Yellen's job unlikely to be easy

Published Tue, Jan 7, 2014 · 10:00 PM
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STEPPING into the shoes of an outgoing leader who commanded significant respect and who achieved unparalleled success is a hugely daunting and difficult task - just ask new Manchester United manager David Moyes whose first few months as Sir Alex Ferguson's replacement have been unspectacular, to say the least. So it will be for Janet Yellen who was confirmed as the new chair of the United States Federal Reserve on Monday, replacing the outgoing Ben Bernanke.

Like Mr Ferguson, who is English football's most successful manager with 38 major trophies for Man United, Mr Bernanke's accomplishments are unprecedented in history. He expanded the Fed's balance sheet by almost US$4 trillion, staved off a Great Depression and brought the economy to the point where it looks like it will soon be able to fend for itself without the financial crutch of the Fed's quantitative easing (QE) money printing programme.

Moreover, like Mr Ferguson and his replacement Mr Moyes, Ms Yellen comes from a similar background and shares the same economic convictions as Mr Bernanke. That this is important to markets which have grown used to large financial handouts under Mr Bernanke was clearly demonstrated in November last year when the hawkish Lawrence Summers, who was President Obama's first choice to head the Fed, withdrew and left the way clear for the dovish Ms Yellen. In response, markets around the globe surged in celebration because it meant the money printing would continue.

But as Mr Moyes has discovered to his dismay - as well as that of millions of fans of Manchester United worldwide - having appropriate credentials, backgrounds and beliefs is one thing, but keeping the ball rolling smoothly is another. Results have been poor, the team is floundering and there is now tremendous pressure on Mr Moyes to turn things around quickly. You'd have to wonder - will Ms Yellen encounter similar difficulties? If so, what might they be?

Many experts believe Ms Yellen will seamlessly assume control of the Fed on Feb 1 and pick up where Mr Bernanke left off. If so, then her biggest challenge will be deciding when to taper QE and how to communicate the Fed's tapering schedule to markets. In other words, continuing Mr Bernanke's work and ensuring markets are kept up to date on the Fed's thinking.

Few, however, have spoken of the bubble that is Wall Street as being a threat, partly because Ms Yellen herself in November said there is no bubble in stock prices and that valuations are reasonable. As a result, the vast majority of investment houses have recommended a "buy" on US stocks.

In our view, this is dangerous complacency, the belief that a stock market that rose to 51 all-time highs last year as measured by the Dow Jones Industrial Average (44 if the S&P 500 is used) and one that is almost 200 per cent off its 2008 lows is still a "buy", and will continue to rise because interest rates will remain low, because the money printing will still continue although at US$75 billion per month instead of US$85 billion, and because there is a flickering recovery on the horizon.

As most investors would know, valuations and what is reasonable, reside in the realm of the sentiment-driven investor, and this can change overnight. Price-earnings (PE) ratios, price/book values and more sophisticated metrics like the Schiller PE are all based on forecasts of a largely unknowable future, so what is cheap today could suddenly become expensive tomorrow - especially since the S&P 500 has not had a 10 per cent correction since Oct 2011.

Furthermore, critics of the Fed's QE still believe that it hasn't really worked as advertised, and that it has merely created hot money that has pumped up markets and not the real economy, and that what awaits Ms Yellen is not recovery but severe inflation.

If this view proves correct and if Wall Street today is rising really because of an improving economic outlook and not because of relief that QE will only be tapered minimally, then it would be disastrous if the US economy backslides since this would force the Fed to backtrack and ratchet up QE instead of tapering it.

Like Mr Moyes over in England, Ms Yellen will have her work cut out for her.

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