The Fed’s medicine is working: Brown Brothers

A revival in bank lending is good news for investing in US assets, argues Jeffrey Schoenfeld, CIO and partner at Brown Brothers Harriman.
The Fed’s medicine is working: Brown Brothers

Investors are too pessimistic about the US economy, reflected in undervalued corporate bonds issued by the financial sector, says New York-based Jeffrey Schoenfeld, partner at Brown Brothers Harriman.

Fears of a sovereign crisis are overdone, which explains why global investors continue to pay the US government to take their money, in real terms: the 10-year Treasury yield of about 2% is negative when adjusted for inflation.

Nominal 10-year Treasury yields historically track nominal GDP, so a 2% yield, when adjusted for inflation, implies the US economy won’t grow at all. Schoenfeld says this pessimism would be justified if the economy were not adjusting; if, say, the US was facing a Japan-like scenario of prolonged stagnation.

He argues that this is not the case, because both households and banks, which were the source of America’s imbalances, have both made substantial changes.

Crucially, banks have completely restructured and are lending again. By any measure – capital, leverage, impaired assets – they are far more healthy than in 2008, although individual banks do lag.

“The system is healthy, but not every bank is healthy,” Schoenfeld says. Citing strong quarterly earnings by Wells Fargo and JP Morgan, he says most banks are making money despite short-term interest rates being virtually zero.

“When interest rates eventually rise, that first 100 basis points is going to be exponentially profitable for the banks, worldwide,” he says, because they will be able to raise lending rates without passing on the full increase to what they pay depositors.

Households are still indebted but, thanks to the Federal Reserve Bank’s policies, are healing, says Schoenfeld. In 2008, the Fed’s only tool to address runaway indebtedness among households was to ease the burden of servicing those debts, so it has done everything in its power to push down short and long-term interest rates.

As a portion of disposable income, monthly debt servicing levels have risen to an extent not seen since the 1994 Clinton-era. Although households still have three times the amount of debt they owed in 1994, the adjustment is under way.

“You won’t hear us be critical of the Fed, at least not post-2008,” Schoenfeld says.

The fact that households and banks are both recovering shows the US has not repeated Japan’s mistake, which was to allow zombie banks and corporations to persist for so long. This sets the stage for growth to help the US gradually ease its way back from quantitative easing.

The downside is government debt, which remains out of control, and a political divide that isn’t able to lead the country to a sounder footing. Schoenfeld suspects nothing substantial will be achieved without market pressure, although he dismisses the notion that the US could turn into another Greece, because of the primacy of the US dollar.

Housing is still in a slump, but the country has at least stopped building new stock. There is excess residential inventory of about two million dwellings. The US is creating about one million new dwellings each year, suggesting at the national level that two more years are needed before housing prices can appreciate. That will dampen growth for the time being, as will the ongoing need for households to deleverage. Exports are the main source of growth right now.

Although that does not suggest a bull market, Schoenfeld says markets are too bearish, arguing current prices assume the next decade will resemble the past few years. “The next two years may look like what we’ve had recently, but not the next 10 years,” he says. “Given the substantial adjustments taking place in the US economy, it’s way too pessimistic to project anaemic growth forever. The US economy is not fragile, it’s just growing slowly.”

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