2018, Man of the year, goes to the FED chairman Jerome Powell. Sorry, it’s not Bradley Cooper and in fact, I am yet to watch A Star is Born. In spite of unwanted criticism, Jerome Powell is a hero. When he got nominated as FED chief I was a bit skeptical. FED maybe is the only reserve bank which has a history of nominating chairman who does not have a Ph.D. Jerome following Alan Greenspan footsteps does not have one. At the same time, Mr. Powell outshines as a leader for his outstanding vision, tenacity, fortitude, and acumen in guiding the US economy through uncharted waters in 2018. He has been spot on increasing rates to not only stem inflation but also to give space for monetary flexibility once the recession hits the United States in near future. US today has one of the lowest unemployment rates thanks to sustained innovation and prolonged low rates and along with rising wage growth, fueling inflation in the US to 2%. Back it up with a 24% increase in earnings in 350 S&P 500 companies compared to the previous year beating analyst forecast of 20%, according to WSJ. All are telltale signs of an economy heating up due to low lending rates and increased consumer spending. Continuing real negative interest rates would have further fueled asset prices resulting in an imminent collapse fulfilling the doomsday prophecy.
On the other hand, US yield curve which is the best predictor of a recession might soon be inverted showcasing that short-term rates are higher than long-term rates. US yield curve is flattening and an inverted yield curve has been a harbinger for seven recessions in the US. Education loan defaults might near $1.5 tr and the housing market is already showing signs of a drop in home prices especially in Texas. Global uncertainty due to the trade war and rising fiscal deficit under Trump administration is worrisome. Until recently 75% of US Treasuries were selling below par according to a Bloomberg report. (Citation needed)
Further, the earnings in the US companies are heavily skewed in the technology sector among a few companies. Apple with the biggest cash cow technology product in the world, iPhones, is yet to find a product which is a star in the BCG Matrix. Apple’s strategy in India has not worked well and its share today in the fastest growing smart phone market is down to 1%. Other areas like virtual reality and driverless cars are still a long way off to generate sustainable profits for any company in the world. Amazon has never been known for generating iterative profits rather for its aggressive expansion strategy and will always trade at astronomical PE ratios. This is to highlight that if the recession does hit the US mid to late 2019, the FED will have more tools to stimulate growth. In fact, FED raising short-term rates have been a catalyst in slowing a very hard landing in the US economy sometime in near future. Remember, the FED can only stimulate short-term rates, market directs long-term rates. (Traders/ Economists sitting in asset management companies and banks).
Not only the US but the world owes Jerome a favor for standing tall on his and his team’s conviction of increasing rates and relying on market data for policy-making. Higher rates would affect corporate earnings considering a higher discount rate when modeling for future returns. A higher cost of borrowing would dissuade companies in investing in projects which are zero or negative net present value. This would differentiate men from the boys and women from girls. I am being more inclusive here and fair in my choice of words.
There a few pointers which are very important going forward.
First, negative or low-interest rates is not a panacea for solving the crisis. It is only a remedy for postponing another one unless structural changes are resolved. Corporate leverage which was one of the key impact factors for the subprime crisis has resulted in government leverage. With more increased borrowing by the government, its interesting to understand how the FED will deleverage its balance sheet.
Perhaps a more prudent approach would be to make it mandatory for banks to lend to small and medium enterprises with sustainable business models. To promote research and development through inbuilt covenants in loans to large conglomerates will go a long way in driving innovation and creating long lasting jobs within the society. Secondly, enforcing a percentage of profits to accountable, measurable social good will imbibe a code of ethics among the companies. Finally, central banks globally have to revise monetary tools for effective governance and come out with a liquid and quantifiable benchmark which measures credit moving into the economy.
On a promising note, as a Christmas gift to my fellow Americans who have taken education loans. One way to curtail the rising defaults in education loans is to promote low and constant interest rates like the ones in Scandinavian countries. By making the rates not market driven helps in removing cyclical loan rates, making repaying predictable, quantifiable and discernible.
In the end, want to wish Jerome and his team a Merry Christmas and a Happy New Year.