Guide to Working with Monetary Napalm

Napalm is a highly incendiary form of jellied fuel. It was used extensively in the Vietnam War to quickly ignite massive fires over large areas of land. In the world of financial incendiaries, the Fed’s overwhelming monetary stimulus has ignited asset prices in the United States with the force and effectiveness of napalm. Is the fire short lived? Are the gains in asset prices temporary or can they be believed? Are the housing and stock markets on fire just because of the Fed’s quantitative easing (QE) or could there be a much more fundamental reason?

The equity markets have done a pretty interesting trick since they bottomed in March 2008. From the bottom, equity prices have essentially more than doubled even as individual investors have been removing money from the market. Now, popular indices like the Dow Jones Industrials and S&P 500 are achieving all-time highs. What happens when the Fed stops applying the napalm? Will the fire go out? Is it too late to get in?

The answer, in our opinion, to this quandary is actually quite basic. The Fed’s actions are indeed record setting. Never before in the history of the United States has the Federal Reserve kept monetary policy so easy for so long. Zero percent interest rates are asphyxiating fixed income investors of yield, forcing them to seek other more risky assets to move into. Quantitative easing through the bond-buying program is targeted at creating aggregate demand, as well as raising inflation expectations. Together, these actions by the Fed have delivered a one-two punch that is record setting in both breadth and scope.

Many market pundits have attributed the move in asset prices to all of the excess liquidity that the Fed is injecting. I think the answer may be more fundamental than that. Easy monetary policy is supportive of actual economic growth. Putting the monetary “pedal to the metal,” or applying monetary napalm has acted to jump start the seeds of economic growth. Yes, growth has been slow out of the depths of our financial despair of 2008, but it has been much faster than other parts of the financial world. We would argue that the monetary napalm has caused an accelerated germination of the seeds of growth and not a false feeling of growth.

New homes being built are being done so to quench a number of new buyers who now can qualify for financing. The refinancing of America has put discretionary income in the hands of both homeowners and corporations in the form of lower debt payments. Manufacturing jobs and energy independence spell a very bright future for the American economy. Almost across the board we are seeing a recovery that was slow to start but now appears to be gaining traction. Markets tend to be forward looking and we think that the record levels are seeing a solid recovery and growth.

The question of how much higher can prices get, I would just mention Sir Isaac Newton’s 3rd Law of Motion: For every action there is an equal and opposite reaction. We believe this law applied to monetary policy would mean that the size of the response of a market is directly correlated to the size of the stimulus. Thus, given that the Fed is applying a record-setting amount of stimulus to the U.S. economy, we expect a similar-sized response in growth and asset price potential. Using monetary napalm to get huge results should logically produce huge results. We believe that the equity markets are not in danger of a meltdown but more likely to experience a melt-up!

With every analysis we also have to point out areas of caution for investors. At all-time lows for bond yields, we note that bonds are priced to deliver likely generational-low returns going forward. We believe the bond market is in the final stages of a secular bull market that began in 1982 with the 10-year Treasury hitting 15%. Now, yield has hit a low of 1.38% in 2012 and should begin to rise over time as the Fed successfully creates inflation expectations. We are not telling people to sell all of their bonds, but using bonds as a concentrated allocation in a risk-adverse portfolio may have latent risks. Because prices are so high and yields are so low, duration risk is at an all-time high. That means that if rates climb over time, total returns for bond holders could suffer. We also note that most of the financial advisors in the business today have never lived in any bond market other than one that goes up. Exchange Traded Fund (ETF) and bond mutual fund investors may be in for an ugly surprise if we are right.

There are still outsized investment opportunities around the globe. We would point out that our global neighbors abroad are getting into the QE game. Over the past couple of months we have seen Japan, China, Australia and the European Union begin to ease. Japan is employing “Super Napalm” as a means of juicing up an economy and inflation expectations that have been asleep for over two decades. These global central bank want-to-be’s should succeed in restarting their economies as they feel emboldened to do more easing. Thus, as the global economies become poised for growth our feeling is that ownership of energy and natural resources should do well. These are areas that are priced closer to the lows of 2009 and present real value. We don’t believe the commodity super-cycle is over and think this is just a correction in prices along the way. Secular bull markets tend to end with plenty of fireworks and unthinkable prices. We don’t think we have seen the “euphoria” stage yet. Rising inflation expectations would be supportive to our suggestion as well. We think this area is deserving of an over allocation in the investment portfolio.

Finally, we believe that emerging markets are turning the corner and should benefit from expansion in the United States and Asia. Thus BRIC ( Brazil, Russia, India and China) investments would seem timely as those economies benefit from monetary stimulus. We would also look to dip our toe in Europe as they too are medicating themselves with the monetary elixir. The outlook is good for these under-loved markets and recent developments will prove positive for them.

© Advisors Asset Management

© Advisors Asset Management

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