July 9, 2012

Hussman’s Scary Question: ‘What if Fed Throws a QE3 and Nobody Comes?’

The noted portfolio manager says problems can't be solved by ‘more reckless bubble-blowing’ by the Fed

John HussmanWhat if the Fed throws a QE3 and nobody comes? That is the ominous question portfolio manager John Hussman asks in his latest letter to Hussman Funds shareholders, and his answer will not encourage traders looking to the Fed for portfolio salvation.

Hussman’s letter, published Monday, follows a week of negative economic data accompanied by easing moves by the ECB, Bank of England and the People’s Bank of China that failed to inspire investors.

The former business school professor-turned-money manager characteristically parsed the data to show that it is both worse than it perhaps seems on initial inspection. Of Friday’s job report, for example, Hussman (left) says the “internals” were “more dismal than the headline number” of 8.2%.

Most of the employment gains in the June employment figures benefited, surprisingly, the 16-19 age cohort and workers over the age of 55, masking a “plunge” in the key demographic of 25-54-year-old workers. Also, those counted as employed included “277,000 workers shifted to the classification ‘part-time for economic reasons: slack work or business conditions.’”

While Hussman, who believes we are already in the midst of an “unfolding global recession,” believes the June jobs report “may be looked on longingly within a few months,” the main point of his letter is to show that the Federal Reserve has a markedly declining ability to stem market losses.

Hussman marshals evidence from a study by Nautilus Capital to show that each new effort by central banks to inject liquidity into the financial system has less and less impact as time progresses. The pattern, for the Fed, ECB and Bank of England, is captured by stock market bar charts that in general rise to lower and lower peaks following central bank easing.

And the reason for this is that quantitative easing is meant to drive interest rates down to encourage some investors into risky investments. But, “if interest rates are low already, and risky assets are already priced to achieve weak long-term returns (we estimate that the S&P 500 is likely to achieve total returns of less than 4.8% over the coming decade), there is not nearly as much room for QE to produce a speculative run,” Hussman wites.

Eventually, investors become “indifferent between continuing to hold that cash versus holding some other security.” Consequently, quantitative easing can barely lift markets beyond the decline that preceded and prompted it, Hussman adds.

And this is totally apart from the fact that GDP growth is weakly related to market fluctuations in the first place (meaning that QE is a poor policy choice if the objective is to revive the economy).

So as many investors await QE3, Hussman expects it will be of little avail:

“Our economic problems run far deeper than what can be healed by more reckless bubble-blowing by the Federal Reserve. At the center of global economic turmoil is a mountain of bad debt that was extended on easy terms by weakly regulated lenders with a government safety net. Global leaders have done all they can to protect the lenders at the expense of the public – to make good on the bond contracts of mismanaged financial institutions by breaking the social contracts with their own citizens. The limit of this unprincipled madness is being reached,” Hussman writes.

The key distinction Hussman makes is between liquidity, which central banks are providing, and solvency, which they are not and which can only be obtained through debt restructuring, especially among European banks.

“The worst nightmare,” Hussman warns, “is that global leaders will deny the necessity and belatedly discover that they have squandered the last opportunity to avoid a disorderly finale.”

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