By Anders J. Maxwell

U.S. equity and bond markets have now retraced their steps and are fully recovered from the precipitous fall of 2008. The financial markets’ rebound is in stark contrast to the “real economy.” September’s headline-grabbing jobless rate remains at 9.6%, with the Commerce Department estimating that one in five Americans are either un- or under-employed. The erosion in housing prices continues to impair household net worth, dampening consumer spending. The related collapse in new construction magnifies this depressing effect. More fundamentally, the issue dogging the economy remains too much leverage. Aggregate indebtedness stands at 350% of GDP, a burden imposed previously only at the height of the Second World War.

This fall’s breaking story has been the controversy over the Federal Reserve’s anticipated open market initiative. Referred to as “quantitative easing,” or “QE,” the argument hinges on three points: what’s the theory; does QE work, and what does it mean for credit markets and distressed investors?

This Is “Easing”?
A current preoccupation, quantitative easing was introduced as a part of the stimulus applied by the federal government to stabilize markets in the aftermath of Lehman Brothers’ collapse. An extension of the traditional central bank’s open market monetary activity - frequently referred to as “printing money” - QE has been considered a last resort and applied in those exceptional circumstances where short term rates are deemed so low as to leave conventional levers ineffective. The only applicable example of QE prior to 2008 had been the Bank of Japan’s actions in the period 2001 to 2006. QE involves direct purchases by the central bank of long-dated securities with the stated objective of stimulating corporate investment and consumer demand. Less benign is an implied goal to raise the specter of future price inflation in order to defuse deflationary expectations perceived as depressing consumption. This hoped for inflation also affords the prospect of benefitting leveraged financial institutions, out-of-the-money homeowners, and a deeply indebted U.S. Treasury. This benefit comes, however, at the expense of creditors, those on fixed incomes and anyone holding US dollars.

Reflecting the discrepancy between rejuvenated financial markets and depressed employment and personal income, the Fed has raised the likelihood of moving forward with another round of easing, dubbed “QE2.” However well-intentioned, should the Fed go down this road, the U.S. economy will suffer further dislocation and anemic performance. This conclusion reflects three fundamental flaws of QE: it doesn’t work; it has unintended negative consequences; and, most significant, it portends incalculable long-term economic loss.

In the first instance, the root cause of the current malaise is the overdue process referenced above of deleveraging banks and consumers’ balance sheets. By its nature, this depresses economic growth. The premise of QE is that central banks can still “prime the pump.” Given the size and complexity of contemporary global credit markets, this basic tenet has been disputed for over a decade by Peter Warburton, the U.K. economist, and as recently as October 19 by economist Joseph Stiglitz. More to the point, there is nothing in either the Bank of Japan’s experience or our own since 2008, to suggest QE works. It certainly wasn’t QE that ameliorated the housing crash, but rather the Treasury’s takeover of Freddie Mac and Fannie Mae.

Second, there are demonstrable risks to a central bank tampering with capital markets. China’s Commerce minister framed a major concern this week in a remarkably blunt statement to Reuters, “Because the United States issuance of dollars is out of control and international commodity prices are continuing to rise, China is being attacked by imported inflation.” Recognizing this critic is the largest holder of the Treasury’s debt, it seems imprudent to ignore China’s objections and continue to run the presses. Another risk is that the Fed already holds over $2 trillion in mortgages and long-dated Treasuries. Clearly, additional purchases only increase the uncertain impact on markets of this inventory overhang.

Third, and most concerning, is that regardless of the selectiveness of the Fed’s purchases, such intervention disrupts markets, misallocates investment and, in so doing, places in question the country’s future economic prosperity. In the current environment, with consumers repairing balance sheets and business flush with working capital, plying markets with more liquidity is truly “pushing on a string.” Nowhere are the attendant risks more apparent than the current high yield credit bubble.

Bubble Trouble
The liquidity flood resulting from the Fed’s largesse to date, and the market’s anticipating more to come, has propelled high yield issuance. Junk spreads are at pre-Lehman levels, while yields are back to records set mid-decade. This is particularly disconcerting given heightened volatility and issuer risk. Moreover, for the first nine months of 2010, high yield issuance has exceeded previous full-year records! Most of this volume reflects corporate borrowers refinancing bank loans in public markets, rather than growth. Substantiating a degradation in credit quality, controversial “covenant-lite” and “PIK toggle” structures are again in vogue. More troubling, the current week’s calendar includes a dozen or more issues, in aggregate providing over $3 billion, to fund dividend recaps. This preponderance of high cost financing to cash out equity has historically been a clear bellwether of a market top. Based on history, we are no more than months away from this bubble bursting.

Back To Basics
While waiting for the bubble to pop and a new wave of selling, where’s the opportunity for value investors? In light of the Fed’s apparent predisposition to disrupt markets, distressed investors should consider a strategy to offset this risk by targeting those tradable assets least prone to credit market manipulation. Characteristics of qualifying assets are those which are fixed in supply (to avoid future excesses), reasonably free of both anti-competitive practice (that is, manipulation), as well as speculative derivatives (futures and options). This approach may be reflected in the renewed interest this year in real estate assets. In any event, given the inevitable dislocation as the economy continues to stumble, distressed investors, traders and advisors will have ample challenges and opportunities in the months ahead.

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