The Fed insists it will maintain interest rates at 'exceptionally low levels' for an 'extended period', writes Martin Currie's Tom Walker
After spending more than four years as chairman of the Federal Reserve, Ben Bernanke will have grown accustomed to a degree of criticism: it goes with the turf. But over the last 12 months, a new charge has been levelled at ‘Helicopter Ben’ and his colleagues on the Fed’s rate-setting committee. According to the hawks, the Fed is overlooking a principle of physics familiar to anyone who has tried – and failed – to apply a modest dollop of ketchup to the side of his plate:
“Shake, shake the ketchup bottle. First none’ll come, And then a lot’ll.”
Having fallen into disuse (blame squeezy bottles) this once-popular piece of doggerel has been granted a new lease of life, being quoted repeatedly by inflation hawks to illustrate their fear that the Fed’s loose monetary policy will eventually result in runaway prices.
In recent weeks, a number of prominent hawks, such as Thomas Hoenig, president of the Kansas City Fed, have gone public with their demands that the Fed raise interest rates sooner rather than later. In their eyes, Bernanke has been ‘shaking the bottle’ since December 2008 by holding rates between zero and 0.25%. Yet despite this period of loose monetary policy, there has been little sign of mounting inflationary pressure. The Fed, therefore, has kept on shaking. If the rhyme is to be believed, the result will be predictable: a sudden, unstoppable gush of inflation.
Despite the vivid imagery deployed by its critics, the Fed shows no signs of abandoning its easy monetary policy. In its regular statements, it insists that it will maintain interest rates at ‘exceptionally low levels’ for an ‘extended period’. Indeed, when it increased the discount rate earlier this year, the Fed was at pains to state this had no implication for its main lending rate. When a rate increase does eventually arrive, it is unlikely to take the market by surprise; the Fed takes great pride in its ability to manage the market’s expectations.
Inflation: the lesser of two evils?
The market’s expectations today are clear: the overwhelming consensus is rates will not rise until 2011 at the earliest. Investors might not care for the expanding federal budget deficit, but low yields on US Treasuries indicate it has bigger worries. Even as hawks fret about record levels of debt issuance, yields on 10-year Treasuries (just 3.2% at the time of writing) remain close to crisis levels.
These low yields might also be a signal deflation is a bigger threat than inflation. In the year to April, core consumer prices in the US rose by just 0.9%, the slowest pace in four decades. Consumer prices actually fell in April, albeit by just 0.1%. And, if signals from the Treasury Inflation-Protected Securities (Tips) market are to be believed, inflation will continue to undershoot the Fed’s target for some time. Money-supply growth is remarkably weak, raising the uncomfortable spectre that the US might see a replay of the deflationary problems faced by Japan in the 1990s.
Given a choice between the threat of deflation today and the possibility of rising prices tomorrow, it seems likely that Bernanke – a proponent of the theory the Great Depression was a consequence of debt deflation – will view inflation as the lesser of two evils.
Micro trends and niche markets
So it seems unlikely the Fed will raise rates any time soon. The US economy is recovering – but the recovery remains fragile. Jobs are being created – but not at the rate we might have hoped for at this stage of the economic cycle. And Europe’s belated embrace of fiscal austerity could weigh on global demand for several years.
Within that generally lacklustre macro picture, however, there are numerous positive trends on a micro level; niche markets are thriving and a number of US companies are taking advantage. To take just two very different examples, Quanta Services and McDonald’s are both demonstrating the positive change that we invest in – but for very different reasons. Quanta Services is a speciality contractor servicing the electric and gas transmission and distribution (T&D) markets.
To avert a catastrophic wave of power blackouts, the US needs to invest heavily in its ageing power grid. Long-term underinvestment in transmission has created a congested network, and the effect has been compounded by the ‘wait and see’ approach adopted by utility companies during the economic downturn. There are, however, signs that this underinvestment is being addressed. Federal stimulus funding is finally being disbursed; major project announcements are imminent.
McDonald’s, meanwhile, performed very well for our portfolio through the US recession by offering value to hard-pressed consumers. Its new-look restaurants and emphasis on higher-quality coffee make it an attractive alternative to Starbucks. We believe this experience is about to be repeated in Europe. As the ‘Club Med’ countries embark on a period of austerity, the weaker euro will weigh on McDonald’s dollar-denominated earnings. But that should be more than offset by rising demand for value meals and cut-price lattes from cash-strapped consumers.
The US economy: positive change
Quanta Services and McDonald’s are just two of dozens of US companies that are enjoying positive change despite an uninspiring domestic economic environment. Across the corporate sector, we can find a huge number of stocks that exhibit all the signs of rude corporate health: strong balance sheets, strong cashflows, falling debt and share buybacks. These are the companies in which we invest and which we think will prosper despite the choppy market environment.
Looking further ahead, there are two good reasons to be cautiously optimistic about the prospects for the US economy as a whole: low business inventories and rising capex. Earlier this year, the inventory-to-sales ratio hit its lowest level since records began. If consumer demand continues its recovery, inventories will need to increase significantly if they are to keep pace with sales.
And, in terms of capital investment, companies have slashed their expenditure over the last two years. At present, capex is running at a lower rate than depreciation – a 25-year low – meaning the asset base has been steadily shrinking. But that will not last. As managers start to think strategically again, they should start to loosen the purse strings and invest.
Eventually, inventory replenishment and rising capex should lead to a stronger recovery, rising prices and, in turn, put pressure on the Fed to raise rates. For once, however, investors should welcome rising borrowing costs: it is only when rates go up that we will be certain the recovery is firmly established. That will be the time to start worrying about how much ketchup Bernanke has spilled.
Tom Walker is manager of the Martin Currie Portfolio Investment Trust
