Author Archives: Ricardo Tejero

The four pillars of global financial insanity

We are all kinda long “awe” today -aren’t we? Wait, better make it “shock and awe” for me. Yeah, even bulls are watching stupefied by now. I have no words to convey my feelings, or thoughts, for what we see in capital markets. A mind-blowing, once-in-a-lifetime experience I thought I would never endure -even after spending the best part of thirty years trading global markets.

We are all also short of time, so let’s get straight to the point. What on earth is propelling this “Everything bubble” blow-off top, and helping degrade the past bubbles to the child’s play category?

To follow up on my literary vein (see the previous post), I will paraphrase Ken Follet to try and synthesize the four main pillars of global financial insanity:

1.- The Fed/Central Bank Put and forward guidance.

2.- Debt, and sustained incremental debt growth.

3.- Fiat Money debasement by most CB’s (cum laude in 2017).

4.- Financially repressive interest rates.

So, we’ve got four pillars to explain insane behavior by investors. But it gets worse: I do not think we need all four pillars to keep this going. They are formidable pillars, and the excellent architectural design allows for some weakness in some of them at times (provided the rest remain powerful enough). The latest rate rises in the US are a case in point. Markets couldn’t care less. We just need two or three of the pillars to work simultaneously -and the induced “nirvana” could go on for long enough to surpass the effects of the time-worn widow maker trade in JGB’s. Central Banks have managed to blend absurdity with eternity. We have a planetary, fault tolerant, monetary boom!

I will admit to being unable to distribute uneven weightings between them four. Every single one of them implies a policy that is anathema to me, and thus I am incapable of underlining the particular incongruity of any of them. It is evident that Keynes was right when he stated that irrationality could outlast solvency. Some inconsistencies have gone on for decades now: think Japanese sovereign debt ratios to GDP, JGB yields and, of late, a stupendous money base increase up to 90% of GDP (no, no “typo” there, and no kidding either). Add European junk debt prices to the list more recently. Examples abound.

Of course, for our well-being and our future as a species, this global economic strategy is just brainless -and grossly negligent. At some point, we will all pay a hefty price for it: the longer it goes on, the higher the price tag. Regrettably, by then it probably won’t matter to a bunch of my macro colleagues or me. As I write, I am still nearly entirely stand-by regarding risk-on risk-off positioning, but this situation is unsustainable. For some of us, fear of missing out (FOMO) was never a sentiment to take care of, and, sure enough, I’ve not only missed out but lost significant money in these last ten months. The latest chain of monthly drains, even with low commitment in my positioning, is small but psychologically unbearable. Keynes did get a couple of things right: failing “unconventionally” is tough on anybody’s emotional equilibrium. 

1.- The original Greenspan put -and iterations.

This term was coined in the late nineties to describe the Fed’s reaction to LTCM’s demise. In fact, by then it was also factoring in the previous response to the 1987 stock market crash.  It was the second time in a row that the Fed bailed the market out. A lot more of the kind was to come later, but we did not know then.

Moral hazard is another way to describe what happened -and you can read tons of literature on the subject. The term has evolved and consolidated. Forcefull CB reaction to the tech bubble burst and, seven years later, to the sub-prime excesses, solidified the strategy providing risk-taking investors with a “de facto” riskless trip. Bernanke certainly helped make sure this “fully insured” feeling remained steadfast in the investor’s mentality.

Then year 2k happened -but the damage was relatively contained to some areas of the markets. 2008 was a different story, a global bust. It took a long time to get investor confidence back after CB’s miserably failed to honor that put in 2008/2009. Trust is essential in finance -and you know the saying: once bitten twice shy. But finally, they did it. A couple of forces played a role:

  • Over time, TINA helped investors allow themselves to trust CB’s again. You want to “buy” that something will work when you have no alternative to keep your job or need to attain your financial targets (particularly if you need the money).
  • ETF’s did their part as well. After all, if you buy the index basket you are buying “the system”. You are suppressing the manager/human error risk. If there is no financial system there is no life (or so we think), so we might just as well play along and accept whatever the future may bring for all.
  • Lastly, the powerful CB volatility short (Powell, 2012 Fed minutes reproduced later) rubber-stamped the deal. Risk had been swapped for uncertainty. Uncertainty for the human race was the only consideration weighing against risky investments. Major Investment risk had all but disappeared (selling puts made a lot of sense). The only risk left is systemic uncertainty (I exclude the term risk because risk can be handled mathematically, while uncertainty can not: it is like flipping a coin just once).

Regrettably, unlike Rosalind did (“As you like it”, William Shakespeare), CB’s did not rhetorically question themselves if their desire to remove risk and volatility was “too much of a good thing”. Investors don’t know, but I am 100% sure they are now terrified (read Dudley’s latest speech) at the sight of the current “Frankeinsmarket”. A market that eases financial conditions with every “dovish hike”. I remember bashing dovish hikes a year ago as an absurd concept tailored to then CB’s needs. It is now coming back to haunt them. Once magnificent “Paint drying” descriptions to depict the consequences of QT look as if they will follow the same fate.

So what follows? We shall take our evidence as it comes because I’m fed up with trying to anticipate FOMC behavior: you cannot front-run paranoic decisions. But let me suggest that this quote hints at some understanding of the problem by top gun “Jay”.

I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.

Jerome Powell. Excerpt from the official transcript of the Fed meeting in October 2012

And it does look as if he is aware of what is at stake:

When it is time for us (The Fed) to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position.

But don’t ask me what they are going to do about it. My bet? Nothing substantial, but they are scared by now. I would unwind the volatility short and try to shake the market up.  We need ups and downs, extensions and retracements, more extensive intraday ranges and some squeezing of vol shorts now and then. And, no doubts, I would scrap forward guidance and dot plots. We have to go back to those times when if you thought you understood what Greenspan was saying “you were probably wrong”. I liked that situation (wow, how I miss those real markets when thinking made a difference).

All the same, I think we will need more than that to stop the massive stampede. Not infrequently, success has a bittersweet flavor to it. CBs now have to handle the investor charge for “risk” that they provoked.

2.- Debt and sustained and incremental debt growth.- 

One chart is worth a thousand words. We are still notoriously indebting ourselves into growth. And we do it “in crescendo” (positive second derivative, with the tangent line below the function graph). We grow because we add to the debt pile and not only do we further indebt, we do not save near enough (the US is nearly savings-less). To add insult to injury, we then use fractional reserve banking and monetary debasement to fund that debt.

During the first nine months of 2017, the world added 16 trillion of new debt taking the total to 233 trillion (IIF chart via Business Insider). As a reference, let’s remember that world GDP is 78 trillion. The good news is that we are not increasing the debt to GDP thanks to healthy nominal global GDP growth. The bad news is that debt grows 2.5 times as much as nominal GDP. And, not to forget, it is not infrastructure-related or supply-side investment-related debt: we still anticipate future consumption effectively subsidizing aggregate demand. 

Not only do we subsidize aggregate demand, blurring and softening the line of consequences of inequality, we also use debt to lever up the capital base of our supply side. You hear lots of stories about enterprise leverage above six times EBITDA. I heard of a new one last week. It will be Ok while the going is good. But, if at some point the consumer is forced to delever, we have also compromised the financial health of our NFC’s for our next recession. Never mind the inherently unstable banks (tier one ratios of 10 or even 12 are way too low, and fractional reserve banking should be outlawed). They are better off than in the past bubble -but the magnitude of the potential disruption is 2008 many times over. In a depression, they are financially dead. Nobody cares because we assume that the CBs will prevent the next recession forever.

For as long as debt thrives, and nobody questions its validity (people accept it will be paid) the show will go on. Debt growth helps generate liquidity, stimulates economic growth, alleviates the consequences of inequality and keeps families afloat. It helps markets and the wealth effect as well increasing demand for common stock and favoring healthy corporate buy-back demand. Great, but, for God’s sake, somebody ought to take a look at the long-term consequences!

3.- Monetary debasement of Fiat currencies.-

Albert Edwards produced this last chart in his latest London presentation -the Woodstock for bears annual event. I went last year. It shows the amount of printing that has taken place since 2007. And it puts the 2017 hallelujah in context. We are getting better at printing: we nearly beat 2008 figures!

Keynesians will say: what’s not to like about inflating CB balance sheets if there is no goods and services inflation? Well, not to forget, all reserves generated are high powered money and subject to second round growth using the fractional reserve banking system. That has not been particularly harmful up to now, what has been detrimental is that those funds, unable to creep into the ordinary business cycle, have found their way into financial products. And because positive real interest rates are for most currencies an obsolete concept, they have found their way into risk assets. An enormous percentage of them has been incremental demand for stocks and risky investments.

That’s not all. Some CBs have gone into overdrive: no need to use the banking system or induce investments by third parties. The SNB and the BOJ directly buy stock against their money base in the secondary market. It’s mostly Apple stock and other FAANGS for the SNB -and more subtle and more spread out ETF buying for the BOJ. But the money created out of nothing ends pressuring prices up.

On top of that, even if it is not strictly speaking freshly minted money, the almighty Jap public pension fund is switching to equities, and the Norwegian sovereign fund as well. And they are resorting to leverage! Pension funds are also “risking up” to attain impossible return targets. The public sector is a now a prominent bubble blower (and are even bragging about it).

What happens if this stops? Nothing, provided the other pillars are still in place. This is a very robust building we are looking at. The rest of the pillars are stable enough. The mother of all bubbles it is.

4.- Financially repressive interest rates.-

Bill Gross introduced the concept of financial repression in modern economic literature. I think it can be defined as the use of monetary power by CBs to deprive savers of their legitimate income. What income is legitimate? I think a decent starting point is nominal GDP growth. Or at the very least short-term rates higher than the GDP deflator.

Financial repression is key to the bubble. It indecently shoves everybody into risky assets.  I am strongly against it (always have been save for exceptional moments when you have to try to keep the market functioning).

