Whatever the reason, the phenomenon is significant for investors, according to Loomis Sayles Vice Chairman Dan Fuss, who addressed this subject with Patel at Financial Advisor’s Asset Management Showcase on October 7. “More strikingly, those stocks now yield more than 30-year U.S. Treasury bonds,” he says. “Anytime those ‘dividend growers’ have a reasonable size sell-off, buying comes in.” Fuss is more sympathetic to Fed policy than Patel, but he agrees that minor changes in policy, like not reinvesting coupons from bonds on the Fed’s balance sheet, would be welcome.

Capital Allocation Decisions
Cheap money undoubtedly is driving capital allocation decisions as much as the relationship between stock and bond yields, however. A weak global economy and uncertainty about increased regulations are prompting corporations to favor financial engineering over investing in organic growth, according to Michael Cuggino, CIO of Permanent Portfolio Funds. “Many are borrowing [at very low rates] to increase dividends and buy back stock,” he notes. One reason behind the equity market’s weakness this year is that investors are no longer impressed by companies’ use of engineering techniques to boost earnings per share, which coincidentally happens to be a key metric of CEO compensation.

Some like Bob Eisenbeis, chief monetary economist at Cumberland Advisors and former executive vice president of the Atlanta Fed, also believe that the Fed’s zero interest rate policy (ZIRP) is seducing investors to reach for yield and take more risk than they understand. The upshot is they aren’t getting compensated adequately. Equities and real estate have boomed, in part, because they offer tremendous liquidity. Cuggino notes that vehicles like leveraged loans, distressed debt, asset-backed securities and certain structured derivative products have boomed even though they are less liquid and often quite complicated.

When it was established a century ago, the Federal Reserve was structured to regulate the nation’s banking system and to resolve or at least moderate the recurrent panics that plagued the nation for 50 years following the Civil War. Its mandate has always been broader in reality than what Congress spelled out when the central bank was conceived.

In the early 1970s, Fuss was running Yale University’s endowment fund and reporting to former Fed Chairman William McChesney Martin, then a board member of the Yale Corporation. During one of their conversations, Fuss suggested a logical course of Fed action to address the emerging problem of stagflation. Martin told the young endowment manager that his sound, sensible prescriptions would never materialize because the Fed was “completely a creature of Congress.”

In 1977, the Federal Reserve Act was amended to expand its mandate. As if it needed to be put in writing, the central bank was given the authority to “maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

Fast-forward to the post-crisis world of global QE, when many question whether there is any political or economic goal that falls outside of the Fed’s purview. In the September issue of Financial Advisor, Salient Partners’ chief risk officer W. Ben Hunt predicted that the “TVA political experience of the 1930s is coming soon to the capital markets of today. Scratch that. It’s already here.”

Hunt posited the notion that if the capital markets morphed into an economic vehicle similar to a public utility, investors might be able to expect both a floor and ceiling on what they could expect in terms of asset price inflation and deflation. “You’re probably not going to lose money, but you’re not going to make a lot of money, either,” he wrote. “All of your capital market assumptions are now at risk, subject to the tsunami force of status quo politicians with their backs up against a debt wall.”

From a central banker’s viewpoint, the stable predictable world described by Hunt is an optimal environment. But how much control do they ultimately have?