Some Thoughts for 2014

Some Thoughts for 2014

January 5, 2014 1 Comment

When our daughter Katie was 3 years old, she referred to the list of things you make at the beginning of every year as “New Year’s Revolutions.” One of my New Year’s revolutions for 2014 is to start writing again.

In particular, there are two things on my mind. The first is practical; I believe that we are in the early stages of a change in economic direction that will rival the shift of inflation that separated the ’70s from the ’80s, only in the opposite direction.

The second is more theoretical. I started my professional life as an academic economist doing all the things professors do. Then, like Odysseus, I wandered off to try my hand at being policy adviser, forecaster, restructuring adviser, board member, and finally private equity investor. After 30 years, I too found my way home–in my case back to teaching. For the past 3 years I have taught Macroeconomics, Finance, and a course I invented called Topics in Far From Equilibrium Economics and Finance to the PhD students at Claremont Graduate University. To do that, I had to read all of research published while I was away. Although I love the students, I find the state of economics today to be very strange–almost silly–and nearly useless. I want to write down a few of these “Rip Van Winkle” thoughts (I know I am changing metaphors here but I don’t think that either Rip or Odysseus would be offended and, besides, it’s my blog 🙂

Here are a few thoughts on the first topic that I wrote up to brief Larry Kudlow before doing the last show of the year with him on New Year’s Eve. Our topic was what investors should expect for 2014. You can watch a video of the spot at the following url:

  • 2014 is going to be a ‘feel good’ year, like the front end of a New Years Eve binge, with increased Fed stimulus, higher growth, contained inflation, and strong stock and real estate markets. Investors need to take full advantage of 2014 and protect themselves against rising interest rates down the road.
  • There is only one big story for 2014, the Fed. Contrary to the common belief that the Fed tightening, Fed stimulus will be greater in 2014 than in any previous year. The right way to measure stimulus–the pressure of policy on growth and prices–is not whether the Fed is ‘buying bonds’, it is the stock of outstanding bank reserves that banks can still convert to business and consumer loans. Bank reserves today stand at $2.6 trillion and banks hold $2.5 of which are excess reserves in excess of reserve requirements earning 0.25% interest. Before the financial crisis, total bank reserves were $85 billion; excess reserves were $0, their normal level. But the Fed is still increasing reserves by $75 billion per month, which will push excess reserves past the $3 trillion mark by early next summer.
  • There is no example in the history of the world where banks permanently sat on a mountain of excess reserves. Banks face the same investment (arbitrage) incentives as we do. They earn less than 1% on their cash reserves at a time when stock prices are rising at 25% per year and home prices are rising 13% per year. That arbitrage is irresistible, which is why business loans have been growing every week from $1200 billion at the bottom of the financial crisis  to $1603B today, higher than pre-crisis levels. The burden of new regulations are making them lend slowly (especially  small banks); but they are lending.
  • The $2.5 trillion wall of excess reserves has been leaking through the banking system in the form of rising asset prices. In the early days, it showed up as vanishing discounts on the assets–mortgage backed securities and secondary private equity interests–that had collapsed during the meltdown. Now liquidity is pushing into stock and real estate markets; over the past 2 years, stock prices are up +45% and home prices are up +25%. Banks are making ‘covenant lite’ loans to private equity firms again, which is fueling rising M&A and IPO activity. These gains will continue as long as the wall of excess reserves is in place.
  • Fed stimulus is leaking through into spending and growth too. Net worth is up +$6 trillion over the last year to $77 trillion, and more people are working. GDP will grow by more than +3% in 2014.
  • Short-term interest rates will remain low next year but long rates will resume their climb.
  • Stay fully invested. Both stock and real estate prices will rise in 2014.
  • Asset prices will rise but not all assets will be equal. Real estate is the sweet spot, along with leveraged finance, where private equity sponsors are benefiting from increasingly available debt financing to buy companies with weak trailing profit histories cheap and sell them at higher multiples in a few years. (Blackstone (BX), Apollo (APO), and Oaktree (OAK) are good examples. FYI: I own all three.) Small companies—dependent on banks for working capital–will outperform big ones too as the credit crisis thaws and they enjoy improved access to working capital and sharply lower cost of capital.

Happy New Year and more to come,


John Rutledge

1 Comment

  1. Martin Holland

    January 24, 2014

    Dr. Rutledge,

    Thanks for posting this. I haven't seen much mention about the excess reserves since I was at Pru in 2009 and we were trying to figure out who had money and where it went. I'll continue to follow your blog and look forward to continue learning from you.


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