  • It is never a good idea to be unfair to a portion of the economic players. They will take their punishment on the chin, but they will not help the economy prosper. Resentment is a nasty feeling with very long “duration”.
  • Savers used to be a source of sustainable aggregate demand. And it was a low beta aggregate demand (with low sensitivity to the point of the cycle). We should be careful with aggregate demand preservation.
  • Low rates favor debt growth. We have to stop that asap. Infinite debt is not a nirvana!
  • Low rates favor playing games with the WACC and allow NFC’s gearing up.
  • Low rates encourage risky behavior by individuals  -when investing and when consuming as well.

Interest rates are at their most repressive point since 2007. They’ve been lower before (in some places) but not against current nominal GDP growth. The Bund is the paradigmatic example. Eurozone nominal GDP growth is roughly 3.5%. Inflation is 1.4%. Growth is 2.1%. Real rates are negative 200 bps (in the shortest end of the curve) and even negative 90 bps for the ten-year Bund. I can’t help scratching my head daily. I still don’t “get” the rationale behind this policy.

Trying to remain sane in an insane environment.-

This interesting time in which we are continually debating the burlesque insanity of the ineffable Trump is better than any other to introspectively question oneself thoroughly. Or, why not just blame others? Ought we be concerned instead about the sanity of the rest of the market players and their FOMO syndrome? 

But, if I opt not to blame anybody else, does that mean I am a genetically engineered subspecies of the permabear? It is in those moments of despair that I find some solace in my reading. And, voilà, here comes no other than Powell, the new supreme God of the Keynesian mount Olympus, quoted above, voicing the same concern. Maybe, only maybe, it is justified that I find minor pricing discrepancies between sectors, asset classes, or individual stocks, so unmotivating.  It is uncertainty that’s killing me. The elephant in the room is the herd’s en masse response to the Central Bank’s call for financial risk exposure as the ultimate cure for our economic ails. The Greek 10y bond price is a great example (chart zerohedge). The Argentine 100-year bond is a close second.

Labelling my disorder as obsessive-compulsive might be understating things. I toil day and night trying to find some alternative investments with even a pyrrhic return for a euro-based fund (something in the very low positive numbers after fund expenses). I see none.  In this last “everything bubble” there is no place to hide.

  • You could avoid Japanese stocks and real estate in 1989, or the 1987 October equity crash (with adequate diversification, interest rate income was good and improving seriously). I did.
  • You could stand aside from the NASDAQ bubble easily. There was no scarcity of alternative playing fields to try and make money.
  • It was harder to bypass the (2000-2008) real estate bubble and its deadly effect on financial markets.  I played the run-up in Gold from the lows, the odd trade coming up,  and a balanced portfolio to come out more or less satisfactorily (in the black).
  • Then the last quarter of 2008 happened. 2009 looked like a planetary collapse saved “just in time” by the suppression of the “mark to market” rule for bank portfolios -together with a well-justified initial generous dose of QE. But then, and in the years that followed, there were abundant places to make money. The currency arena up to the Shanghai accord was fine. And the rally in bonds was great.

In all those instances there was no lack of investment opportunities compatible with a portfolio with low systemic risk. Or, in Hunt’s vocabulary, an asset management style with lots of risky trades but low uncertainty was feasible. Correlation coefficients between trades were still manageable. You could be a bubble skeptic and still make money.

Not anymore. Today you are faced with an uncertain decision that cannot be supplanted and bypassed by a series of risky decisions with moderate correlation. You are “in” with the CBs, or you are “out”. Of course, you can split your portfolio in two, but you cannot proceed with an integrated portfolio approach that uses a series of risky decisions to make money while avoiding systemic risk. An excellent, if somewhat long, post by Ben Hunt (Epsilon Theory. “The three-body problem”) explains this.

A risky decision is when you have a pretty good sense of the odds and the pay-offs. It lends itself to statistical analysis and econometrics, particularly if it’s a decision you will have the opportunity to make multiple times.

An uncertain decision is when you don’t have a good sense of odds and pay-offs. Here, statistical analysis may very well kill you, particularly if you’re not going to get many cracks at the game, or if you don’t know how many times you’ll get to make a choice. You need game theory to make sense of decisions made under uncertainty. (…)

Basis uncertainty is the core problem facing every investor today… There is a non-trivial chance that structural changes in our social worlds of politics and markets have made it impossible to identify predictive/derivative patterns. (…)

To make things worse, the colossal CB balance sheets and the infinite elasticity of their size adds a second layer of uncertainty over uncertainty. Ben Hunt again.

Henri Poincaré proved that the motion of the three objects, with the exception of a few special starting cases, is non-repeating. This is a chaotic system, meaning that the historical pattern of object positions has ZERO predictive power in figuring out where these objects will be in the future. (…)

What we have to accept is that there is an Object 3 that has moved into a position such that its gravity absolutely swamps the impact of Objects 1 and 2. This Object 3, of course, is extraordinary monetary policy, specifically the purchase of $20 TRILLION worth of financial assets by the Big 4 central banks — the Fed, the ECB, the BOJ, and the PBOC. (…)

I tried to be a hero and short some obscene valuations. I got crushed. I now stand aside and wait because, we can be heroes, but likely, just for one day. Lovable as they are, heroes never last long. It pays to wait. The four-pillared bubble building boasts robust construction and fault-tolerant functioning. Nevertheless, be sure that all bubbles burst -it just might take a long wait this time around unless something unexpectedly moves in the CB  (object 3) space.

 

The four Horsemen of the Apocalypse

Come Christmas 2015 and the economic and financial “QE” cycle (March 2009 to December 2017 and counting) looked exhausted. It was. At that time, I went “all in” with a high conviction, massive short. I was up nearly 15% YTD mid-February 2016.

A brief, intense moment of joy ensued: I thought I’d hit a home run -and there was a lot more to come. Sadly for my interests though, that was it. I ought to have cashed in. In hindsight, it all turned around after a new round of effective, coordinated intervention. The last element of tightening left, the dollar appreciation, was taken care of in the Shanghai G20 meeting that gave place to the “Shanghai Accord”. Of course, unlike in the “Plaza” precedent, official confirmation is pending. Manipulation is far more efficient behind closed doors. Dot plots cannot hide the fact that transparency is a prominent casualty of this financial cycle.

The economic cycle had been magically elongated. A couple of trillion of extra CB money in Japan and Europe (see chart below), and (most importantly) further egregious credit growth in China, both did the job once again. The power of monetary alchemy. I never learn.

We are still living the same politburo protected Nirvana. Ever since that early 2016 scare markets have been buoyant, and I’ve gone the other way. US equities are up well over 30% in this last explosive tranche of the bull (23% post-Trump), and the rest are not far behind. In retrospect, I grossly underestimated the power of synchronized printing and credit growth. Freshly minted “money makes the world go round, the world go round”…

Monetary largesse has come accompanied by air support from the POMO desks, permanently involved in strenuous market interventions.  Alongside, we have seen widening social inequality, and increasingly fraudulent economic data. Even Benoit Couré at the ECB admits to fake economic statistics -if only to blame governments for some of the market dysfunction that is now obvious to all.

We now have fake money and predominantly fake data. That’s not all; we also have fake markets (plunge protection teams and POMO desks are all over the place), fake term premiums, and fake credit spreads. Fake news abound too. Virtual reality is as close as it gets to the real thing.

As a side effect of the abovementioned facts, the VIX has nearly gone underground (is negative volatility a possible new concept worth investigating?), and realized and implied volatility in bond markets is unbelievable. Not to mention the hunt for yield taking junk to astonishing levels and investment grade bonds to negligible mid-swap spreads. Today, holding Sovereigns has relative merit -if it weren’t for the fact that they are all bankrupt if you adequately account for future entitlement contingencies (49 trillion in the US according to Fed’s Kaplan). Unfortunately, Sovereigns are not the solution. It pays not to forget that the pricing of some sovereigns is absurd beyond belief. Italian ten-year bonds yield 65 bps less than Treasuries!

The economic and financial consequences of this mother of all bubbles are already and will be, dire -even if it all looks great reading current press headlines. Yes, it is a bubble only it’s so big that we have run out of distinct reference points to measure it. Everything is inflated to the extreme. And, whatever they tell you, it is not fundamentals at work: this chart puts fundamentals in context while analyzing the S&P 500.Not only everything is insanely overpriced: relative pricing of many assets is upside down (European high yield returning less than Treasuries is a case in point), making it tough to invest in this seemingly lunar landscape -unless you have faith in our CB Gods. Religious faith. I like the way Viktor Shvets from Macquarie Capital outlines the only  (but undoubtedly compelling) reason to remain long risk (emphasis mine):

“We therefore remain constructive on financial assets (as we have been for quite some time), not because we believe in a sustainable and private sector-led recovery but rather because we do not believe in one, and thus we do not see any viable alternatives to an ongoing financialization, which needs to be facilitated through excess liquidity, and avoiding proper price and risk discovery, and thus avoiding asset price volatilities.”

This is not just any bull; it is an unrestrained bull. Shvets is undoubtedly right in his appreciation that for CBs there is no alternative to supporting easy financial conditions (even while trying to tighten them as much as they dare). This QE cycle is a one-way road that ends at some point with the implosion of the whole system. A Mises depicted boom-bust cycle on a planetary scale. I liked the Fasanara measurement charts for both bond and stock bubbles.

Let’s try to put a positive spin on this financial malfunction -so much for describing the causes of what happened since February 2016. Where does this take us? Well, even accepting the fact that CBs also face a TINA choice, and that they will have to keep this pantomime going for as long as they can, there is an end to everything.

The practical question is not only timing the bubble burst but also determining which of the two is set to burst first. That depends on the catalyst that will finally end it. And, now that I mentioned the Bible, I am reminded of the seven seals mentioned in the book of Revelation (6:1-8). Open four of them you find yourself against the well known four Horsemen of the Apocalypse. Namely pestilence, famine, war, and death. I will use them as symbols of the four most likely drivers of the cycle’s demise.

It will be a combination of the acts of these horsemen that will kill the bull at some point. And I see them all relentlessly closing in. It’s not a gallop yet, but they are coming closer to it.

The first horseman is pestilence, the long-forgotten “inflation.”

