I’ve started to talk myself into a line of thinking and hoping someone can find the flaw in my logic. My conclusion is too bearish, it makes me feel like I’m reading a zerohedge article, so I’m definitely missing a piece of logic somewhere.
Essentially I see our economy stuck in a self-fulfilling cycle of QE that simply delays a healthy recession and in the meantime encourages malinvestment, which hurts the future growth of the economy. The longer this cycle repeats, the more damage that will be done when the market is allowed to correct itself.
-
We have a debt problem. Companies, households and governments have too much debt, which makes their balance sheets fundamentally less secure.
-
Less fundamentally secure balance sheets make the economy more vulnerable to external shocks. Small shocks are more likely to have a larger impact than they have historically.
-
When a shock occurs, this reduces the quality of balance sheets, which are more dependent than ever on the value of the entities assets to support higher debt levels. This is to say, the economy is less financially secure and less able to weather a period of stress. A decline in asset values makes this more quickly evident than it would have in the past.
-
If the shock is large enough to destabilize the economy, QE is needed to support asset values. An economy with less stable balance sheets becomes destabilized more easily. The main purpose of the QE is to prevent a large decline in asset values, which would expose the fragility of balance sheets. The threshold for additional QE is increasingly being lowered.
-
QE, at least so far, successfully allows the economy to avoid crisis. This prevents a purge of companies which should have gone bankrupt and provides bad incentives for even the healthy companies that remain.
-
Corporations respond to the QE stimulus by engaging in activities that provide the most value to the companies. Since the recession, this has increasingly been to engage in stock buybacks to boost share prices. Many companies issue debt to repurchase shares since interest rates remain low enough to make this an attractive move. This furthers the debt problem.
-
Every additional dollar that goes to share repurchases, rather than investment in capex or R&D, boosts stock returns today at the expense of earnings growth in the future.
-
This malinvestment, over time, results in slower sales growth, earnings growth, and wage growth.
-
Poor real wage growth constrains consumer spending.
-
Poor spending growth results in lower corporate revenue. This, in turn, reduces future expected corporate earnings growth.
-
Deteriorating fundamentals result in the potential for lower asset prices.
-
Lower asset prices result in higher debt burdens. (See step #1)
Essentially my logic tells me that as long as we have QE, corporate incentives are going to drive them to continue with high levels of share repurchases, rather than invest in capex and R&D. As long as they continue to do this, they will be sacrificing future growth for immediate benefits to stock prices. The end result is that future growth is not high enough to support current debt loads. Normally this would result in a healthy recession, but QE essentially prevents that from occuring.
QE can’t prevent all future crisis, so eventually this cycle will implode on itself, but it seems like the further we delay the worse that crisis will be. It’ll be interesting to see how a crisis plays out when the Fed is effectively powerless to intervene and government debt levels cause their involvement to be less effective than they were historically.