Media pundits have attributed recent stock skittishness to geopolitical tension in Eastern Europe, military conflict in the Middle East, a 4.0% initial reading for 2nd quarter GDP growth, a hawkish dissenter in the ranks of the Federal Reserve, a surprisingly strong jump in employment costs, a 10-basis point pop higher in the 10-year yield, deflation in the euro-zone, trouble at a prominent Portuguese bank, an Argentinian sovereign debt default and even low summertime trading volume. The truth is actually much simpler; investors fear that when an economy has been propped up by ultra-low borrowing costs for five-and-a-half years, an economy will likely falter without a continuation of the ultra-easy monetary policy.
I recognize that a number of economists, analysts and thinkers disagree with me. They believe the “recovery” is gaining traction. (Why we still talk about a “recovery” after five-plus years is telling in and of itself, but I digress.) These are the same folks who predicted that the 10-year yield would rise from 3.0% to 3.4% before the year was out. Instead, the durability of longer-term treasuries has become the monster story of 2014, as investors sought refuge in an environment where self-sustaining economic growth has yet to materialize.
Think of the U.S. economy as a tricycle. It has three wheels that, if they are all working together, you can get extraordinary and very real growth. The back two tires include the size of the workforce and inflation-adjusted family income. The front tire is credit — an ability to borrow and spend. If two or more of these tires have the right amount of air in them, the tricycle is likely to move down the sidewalk. If all three are properly inflated, you probably have an economy that will perform at its peak for a period.
Over the last five-plus years, though, the back two tires have been entirely flat. Inflation-adjusted median income has gone nowhere, and as many people have left the workforce as have been joining it. Indeed, the proportion of the country’s working-aged population has flat-lined since 2010.
Now imagine the front tire — borrowing-n-spending — doing all of the work. The U.S. Federal Reserve has maintained 0% overnight lending rates for the entire “recovery” as well as created electronic money to buy bonds for the purpose of pushing down interest rates. The lower rates allowed businesses to refinance debts as well as buy back shares of stock, while some consumers have been able to acquire additional real estate and others have been bold enough to purchase new cars. Yet what happens if the Federal Reserve lets air out of the front tire of the trike? How can the economy grow at its sub-standard, paltry 2% when neither the size of the workforce is expanding nor the size of the family’s collective wallet is growing?