In one of my recent misjudgments, I wrote down inflation as a concern. That was only a couple of months ago. In my defense, I can say I tried to change course as early as last month suggesting rather humbly that it could well be that Janet was right after all. I am confident that demand-pull inflation will be non-existent until we fix Aggregate demand -and that is not going to happen without significant disruption. I ruled that out, and I stand by that assertion.

That leaves cost-push inflation as our only chance to get inflation back (should we want it back?), and things can get interesting regarding this issue. Data for the first half of the year seemed to point in the direction of no inflationary trends. That put me off. But recent data paint a different picture, even if it is too early to say if this is the beginning of a trend. Shelter, Healthcare, regulatory (government costs), wages, and productivity are the primary variables to watch.

  • Talking wage growth, it is important to analyze in further detail than that provided by the series of AHE. Some analysts go deeper into the data and try to bypass the skew introduced by the substitution of baby boomers by millennials. Regardless of generational subtleties, the fact is that technological disruption, and the increasingly oligopolistic structure of the supply side, push wages down. Real Wages are still down: placed at the bargaining table, I see no clout on the worker’s hand. The Deutsche Bank chart below says it all. And the nightmare is not over: robotics will deteriorate workers’ position further. Still, I have that uneasy feeling about workers being against the wall when trying to make ends meet: we have to allow workers to survive!
  • The cost of shelter is always a vital component of the cost of living. Low-interest rates together with abundant liquidity ensure a terrible outcome on this front. The pressure on the working population is becoming unbearable. It’s Ok if Tesla common stock surges tenfold, but we need houses for people to live in -at affordable prices- or we have to increase salaries. Likely the latter, unless a bust ends the cycle.
  • Healthcare costs are also a one-way bet. As we increase life expectancy and the population ages, they are going parabolic. Add some further technological accomplishments (with their associated costs) in the diagnostics area, and the results are unpalatable. We will not die of old age: we will die when we run out of money to support life extension with expensive medical or surgical treatments. Think the latest immunotherapy oriented cancer-fighting drugs. Healthcare costs absorb an increasingly higher portion of Disposable Income. And Disposable Income is not doing all that well to be able to absorb them (chart via zerohedge). That pressures salaries (and entitlements) upwards as well. 
  • Regulatory and tax-related costs are in a relentless uptrend. Social expenditure is a near perpetual bull market. Up since 1980 from 13% to 20% of GDP in the US, or from 15% to 25% in Spain (as a proxy for entitlement land -Europe). Of course, we can deficit-finance those payments, but for how long? Taxes are unlikely to ebb (Trumpian stupidities aside). Regulations suffocate entrepreneurs everywhere, and the trend is terrible save for, something that Trump got right, the US. And I doubt that reverse trend is going to last. For that matter, I doubt Trump is going to last.
  • Productivity growth can be split into three major components: economies of scale, technological progress, or worker skills. Economies of scale are unlikely to be the primary driver for productivity in the future: final sales growth does not look great. Aggregate demand is dead, and forceful population growth as well. Unfortunately, educational levels do not bode well for skill related productivity enhancements to fill the gap. Education is a must fix. That leaves technology as the main contributor to supply-side efficiency improvements. Whatever’s left of workers’ bargaining power is likely to erode pretty soon. Robots are the new “Chinese” workers crowding out the developed and emerging market world workers. The winner (the FAANG du jour) takes it all. An ominous trend for those of us who think inequality will take us all the way to a nuclear war -if we don’t fix it soon.

Whatever happens to wages is critical. If they languish, Disposable Income of the lower percentiles of the population will not grow. We will have no inflation, and the easy money will go on because Central Banks have no alternative policy available. Low inflation is the great enabler of ultra-lax monetary policies in the global village.

On the other side, If wages begin to recover some lost ground, we will see an inflation uptick and, POMO desks allowing, yields will move up -particularly near the long end of the curve. That would be key for the market. If the long bond goes, so does the stock market. Not less because an inflationary uptick would tie CBs’ hands: additional liquidity would be difficult for them to justify (at least in principle -you never know what these Keynesians at the politburos might end up doing.

The paradoxes of life. CBs want the very inflation that would tie their hands and probably end the cycle. Why? They need it to alleviate debt loads and, not least, their Phillips curve infatuated egos. As the cycle extends contradictions mount: we need asset price booms, but they should exclude home prices, and we need inflation -but not too much of it. They want just the right amount of inflation: a goldilocks inflation (or a fake number to resemble it).

The second horse is ridden by famine. In economic terms, a recession

A Recession has two possible drivers. One hasn’t worked for decades: Aggregate Demand restraint. This driver ought to be the natural cause of a recession. Malinvestments,  inequality, and at times excessive taxation and the inefficiencies it generates, should impact Aggregate Demand. Without external support (more money on the cheap, and additional credit growth)  the weakness in Aggregate demand induces a contraction in the economy. Malinvestments that generate no return decrease the buying capacity in the Walrasian circular flow. Inequality kills the propensity to consume while accumulating wealth where it is not needed to stimulate our economy. High taxes suppress entrepreneurial stimulus and allow for wasteful spending. Now and then, some excesses not well dealt with in the natural Schumpeterian process should precipitate a contraction. Without a previous credit boom, they should be garden variety -and thus unthreatening to bank balance sheets or global asset prices.

Recent history proves that monetary tightening (that makes itself explicit via yield curve inversion) is the most frequent cause of recession -ever since we started the fiat money regime with Richard Nixon. Monetary booms and busts are the nearly exclusive cause of recession for the last almost fifty years. People are now worried about an interest rate increase induced recession in the US. They see an imminent inversion of the curve. Maybe. But I don’t see it as a likely event. The Fed will stop well short of that. They will tighten as much as they dare -but always on their toes to avoid inducing a recession. There might be a policy mistake, but I would not place too many odds in that particular basket.

In the long run, unless the working population Disposable Income grows (average and median statistical data for the population are becoming useless criteria), Aggregate Demand will be more and more costly to activate. We will need more credit and deficit spending to help it support the economy. Only pushing the monetary pedal to the metal helps alleviate the natural stagnation of Aggregate Demand. We not only need a neutral monetary policy to avoid a monetarily induced recession: we need constant monetary stimulation to compensate the inefficiencies of a global business model that generates Disposable income stagnation (or even decrease) on a per capita basis.

Absent inflation, monetary pumping can go on, offset Aggregate Demand weakness, and effectively impede recessions.  A recession might take a long time to come in that context. But when it comes it will not be benign. We have to hope it will be something for our grandchildren to take care of.

The third horse brings war. In economic terms a revolutionary reset of the business model -and a wealth redistribution Robin Hood style.

Inequality is like hypertension. It kills slowly, silently. To be fair, we do try to fight it to an extent. We use taxes and progressive rates to that effect. We also use subsidies and entitlements never ending a continuous increase in the size of the state. But we fail to dent the inequality progression meaningfully.

It is not about improving the redistribution of rent and wealth. Redistribution is costly, prone to unfair practices and corruption, and hinders wealth generation. It is about setting up the right system with the right incentives and level playing grounds that enable a fair bargaining process between the different actors involved. Right now, savers and workers are being sacrificed in the altar of Banks and NFC. Savers and workers are the backbones of this society, and of the demand side of the economic system. Unless we strive to ensure they get a fair deal, the FAANGS and Golmanites will take the lion share of it all. The global economy will depend on monetary stimulus. And the social price to pay for inequality is worse: nuclear!

We are in a lose-lose situation. If we fail to allocate a higher portion of GDP to savers (higher interest rates) and workers (higher wages), inequality will mount, aggregate demand will suffer, and social stability will deteriorate. If we do manage to give workers a more significant share of the pie, inflation and or company profits will suffer. In the short term, low wage growth and low inflation sustain this monetary cycle, but in the long run, we all end up killing each other. Korea, Syria, Saudi Arabia -or some different tension to flare up at some point- will end all of this.

If we want peace to last, we must bridge the distance between the haves and the have-nots, but whether we do or not, at some point equity prices will suffer. If we reallocate GDP slices accrued to the different players, wage and interest costs take a hit, and margins deteriorate. Thankfully we should get a boost from a long-awaited sales increase to offset some of the margin pain. If we don’t, a war will wipe out profits anyway. You cannot remain long current profit margins: one way or another they are unsustainable! It is essential to value stocks using margin adjusted PEs. Very few do so.

The fourth horseman of the apocalypse is death. A massive plunge in asset values that would reset the whole economic system -effectively bankrupting a substantial portion of economic players.

In this scenario, it is the financial economy that pulls the plug. It can happen in two straightforward ways. Insufficient liquidity to keep asset values moving north, or a credit event or that ends the paradigm that our current planetary debt pile of 216 trillion can be booked at nominal value (creditwise) because it will be paid sometime in the future.

Naturally, CBs are well aware of this. They will maneuver to preclude credit events and ensure enough liquidity is provided to financial assets to keep them levitating. A mistake is also possible here -but unlikely. A sharp reduction in liquidity generation is scheduled, but it is a tentative monthly target, to be adjusted to whatever event might put the bubbles at risk.

I find it difficult to believe that serious mistakes will be made by policymakers. We all know what’s at stake. They will be very careful. An excessive liquidity withdrawal or a credit event that question the balance sheet valuation of the debt pile is an unlikely black swan.

We have no real financial markets finding effective clearing prices for securities. That is a severe risk not to forget. But CB’s are also taking care of this. Regarding market functioning, POMO desks make sure that volatility is contained and market action is “orderly” in a way that precludes real price discovery and perpetuates central bank fixed pricing. They are ultra-cautious about a financial rout. It might happen, but they will do their best to suppress volatility and price discovery. And it ought to be enough: the BOJ has been able to keep the 10-year bond in a yield range of 0 to 0,10% for what seems an eternity. Sudden death is low odds.

A revolutionary period or even open war is the most likely outcome.

CBs are doing a good job to preserve this scam. They have it all covered. But something’s gotta give.

