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The Frankenstein Economy

The Frankenstein Economy

By Expert Panel 20.05.2013


Over the next few weeks, I will be publishing a series of columns that I hope will help investors understand what will be the global economic drivers for the next 10 years. I will discuss their effects on our lives and how to profit from the changes ahead through a series of 10 investment themes. So far we discussed the Growth of the world population and the situation of the Global Debt.

If you remember high school Economics 101 you will recall that there is a natural cycle to the economy. Periods of expansion are followed by periods of contraction. During the expansion new corporate leaders are born and during the contraction the weakest links disappear, paving the way for new innovations and future expansion.

In 1818, Mary Shelley wrote the novel Frankenstein. Everyone is familiar with the story; Dr. Frankenstein defies the law of nature and brings back to life a creature made from a dead corpse, which wanders from place to place in search of a purpose. In my opinion, from the great recession of 2008 has emerged Dr. Frankenstein, in the person of Dr. Bernanke.  Like Victor, the good Doctor in the novel, Dr. Bernanke took it upon himself to resuscitate the economy with the unnatural injection of monetary easing. The effects were similar; the economy came back from the dead but without a soul. So weak that it limps along, barely escaping recession year after year.

I am of the view that the Federal Reserve and the US Government should have not intervened as aggressively in the natural cycle of the economy. Bankrupted financial institutions should have been nationalised, fixed and brought back to the market in a similar way as was done for General Motors. The weakest links would have perished, replaced by more dynamic and innovative corporations.

So what's ahead of us? Before we answer this question let's review how the Fed revived the economy over the past 5 years.

Fig 1

Looking at this chart (Fig 1), we can see that the Monetary Base has increased drastically since 2009, moving from USD800 Billion to USD2.9 Trillion, an increase of more then 350%. During the same period we also saw the Monetary supply (M2) increase by 55%. Any economic books written over the last 100 years would tell you that such an increase in liquidity should produce massive inflation. However, over the last four years, inflation was nowhere to be seen.

The lack of inflation since 2009 can be attributed to many factors, the most important being the banking systems hestitancy to lend to corporations and individuals, thereby restraining the velocity of capital. Coming out of the financial crisis of 2008, the banks looked to fix balance sheets and accumulate as much capital as possible. After four years, we'd expect banks to be aggressively lending, however they seem to show little confidence in the economic situation going forward.

The US unemployment situation hasn’t created an environment where lending could flourish. The following graph illustrates the poor employment situation America has faced since the financial crisis.

Fig 2

As the economy struggles to recreate the jobs lost during the great recession it is difficult for banks to lend confidently. However, the economy is producing jobs, slowly but surely, and the situation is gradually improving. Should we therefore expect more lending and inflation going forward?

The answer is in the hand of Dr. Bernanke. We see two possible scenarios from this point. Under scenario 1 the Fed reduces the accommodative stance taken five years ago.  This would send interest rates higher rapidly and would probably trigger a new recession. This recession may annihilate all the benefits brought by the quantitative easing policy to date. Under this scenario stocks and bonds would plummet, cash would be king and the world would enter into a prolonged period of deflation.

However, as jobs are created and the economy slowly improves, the Federal Reserve may elect to keep interest low. This would probably lead to higher inflation. Under this scenario bonds would keep their value but present limited upside and stocks should extent their positive returns over the short to mid-term. In time, as inflation moved higher, we would expect the Fed to contemplate scenario 1 and again shock the economy and bring it back to square one.

The market is now addicted to accommodative policy and both scenarios present important down side risk going forward. I am of the view that the Fed will remain accommodative for many more years. We should, therefore, expect to see inflation slowly rising in the coming months. This slow rise in inflation will be beneficial to equity and hurt fixed income. This situation should remain until the Fed removes the punch bowl. We expect at least 18 months more of quantitative easing and, if the situation in Europe or Japan deteriorates, even longer.

