Policy matters. The three large domains of government economic policy (Monetary, Fiscal and Regulatory) impact the economy through the “wedge” model. A wedge is created anytime a policy comes between work effort and reward. Policy wedges can be increasing, decreasing or stable. A simple wedge example is the capital gains tax. Higher marginal capital gains tax rates increase the wedge between capital risk taking and after tax profits to risk takers, resulting in less of both. The overall policy/wedge mix directly determines two key drivers of any economy, the growth rate and the currency value. We highlight these in the Policy Map section of the newsletter.
Below are charts of three publicly traded ETFs that represent different countries’ stock markets since 2012. We have removed the names, ticker symbols and price data. All that is shown is a long term moving average of prices. Let’s play a game called “Pick the Policy.” Can you identify which market represents the good policy zone, the bad policy zone and the undecided zone? We provide one hint, a quote from Jude Wanniski that epitomizes how the policy wedge model affects markets.
“The stock market, which is the most efficient and accurate gauge of future economic activity, moves on a path traced by the wedge model. It moves up or down, appreciating or depreciating the value of the financial assets it embraces, by interpreting the impact of public policy on commerce between individuals and nations. It moves up when it projects a narrowing of the wedge that inhibits such commerce; down when it projects a widening of the wedge.”
Chart 1 is the S&P500 (SPY) – good policy
Chart 2 is Europe. (VGK) – undecided policy
Chart 3 is Russia (RSX) – bad policy
The S&P 500 has been in a solid uptrend since 2012. Policies here at home are far from ideal, but they have been steadily improving towards pro growth with the GOP capture of the House, the fiscal cliff/sequester deal, and the recent GOP capture of the Senate. Note, this pro growth improvement has nothing to do with partisan politics. It just so happens that the GOP is currently the more pro growth party. This was not the case under George Bush, and the opposite was true under Clinton’s pro growth policy agenda. The improving policy trajectory has helped the US remain the “least bad place to invest” in a world where good policies are scarce. Scott Grannis does an excellent job in his article below spelling out the bullish case for US equities versus the current bearish mainstream view.
Walls of Worry Persist by Scott Grannis, Calafia Beach Pundit.
Europe has gone from good times to undecided/troubling times. From 2012 to mid 2014 Europe seemed to be turning the policy corner. Failing austerity plans were being abandoned in speeches by EU leaders, and the Euro currency was strong and stable. Pro growth policies were only talk, but at least they were being discussed. That optimism gave way to reality in mid 2014 when EU policymakers failed to deliver any tangible pro growth agendas. In many countries, policy continues to worsen down the higher tax/higher government spend path. Coupled with economic sanctions on Russia that act as a 100% prohibitive tax rate on targeted activities and recent quantitative easing policy by the ECB that is weakening the Euro, markets are reflecting how European growth prospects have faded. We agree with Brian Domitrovic who examines why Europe’s path back to growth is not paved by poor monetary policy.
Europe’s Past Economic Success Lay Not in Quantitative Easing by Brian Domitrovic, Forbes
Lastly, Russia’s economy is riddled with bad and worsening policy. The Russian economy and currency are fully levered to oil/commodity prices. In periods of weak US$ monetary policy, commodity prices and commodity price exporters like Russia thrive. As the US$ began stabilizing in 2012 and then rapidly appreciating in 2013, the Russian market took notice. Bad times were exacerbated by economic sanctions and a continued period of stable/falling gold prices through 2014. Headlines like the one below are only surprising because they seem to be about three years late to the front pages. Watching gold prices and “Footprints” of equity markets in commodity exporting countries like Russia alerted one to this theme long ago.
S&P Cuts Russia Credit Rating to Junk, Bloomberg
By the way, what do you think the “Footprints” look like in another market whose economy is heavily leveraged to exporting commodities – Brazil?
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