  • One plausible scenario is that of wages and inflation rising meaningfully. Let’s remember though, that cost inflation largely depends on wage increases being transformed into incremental unit labor costs because of weak productivity data. In this scenario, Even if it happens, we do not know if the sell-off would take place in bonds if inflationary expectations surge, or it is in equity if Corporates are unable to pass on the cost increases, and margins bear the brunt of the cost increase. Risk parity strategies would spread the disease. Any case, inflation is a game changer.
  • It is also plausible that total wages rise significantly,  but productivity offsets the increase keeping unit labor costs contained and preventing inflation. It is unlikely though because it is the macro wage figures that count -and the only improvements in productivity I see are technology driven, and the salary increase for some is compensated by others running out of a job. Job automation affects unit labor costs but does not allow for a rise in total wages and thus for a stable non-subsidized aggregate demand.
  • If total wages do not grow, profit margins are protected and monetary pumping keeps things going until a revolution ends it all.  I hate to say so, but everything points in that direction. History is not kind to other non-disruptive alternatives. The establishment will not let go peacefully. It never does.

Financially speaking, the best risk-adjusted probability is playing the game alongside the Central Banks. Or at least standing aside. That is where I sit as I write this post. I find myself unable to join the party. A party consisting in a game of bluff in which we all know that none of the quotes is real, but is likely to remain where it is because the current establishment works to perpetuate price levels -with high chances of succeeding for a long time. Not forever: only for a time as long as the have-nots decide to comply with the system’s rules. I hope they are very patient.

That nagging feeling of impending doom.

I can’t help it. The pervasive feeling of doom, I mean. Not that I should try to stop it: you must embrace that sentiment today. In the midst of a noisy, chaotic environment it is the only certain truth. Like in most pre-revolutionary times, our current situation is mostly made up of lies, lie-statistics and monopoly money aplenty.

Nevertheless, I do my best to remain optimistic. I have always considered myself a cheery individual trying to help build a better world -and make some money for my sail racing needs in the meantime. But it takes an increasingly vigorous effort to remain that way when you feel like in a financial death corridor -waiting for the hangman to appear any day. Reality is there for you to see. You can’t help casting a glance now and then. And it is indeed sobering.

We all know that the real economy is only hitting the apparently right numbers because of the continuous printing and credit aggregate increases (direct credit to consumers, or indirect credit using marginal sovereign credit and then entitlements paid out by those sovereigns). The next two charts by 720 global are very, very explicit -and fully back my previous assertion. Take your time with them.

The first chart shows why GDP growth of any kind fails to ignite aggregate demand moves. Fixing inequality in Disposable Income generation is not only a moral imperative. We need to do so to get the Walrasian equilibrium working again. This business model will not generate sustainable growth if it can’t generate sustainable aggregate demand.

But wait, if that first chart was appalling (growth is impossible), the second graph is shocking. It shows the precarious health of US aggregate demand after more than a decade of daunting inequality. We’re pondering US data, but figures are worse in entitlement land -Europe. Much worse.

The Walrasian equilibrium is already broken beyond non-disruptive repair. The system only works because CB’s inject external money or fresh credit (indirectly via the fractional banking system) on a daily basis. Supply no longer generates its own demand. Aggregate demand is markedly artificial. Nearly 50% of consumption is financed, not by supply-side generated disposable income, but by credit or entitlements. Immigrants unsurprisingly want to share the entitlement pie. It is a consequence of the entitlement-driven, aggregate demand led, economic model. A self-reinforcing negative loop of entitlement and credit led growth.

Things can get worse -and they sure will. Can you imagine the impact on aggregate demand of having to reduce pensions sometime in the not too distant future (to preclude state bankruptcies)? Just ask Greece how it felt. The developed world GDP will collapse. We survive because we go further in debt, rob savers of their income, curtail savings (never mind the funding disaster of most pension funds, private or public), and, not to forget, print. We print like there is no tomorrow. Fiat money debasement is the only reason for the real economy to keep chugging along. It is understandable that people are unable to see this. What’s surprising about it is that the standard mainstream economist is unable as well. They don’t want to see it. The establishment pays them well not to do so. Peak blindness is that of those who do not want to see.

And what do we get for all this artificial, unsustainable stimulus? Not much growth, or population satisfaction I’m afraid. To add to our woes, the ratio of money growth to economic activity keeps deteriorating. We need more and more monetary stimulus just to remain afloat. Jeffrey Snider keeps editing a chart that saves a thousand words.

Things are not better in the financial world. We are aware that financial market pricing is the result of a sophisticated fabrication process sponsored by global Central Banks. Everything is fake, market functioning is rigged, and fiat money is no longer a stable valuation tool for assets. Bitcoin and gold are in my view no robust, foolproof alternatives. We even know that our current itinerary is a direct course to economic hell: we cannot keep growing on new credit and freshly minted money, forever. But we like to see the sunny side of things: we feel that there might be some time left to enjoy. Like Saint Augustine, we plan to be chaste but not yet: lets print just a little more. Bull markets are adorable, aren’t they?

We pretend not to care much while listening to the Titanic orchestra in full splendor, but in truth we do. Jobs and pensions are a permanent concern to all. War to some of us. Many can’t sleep when they consider portfolio risks: put me in that lot. Only ETF and long-only fund managers can afford some decent sleep. They don’t care when this ends; they just have to keep a steady portfolio going. Easy for ETF managers, difficult for the long only’s, but nowhere near impossible. Unfortunately, timing Armaggedon is. The odds are stacked against you even if it is not a matter of “if” but only of “when”.

I keep on reading everything decent I can put my hands onto. We all sound like a broken record to some extent. Tell me the author and I can anticipate the content. Some insist in outlining, with surgical precision, the valuation case against financial markets at current levels (exquisite Hussman, a must read). His table with correlations for the different valuation parameters is excellent, despite underestimating the high validity of the Fed model (sarcasm alert). Valuations are atrocious.Other authors delve into the absurd real interest rate level suggesting the fixed income market is out of whack. Historical charts prove current negative real rates are incompatible with 2017 growth levels -however brittle that monetarily induced growth might be. I hand-picked one BlackRock chart for that end. There are lots more proving the same insanity. It’s just that aggregate demand is so sick that even this crazy monetary environment consistently fails to ignite severe inflation. And the money printing process feeds back on itself.

Both bonds and equities are a bubble. The mother of all bubbles if you consider the chart underneath (via zerohedge). Of course, there is always an alternative read to events. Maybe we have all been so smart that we have achieved the highest wealth to income ratio in history in just ten years. We have to thank Paul and Ben for that. Do we?Every single asset price is bubbly -unless you consider the currency debasement in the ROI calculations. Maybe your expected return is zero in real inflationary adjusted terms, but it pays to hold that asset if you know the real economic value of the currency (GDP/monetary base) is going down close to ten percent yearly (Japan, Europe 2016). The fact that goods and services inflation is contained helps hide the colossal debasement in the value of fiat in economic flow terms. Inflation is not the way to measure the value of money if we want to be coherent. Valuing wealth is 6.5 times more important than evaluating disposable income -according to the chart above.

A couple of pundits (more than two in Fedspeak), have brought back the goods and services pricing debate. They have a point. Inflation appears to be inching back after literally dying only a few months ago. Maybe it wasn’t as dead as I thought. Perhaps Yellen was right for once. The implications of a surge in inflation would be huuuge! Can we still generate inflation -regardless of the chronic state of decay of aggregate demand? If you want to delay chasteness, Saint Augustine style, we’d better not. If rates turn loose … that’s a game changer.

CBs should be careful about what they wish. A rapid rise in rates would wreak havoc in financial market pricing. The desperate search for yield has generated a 1.4 trillion short of volatility worldwide -according to Cole at Artemis. Part of that is an explicit volatility short (gamma short of option selling), and the rest is an implicit short. Investors unknowingly engineer strategies that are naturally exposed to the same risks as a short option portfolio.

While the situation is calm on the outside, the number of critical variables keeps growing. We have long been unable to afford a recession to uphold the debt sustainability paradigm. And we’ve had to be careful about interest rises and the increase in the cost of rolling over the debt pile for some time now. Now we have to worry about earnings leverage as well, as Corporates have overplayed the buyback engineering option to keeps eps growing (in a context where revenue is not). Lastly, in the last twist of events, we have to be terrified about a possible unwinding of the short volatility trade or the possible selling avalanche of the risk parity strategies if the VIX or bond volatility spike. Do you still think nothing will go wrong?

In the meantime, everything is awesome; we macro fund managers and other hedgies have all bought ourselves a beautiful Japanese sword. We will all die with dignity -like the last samurai. Matter of factly writing, before I forget, Kyle Bass is engaged in a new country short, Italy, after getting killed in China by the top manipulator ever: the PBOC. By the way, he is fundamentally right regarding both China and Italy -but I don’t think that’s relevant to his final fate. The PBOC and the ECB are.

The real question is: does all this matter at all? Sabre-rattling, stratospheric valuation, the huge volatility short, bankrupt banking systems, hidden contingencies (future pension and subsidy discounted value -never mind the rate), increasingly subsidized aggregate demand, and daunting inequality?

Let’s be realistic: it does not. For as long as we can keep growing money and credit aggregates at no inflationary or socially disruptive cost, the show will go on. Bill Gross dubbed the ongoing process as “writing checks for free”, and that adequately describes the ultimate functionality of what we are doing.

We have all seen this game being played before, but not on a planetary basis. Charles Ponzi invented the game -and now it is a necessary exercise for money managers. Ignominy and final harakiri are your destiny if you are left out. Full Armaggedon someday if you play ETF investing.

All in all, it reminds me of “Le Choix de Sophie”.  Less dramatic, for sure, but essentially the same kind of insurmountable choice. I can’t help that deeply melancholic feeling when listening to the song. It helps prepare for the ultimate harakiri moment for money managers -when bubble blowing goes eternal, and we have become entirely obsolete. Not that far away, I fear.

Regardless, I’ll keep waiting: the law of gravity will reassert itself at some point. If it can’t go on forever, it’s going to stop. I know it’s asking too much, but we need the patience of the fisherman and the resilience of Nelson Mandela. Will God provide?

