What does it mean for investors?
For investors, I believe it means that market forces are taking the upper hand – for now. That may be a good thing if you are short 'risk assets' (notably equities): as the steam is released from the pressure cooker, asset prices may deflate once again. It's the sort of scenario Bernanke might be terrified about, as the 'progress' of QE may be undone. A Yellen Fed may rightfully say that it's not their job to keep equity prices high, and that she is more concerned about the labor market. That's all well and good, except that the recovery was, in our assessment, largely based on asset price inflation. As such, when asset prices plunge, it also provides a headwind to the real economy.
Mr. Draghi at the ECB and Mr. Kuroda at the Bank of Japan (BoJ) may well see that and try to counter what they may perceive as an alarming development. Yet, we feel it's the Fed that's the biggest elephant in the room (it's the issuer of the worlds reserve currency and given the amount of global dollar credit that's been raised since 2008, it may effectively be the emerging markets' central bank); in that context, the bazookas of the ECB and BoJ may appear as mere water pistols.
Yellen, if we are not mistaken, may only react in earnest once the effect is felt on the real economy. It also means that what we believe is a bear market will be able to play out in full. Keep in mind also that some of the necessary adjustments in the marketplace will take some time to play out: low interest rates may allow many otherwise unsustainable businesses to stick around until they need to refinance their debt. As such, the adjustment in the oil sector, for example, may take much longer; and it's not just on the corporate side, as the International Monetary Fund (IMF) may be extending loans to governments of oil producing countries, thus also contributing to elevated global oil production.
In practice, the selling may end when most investors have shifted towards a capital preservation mode. This won't be a straight line, as bear markets can have violent rallies. And not only will the BoJ and ECB not sit idle on the sidelines, but ripple effects may go through the markets as the Fed is gradually coming to grips with reality.
How to get out of this mess?
Some have suggested that my assessment equates to an endorsement of more QE or negative rates. Absolutely not. To get out of this mess, I say the same thing I said in 2008: the best short-term policy is a good long-term policy. What's a good long-term policy when governments around the world have, as I believe, too much debt and low growth? Based on my analysis, the answer must be in monetary or fiscal policy to make debt sustainable as a percentage of Gross Domestic Product (GDP). The successful investor should be able to navigate how different countries address these challenges. In that context, it matters little what I think should happen, given my framework. It may matter more what will happen given the policymaker's framework.
But since you asked, I believe the answer is not in monetary policy. You cannot print your way to prosperity. That path risks destroying purchasing power and a destruction of the middle class. The result may be public resentment, the rise of populist politicians and reduced political stability, even war.
When it comes to fiscal policy, there are more choices than are commonly discussed. First, the extension of 'printing money' on the fiscal side would be a form of default. We've already heard some say that the Bank of Japan should simply wipe out the debt it has purchased in the markets. As a central bank, writing off such debt is a mere accounting entry, as central banks can live on with negative equity. Some debt will need to be restructured, and indeed, I believe much of the work in the Eurozone has been to get the financial system strong enough to stomach a sovereign default.
Fiscal policy can also be the pursuit of austerity. It works for Germany, but not for Greece. In Greece and many other countries, it causes popular backlash that can destabilize a country.
Then there is a pursuit of growth, typically associated with massive fiscal spending programs. Bond king Bill Gross has indicated we need to have fiscal expansion as monetary policy has reached its limits. So has the head of the world's largest hedge fund, Ray Dalio.
Unfortunately, the only 'fiscal stimulus' that I know that can break the deflationary cycle is war. That's what we got after the Great Depression, and I don't look forward to a repeat.