Bernanke Wins Nobel Prize, Market Shrugs at CPI?

When I walk my dog, I’m struck by how obsessive he is about his actions. He will spend, what seems to me, like a ridiculous amount of time searching for the perfect spot to relieve himself—re-positioning himself countless times as if the future of the free world depends upon the outcome. For him, this process is vital to is existence—to me, it is a waste of time. The animal brain is dominated by what it chooses to focus on. Maybe in that regard I’m not so much different from my dog. In the midst of all the market chaos this week, my brain chooses to focus on the news that Ben Bernanke, former Federal Reserve Chairman, won the Nobel Prize for Economics.

Ben Bernanke was at the helm during the Great Financial Crisis in 2008. As a student of the Great Depression, Bernanke played a critical role in TARP, the government action to bail out the banks, Quantitative Easing, and a zero-interest rate policy. In awarding this prize to Bernanke, the committee is issuing its verdict that central bank policies around the world in the years following the financial crisis have been a resounding success. But for me, I would have to say let’s just hold off a little bit longer before we issue that pronouncement.

You see, the problem with the determining the success of the actions taken in response to the crisis are multi-layered. First the obvious, we cannot assume causation. We know that the Fed took actions and that the economy and financial markets recovered, but we cannot be certain that those actions actually caused the US economy to recover. In fact, considering that central banks in Japan and Europe enacted the same policies and have not seen nearly the same results would seem to argue that there may have been more at play in our recovery than simply the actions of one superhero bureaucrat.

Second, and more importantly, in order to assess the success of any government intervention we have to see how we succeed in unwinding those actions. Example: if looked at through a narrow lens, the actions of military action in Afghanistan resulted in the eventual death of Osama Bin Laden but was the intervention a success. Trillions of dollars spent to apprehend on person, with the final result being the return to power of the Taliban in leadership in the country. For me, this action gets a D-. Similarly, after 14 years of zero interest rates and quantitative easing we are now facing rampant inflation and rising interest rates that have had a bruising, if not crushing, effect on financial markets. Oh, and we are still not out of the woods.

While yesterday’s CPI report showed continued, unchecked inflation the stock market staged a remarkable turnaround to finish dramatically higher. However, this doesn’t change the fact that interest rates will need to go even higher to choke off inflation; and once inflation is “choked off” will it eventually strangle our economy. But perhaps interest rates are just the tip of the iceberg. The scarier correlation over the last 14 years has been the relationship between the Federal Reserve balance sheet and the returns of the S&P 500. Since 2008, the Fed’s balance sheet (the amount of mortgage, corporate and US Treasury bonds owned by the Fed) has grown from less than $900 billion to a peak of nearly $9 trillion as of April 2022. Right before Covid hit that number was around $4 trillion.

During the last 14 years there have only been short periods over which the balance sheet has shrunk—the longest period was from late 2017 through August 2019. If you recall, financial markets did not have a very good 2018. As painful as this year has been so far, the Fed only began shrinking its balance sheet in May. Since that time, it has only declined by 2%. Unfortunately, for the sake of brevity, I will need to get to the point for investors. The facts as I see them are these: first, the Fed’s interference in the financial system has created a drug addict mentality for markets, maintaining is not good enough, more and more is always required; second, there will be a time when no amount of “more” will do the trick and the whole system will be at risk of cannibalizing itself.

From an investment management standpoint this whole process leaves very few clear actions. At the beginning of the year, we knew that inflation was high and interest rates were zero—the return on a cash represented a real return of negative 8%. Long-term bonds offered little in the realm of guaranteed interest. Stocks were high by many valuations. Today, the rate on a 2-year Treasury bond is yielding close to 4.5%, but inflation is running at 8%, or a potential negative 3.5% return should inflation remain. The year-to-date return on stocks and long-term bonds is down roughly 25%. The quandary is this: cash offered a guaranteed loss at the beginning of the year, but was clearly the better investment; now that cash offers some nominal return while the other investments are 25% off their all-time highs, which investment offers the better 3-5 year return?

Finally, if these questions are difficult for me as a financial advisor, what about the challenges of navigating this environment for the people running companies around the globe? The Fed has certainly created a lot of problems without clear answers—only fear and uncertainty. Enjoy your Nobel Prize Ben, the rest of us will be left with some heavy lifting.

Thanks for reading

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