Why efforts to further stimulate the economy may cause more harm than good.
With the end of QE 2 closing in, the U.S. debt ceiling being breached and slower economic numbers coming in, one question stands out: How close are we to the Keynesian end point?
The Keynesian end point, which I suspect we’ll hear much more about in the near future, was recently described by Pimco’s Bill Gross as the point where the government’s balance sheet has been tapped out. Kyle Bass of Hayman Capital explains it as the point where debt service exceeds revenues, creating a permanent structural deficit.
Both definitions suggest that further debt-fueled attempts at reviving the economy are not only likely to be ineffective, they could actually be making things worse by creating unwanted inflation and deepening the indebtedness.
When I think about this possibility, I see a team of people pushing a car up a hill. The car is the economy and the people pushing are the stimulus. Whether the car is being pushed up the hill or is cresting over the top and starting to roll on its own is all about the underlying economic momentum. The gravity and weight of the car are like the head winds of destructive inflation, deflationary forces and/or any other forces keeping the real economy from kicking in.
The goal, as has arguably been achieved in every postwar recovery from recession, is to recruit enough people to push the car far enough back up the hill until it can begin to roll forward downhill again.
Again, downhill in this analogy is a good thing, as it represents the virtuous cycle of credit creation and private-market growth independent of government stimulus. Some people call this idea “escape velocity.”
In my view, the recent economic figures suggest we haven’t gotten the car moving on its own yet, and what I’ll call “deflationary gravity” will ultimately take its toll. Consider the recent flow of economic data:
- Last week’s disappointing Philly Fed manufacturing survey coming in at 3.9 from 18.5 in April
- ECRI’s Long Leading Index of global industrial growth indicator showing a summer slowdown, as it printed 0.1 in March, its lowest levels since 1980
- A sinking housing market as Case-Shiller approaches the April 2009 lows more than 30 percent off peak prices in 2006
In other words, the idea that the car is starting to roll backward isn’t too far-fetched.
This is critical, because a situation where the car begins to roll backward despite the massive team of people already pushing it implies that QE and fiscal stimulus aren’t achieving what they were designed to do.
So, if the Fed adds three more people to push the car, it will also be adding more weight to the car in the form of even more inflation and indebtedness—a perfect illustration of the game of diminishing returns the U.S. economy finds itself in.
While this doesn’t necessarily mean the end of the world as we know it, it paints a compelling case to be defensive as the investment community starts to contemplate this scenario.
Keeping equity exposure focused on high-quality, dividend-paying instruments like the iShares Dow Jones Select Dividend Index Fund (NYSEArca: DVY) is one idea to mitigate downside risk.
On the bond side, it would be prudent to follow Pimco’s idea of “safe spreads” by taking positions in nondollar-denominated bonds and high-quality corporates, as Treasuries are offering little value.
At the end of the day, a tactical approach remains the strategy of choice, as I believe the prospect of a Keynesian end point may be approaching more quickly than many appreciate.
Chadd Bennett is a former financial advisor specializing in fixed income. He worked at Bear Stearns when it collapsed, then joined Morgan Stanley Smith Barney.