KRUGER INSIGHTS TUESDAY, OCTOBER 8, 2013

By: Joel Kruger

ONE WAY STREET – The short-term distractions of the government shutdown and upcoming debt ceiling deadline continue to be the focus of markets. However, as I have highlighted many times, these storylines are non-factors in the medium-term and will not be what ultimately drives investor interest. The key theme will be preparation for Fed exit and the implications on the US and global economy. We have already reached the point where the only easing tool left in the Fed’s bag is time. Interest rates are at zero and quantitative easing has been fully extended. So at this point, all the markets have to get excited about is the possibility that policy will stay as is for a while longer. But if you ask anyone with half a head on their shoulders, there is no denying that one of the very real side effects (and irony) of current policy is the asset bubble that it has created. Risk assets have skyrocketed in recent years on the incentive to be holding these assets rather than on the underlying fundamental value of the assets themselves. This reality carries some serious implications going forward, as once policy is finally reversed, these assets will become seriously exposed. While the implementation of such policy has been a necessary means to help stimulate the global economy back into recovery, let us not be fooled. This is a policy that incentivizes the purchase of risky assets in a time where investors should be anywhere but risky assets. Equities are not near record levels because the fundamentals are supportive, and emerging markets are not outperforming because of the massive growth prospects in these regions. These markets are simply the beneficiaries of a policy that has laid down a one way street to risk assets. Unfortunately, it is the real economy that is the better gauge of the health of the recovery, and it is here where we get a better indication of where things stand. Thankfully, we have been seeing improvement in the real economy and I believe we are on a path to recovery. At the same time, this recovery is nowhere near correlated to the recovery we have seen in financial markets and risk assets. Risk assets continue to ignore this fact, and do not appear to be ready to wake up to reality until it slams these assets in the face. The Fed will be the source of this blow and again, it is not a question of if but when.

TESTING THE WATERS – A lot of this now rides on the shoulders of President Obama who is in the process of deciding the next Fed Chair. The leading candidate has been Janet Yellen, an ultra-dove who would likely continue to spoil the financial markets and further incentivize upward pressure on risk assets. However, there has been increased speculation in recent days that Donald Kohn may be the one to take over at the helm. Mr. Kohn would be my choice (of these two), as he is closer to the hawkish side, and would not be afraid to make the tough decision of starting the reversal process and bringing asset prices back to reality. In a recent interview on the topic of the next Fed Chair, President Obama said that his nominee is “going to be making sure that — they keep an eye on inflation, that they’re not encouraging some of the bubbles that we’ve seen — in our economy that- – have resulted in bust. But they’re also going to stay focused on the fact that — our unemployment rate is still too high. And ordinary workers out there — still — need — an economy that’s strengthened, aggregate demand that’s strengthened so that we can end up — putting more people back to work with better wages.” The first part of Obama’s quote (“they keep an eye on inflation, that they’re not encouraging some of the bubbles that we’ve seen”) is what has been fueling increased speculation that the choice may in fact end up being Kohn, and this indeed would be bearish risk assets (equities, commodity bloc, emerging markets). But I am not so sure that this is the case, as a Kohn appointment would hurt the stock markets and would in turn threaten the President’s popularity. In this context, a Kohn appointment would not make sense. So perhaps the President’s real intention with this quote was to just appease hawks by saying that although I may pick an uber-dove, don’t worry, I will make sure she knows to also be concerned with asset bubble and inflation risks (even though they won’t really..wink wink). I have argued that the markets need to finally stand without the support of artificial monetary policy, and I believe that a Kohn appointment would get us closer to a true recovery path. Nevertheless, the fact remains that we are at the end of this ultra accommodative monetary policy road, and even if Janet Yellen were to take over, it would only be a matter of time before this new world reality set in. The wheels are in motion.