When forecasting the economic future we tend to choose a few data points from the past and mentally draw a straight line so as to forecast the economic environment at some future point in time. This may work if the economic landscape has not materially changed but that is definitely not the world in which we live today. What changed is that in the developed world economic growth (GDP) has collapsed, productivity growth is near zero, debt as a percent of GDP (Gross domestic product) has skyrocketed, and the welfare state as we know it is clearly not sustainable. In the US real wages are lower today than they were two decades ago and the middle class is being gutted such that the top wealthiest 1% own 40% of the nation’s wealth while the bottom 80% own 7%. In the developing world commodity prices have collapsed and with it the state’s primary source of revenue. China’s growth has been fueled by an unsustainable credit binge (and malinvestment that is the result of a centrally-planned economy) and its transition from a production-based to a consumption-based economy is in doubt (China’s per capita GDP is one fourth that of the US). What is really surprising is that with all these economic headwinds the S&P 500 is at 25 times GAAP earnings (historical average is 15) and most developed country sovereign bonds have either a near-zero or negative yield. To quote Dorothy: "Toto, I've a feeling we're not in Kansas anymore."

Monetary policy involves changing the interest rate and influencing the money supply. Fiscal policy involves changing tax rates and levels of government spending to influence aggregate demand. With high levels of both sovereign debt and deficit spending fiscal policy is off the table. To quote Mohammed El-Erian: “Central banks are the only game in town.” Central Banks in the US, the EU, Japan, China, etc. have coordinated efforts to reduce interest rates to spur both economic growth and inflation. These Central Bank activities have definitely increased financial asset prices but have had little or no effect on GDP growth or inflation. Have the Central Bank’s painted themselves into a corner where these temporary and extreme measures are now permanent?

In simplistic terms we can look at the economy as being comprised of the Financial Economy and the Real Economy. The Financial Economy is the economy that pertains to investment in stocks, bonds and other financial assets. Unless we have an E-Trade account or watch the nightly business news we don’t see this economy in our every day lives. The Real Economy on the other hand is what we see every day. This is the economy of the entrepreneur, employer-employee, small business, etc. Changing interest rates and the money supply, which is the purview of the Central Banks, directly affects the Financial Economy and has little effect on the Real Economy, which is the economy that needs first aid. The whole idea behind QE1, QE2, etc. was to increase asset prices in the Financial Economy such that the increase in wealth that accrues to the owners of those financial assets spills over into the Real Economy via the “Wealth Effect”. Wealth that spills over into the Real Economy would increase economic fundamentals (demand, earnings growth, investment, GDP) which in turn would support the increase in financial asset prices (i.e. the loop is completed). The first half of the scheme worked but after eight years of Central Bank stimulus the second half of the scheme failed by almost any measure. What we may be left with are asset prices that have been inflated but are no longer supported by the economic fundamentals of the Real Economy. Agents that are active in the Financial Economy believe that the Central Banks will continue to support asset prices such that economic fundamentals no longer matter. Is the new normal a centrally-planned vs a free market economy? Can inflated stock prices and negative yielding debt securities last in perpetuity? We have to remember that the positive effects of these extreme Central Bank measures are purely hypothetical and have absolutely no precedent in economic history. The denizens of this economy are literally bacteria in a petri dish where the mad scientists are the Central Bankers and staff academics. There is a decent chance that this may not end well and we have to take the appropriate action to insulate our investment portfolios from loss and maybe profit from the correction.