August 14, 2006
What Greenspan Had that Bernanke Doesn't
Answer: DIsciplined fiscal policy.
Sometimes a picture is worth a thousand words. Greenspan's term began in 1987. Only recently did inflation turn persistently higher. This isn't hard to understand. During Greenspan's term, the fiscal discipline of both Republican and Democratic leadership brought the growth rate of the U.S. gross public debt down from 16% at an annual rate, to just 2% annually. It's relatively easy for the economy to thrive and for inflation to fall, provided the government isn't sopping up the economy's resources and issuing liabilities in return.
The Fed's job is essentially to decide whether government debt should be forced into the hands of the public as Treasury securities, or purchased by the Federal Reserve (thereby creating currency and bank reserves instead). So while the Fed can control the form that the U.S. government's liabilities take, it has no control over the total quantity of those government liabilities (which is determined solely by fiscal policy). Fiscal discipline can make a genius out of any Fed Chairman. Fiscal irresponsibility, on the other hand, cannot even be rescued by genius.
Dr. Greenspan will undoubtedly be glad that his exit was so fortunately timed. Dr. Bernanke, probably not so much. His main fault, most likely, will be in believing that the Fed can actually exert much power independent of fiscal policy.
Fresh inflation figures are due on Tuesday (PPI) and Wednesday (CPI). Though month-to-month figures have a certain amount of noise, we've observed persistent surprises in other recent data, including wage inflation, unit labor costs, and import prices.
It's clear that the prevailing thesis in the market is that slower economic growth will be coupled with slower inflation. That thesis is most probably responsible for the market's resilience in the face of recent day-to-day news events. While resilience in the face of negative news certainly can be a favorable sign, it's notable that we're really not seeing anything resembling “sponsorship” on the basis of price/volume behavior. Instead, the market is meandering on relatively tame volume, which suggests more of a “wait and see” attitude than any robust preference to accept market risk.
So though the market is expecting (and has effectively priced in) the idea that inflation pressures will abate soon, the market does not seem to have priced in the alternate thesis – principally, that the economy will continue to slow, but that inflation pressures will persist. That potential for a change in thesis is where the main risks to the market probably reside.
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. Until we observe better valuations or evidence of sponsorship through internal market action, price/volume behavior, and other measures, I expect that we'll remain fairly defensive. For now, we observe conditions that have historically been associated with a very poor return/risk profile for the market, on average. Until that observable evidence on valuations and market action changes, arguments about monetary policy, as well as arguments that economic changes are coming, might come, or won't come, are all basically entertainment. We remain fully hedged.
In bonds, the Market Climate remained characterized by modestly unfavorable valuations and modestly unfavorable market action, holding the Strategic Total Return Fund to a defensively short duration of less than 2-years, mostly in Treasury inflation protected securities. The Fund also holds just under 20% of assets in precious metals shares. The majority of the day-to-day fluctuation in the Fund is likely to result from those precious metals positions. For example, a 5% one-day change in the value of precious metals shares (which is rare, but can and does happen from time to time) would be expected to induce a roughly 1% fluctuation in Fund value.
On the fixed income front, I recognize that our defensiveness in bonds is somewhat counter to the prevailing thesis that bonds are a “buy” here because the economy is slowing. But that's exactly the point. At least at present, the observable evidence suggests that the accepted thesis isn't correct. Either the evidence will change, or the thesis will.
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