New York | Earlier this week we appeared on CNBC’s “Squawk Box” to talk about bank earnings and the Fed. The results from the top-four banks – Bank America (NYSE:BAC), JPMorgan (NYSE:JPM), Wells Fargo (NYSE:WFC) and Citigroup (NYSE:C) – are really no surprise to readers of The IRA. The largest banks all beat small on revenue and earnings, but showed weakness on fixed income and the mortgage banking lines.
We suspect that there will be even more pain on the mortgage banking line for WFC, JPM and BAC next quarter. As we told Andrew Ross Sorkin, bank stocks have essentially been going sideways since February and are likely to continue side-stepping because most of the large cap names are fully valued after the Trump Bump. But the biggest obstacle to rising bank stock valuations is the Federal Reserve System’s policies of low rates and open market purchases of debt.
At the Fed of New York back in the 1980s, one and a quarter times book was seen as the natural limit for bank valuations. Have a look at our previous note if you have any questions on the particulars. Suffice to say that 1x book value for BAC is about right given the bank’s asset and equity returns, and the state of the credit markets. Tight credit spreads make life tough for all but the best run banks.
When we suggested US Bancorp (NASDAQ:USB) to Squawk Box as our favorite large cap, that was because of the operational excellence as opposed to the stock price, which trades above 2x book value. But the more interesting question from CNBC's Andrew Sorkin had to do with the choice of the next Fed Chairman.
News reports suggest that White House chief of staff Gary Cohn is the leading contender to take over from Fed Chair Janet Yellen. We would welcome Cohn’s appointment not because he is an alumnus of Goldman Sachs (NYSE:GS), but because he understands financial markets and is not a PhD economist.
For too long the Fed’s internal deliberations have been dominated by academic economists who do not understand the real world impact of monetary mechanics much less the workings of the financial markets. Having Cohn and other non-economists on the Federal Open Market Committee would be a welcome change that would support economic growth by encouraging investment.
During our trip last week to Jackson Hole, we had the pleasure of hearing from Paul McCulley, an American economist and former managing director at PIMCO who is now teaching at Cornell. Paul is an articulate and unabashed advocated of neo-Keynesian economics (aka “socialism”). He is noted for authoring such memorable phrases as “shadow banking” and “Minski Moments.”
Like most of the members of the FOMC, Paul believes that additional deficit spending was the proper response to the financial crisis of 2008. And like Chair Yellen, he apparently thinks that the fact that Congress refused to ratchet up public spending five years ago was a sufficient excuse for the unelected central bankers to “do something” in their stead in the form of near-zero interest rates and, more important, quantitative easing or “QE.”
Paul explicitly equates democracy and socialism, believing that people of modest means will always vote for the smiling bureaucrat offering a bag of free groceries or subsidized health care. He also says that the Fed has too much independence and should coordinate its actions with fiscal policy. To his credit, McCulley at least concedes that while QE was the right policy "there is collateral damage.”
There are two basic problems with the pro-fiscal spending argument of liberal economists. First, it is pretty clear from the literature that deficit spending does not produce any benefit in terms of increased consumer spending or jobs. For decades, American policy makers have been pulling tomorrow’s sales into today by using cheaper credit, but the efficacy of such policies has been pretty much exhausted. Some even believe rising public deficits choke off growth.
The second and more important issue is that Congress has shown itself to be completely incapable of restraining spending during good times to balance off Keynesian stimulus during slack times. Keynes was no apologist for debt and explicitly assumed that government would in good times promptly repay debt incurred to fund public spending. Today repayment of public debt is never even discussed. Davidson (2003), for example, notes that Keynes believed that government should always maintain a balanced operating budget.
When considering the arguments of economists such as McCulley and others who advocate increased federal deficits, the only conclusion possible is that they implicitly are taking us down the road to eventual debt default and hyperinflation. Since they never once suggest that the debt incurred to fund deficit spending should be repaid in kind, as Keynes would have insisted, the only reasonable scenario would be for the FOMC to eventually make QE a permanent feature of the American political economy.
In such a scenario where the FOMC explicitly and continuously suppresses interest rates and credit spreads, and monetizes the Federal debt with open market purchases, private sector entities such as banks, companies and pension funds soon will become superfluous. Quaint notions about private property and free enterprise would be discarded in favor of a “single payer” model for the entire US economy – namely the Fed. The free market capitalism of the US would mutate into something that looks a lot like the state-directed economy of Communist China.
Fortunately there still are enough Americans who understand the fallacy of the neo-Keynesian socialist model. The path to making America “great again” has nothing to do with who is in the White House, but a great deal to do with who occupies those seven seats on the Federal Reserve Board. In particular, we need a Fed Chairman and governors who are not afraid to say “no” to the fiscal profligacy in Washington.
Rather than facilitating the issuance of public and private debt as the FOMC has done under Yellen, the US central bank needs to become an advocate for savers and private investment, and a vocal critic of the dissolute fiscal policies of the Congress. The members of the FOMC need to appreciate that the polices followed by Chair Yellen and the FOMC after QE1 (which re-liquefied the US banking system) were detrimental to job growth and economic expansion.
Subsidizing public and private debtors at the expense of savers is no formula for private sector economic growth and job creation. For example, the folks on the FOMC don’t seem to understand that low interest rates and artificially tight credit spreads retard private business investment and advances in productivity. Since 2012 when the Fed started QE, public companies have eschewed new investment – and instead bought back trillions of dollars worth of stock financed with debt. As Ben Hunt wrote in his blog Epsilon Theory:
“In exactly the same way that QE was deflationary in practice when it was inflationary in theory, so will the end of QE be inflationary in practice when it is deflationary in theory. That’s the real world impact I’m talking about, the world of wages and output and productivity. You know, the real world that used to be the touchstone of our markets.”
We told Andrew Ross Sorkin today that we like the idea of Gary Cohn as Fed Chairman because he would normalize monetary policy. We like the idea of JPM CEO Jamie Dimon running for President in 2020 even better. Based upon on his recent public comments, Dimon seems to be interested: ““And you know at one point we all have to get our act together [so that] we will do what we’re supposed to do [for] the average Americans.” Ditto Jamie.
America hungers for credible leadership that can truly foster a positive environment for the US economy to grow and create opportunities for our people. The markets were hopeful that Donald Trump would provide that leadership, but this hope has been dashed. If Cohn takes the job as Fed Chairman, that is a pretty good sign that the former GS partner has given up on Trump and is looking for his next challenge. But that could be the most bullish signal investors see coming from Washington this year.