This is not to say that stocks will go up in a straight line.  The best method is to apply a tactical asset mix approach to your portfolio, overweighting or underweighting the different asset classes according to a three-month forecast. Personally I use a series of different indicators to forecast the direction of the market.  The price of oil, P/E forward and FX directions are examples of quantitative indicators important to our approach. On the qualitative side, I like to see many bullish commentators on news networks before turning bearish and only when Roubinni and Faber become regular on the different shows do I start being bullish again…

In conclusion, the Federal Reserve needs to remember that playing God and trying to modify the laws of nature carries important risk. Like Dr. Frankenstein who perished at the hand of the creature he created, Dr. Bernanke will see his creation destroy his legacy. The question now is when?

(Disclosure: I receive no remuneration from any websites where I am published and do not publish or promote subscriptions to any newsletters.)

Eric St-Cyr is the founder and CEO of Clover Asset Management, a Brokerage and Wealth Management company located in the offshore jurisdiction of the Cayman Islands and servicing clients across the world. Before founding Clover Asset Management, Eric led the investment arm of one of the largest Life Insurance companies in the region, providing investors with impressive performance. Eric spent the first twenty years of his career working in Canada where he became Senior Vice President of one of the largest asset management firms, with assets under management exceeding $60 Billion. Eric can be reach at: eric@clover.ky

Click on the links below to read other articles from this week's newsletter

1. 6 Stocks For Yield And Growth (GARP): Why not look for income stocks with good growth...

2. 18 Share Tips - 20 May 2013: 18 Share Tips to BUY, SELL & HOLD from...

3. Many Income Stocks Are Overvalued - So Where To For Yield?: They provide low-cost, index-like returns...

4. The Best Way To Protect Your Portfolio From Losses: Be wary of investment options that promise too...

5. Trade Forex On Herd Instinct: Being a contrarian may enable you to reap...

6. The Frankenstein Economy: From the great recession of 2008 has emerged...

7. Professional Trader: How To Take Trading Losses: I began to manage my trading like I was...

8. Top 10 shorted stocks: Each day we feature the top 10 shorted stocks...

9. Stocks on a roll: ASX rolling 52-week highs for the previous...

10. Stocks on the slide: ASX rolling 52-week lows for the previous...

 



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WHAT’S ON THIS WEEK

week 25 July 2014
    • 21
    • CBA Commonwealth Bank business sales indicator | 2:18 AM
    • AQA Aquila Resources quarterly activity report | 2:19 AM
    • 22
    • Anika Foundation Luncheon Address by Glenn Stevens, Governor, to the Anika Foundation Luncheon, Sydney | 1:03 AM
    • RBA Panel participation by RBA assistant governor (financial markets), Guy Debelle, at the 2nd Latin American Australia Investors Forum, Sydney | 2:17 AM
    • 23
    • ABS ABS Consumer price index for June quarter | 1:00 AM
    • SGM Sims Metals strategic review presentation | 1:02 AM
    • BHP BHP June quarter report | 1:02 AM
    • PSA Petsec Energy - June quarter results released | 1:54 AM
    • CQ Functions, Queens St, Melbourne Four companies to present updates and investment opportunities (Altona Mining, Arafura Resources, Bassari Resources, Excelsior Gold). CQ Functions, Queens St, Melbourne. | 2:17 AM
    • 24
    • OGC Oceana Gold Q2 results | 1:00 AM
    • MQG Macquarie Group AGM | 1:01 AM
    • PSA Petsec Energy hosts an investor and media conference call about its June quarter results | 1:01 AM
    • AGO Atlas Iron - June quarter report. | 1:02 AM
    • NCM Newcrest Mining quarterly production report | 2:18 AM
    • HIA HIA Summit - Guest speakers include Dianne Spaulding from the non profit Housing Association of Northern California, and Counterpoint Communications Inc's Bob Ransford, Sofitel, Phillip Street, Sydney. | 2:23 AM
    • Peppers and Rogers Group Peppers and Rogers Group founder Don Peppers talks about making better decisions with Data/business management. Hilton, George St, Sydney. | 3:18 AM
    • 25

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