Capital Markets Update #25

This week we thought we would step away from our traditional, data-centric approach to constructing a thought piece and, instead, touch on a relevant theme we’ve noted in recent Fed Chair Warsh speaking engagements. 

Fed Chair Warsh has been quite consistent in his principles for the last year in which we’ve followed his ascent to the Chairmanship.  He believes the Fed should remain strictly independent from bias or outside influence, should attempt to meddle less not more in markets, should evolve its strategies around data gathering, lean into productivity growth and shut up (basically).  The one we find most interesting is Chair Warsh’s stance on supporting the economy during a crisis, a subject captured under the bold heading of Economic Meddling.  The below statements were made during Wednesday’s Monetary Policy Report to Congress hearing by Chair Warsh in response to Rep. Sherman outlining how Powell stood up repo, asset purchase and direct lending facilities during Covid to provide liquidity to various components of our capital markets system.  Rep. Sherman was particularly interested in whether Chair Warsh would bail out crypto if it tanked, notably mentioning President Trump’s direct connection to a segment of the industry, etc. That’s all somewhat irrelevant, in our view.  What is relevant was Chair Warsh’s broad view on what he calls “bailouts.”  It’s important to note Rep. Sherman continuously referenced then Chair Powell’s money market liquidity facility formed during Covid as he put these questions to Chair Warsh.  In response, Chair Warsh stated “I still have the scars from the 2008 financial crisis….We do not want to be in the bailout business, full stop.”  Rep Sherman: “But your  predecessor did provide a liquidity facility for money market funds. If, God forbid, we faced a similar circumstance in the crypto world, would you bail them out?”   Chair Warsh: “So I want to be very clear, we’re going to do everything we can to mitigate those sorts of extraordinary risks.  If and when they come, we want to be in a position where we’re not bailing out anybody, including crypto.”

We’ve made the contention, in this publication, that there are really two primary contributors to the expanded forward PE multiples we’ve experienced in the stock market since say 2015; those being stronger, more durable earnings growth and the reliability of what’s known as the “Fed Put.”  Translated into basic English, that’s stronger growth with a higher downside floor. If someone came to you with that simple pitch, you might be willing to pay a premium, as well.  The Fed learned in 2008 it could develop a broad range of extraordinary measures to combat economic insecurity beyond its relatively narrow remit to control monetary policy through the Fed Funds rate.  During the 2007 – 2008 financial crisis, the Fed created the Primary Dealer Credit Facility, Term Auction Facility, Commercial Paper Funding Facility, Term Securities Lending Facility, and Money Market Funding Facility, amongst others.  The Fed, under Chair Powell, perfected the practice during Covid, standing up close to ten separate liquidity and market support programs to bolster the US capital markets.  This almost unprecedented response represented an extraordinary extrapolation of the monetary policy powers afforded to the Fed in its charter and certainly advanced, both in scope and effect, many of the programs instituted in 2008.  To be clear, we’re all thankful for it...or we should be.  It’s because of the Fed’s actions that the US capital markets remained liquid during the crisis, banks and corporations did not experience deep distress and the US rocketed out of 2020 as the world’s target for capital deployment.  Like cleaning a cut before it goes septic, the Fed stepped in and provided critical antiseptic at the right time of market need.  The patient (the US economy, in this metaphor) would definitely have survived without it, but the pain and ensuing recovery would have been significantly more arduous had its wounds been left untreated to heal naturally.  From a cost / benefit perspective, our view is the Fed’s policy creativity during this critical period was brainpower well used leading to money well spent, or perhaps more appropriately, risk well taken. 

The point we’re trying to tease out is whether Chair Warsh’s statements represent insight into his intent to potentially move the Fed away from some of the precedent set in 2008 and 2021.    Basically, it’s unclear as to what Chair Warsh is referring to as it relates to “no bailouts”.  Are we talking about TARP, where the Treasury literally went in and bought bank, insurance company and auto company stock and bonds?  Probably not – that wasn’t really a Fed function.  However, given Chair Warsh’s known stance against an expanded Fed balance sheet, market manipulation and now “bailouts,” he may very well be against the institution of many of these asset purchase, lending and liquidity facilities which have served the stock market (and US economy, for that matter) extraordinarily well during periods of distress.  We’re literally trying to read between the lines here, but watch or listen to Chair Warsh’s testimony on Wednesday and see, for yourself, if you come away with a different conclusion.  We’re not, by any means, doubting Chair Warsh’s ability to navigate a financial crisis.  We just think he may do it differently, by his own admission, then his predecessors Bernanke and Powell – to the extent that he has solemnly sworn his aversion to “bailouts.” 

So do with this what you will.  We have a new Fed Chair, who admittedly is one member of an eight-member panel of Fed voters each meeting.  But the Chair is the Chair, they make the final call.  We don’t think the market should all of the sudden sell off upon reading this piece.  We’ve got no readership and we admit that.  But smart managers constantly accept new information at face value.  As we’ve written in the past, US government institutions have historically proven both their willingness and industry as it relates to manipulating markets to the benefit of the American economy.  This practice has frankly served the US investor and equity stakeholder quite well for the last 20 years.  The question is whether an exceptionally powerful arm of the US government, that being the Fed, is literally telling you it will do what it can to avoid such market manipulation in the future – even to the potential detriment of the US economy.