Catalonian Intifada (but no violence please).

Liberalism knows no conquests, no annexations; just as it is indifferent towards the state itself, so the problem of the size of the state is unimportant to it. It forces no one against his will into the structure of the state. (…)

State practice has gradually perverted the pacifistic nationality principle of liberalism into its opposite, into the militant, imperialistic nationality principle of oppression. It has set up a new ideal that claims a value of its own, that of the sheer numerical size of the nation. (…)

For a long time nations have been regarded as unchanging categories, and it has not been noticed that peoples and languages are subject to very great changes in the course of history. (…) For an individual, belonging to a nation is no unchangeable characteristic. One can come closer to one’s nation or become alienated from it; one can even leave it entirely and exchange it for another. (…)

Democracy is self-determination, self-government, self-rule. In a democracy, too, the citizen submits to laws and obeys state authorities and civil servants. But the laws were enacted with his concurrence; the bearers of official power got into office with his indirect or direct concurrence. The laws can be repealed or amended, officeholders can be removed, if the majority of the citizens so wishes. That is the essence of democracy; that is why the citizens in a democracy feel free.

Nation and State. Ludwig Von Mises, 1919 (emphasis mine).

Sometimes, to anticipate what your view is going to be on a subject, you just have to listen to other people’s beliefs. When I hear Macron (the paradigmatic European imperialist), Juncker (the self-declared political liar), Trump (top presidential moron in history), or Mariano “Nicolas” Rajoy, not to mention smarty pants Soraya (Spanish VP), all sustaining the same side of the contention … I know where I stand: 99.9% of the time I am going to take the opposite view. On virtually any philosophical or sociological issue: from drinking to sex, life, love or death.

Lots of people ask me how come I became a Catalan nationalist (see “Freedom for Catalonia”). I have not. I am not a nationalist. I am a liberal, and I have long endorsed the supremacy of the Austrian economist’s view of the world. Almost by definition, I happen to agree with Ludwig Von Mises most of the time. So it is not an issue of proclaiming the superiority of the Arian (Catalonian) race or any other, but a matter of profound principles.

To keep it short, I stand for most, if not all, separatist movements based on the principle of self-determination. Provided a majority backs that option (something evident at this point in Catalonia, but not the case just a year ago).

I think the paragraphs I have quoted sum it all up:

  • Freedom and liberalism come before a state-size desideratum. They are superior principles. When in conflict always opt for human rights. Freedom as a quest still beats the desire for wealth -or the cowardly addiction to pragmatism now prevalent. If we concede to state needs above individual rights, it is the beginning of the end.
  • There is no democracy without self-determination. The first and most critical vote for a democratic society must help determine what laws people want to submit to. Choosing their nation-state is the reason to be able to demand those citizens comply with that nation’s regulations. The French and Palestinians did not opt for Petain’s Vichy regime or the Israelian dominance. You could not expect them to obey the law if they did not choose it. We have rejected Spanish law as explicitly as we possibly could -in extraordinarily repressive circumstances (Soraya’s police corps is even harsher than Maduro’s when playing innocent population’s repression). It is not our natural law anymore. It can’t be unless a majority says so.
  • The ideal state-size is not an absolute concept. Even if it was, nations are not unchanging categories because people, culture, ideas, and languages change. And it is best if they continue to do so. 
    • The desirable State size has evolved through history, much like the perfect, iconic female body is not what it was like when Rubens was painting.  There is no such thing as a “perfect-size” for anything. Rubens liked them fat, and now we look at 90-60-90 centimeters as the perceived feminine perfection. There are no ideal measures for men either (well, admittedly, size seems to matter to ladies). Okay. No kidding now: medieval times brought the supremacy of the city-state and it is only in the 20th-century that the desire for huge sovereigns is a prevalent call (conveniently suggested by interested elites). Why is forty million pax a better size than six million?
    • It is radically false to suggest that downsizing countries runs against the sign of the times. I respect that point of view -but it is wrong! I have no doubts that history will confirm this as the appropriate view. Certain situations may make it best for sovereigns to grow in size and reduce in number. At other times it might be the other way around. I strongly suggest smaller sovereigns and more coordination instead of subordination to supranational organizations. Think about it. It is not suitable for Juncker, Mariano-Nicolas, and friends: it is probably right for you!
    • Even if a state size consensus can be traced to a specific time frame in history, at that particular time, there will always be different views on the ideal size for countries. The Austrian school has long advocated that small is better for sovereigns. A Keynesian establishment mandated picture would be just the opposite. One must be right, but the other proposal assuredly is not: let people judge for themselves! The “one size fits all” category is disgusting for nearly everything, above all, thinking.
  • Law and justice are not the same notions. Unfair laws abound. Sometimes determining fairness can be tricky and fickle. But in some cases, it is pretty apparent. It is not a law but a swindle when they take at least five to seven percent of your GDP yearly, to subsidize the south, and that goes on for forty years with no tangible results. It is not a fair law when it says that a Catalan has to be taxed and contribute to other region’s welfare in hugely different terms to the contribution from the Basque region. In fact, it is not constitutional because it discriminates different regions within the same country. Of course, it would be hopeless to bring that up in our politically designated Constitutional Court. Montesquieu never lived in Spain. The ruling party handpicks the judiciary in true Erdogan style: no dissidents allowed.
  • Law enforcement is based on two principles. Democracy, and there is no democracy without self-determination. And Fairness: there is no fairness when it discriminates between identical regions. If the law is not democratic (it has been imposed by a state that the majority of the population despises), and or it is notoriously unfair, you have “the moral obligation to disobey” (MLK)

Independence is a marathon, not a sprint.

In the short run, they call the shots. In the long term, we win. Like the French would say, “patientez”, but keep fighting oppression. It is Spanish oppression today. Some other country might be coming up on your radar screen as soon as tomorrow. On any issue confronting civil rights against legal, establishment-convenient, rulings.

Maybe they won’t allow you to kneel to protest when listening to the national anthem. Maybe it will be compulsory to shout “God save the King”, or suggest he is a smart and nice guy. It might be your country next: beware putting state desires before individual rights!

Europe is in this case, as in many other fields, a disgrace. I feel ashamed: I’d rather be ruled by Mugabwe or Erdogan -I would be better off with my civil rights. Great Britain did the right thing. Brexit will come at a hefty price -but jumping the European ship is worth every penny. If I were Theresa May I would not pay them one euro unless the negotiate on a peer to peer basis. No more European arrogance!

I always disagree with Keynes: the long run matters most. If you are economically efficient, you survive corporate moves changing a couple of things. Sovereigns and Corporations are all the same interest. Scrapping corporate tax and labor social security costs for an aggregate demand tax instead is the first hit. A lot more is possible if you have the right productive culture: like ours. The one Spain has been feasting on for decades.

We have to ignore threats and pragmatism and never accept to be subjugated. Freedom comes first. Without freedom, the rest doesn’t matter. A country that rejects fundamental civil rights is hardly your best option in a crazy, unfair world. Catalonian intifada!

 

When they go low, we must go high.

Most likely, history will preserve Michelle Obama’s famous quote for a long time. Wise and to the point, the message neatly underlined the meanness of some press commentaries about her children. There is always a moment in our lives when we are under pressure -and have to choose between going low (the statistically “normal” choice), or going high. That applies to everybody, not only journalists and political commentators. Good nature, integrity, and dignity, are in short supply. Always have been.

And, talking ethics, what Central Banks have done to us all might be as legal as those press clips -but it is certainly immoral and reckless as well. Consequently, their politburo chairs still hold the “potestas” but have for certain lost the “auctoritas” (much like Mariano “Nicolas” Rajoy in Spain). I know some are still in the stages of adoration of the Central Bankers that supposedly saved the world. No other than Kevin Warsh opines that Ben Bernanke “stood tall” in the terrible days of the GFC. Wow! Does he really think so, or is he just trying to mend fences with his former boss?

I think he went lower and lower during his tenure as chairman of the FED. And he was not alone in his quest for the lows (Dragui flies lower yet: sucks junk sovereign debt into his -our- balance sheet). You have to concede to the fact that only one of them has lived up to what I would depict as “decent expectations” for their performance at the job. Bastiat or Hayek, if alive, would have confronted them openly. Immanuel Kant would have rated their conduct as not coming anywhere near a categorical imperative. Only the moral relativism now in vogue might allow for a favorable judgment of their misconduct.

Draghi’s well known smug smile. Not easy to go much lower than that. The establishment adores him.

You never read enough, and thus there is always the chance you are missing somebody out. Volcker is the only Central Banker of the fiat money era I can recall as really standing tall. His solitude goes a long way to prove that the fiat money system with fractional banking backed by a last resort central banker to bail them out when required, is notoriously wrong. It has to be when you observe that only one of them Central Bankers preserved the value of money decently -and precluded inordinate financial bubbles. As Warren Buffet would say, if the business model is sound it shouldn’t take an exceptionally able individual to run it.

Reality always sinks in.

Most economists are finally coming to terms with this fact -after a never-ending love story with Keynesianism. Passionate sex helped prolong the ecstasy. Fast forward and not a day passes without reading some pundit expressing an understanding of what happened to financial asset prices over the last decade and well before that. Even the Government Sachs people are worried and calling for caution. About time! Hayek would be pleased to see some wisdom finally creeping in.

“We shall not grow wiser before we learn that much that we have done was very foolish.”

Understanding our past foolishness is then a prerequisite to beginning the process to fix what hasn’t worked. Fiat money -with no explicit limits to CB balance sheet size- is always going to end up promoting boom and bust cycles. Human nature ain’t that reliable. Sure enough, even though “theory” is not always the same as practice, this statement is supported by a long series of arrogant and clientelist Central Bankers that knowingly allowed this to happen. They will do it again unless we stop the printing by law. We need stable money and stable credit aggregates to move forward -even if that requires a bust of the everything bubble now upholding the show.

We will pay dearly for this last “everything bubble”: the die is cast. Regardless, as Michelle said, we have to go high and let history do the judgment. It is not our job to judge. Sometimes you have to sit back and realize that our mandate is not to conduct or evaluate monetary policy -however glaringly wrong or “low” minded it may be-, but try to make money while preserving the value of capital.

