). It also has an alternative impact due to the bag of money left at the doorstep of the banks. The banks can now take this money and spend it. They can purchase treasury bonds, corporate bonds, and municipal bonds (plus a few other assets we'll get to in a moment).

This bond purchasing lowers the cost of borrowing for everyone as lower interest rates allow corporations, local governments, and the federal government to borrow more. This is the Fed's second goal: to lower the cost of borrowing to stimulate the economy.

Stocks rise with the Fed easing in part for the very reason just discussed. If it costs corporations less to borrow money it increases their profits and allows them more opportunity to grow. QE also has the ability to push up stock prices because banks now have more fresh cash that they can put to work in the stock market.

The positive benefit of QE, the happy part of the story, is essentially what we have experienced since the first QE program began in March of 2009. Interest rates on every type of bond in America: treasury, corporate, municipal, mortgage, auto, credit card, and junk bonds have fallen significantly.

Stocks have soared, rising over 100% in the S&P 500 since the first QE began that March. This creates an immediate wealth effect for those holding stocks (their portfolio says $400,000 instead of $200,000 making them more likely to spend and boost the economy).

Corporate profits have surged with the lower cost of borrowing, the massive reduction in expenses (mostly through employee layoffs), and an increase in productivity.

Over the past 3.5 years when rolling out QE 1 & 2 the dollar index has moved sideways and even appreciated (due mainly to the over weighting of the index to the euro).

So far we have only experienced the good part of inflation. We have only experienced the high of the drug, and the buzz of the alcohol. If the story ended here today it would appear that QE was the correct decision all along and that the unlimited QE program announced today has no reason to be anything but positive.

But the story will not end here today. We will look now look at what comes next.

Part 2: The Dark Side Of QE (2013 - 2016)

This is where we move away from the fairy tale and back into reality.

When the Fed shows up at the bank with the bag of cash there is another asset class the bank can purchase with the money: commodities.

Commodities include agriculture (food), energy (oil and natural gas), metals (copper, steel, aluminum), lumber, water, precious metals, and every other tangible good in the world. Many of these items are either directly purchased by consumers (food and energy) or they are purchased as a byproduct of other items they use such as a car, shirt, or washer and dryer. This directly raises the cost of living for consumers. A higher cost of living means less disposable income and less money available to buy goods such as iPads, furniture, vacations, or cars. A slow down in spending in these areas not only impacts the stock prices of these companies, it spurs lay offs at them as well.

This is looking directly at the consumer side, but what about the corporate side? At the end of the day a company is judged (with its stock price) based on its ability to generate profits. If the cost of goods to produce rises (with rising commodity prices) and companies are not able to raise prices enough to offset those costs (which would occur if wages were not rising at an equal or greater pace) then profit margins fall.

Do you see, based on the fundamentals of economics, how inflation does not help the price of stocks. This is, in part, why stocks were crushed during the stagflationary period of the 1970's.

What about bonds?

Bonds face a similar dilemma, only magnified. Why? Because bonds do not have the ability to raise prices the way a company can to offset inflation (even though we just saw how companies can only raise prices so far without choking off all demand). Bonds are set at a fixed interest rate. If the underlying value of the currency the bond is held in depreciates in value then the investor is trapped.

Many bonds today actually have a negative yield. This means that the cost of living is rising more rapidly every year than what is paid out in interest. Investors buying these bonds know going in that they are losing purchasing power. Why would anyone ever do this? I have no idea. Why would they purchase Internet stocks in the year 2000 at sky high valuations when the companies had no profits? Bonds today, like stocks then, are in a bubble. The madness of crowds has set in.

At some point, as new QE money enters the money supply and continues to depreciate the value of the currency there will be an awakening moment for bond holders. What will trigger this "moment?" I have no idea. But I know that it is coming. Those trapped inside the long term bonds that have been front running the Fed's QE programs will suddenly realize that they are running in quicksand.

How about the currency itself? Paper bills. They have no interest rate risk right? They have no corporate margins to worry about right? Holding cash at the bank seems like the best available option.

In reality it will be ultimately be the worst. The only thing worse than a low interest rate during a period of high inflation is no interest rate. We live in a borderless world today where investors do not have to hold their money in a domestic bank (just watch what is taking place right now in Spain). Money can be moved to a bank in Switzerland, Hong Kong, Brazil, or Canada. It can also be held in those currencies at those banks.

This is what will take place at first slowly in America and then in a rush at the end. Most will likely not be allowed to escape as the borders are shut when the politicians realize what is taking place. Their money will be trapped inside the closed room being filled with water by Bernanke. Their purchasing power will drown.

How about real estate? This is one of the favorites for those arguing for an inflation investment. The problem is that real estate is purchased with debt. If the cost of the debt rises significantly (interest rates rise) then the price of the asset is going to fall, even if the cost of building a new home is rising as well. This will only occur over the short term because we still have an enormous amount of untapped supply to mop up. It is only in a hyperinflationary environment, not a very high inflationary environment, that real estate will be a strong investment.

So after understanding why stocks, bonds, cash, and real estate fundamentally should go down in a high inflationary environment, what is the best investment option?

Commodities

I have explained numerous times using historical examples and charts how we are in a long term secular bull market for commodities which began in the year 2000. Energy, agriculture, water, rare earths, and precious metals have been and still are my personal favorites.

If the Fed prints more money tomorrow there is no fundamental downside for the price of gold. There are no corporate margins squeezed. There are no interest rate risks. There is no dilution of the money. It is just a larger amount of paper money chasing a stable amount of physical gold. Throughout history that has only led to one thing: a price adjustment in the price of gold to account for the paper money that has been created.

Usually this happens very slowly over a long period of time and then very suddenly and violently at the end. Almost all of the entire bull market run in gold during the 1970's happened in the last 90 days leading into January 1980. I think it will be the same this time as well.