re: Discussion of Fed Liquidity’s Impact on Equity Markets

Thanks, I'll check it out.

Warning: long post ahead

As a compliment to my previous post, I ran some numbers from FRED. What you see are corporate profits scaled logarithmically going back to 1980 (first chart = after-tax and second chart = pre-tax; both shown as blue line) and the 8-qtr. moving average (both shown as red line). Both charts ignore inventory valuation and capital consumption adjustments. All data are taken from the BEA's quarterly GDP reports via FRED.

Looking at the after-tax data first, you can see corporate earnings after-tax reached a new zenith in 3Q of 2019, but just barely. For the most part, corporate earnings after-tax have been flat since 2012.

On a before-tax basis, the small recent uplift since 2016 falls off, as all of that small recent uplift was due to the Trump tax cuts.



Where does that leave us? Basically, this is the longest period of flat corporate earnings "growth" going back to the late 1990s (and this is actually true going back to the earliest date in the series (1946) - which I cut off for presentation's sake).

The primary difference between today and the late 1990s is that the Fed Funds Target Rate in the late 1990s prior to the Dot.Com bust was 6.5%*. As Greenspan lowered rates from 6.5% to 1.0% over 2000-2004, you can see that this spurred a robust recovery in economic activity. That's the beauty of having higher rates BEFORE a recession. The fact we went into our recent recession with the lowest rates in history is a travesty of policy making, in my view.

Fast forward to today, the Fed Funds Target Rate is at 0.25%. In addition, Public Debt-to-GDP was approximately 50% in 2000, approximately 16 p.p. less than where it had been in the mid-90s. Thus, it was hardly problematic when fiscal stimulus between 2000 and 2004 raised this to only 60% or so. What is that figure today? 108%. You think we're going to have diminishing marginal returns on fiscal stimulus today vs. the last time we had a bubble of this size? (Lacy Hunt would stress the "overuse of one factor of production.")

Finally, corporate tax rates then were 35%. Today, they are 21%. Given the ballooning Public Debt-to-GDP, what's going to look like an attractive solution to the problem, particularly to a Democrat? And if that event occurs, how will that impact our blue line in the first chart above?

As I see it, the Fed's solution to all of this is to tinker around with QE since they've more or less given themselves an artificial floor of 0% when it comes to nominal rates. Thus, how do you get real rates lower if you're forced to keep nominal rates at 0%? You inflate the hell out of your currency, which is exactly what they are trying to do. BUT ... and this is a big but ... if the Fed fails to produce inflation and we have deflation, that means real rates would be going higher (0% nominal rate minus negative inflation equals a positive number). You couldn't have a more reliable pin to prick a bubble than effective interest rate "hikes" in an overly indebted economy.

Some claim that technological progress will save the day, and that's possible. But the chances of us experiencing the kind of step function technological progress we saw with things like the electricity grid, the advent of mass production during the World War periods, the Internet, etc. are likely pretty low. In addition, the government has been crowding private investment out of the market in their endless quest for deficit dollars. Look how much less currency in the economy circulates as US government spending increases.



This all leads me to believe that we may finally be facing the consequences of failing to deleverage after the Great Recession and keeping rates artificially low for years on end. This is also why I believe the inflation vs. deflation debate is the key to all of this.

*Of course, Greenspan's decision to raise rates to 6.5% in the first place is often attributed as the pin that pricked the Dot.Com bubble, but that's beside the point. Even before that, he still had about 500bps to work with vs J. Pow's 25bps at present.