Investing strategically in this context is a fool’s errand. Money is no longer a stable unit of value.

The problem with trying to make money (the honest way) in financial markets, is that investing is now a rigged game. You can’t play monopoly and expect to win consistently when one of the players controls the bank and can print money and manipulate rates at will. Ask most -if not all- macro hedge fund managers. If one player controls the value of money, it isn’t a game any longer: it’s a scam. Monopoly is the only game we investors can play. So we buy and sell stuff without knowing to what extent money is going to come flowing into the game or vice-versa (if QT survives the first quarter with a mostly symbolic balance sheet reduction).

Valuations are useless because the value of the units we use to value is subject to massive changes. I don’t care if one dollar buys the same amount of goods it did a year ago (if it does, I am not that certain that inflation figures are right). It is the total stock of minted dollars, relative to the size of the economy and real accumulated savings, that counts. Just think about what it would be like to buy equity in a company that can, on a daily basis, increase (or reduce) the amount of outstanding common stock. And markedly so. You can estimate the enterprise value, but you never know the value per share. Buy-backs should be illegal unless you are going private. Money printing as well. They wreck the game.

In the end, it all amounts to finding out how much they are going to print or tighten. The valuation of the currency unit used to measure value is a lot more important than the valuation of the financial asset itself. Critically, the financial value of a stock of euros equivalent to 20% of GDP is not even comparable to the value of the euro if the ECB has doubled the monetary base. Pure mathematics: a currency bill is a credit on a portion of the value of the underlying stream of assets, goods, and services. A larger monetary base dilutes the value (inflation or not). It is as simple as that.

Global socioeconomic model is broken beyond repair. Winner takes it all.

Recovery from the lows of the GFC looks great on the surface. But

  • Only if you look at it in nominal terms. If you factor currency debasement into the equation, the numbers are strikingly different. We have not recovered if we use real inflation figures and adapt GDP correspondingly. Less so if we consider the portion of debt-financed GDP. It’s easy to keep up GDP if we subsidize consumption with debt-financed subsidies. Only non deficit-financed GDP should be included in official statistics for growth.
  • The now prevalent “winner takes it all” trend is morphing this world into an oligopoly of states and corporations. Small countries are prohibited (funnily enough those that remain are doing exceptionally well though). Companies have become mastodontic and pay fewer and fewer taxes with every year that passes -abusing states and population with government complicity. And Central Bankers’ as well.

The average Joe is on the hook for debt and subsidies he desperately needs to make ends meet. Financial serfdom ensures his reluctant acceptance of government and corporate interests. This will not end well.

But it’s a long wait for the revolution.

Yes, I am fed up with the situation. I don’t trust the current global business model -and that puts me off even more than high valuations. High valuations are sometimes the price to pay to join an awesome party. Let’s go as far as even forgetting their present stratospheric level. Is the current state of affairs remarkable enough to justify euphoria?

When I see how productivity, natality, life expectancy, debt, contingency provisioning (Chicago style), inequality, geostrategic tensions, etc. are behaving, it gives me the creeps. I can compare my strategic thinking process to considering investing in Tesla common stock.

Tesla has become a cult. Not just the cars but the shares too. Short term it looks great. Gorgeous cars and the kind of product addiction Jobs was able to generate a decade ago. Long-term, my case is not against egregious valuation, but against the business model itself. I do not see Tesla competing and surviving the fight with the established large automakers. They will catch up and crucify Tesla. Bankruptcy or a sale is the long-term outlook in my view.

Investing at current levels is the same thing. It is not only that valuations are wrong. It’s the social and economic model that’s broken. Markets will follow with a long lag induced by ETF investing and the desperate quest for yield. Pension funds and people close to retirement need the income and will buy anything to survive. I have posted this chart before: still, look at what an investor stampede for yield looks like.

The bubble is seemingly unstoppable: the stock of real savings needs the yield (pension funds need 7% yearly!), and they will spare no risks to achieve their targets. Accordingly, this period of decadence is taking ages to crystallize into a new world order. The transition will not be pleasant to humankind. I do hope our grandchildren see better times.

We have to wait with the patience of the fisherman. Change is coming, and asset prices will plunge. We don’t know when and we don’t know if it will be in real or nominal terms. We will have to adapt as it goes. We live interesting times.

 

Freedom for Catalonia.

“An unjust law is itself a species of violence. Arrest for its breach is more so.” 

One has a moral responsibility to disobey unjust laws.” 

Mahatma Gandhi / Martin Luther King Jr.

We Catalans want to vote -and break free as well. No decent state can impose its sovereignty on citizens that reject it. At the very least, people have to be able to vote with their feet. The principle of self-determination is a cornerstone of international law. Recently it has been watered down to avoid quests for state shattering independence. But it is still the applicable international, and fair, law. We have a human right to vote out.

I am not a nationalist at heart. Not a Catalonian, Spanish or even a European nationalist for that matter. But, just like Brits did, I hope we place dignity and freedom above convenience and comfort. I favor free trade, and a global world, but from a perspective different to the one that has been used since WW II. Upsizing is wrong. We need smaller units in the future. Smaller Sovereigns and smaller Corporations. Small is beautiful, and “small” is what we should target as a critical methodology to clean up this global mess. My linked thoughts are dated October 2014 -long before this Catalonian independence issue climaxed.

Brits opted out of bigness and bureaucracy. We Catalans are about to choose out of hubris and financial repression. They yearly take away between five and seven percent of our GDP -final figures depending on who does the math. Unsustainable for any country or community when using IMF criteria (and uncommon sense). Greeks were unable to dispose of their debt servitude at their time, and the cost of their public debt is well below that level. But others (or even the Greeks later on) will follow. You can count on that. Is Italeave (the euro) next?

When I read that we have to punish Britain or Catalonia for opting or wanting out, it reminds me of some sage advice my father gave me when I was young. Capitalism and Communism could both be right, but both have intrinsic problems -he said. The difference between them is that in the former they have to keep immigrants out, while communists have to build walls to keep their people inside. What is your choice?

If the EEC or Spain had done their homework correctly, nobody would be voting out. Even if somebody did, it would not be an ominous precedent but a happy “good riddance to bad rubbish” reaction by the rest. We should always read the symptoms and causes, not the consequences. Killing messengers and dissidents might be emotionally rewarding but makes little, if any, sense. We criminalize “leavers” and forget the people and reasons that make us leave: they are the root of the problem.

Freedom never comes cheap. The establishment always refuses to concede when it affects their wallet or their power. As is always the case, Spaniards despise us but want to stymie our departure. Is it due to to the psychological proximity of love and hate, or is it just shameless selfishness?

Hopefully, we will vote our freedom soon. Economic and social problems will follow -but it pays to put as much distance as possible with Spanish hubris, disdain, and blatant inefficiency. A short-term pain for a long-term gain. Divorce is hopelessly messy. Ask Theresa May.


 

Something’s gotta give

“State meddling has successfully stabilized China’s US$7 trillion stock market by curbing volatility and steering valuations to rational levels.”

China Securities Regulatory Commission. (via zero hedge)

 

Everything is under control. We are entitled to timeless prosperity. Perpetual money printing. Never-ending bullish markets. Infinite credit … Perhaps!

Regardless, when I read the previously quoted official statement, I corroborate not only how dumb the regulators are at times, but more worryingly, how deeply complacent. Not only The Donald brags about his stock market success. Yellen assures us that a new financial crisis is nearly impossible in our lifetimes. Draghi continues to be infinitely pleased with himself and exudes confidence when he talks. They pat each other on the back. Our Gods are feeling good about themselves. Interesting.

Even the people at the Chinese POMO desks are claiming victory. This last statement caught me off guard. You have to be particularly stupid to boast about your proficiency at market manipulation. And these are the great Central Bankers and regulators that will supposedly save the world? One thing I am sure of is that humanity will need a merciful God when this breaks!

In financial markets, as in life, everything only lasts so long. Eternity is, as Kafka said, a long time (surtout vers la fin) and is only applicable to heavenly concepts, Muslim faith or the Buddhist nirvana. To be honest, I even doubt that. According to ordinary mortals like Minsky (and uncommon sense), financial stability breeds instability. Whatever the sell-side or the bulls say, stability and growth cannot be forever extrapolated into the future. At some point, reality rears its ugly head. I’m going to elaborate on the most relevant issue of them all. What catalyst will put an end to this egregious bubble?

Answering that question implies a lengthy reply. First of all, I think we have to exclude some relevant potential factors -borrowing a clinical approach to diagnosing the precise pathology of an ailing patient. You engage in successive diagnostic tests to help discard possibilities -until you focus on the right disease or infection. Hey, I feel like Dr. House!

For starters, I think the traditional catalyst is out. It has always been inflationary pressures that urged rates up, slowed activity, lifted default rates and finally induced a recession when the long end of the curve collapsed and inverted. A bearish steepening and spread increase, followed by a bullish flattening. Things change: we have to rule out inflation as the catalyst for anything nowadays. If a near doubling of petrol prices in a context of synchronized global GDP growth was unable to generate inflation and AHE growth this year, what’s going to get the job done?

Inflation and maybe hyperinflation might very well be the outcome after CBs throw the kitchen sink at the next recession -or financial market collapse. But it will not be the catalyst for anything. A chronically shabby aggregate demand will preclude an unfortunate inflationary behavior acting as the detonator for the next crisis. Inflationary threats will move rates and currency crosses, and maybe alter the social landscape -but are unlikely to bust this bubble.

As usual, some caveats apply. We can’t write-off inflation entirely. I am just excluding the kind of inflation that would pressure CBs to raise rates significantly.

Underground inflation, the one that kills families without showing up too badly in macro data, is alive and well. Think tuition, health care and the other concepts featured in the chart. Similar trends apply outside the US. And it bears remembering that even mild inflation is not without consequences, particularly in a context of stagnant wages. It relentlessly tears up the social fabric of our peaceful coexistence.

