The Fed Inflator

The Fed Inflator

Published On: May 11, 2020

Written by: Ben Atwater and Matt Malick

Since the S&P 500’s near-term bottom on March 23rd, the index has risen by 31.25%, including dividends, recouping much of the losses from the February 19th peak.  This turnaround seems inexplicable given the havoc that COVID-19 is wreaking on the real economy.  Stocks appear to be untethered from economic fundamentals.

But then again, the stock market has been only loosely linked to economic output for quite some time.  From the beginning of the last bull market in March of 2009 through the end of 2019, S&P 500 prices grew over seven times faster than the U.S. economy, as measured by nominal Gross Domestic Product (GDP).

There was a time when economic growth mattered more for stock prices.  From 1950 through 2009, the S&P 500 price index and nominal U.S. GDP grew by roughly the same amount.  Stocks were much more volatile than the general economy, but the rate of appreciation was nearly identical over this 59-year span.

As you can see above, a major disconnect between economic growth and stock market performance began when the market started recovering from the financial crisis in early 2009.  In our view, there is only one obvious cause of the disconnect, the U.S Federal Reserve. 

During the Financial Crisis and Great Recession of 2007-09, the Fed began an aggressive expansion of its balance sheet, purchasing Treasury securities, agency bonds and mortgage-backed securities.  Recently, the Fed has now expanded those purchases to include municipal and corporate bonds.  The result has been a massive increase in liquidity and a propping-up of all asset prices.

Moving forward, it is hard to imagine the Fed stopping anytime soon.  A second leg lower for equities would likely even lead to chatter about the Fed stepping in to purchase stocks directly via exchange-traded funds.  A central bank buying equities would not be unprecedented as the Japanese Central Bank owns about 5% of the Japanese stock market.  One can imagine the justification that Americans need support to protect their hard-earned retirement savings from this unpredictable health crisis. 

In economics, however, there should be no such thing as a free lunch.  Or so economists say.  A central bank should not be able to create limitless liquidity and drive asset prices higher forever.  Eventually, fundamentals should matter and stock prices should regain some link to economic growth.  But there is certainly no guarantee.  Theoretically, the Fed can expand its balance sheet ad infinitum. 

As always, there are many potential outcomes.  Perhaps the Fed’s actions will eventually result in the law of diminishing returns and be less of a catalyst for stocks?  Or maybe economic growth rapidly accelerates post-pandemic and the real economy catches up to asset prices?  Or perhaps persistent deflation risk allows an ever-expanding Fed balance sheet to forever buoy stocks?  Conversely, high inflation might force Fed officials to reduce liquidity and pare their balance sheet?

Regardless, the number one lesson remains the inability to time markets, whether that be the direction of stock markets or the direction of interest rates.  The Fed is simply another wildly unpredictable, but hugely important, cog in the complex machine that is asset prices. 

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