Ben Bernanke: Market's rise not all predicated on U.S. fiscal policies

Former Fed Chair says the long bull market is justified by economic recovery, low interest rates, and low inflation. It's not clear yet whether current expectations for changes to fiscal and regulatory policies will be met, which is a risk to asset prices. Still, other factors are positive, including improved economic conditions globally. (Source: Schwab event, 3/9/17).

As chairman of the Federal Reserve from 2006 to 2014, Ben Bernanke held a lot of sway over the global economy and financial markets. His words were regularly dissected far and wide for hints about the direction of interest rates. Now comfortably back in the private sector, Dr. Bernanke is free to express his opinions, yet his perspective is still rooted in the quantitative analysis that helped him steer the U.S. economy through one of the most challenging periods in its history during the global financial crisis. Hear Dr. Bernanke's thoughts on a wide range of contemporary issues.

Ben Bernanke, Former Federal Reserve Chair

"Part of the reason the market is up is that the global economy is doing somewhat better." —Ben Bernanke, Former Federal Reserve Chair

The U.S. stock market's eight-year bull run and the prevailing uncertainty about whether it can be sustained was one such issue. Dr. Bernanke said that the long bull market in stocks and other assets was largely justified by fundamentals. Some market watchers believe prices have risen in anticipation of pro-growth policies from a new U.S. administration that may or may not materialize. Dr. Bernanke agreed that "it's a good question" whether the markets have risen too much on the basis of those assumptions, a possibility which poses some near-term risks, but he said that there are other supportive factors even if Washington does not provide as much in the way of tax cuts and other policy changes as investors expect:

"The basic fact is that we are in a low-return world and it's not just a monetary policy issue."

Market driver #1: Global growth

At the core of the markets' rise, Dr. Bernanke said, is an underlying growth story, not only in the United States but in other markets as well. The U.S. economic expansion is now the third-longest on record, unemployment is near the lowest levels in a decade, and wages are rising. Meanwhile, key overseas economies are showing signs of recovering from prolonged weakness.

"Part of the reason the market is up is that the global economy is doing somewhat better," he said. He cited economic firming in Europe, a stabilizing situation in China, and modest improvement in Japan. "So it's not just a U.S. story. The markets are up in other countries as well."

Dr. Bernanke noted that corporate earnings have risen at the same time; he believes corporate earnings will continue to grow and "catch up" to asset prices. Higher earnings and continued growth will likely provide support for stock prices.

Market driver #2: Low rates

There also remains a global search for returns, driven by savings. Even after three quarter-point increases by the Fed since December 2015, interest rates remain very low by historical standards. That leaves investors in need of investable assets that can offer acceptable returns. "The basic fact is that we are in a low-return world and it's not just a monetary policy issue," Dr. Bernanke said.

When returns are lower, investors have to pay more for those assets that produce the returns they need. So, for example, if investors require a 10% return, they will pay $10 to get $1. But if the rate of return drops to 5%, investors will have to pay $20 for the same $1. On that basis, all assets with acceptable returns are going to go up in price—and equities are the most obvious such asset. The result is higher price-to-earnings multiples for many stocks.

"It's just basic bond math," Dr. Bernanke said. "Whenever yields are low, prices tend to be high. The same is true of other assets."

Market driver #3: Low inflation

Dr. Bernanke said that investor confidence that inflation is well-controlled is another contributor to high asset prices. "A significant move up in inflation would hurt bond prices and it would also feed through to stock prices as well," he said.

For now, though, he believes monetary policy is in line with the economy and ahead of inflation expectations. Inflation is "close" to the Fed's target of 2 percent, Dr. Bernanke said.

Although some market watchers are concerned that the Fed might be behind the curve with its rate hikes, Dr. Bernanke reminded the audience that it wouldn't be the first time that critics have made that charge. He recalled an episode from November 2010, when the Fed was urged not to initiate a second round of quantitative easing, or large-scale bond purchases designed to lower market-based interest rates and promote increased lending activity. Some members of Congress criticized the plan, saying it would cause hyperinflation. The Fed went ahead with the program. "In fact, it took more years of strong monetary action to help the economy get back on track," Dr. Bernanke said.

The Fed has clearly shifted into a higher gear now. After the most recent rate-setting policy meeting on March 14-15, it released economic forecasts that included expectations for two more hikes in 2017.

Risks to the outlook

Dr. Bernanke cautioned that some fiscal policies under consideration in Washington may have the undesirable effect of pushing inflation higher than expected, which in turn would elicit a response from the Fed. He agreed that some government initiatives being considered could be supportive of higher growth. Infrastructure spending, for example, could boost productivity by providing better roads, airports, and schools. But overall, there is "less of a need for fiscal policy" now than during the immediate post-crisis period, he said.

Dr. Bernanke said his successor, Janet Yellen, is "doing a great job" and lauded her and her colleagues at the Fed for being cautious about the pace of interest rate increases. "They intend to continue gradually to normalize interest rates, so long as the outlook continues to be strong and unemployment continues to fall and we see more wage increases and the like," Dr. Bernanke said. "So I think they are on a pretty good track."

But what if stock prices suddenly stop their steady increases or even fall? Would that lead the Fed to stop raising interest rates? Is the Fed focused on keeping the stock market at high levels? Dr. Bernanke said he understands concerns about an explicit linkage between monetary policy and the stock market but that it is "really not true." Fed policymakers have to account for rising stock prices because they make people feel more optimistic and spend more, and that has implications for the broader economy. But in many cases, the Fed is acting on the same factors that are affecting financial markets. For example, when China unexpectedly devalued the yuan in August 2015, global financial markets sank in response. The Fed held off on increasing interest rates at its next meeting—surprising those who expected a rate increase.

"It looked like they were responding to the stock market," Dr. Bernanke said. "More accurately, they were saying: well, the stock market and we are both responding to the same underlying problem which is we don't know what's going on in China." He added there was "no real rush" at the time given where interest rates resided, and waiting was the prudent thing to do.

Lessons learned from two recessions
Dr. Ben Bernanke's academic work focused on the Great Depression, and his research helped shape his response to the financial market collapse of 2008–09. From his studies, he said, he learned about the importance of counteracting deflationary forces with monetary policy. "The Fed allowed the money supply to collapse in the '30s and we had deflation of about 10% a year for a few years," he said. The Great Depression also underscored the economy's reliance on a healthy financial system, a lesson that the Fed took to heart in providing massive amounts of liquidity and working with other government leaders to save large financial institutions in the midst of the crisis. 

The former Fed chairman addressed the ongoing debate over rolling back parts of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The wide-ranging law attempted to reduce the risk of financial market collapse by forcing large banks to carry far more capital; it also created new tools for the Fed to use to prevent bank failure, or, in the worst-case scenario, to liquidate them in an orderly manner. These aspects of the law have proven themselves valuable, Dr. Bernanke said, and so while some elements of the law could be "pruned or changed," particularly those concerning smaller financial institutions, he said it would be a "big mistake" to undo provisions that protect the overall financial system. "The crisis taught us how important maintaining financial stability is for protecting the economy." 

This article is based on a Schwab event on March 9, 2017. Schwab events provide access to deep insights on industry trends and connect advisors from across the country with industry icons, entrepreneurs, leading academics, and analysts. Ask your Schwab Relationship Manager about upcoming events.

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