Stagnant wages I said. I am understating the problem. Wages are a disaster. Employable workers (reasonably skilled labor excluding drug addicts) are in short supply -and have been for some time. Amazingly though,  it hasn’t moved wage costs upwards. The labor market is increasingly oligopolistic (employers have the upper hand), and secularly weak aggregate demand doesn’t give companies much leeway on the matter.

A second pathology to be ruled out is the traditional, rate hike induced, market bust. CB’s see an overheating and hike rates, even before inflationary pressures (unlikely but possible). The Fed is at it right now, and some pundits worry about the timing. It is not the best of times to lift rates, but I think interest rates will not kill the beast either. No matter how clear they voice their intent to raise rates, remember that any increases have been tagged as “data (market) dependent.”

The market knows that full well -and that is the reason for always confronting Fed dot plots. Market dependency means that they will reverse course if markets tank. That behavior not only backs equity prices but is also vigilant of the steepness and levels of the interest rate curve. It is unlikely that they would tighten enough to generate a sustainable market tantrum. Even if there is a policy error (something likely at some stage), they will bail themselves out lowering rates fast and activating POMO desks.

Third, monetary aggregates are not likely to precipitate a downfall. We all know the Fed is going to take some chips off the table (reduce its balance sheet). Regrettably, they also say that it is all subject to the state of the economy, meaning in reality, that it all depends on how much the market can handle. It makes sense to think that QT will deflate asset prices because QE inflated them. That was indeed my initial line of thinking. But politburos at CBs are not dumb. They will fine tune the withdrawal of liquidity and stop it whenever needed. And they will manipulate prices if they think they must, to prevent any negative wealth effects. I doubt QT will have a long life.

Even if aggregate credit growth stalls on its own, they still control the money supply. We play by their rules, and they manage liquidity (very unfair, I know). Even if they surprisingly opted for fair play from now on, we have to presume they are not stupid enough to prick the bubble because of their own doing.

 

If we leave inflation, a disruptive rate rise, or quantitative tightening out, we are left with only three areas of risk:

 

1.- Debt related risks. China and Europe are the likely candidates for the role played by subprime mortgages in 2007. Student, auto loans or state o municipal bankruptcies are not systemic enough to tilt the apple cart. Ponzi debt can be found everywhere, but China and the European periphery are the weakest real credit scores (forget market manipulated pricing and implied risk measures). High yield and credit-spreads also merit a careful follow-up. It is always the weakest link in the chain that breaks first.

Italy is the obvious candidate but, not to forget, credit spreads are priced for a lot more than perfection. The chart below has gone viral. See the Real Vision version using a “Credit Strategist” chart. 

2.- Geopolitical and social risks. We are all increasingly angry with each other, and social and political tensions keep mounting. War of some kind is no longer a questionable call. Civil unrest and systematic terrorism are already integrated into our life style. Trump and Brexit are sideshows. The tensions between nationalists and globalists are widespread and in reality nothing but the intellectual friction area between the haves and the have-nots. The real underlying battle is wealth distribution.

The particular black swan event to come is unidentifiable in advance but is fast decoloring from black to gray. We don’t know what, where, or when, yet we cannot feign surprise when the next major incident takes place. The substrate of social tensions is volcanic. It’s hard to price tail risks, but it is imperative to do so as they inch towards the center of the distribution -and are becoming relevant enough in number and substance. Zero is the market pricing right now -and it is not difficult to certify that it is wrong. Dangerously wrong.

3. A recession is a given sooner or later. Even without social tensions and within stable markets, it is essential to remember that the business cycle has not been repealed forever. Growth will become elusive at some point. Under the weight of an aging cycle, or the accumulated debt pile sapping growth, and or because of ridiculous productivity figures due to malinvestment and insufficient educational levels (in a context of low population growth). Who knows. But before eternity takes over what’s left of us, even our post-GFC lackluster growth is going to stop.

There’s a fair chance it could come very soon. China should not engage in a new macro boost similar to the 2016 credit surge, once the Communist party meeting this fall is over. But it is a wild card to consider given past decisions. The US is cooling even if I have to admit to some contradictory figures. Some macro aggregates are suggesting a recession might be immediate. A Trumpian reaction of some kind has to be factored in, and it’s not an easy one to anticipate because it won’t be very rational.

Anyway, Real Value-added data doesn’t look good. It measures the economy from the supply side and is a rarely used approach. Nonetheless, it seems a reasonable indicator of an impending recession. Carmaggedon is also there to help (with a significant contribution of autos to US GDP helping make it a relevant happening). Savings have plunged, and consumer credit growth is firmly on the rise again. Do we never learn?

But it could very well be that the recession has to wait till 2018 or even later. Anyway, when it happens, it’s 100% curtains for the bubble. And it is the most likely bubble killer. Just to avoid repeating the same things ad nauseam, I will give you Paul Brodsky’s narrative on why a recession ends it all (emphasis mine).

“Consider that wealth is no longer created from production, but rather from financial pricing models and credit creation, credit that must increase at a parabolic pace and can never be extinguished without substantial output contraction and rising unemployment. (…)

Central bank purchases and government investment have been fabricating output growth and asset gains. Central banks now hold about $19 trillion in assets on their balance sheets, up from almost zero in 2008, and are now 20 percent owners of global assets. (…)

Stocks, bonds and real estate collateralize each other while output growth makes it possible to service debt. (…)

The problem is that there are too few dollars for each claim on dollars (credit). The credit that collateralizes equity cannot be repaid and, if output declines, cannot be serviced without more credit. Equity and credit prices will fall (deflate) in tandem as debt service and repayment declines, unless more dollars are created and floated to asset holders. (…)

The current imbalance separating credit (claims on money) from money itself suggests a doubling, tripling or even quadrupling of the money supply in float (yes, 100, 200 or 300 percent monetary inflation directed towards financial markets). This implies nominal asset prices could rise, but not nearly as much as the purchasing power value of the currency they are denominated in would fall.

We doubt all the new money could be distributed to the investor class and then reinvested back into financial markets, and so we think it is highly likely that nominal equity and debt prices will fall markedly in the future, though we cannot know from what level.

In the meantime …

Last February I wrote that the USD was key .. and got it all wrong. I said:

Unfortunately, notwithstanding the difficulty of getting the dollar right, at this stage, it is a must. It is “the dollar” (and not “the Donald”) that will be the main driver of global financial market developments for the next couple of months -and even well after we transition into a new global economic regime.

I nailed the causality, but despite being aware of the key role of the USD, I got the USD prognosis wrong. The USD depreciated strongly in all pairs (particularly in the EURUSD cross), and consequently, it all went risk-on: equities, currencies, credit spreads, rates, etc. To a stratospheric degree. I have to try again. I was right in linking dollar strength with risk-off, but I made a big mistake because it failed to materialize. Will the dollar recover some strength in the near term?

As I said in February, it is challenging to get the USD right. Technicals suggest that the USD’s demise has been greatly exaggerated. No other than Kit Juckes (Societé Generale), a famous euro bull that proposes a three-year target of 1,30 for the eurusd cross, admits to overdone moves. Capital flows (eurusd vs. capital flows), interest rate differentials (eurusd vs. real yields) and peripheral spreads (eurusd versus bund/bono spread) are the three technical criteria he follows most. Here are his three charts on the issue. They speak for themselves.

 

I entirely agree with his take on the short term/technical situation. His reading on the eurusd rate has been excellent. Long term he is a dollar bear against the euro. Again, all things equal I reluctantly tend to agree. My fundamental discrepancy is that all things will not continue to be equal because the European recovery has been based exclusively on QE and a cheap euro. The periphery is heavily indebted and reliant on capital from abroad. If QE goes, and the euro recovers fair value, the periphery will take it on the chin. That is my reasoning for remaining a long term euro bear. Euro appreciation is unsustainable because it undermines the very reasons that support it.

But please take all of this with a grain of salt. Trump wants a weaker dollar, and bubble preservation requires an easy dollar. Politics will play a relevant role, and it’s hard to anticipate which way things will roll. I’d rather bet the ranch on a Chinese bust next winter, or the fact that the periphery will not survive in a strong euro, post-European-QE world. That, I am 100% sure of. The periphery is an unfixable mess if the ECB does not subsidize the south with new credit, low rates, and a weak euro.

Bond trading is not easier. Not foreseeing a spurt in growth and much less so, stable and healthy growth with associated inflation, it is clear that I am not a bond bear. I do think bonds are also in a bubble. Maybe a more pronounced bubble than equities. But the risk of a flight to safety stampede, and my conviction of meager growth at best (a recession cannot be that far out), effectively impede long bond shorts. Bubbly prices also make me uneasy going long duration. I am caught between a rock and a hard place. Just can’t touch bonds with a reasonable degree of conviction.

If you take a look at the next chart, it shows that low rates can be with us for a long time. Zero credit risk rates (if that concept continues to exist in the future once a couple of sovereigns go under) will remain low for at least the next decade. That is of course unless CBs do something foolish (incrementally stupid) and start a hyperinflationary period as a reaction to the next recession or market fall out.

Equities are the perennial TINA choice I have wrongly eschewed for years now. I am running out of patience (and money) but will still wait for a repricing. It’s tough because now I find myself siding with the billionaire bears club way below the minimum wealth level to join it. Not the best place to be because they have deep pockets and can afford to be wrong (I can’t). But that’s how it turned out -and I’m not going to change my point of view because I ain’t rich enough.

Stan Druckenmiller (May 4th at the Ira Sohn Conference): “Get out of the stock market.”

George Soros (June 9th, as reported in the Wall Street Journal): “The billionaire hedge fund founder and philanthropist recently directed a series of big, bearish investments, according to people close to the matter.”

Carl Icahn (June 9th, on CNBC): “I don’t think you can have (near) zero interest rates for much longer without having these bubbles explode on you” while also saying it’s difficult to assess when exactly that might occur.

Jeff Gundlach (last Friday, in an interview with Reuters): “Sell everything. Nothing here looks good.”

Bill Gross (in his monthly investment letter, released last week): “I don’t like bonds. I don’t like most stocks. I don’t like private equity.”

