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By Kevin McDevitt, CFA | 06-21-2012 11:00 AM

Romick: Fed Experiment Won't End Well

The Fed's attempts to manage risk assets could have severe ramifications, argues the FPA Crescent manager.

Kevin McDevitt: Hi, I'm Kevin McDevitt for Morningstar.

We are here at the Morningstar Conference with Steve Romick from FPA. Steve is the lead manager on FPA Crescent.

Steve, you've written a lot about what's happening right now with Fed monetary policy and also with the increasing indebtedness that we are having as a country, with greater Treasury issuance, greater debt-to GDP ratios, all of those things. What are the implications of all this, and what is the effect that you see on asset classes over next three to five years?

Steve Romick: We are living in a grand experiment. We have never lived through times like this before. We have never executed policy in this fashion, like we are doing now. And how it ends is anybody's guess, but just in simple terms, I think by avoiding the ability to clear prices at a normal low level as historically has happened in the past, the Fed's trying to step in and manage risk assets to too great a degree. I don’t think it's going to end well.

And if you look at quantitative easing--QE, QE2 and now Operation Twist--if you were literally to look at the stock market, the S&P 500 chart, during those periods of time, the S&P 500 is going up every time the Fed's active. And it's been falling off when the Fed isn't active. And so, I don't know what kind of indication that might be to you, but to me, it certainly points to the Fed's managing through this in a way that's going to have some severe ramifications.

At the end of the day, the consumer debt, we got overleveraged. Consumer debt came down, hurt the economy. Government debts replaced that. And we've literally had these huge transfer payments to the consumer to try and keep them spending. And it doesn't make any sense to us. At this point in time, I think 44% of our nation is receiving some form of government subsidy. That’s not good. That doesn't reflect strong internals for an economy.

So, at some point in time, there are ramifications. At some point in time, interest rates are going higher, and mind you, with or without inflation, I would argue. So, if interest rates go higher, then it does a couple of different things. One, it does make a difference to those companies that are more highly levered, who haven't termed out their debt, although a lot of companies have.

But more importantly, let’s look at it from the government level--government interest expense as a percentage of the total budget is about 6% today. And it was as high as 7% back in the early '70s. Well, that's a hell of a lot higher today with rates being a lot lower, making these numbers look a lot more attractive. And as far as that goes, the denominator is higher as well because our budget is growing at a faster rate than inflation.

So if interest rates actually were to rise to a 5% to 6% level, what is a 6% interest expense as a percentage of our budget, will rise to someplace in the midteens. There is going to be a lot of crowding out of other types of spending, and that scares the hell out of us.

McDevitt: So, if you are talking about higher interest rates, what does that potentially mean in terms of inflation, and then how are you trying to protect against that? How are you positioning your portfolio in that context?

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