How Free Money Is Keeping Economic Recovery Alive
An interview with Carlos Abadi, president of investment bank ACGM
NEW YORK—Four years into the economic recovery, we have gotten used to the Federal Reserve’s Quantitative Easing (QE) and a rising stock market. Yet, general economic activity remains sluggish and employment growth is lagging.
Carlos Abadi, president of the boutique investment bank ACGM, and a market veteran with decades of experience, sheds light on why the recovery in employment has remained sluggish and why stocks should keep on going up.
“Every crisis in history has resolved itself. The deeper the crisis is in terms of GDP (economic output of the economy) shrinkage, the faster the recovery is. Here, because of the policy response, the loss in GDP wasn’t so severe. Therefore the recovery is going to be slower than in the absence of the collapse that could have happened,” Mr. Abadi said about the crisis and the subsequent recovery.
After staring into the abyss in 2009, the U.S. economy has recovered slowly, with employment gains being primarily in part-time or minimum wage jobs. At the same time, the stock market more than doubled and corporations announced record profits. Corporate profits are a direct result of QE, which drastically lowered the interest rates for consumers and corporations, explains Mr. Abadi.
“You cannot underestimate the power of free money. Companies can make investments with much lower rates of returns. The recovery is clearly not employment led, it’s clearly not consumer led. What’s leading it is investment. And why is it investment? Because Verizon has the ability to issue $50 billion of debt virtually at zero,” he said about negative real interest rates, brought about by the Fed’s QE.
Recently, Verizon Inc. has borrowed a record amount of money to take complete ownership in Verizon Wireless.
The real rate of interest is the percentage rate on a loan, or a bond minus the rate of inflation. If inflation is greater than the nominal interest rate, the borrower effectively receives money for free, because he can pay back the loan in dollars that are worth less.
“It’s the free money that’s available out there which gives corporations the possibility to enter into investments which they would have ordinarily not entered into,” Mr. Abadi adds.
According to him, the only thing driving GDP at this moment is investment in plants and equipment, which is expanding U.S. productive capacity and ultimately results in employment gains.
“The companies are taking advantage of this scenario to over-invest in fact. The growth in the productive capacity is driven by these interest rates. There is no need for investing today, but there is no better time to do it,” he said.
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He also believes the low rates of the Fed and additional QE is necessary to bridge the gap until an organic recovery can take hold.
“Highly negative real interest rates are underpinning a modicum of economic growth. That feeble economic growth we have now would not exist if we had real interest rates, which would be at least neutral,” said Mr. Abadi.
He likens it to a patient on life support: “You need the drip to keep pumping for you to remain alive. That is why Fed policy is so critical to the markets now.”
Once employment picks up sufficiently for consumers to start spending again, the Fed can stop its extraordinary measures.
“They are aiming for a 5.5 percent unemployment rate to get out of the market. That is their goal at which they believe the economy will become self-sustaining, and the Fed will be able to shrink its balance sheet again.”
QE Geared Toward Private Sector
“The monetary stimulus is not geared at getting the government to spend more or less, but getting businesses and households to spend more. It’s purely about the rates. The reason why it’s being done with treasuries and mortgages is because of the constraints of the Fed,” said Mr. Abadi. He added that the Fed could operate even more effectively if it could drive down rates of consumer debt and corporate debt.
Since this is not possible, it takes a detour and drives down the interest rate on government bonds and mortgages, which then has a secondary effect on corporate debt and consumer debt.
“If the central bank had a free reign and wanted to optimize its policy objectives, what it would be doing would be to buy corporate and household debt. It happens not to be allowed to,” he said.
Stocks to Keep Rising
Despite the fact stocks are trading at all-time highs and lofty valuations, Mr. Abadi thinks they have room to go up further.
The reason: The way QE works to push down rates helps companies expand margins and profits. It also makes equity into an investment that outperforms in an inflationary environment.
“Apple can issue debt to produce iPhones and sell them. Maybe if interest rates were higher they would not be innovating as much or launching as frequently because the hurdle rate of return would be set by the rate they could borrow, which would be higher,” Mr. Abadi said.
At a higher interest rate, the projected return for a corporate investment project might not be high enough to justify the borrowing of capital to invest.
And companies are making money off this investment, now and in the future. “You are happy even if only [a small percentage] of your potential target market buys. By virtue of the fact that you are financing that investment so much more cheaply, you are still ahead of the game.”
With respect to high valuation, Mr. Abadi believes equities are pricing in a return to normal after a couple of years.
“The multiple expansion is driven by that, and by the expectation that in the future the economy will normalize, and consumers will regain their confidence. [Equities] tend to be longer term investments. You are getting some revenue from the artificial part of the economy, let’s say for three or four years, and the remaining 25 years from the real economy.”
In addition, equities can protect the investor from inflation if the Fed keeps monetary policy loose for a bit too long.
“For the equity markets, there is no better scenario than this. It is clear to the equity markets that the Fed will either get it exactly right or will start bringing back the kite just a little bit too late. Under either scenario it’s wonderful for the equity market. Get it exactly right and the market grows like the economy plus whatever multiplier you apply to it.
If you are little bit late, it’s inflation, which reduces the value of company liabilities and therefore increases the value of equity,” he says.