In this edition of Q & A with BCA, we are pleased to offer a recent question posed by long-time BCA client, Mr. X. Making his first appearance in 1962, Mr. X has visited our offices at the end of each year to discuss the outlook for economic and financial markets.

Please find below the fifth and final installment of a five-part series recapping our December 2012 meeting.

Mr.X I could spend a lot more time questioning you about the outlook, but we probably should start to wrap things up. In our discussions last year, you worked hard to explain why I was too pessimistic about many of my concerns. And here we are again with the same situation – you have a much more positive view than I do about the various problems facing the global economy and markets. Of course, I have to admit that you have been broadly right about the major market trends over the past year. Equities ground their way higher, as you expected, and interest rates stayed low. You told me not to worry about inflation and although I can’t say that I followed your advice, my fears on that issue did prove unjustified. So I am inclined to follow your recommendations and stay invested in equities and spread product for the moment. But I do not expect to feel comfortable about it.

I realize that central bank money printing and zero interest rates will keep markets propped up for perhaps quite a while so it will be a mistake to hide in cash. Yet I fear it will all come crashing down at some point, unless we see a major breakthrough in boosting economic growth and reducing debt levels. I will rely on you to warn me when I should scale back risk in my portfolio.

BCA  We sympathize with your nervousness about the outlook because there continue to be many complex unresolved economic and financial issues. Moreover, how things play out will depend a lot on politics – especially in the U.S. and Europe. That makes things even more unpredictable than usual. We assume that politicians ultimately will behave rationally, but we could be proven wrong on that. If U.S. politicians decide to send the U.S. over the fiscal cliff and/or euro area politicians fail to agree on greater financial and fiscal integration, then risk assets will fare much worse than we have suggested. That is why we advocate a modest rather than aggressive overweight in equities and other risk assets.

As always, we will adjust our strategy during the course of the year as economic, financial and political developments warrant. We will be paying particularly close attention to money and credit indicators to monitor the progress of private sector deleveraging and whether the monetary transmission channels are starting to unclog. At the same time, purchasing managers’ indexes and other measures of business activity and confidence will help signal if animal spirits are returning to the corporate sector. Finally, it will of course be very important to monitor the progress of peripheral euro area countries in implementing structural reforms.

Thanks for following our five part Q&A series with Mr. X!

Q. Some market participants argue that since we are no longer in crisis mode than there is no need for the Fed to maintain such low interest rates. Can you please highlight some of the consequences (both positive and negative) of a tighter Fed?

A. Thanks for your question regarding Fed policy. Our view is that low interest rates are still required – ongoing pressures to deleverage, fiscal restraint, subdued inflation and subpar economic growth all suggest that interest rates will remain low for some time. I am not a fan of QE3 and did write about the various criticisms that can be leveled at this policy. However, I concluded that most of the criticisms had little validity, even though I doubt QE3 has much positive impact on the economy*.

A tightening in Fed policy now would be a mistake unless it was a response to either a breakout in inflation or a much improved economy. Some may argue that higher rates would boost the returns to savers and would signal that the Fed is more optimistic, thus fueling more optimism in the private sector.

Those arguments are not very good reasons to tighten given the weakness of growth.

Best regards,

Martin Barnes
Chief Economist,
BCA Research

*We are pleased to provide access to Martin’s September 26, 2012 Special Report: The Fed’s Big QE Gamble:  Is It A Huge Mistake?