We are approaching the most important inflection point for the markets in the well-established 4-year election cycle. So, it is time to return to a fuller analysis of how this cycle works and what to do.
This cycle is well established over a period of decades and certainly back to the birth of our current monetary system just over 35 years ago when Nixon severed any link between the US dollar and gold in 1971. Under the current monetary system, the economy and asset markets critically depend on the supply of money which is controlled by the Federal Reserve.
Every four years the policymakers in power seek to boost the economy, and stock markets, to increase their chances of re-election. In other words, the economy ideally needs to reach its peak in activity by or during the election year, in our case 2008.
Given the delays and lags in the time it takes for monetary stimulus to feed through into a strong economy, the maximum monetary boost needs to occur sometime during the previous year, in our case 2007. Prior to this, in 2005 and 2006, governments have the incentive to partially deflate the prior credit bubble so that it does not get out of hand in runaway inflation. So this is a good time to raise interest rates and create the appropriate conditions or platform for the subsequent election boom.
This means, as mentioned above, that we are close to the inflection point when policy switches from restraint to full stimulus. This can occur at any time from the end of 2006 to early 2007. So we need to pay close attention at the current time. If you are too early your portfolio can pay a heavy price at the end of the period of restraint, but if you are too late you may miss the strongest part of the four-year cycle.
The additional factor in the election cycle analysis is that over time its behaviour is changing. Historically, the business cycle has been driven to a large extent by rising employment and real wage growth. This is the natural and healthy model of economic growth. However, underlying wage and employment growth has chronically weakened in recent years, and the only way to stimulate “economic growth” has been for policymakers to switch to “asset-driven” economic growth. This appears to many to be a satisfactory solution, as it appears to work well in the short term. However, it always results in highly unstable and ultimately ruinous circumstances for many.
No doubt election cycle dynamics are alive and well, as there is no change in political motivation, but the cycle has become increasingly manufactured and distorted. As such it is also becoming less stable and reliable, and its character is changing. The apparent stability, resilience, and reliability of the US economy masks a rapidly deteriorating and unstable underlying position.
Badly lagging employment and income growth are the great shortcomings of the present US economic recovery. Absent new tax cuts and against the backdrop of rising inflation rates, real disposable income growth has slumped to zero. Before the economic downturn in 2000, the growth rate was 4.8%. This is the worst income performance in the whole post-war period.
Reported employment growth in the US during the current economic recovery is an outright disaster. In total it is up 1.9% over five years from the end of the recession in November 2001. According to the Economic Policy Institute in Washington, this compares with an average growth of 9.7% over this period in prior post-war recoveries.
In the absence of the conventional mechanism for the business cycle, through income and employment growth, policymakers have had to reach for a more desperate model.
It is no secret how the US economy pulled out of its 2001 recession. The Greenspan Fed succeeded in offsetting the depressive impact of plunging stock prices and business investment, by inflating house prices, which lubricated an unprecedented consumer borrowing and spending binge.
In the US, debts of private households since 2000 have soared from $6,996.7 billion to $11,840.1 billion (Q1 2006). This huge $4,873.4 billion or 70% increase in debt is discarded as irrelevant because the net wealth of private households still managed to increase from $42,113.5 billion to $53,830.3 billion.
Few people seem to be aware of the tremendous leverage inherent in this calculation. No doubt people feel richer with the price of housing rising, but in reality, they are no richer in housing comfort or anything else. They have simply gained higher collateral for higher borrowing.
This model of economic growth is increasingly unstable. The reason for this is that while debt rises substantially, there is only a relatively minor improvement in wages. As a result personal balance sheets deteriorate, and the greater level of debt becomes much harder to service out of income.
These are the conditions that set up the possibility for monetary policy to fail, as it did in the 1930s in the US, and the 1990s in Japan. The decisive problems of a bursting bubble economy are always of three kinds:
The collapse of grossly inflated asset prices hitting balance sheets.
The accumulated horrendous debts.
Prior spending excesses forestall future spending.
The combined result is a mixture of conditions that diminish the effectiveness of monetary policy. Depending on the size of these imbalances, they may completely defeat monetary policy.
The Fed’s actions show their concern about the current fragility inherent in the “bubble” economy they helped create. They have consistently raised interest rates by a timid 25 basis points and have stopped raising rates with underlying inflation well above their stated “comfort” level.
Looking ahead we can anticipate aggressive easing should the economy weaken markedly. After Alan Greenspan’s publicly released Federal Reserve research highlighting the significant impact of the housing market on the growth of the economy in recent years, they are no doubt aware of the acute downside risks to the economy as the housing market weakens. Also, Bernanke has staked his reputation on his ability to avoid any possibility of deflation, based on early and aggressive policy easing in the case of a weakening economy.
On the other hand, if the economy continues to hold up, further tightening should continue to be very modest given the housing market’s current fragility.
Over time the outlook for monetary policy is becoming more and more asymmetrically biased in favor of easing. Politically, we are also now increasingly close to both the mid-term elections and the period of maximum stimulus in advance of the 2008 presidential elections. Ironically, perhaps, the weakness of the incumbents standing in the polls only intensifies the incentive for an easier policy than otherwise.
Fed policy is key to understanding the outlook for the markets, and increasingly it appears that the bias is swinging rapidly in favor of easier policy. This may well be why so far this year we have had only a minor correction for a transition year, and there is a growing probability that we may already have seen the low for the year.
Market participants are all very well aware by now of the four-year election cycle trades, and the key impact of this on all markets. This means that anticipation may well bring about a pre-emptive rally. This idea is reinforced by the outlook of the monetary authorities. They now appear to have a growing incentive to support the markets and economy, both from a political as well as an economic standpoint.
To this extent, it may well be that a more positive stance should be taken as regards the markets, as the chances are that any setbacks to either would most likely be met with significant policy support at this stage.
More than likely the usual election dynamics should bring about a strong 2 year period for stock markets. The authorities have considerable control of both the markets and the economy. Nevertheless, investors need to be aware that the stakes in this cycle have risen significantly. The economy has become increasingly unstable and there is a growing but still small risk that monetary policy is becoming much less effective.
Investment strategy needs to take account of the timing of the election cycle, and the enormous opportunity it can provide. At the same time strategy and money management also need to make allowance for the inherent and growing instability of the methodology of monetary policy as recently practiced by the central banks.