Nick Colas. Convergex (via ZeroHedge August 2017).

La morte a Venezia.

“A crash occurs because the market has entered an unstable phase, and any small disturbance or process may have triggered the instability. Think of a ruler held up vertically on your finger: This very unstable position will lead eventually to its collapse, as a result of a small (or an absence of adequate) motion of your hand or due to any tiny whiff of air. The collapse is fundamentally due to the unstable position; the instantaneous cause of the collapse is secondary.”

Didier Sornette. Expert at mathematical modeling of periodically collapsing bubbles. (Hat tip: Hussman, Mauldin)

 

“Framed as a financial decision problem, one faces a choice between two scenarios:

1) A small probability of losing all of your money all at once at an undisclosed time in the future.

2) A high probability of gradually losing small amounts over an indefinitely long period of time, keeping in mind that persistent small losses over an indefinite time period could lead to large cumulative losses.”

Aleksandar Kocic. Deutsche Bank derivatives strategist.

I loved “Death in Venice.” Visconti had always appealed to me, but this motion picture was a masterpiece. Characterized by most critics like a movie on homosexuality, to my mind, it is rather a film on the inevitability of physical decay and death. It could very well be an epilog to Hamlet, where both ideas regularly recur in most of the imagery. Whatever we do, decay and death are, like in the delightful pop song, right “there” waiting for you.

More importantly, Death in Venice is a rumination on the weaknesses of mankind -and how vice at times, or just benign neglect towards our conduct, gradually take over many of us (if not all) as we age. And a stunning portrait of the decline and subsequent fall of the then bourgeoisie. Their contribution to society was already waning. For some proof just take a look at the ladies loitering along the Venice Lido with their parasols.

All establishments see an end to their period of dominance. Nobility passed the baton to the bourgeoisie who in turn ceded their power to modern politicians. They finally gave in to the economic establishment represented by banks and multinationals. In the last twist of events, post the GFC, our central bankers are the new deities in town, promoted and conditioned to serve that very establishment. They are living their last days in paradise. History always rhymes.

Life is a business that inevitably ends up filing for bankruptcy. The film overtly transmits that it is the very nature of life that leads to death. But the reality of an end to everything, including long economic cycles, or social models, is sometimes adequately turbocharged by extraordinary events. It is the onset of a cholera epidemic that enhances the perception of decay and death in the film -much like CB largesse and Keynesian ideological support has added grandeur to the debt overhang caused by the profligacy of consumers, sovereigns, and corporates.

Moral standards are always relaxed in periods of social or economic decline. I have absolutely nothing against Gustav von Aschenbach’s (the main character) sexual orientation. But, gay or hetero, it is certainly inappropriate to lavishly consent in sexual desire for a naive young male or female. Your first feeling is that of repudiation. But then, the musical score, identified as the result of his work as a composer (in the original novel the main character is a writer), re-conciliates us with Von Aschenbach. If Mahler’s Adagietto is the result of his work, then maybe we can consent to some moral depravation. Aschenbach is a great artist!

Furthermore, what I like most about the film (music and photography are not to be quickly forgotten either) is the convoluted acceptance of his moral sloppiness and, together with it, the acceptance of his last days as a human being. He has surrendered in life. Some of us wish to die with our boots clean, but not few give up the fight well before that. We should all fight the desire to let go. We should all die with our boots clean. But that is an impossible feat for human kind as a whole. It takes too much courage for the ordinary mortal.

Von Aschenbach has given up fighting and lives his last days -perfectly dressed according to his social status- compelling himself to live his somewhat superficial life style to succeed with Tadzio. He extends and pretends until the very end, attempting in vain a near impossible feat (a relationship with Tadzio). CBs are trying to go further into debt to dilute our global debt pile. Their chances of success are strikingly similar if you read Paul Singer. Do you believe in miracles?

In an unforgettable scene, Aschenbach’s hairdresser applies a generous coat of mascara, and some lipstick, to try to rejuvenate him -and succeeds for a time (same as money printing can make things look better for a while). A perfect description of letting oneself go while appearing not to.

If you have ten minutes to spend, do enjoy this long trailer of the film as a divertissement, while listening to the beautiful melody of Aschenbach’s (in reality Mahler’s fifth symphony) Adagietto.

The developed world is acting very much like Von Aschenbach. We know we are an old society on the verge of substantial change. We are aware that some of our problems are insoluble in the short run. We know inequality is metastatic cancer, and we know that increased debt adds to already morbid obesity. We know we are in the midst of a financial cholera epidemic, but we are tired and feel that we need or even deserve some solace. Kicking the can forward helps. But we need more than that.

Any consolation. Drugs, sex, and rock and roll … or money printing and orgiastic spending like there is no tomorrow -all represented jointly in the film by the fantasies with Tadzio. We know a relationship with Tadzio (or more Keynesian spending) is not the answer to boredom, depression, and senectitude. Who cares; we are tired of the GFC and need an easy way out.

We might not crave for sex with a youngster (hopefully), but we let ourselves go regarding money printing, debt, market manipulation, and bubble blowing. Very much like Venetians were aware of Cholera in 1911, we know this CB Keynesian/Phillips Curve model is going to kill us -but we know we are going to die anyway. So why fight?

The outcome is, don’t we all know, not flirting with Tadzio, but financial genocide once the scam is over. That does not deter us from engaging in wishful thinking while living the Venetian “dolce vita.” If we are going to die, let it be fully indebted and invested. People are not that stupid; they are aware of the inevitability of a bust but, very much like a terminal cancer patient, don’t want to talk about it.

We just want to live whatever might be left. Most are aware by now of the fraudulent nature of current financial markets and the subsequent stratospheric pricing. Nevertheless, that doesn’t impede complacency or neglect to adapt to prominent risks. Recent market moves can be easily dubbed as vicious and nonsensical.

European Bank prices are a case in point -if you look at their efficiency ratios, real NPLs, capital structure (most holders of tier 1 or tier 2 securities are blissfully unaware of the risks involved) or balance sheet sovereign risks. Other absurdities abound. Like Covenant light being the new standard for bonds!

But, of late we got a fresh momentum move to ponder. Let’s comment on the EURUSD rate -it shows the most intense rally in decades. I understand that the dollar was too strong, still, a twelve per cent repricing in six months is far too rich. Ultimately the catalyst was Draghi publicly suggesting that the ECB would tolerate EUR appreciation (the famous eyebrow lifting statement in his press conference). Now, please consider the following facts:

  • We have similar GDP growth in both areas (for the first time in nearly a decade, the Eurozone can match US growth). Not for long. The growth prognosis is being altered as I write by the appreciation of the trade weighted euro. Currency crosses are the dominant factor for growth in a secularly mediocre aggregate demand scenario. We are transferring growth from Europe to the US just as we did the other way around with the EURUSD move from 1,14 to 1,04.
  • A 200+ bps differential in two-year rates and 175 bps in the ten-year. The 5-year rate for Bunds is still negative! Core inflation is similar. Unless the USD depreciates 2% yearly, it pays to hold dollars instead of euros. And you have no peripheral risk (I doubt you can count California’s secessionist ideals as a risk).
  • Europe is printing euros to the tune of 60 billion per month, building the largest CB balance sheet in the world. In the meantime and the US monetary base has been stable for three years now and the FOMC is trying to shrink it. There is an international USD shortage. Euros abound. Supply and demand analysis suggests USD strength save for a significant repositioning (like now).
  • Europe sports the highest entitlement contingencies in the world (with a share of 24% of global GDP, Europe pays out nearly 60% of total global entitlements). No wonder we have an immigration problem!. Even with equivalent debt to GDP ratios, Europe is a lot worse off (entitlement contingencies are staggering), and immigration is a serious, pervasive problem for our intensely “welfared” Europe.
  • And yes, we have a great balance-of-payments, if entire attributable to our northern neighbors -while the south rejects or at least indefinitely postpones economic reform enjoying the ECB monetary largesse and fiscal profligacy in the meantime. Internal and external commercial disequilibrium are chronic, and no improvement is to be expected with actual policies. Bickering between the north and the south will continue for years to come.

Keeping things simple, and with the benefit of hindsight, it is all clear to me. The Donald wanted a stronger euro and a stronger yuan; he twisted enough arms around the world to get both. That’s all folks, think about the efficacy of some Trumpian intimidating handshakes and forget the narratives meant to explain the move. He won the battle, but bullying other countries ain’t going to make America great again. Sadly, that’s what he is best at -and likes to do most. He sees it as bargaining. With a Sicilian flavor, it must be. The fact is that a simple and subtle sales tax would have protected America efficiently against unfair trade practices. No need to make “friends” in Europe or China.

Thank God I saw that train coming, held no unnecessary dollars, and hedged my bond dollar exposure to a degree. I wish I had hedged entirely, but the extent of the landslide (sorry, price slide!) has managed to surprise me again. Momentous moves are becoming not only unpredictable but ubiquitous. This move needs to consolidate but it might continue up to the 1,21 level or more. Yet it is sowing the seeds of its own destruction. If growth stalls in the periphery and that is only a matter of time, we will get a severe down move in the EURUSD again!

Why fight? Why not buy the euro and play the CBs hand and the market momentum! Forget the looming sovereign bankruptcies in the south. Yes, I’d love to consider that thinking inappropriate. But I can’t. It makes some sense to me. Maybe more sense than my investment principles. What’s the use of financial virtue when financial vice gives you the best deals? Sex and hopium come cheap and require minimal effort! Let’s indulge. What if we try the next 500 shades of Grey?

Kocic’s options.-

When you consider that investors need the return, that they have seen dissidents like me chopped into pieces, that CB are thoroughly in control, and that there is no other option left (TINA), you have to understand that, like Von Aschenbach, they reluctantly let themselves go. Kocic’s first option is the choice for most: assuming a low probability of being wiped out -but dancing while the music is still playing. They have been right up to know. Why not for the next year or two? Just load up on a couple of ETFs and hope for the best. Don’t forget your mascara and lipstick before you go, you want to look good at all times -and enjoy sex with Tadzio while it lasts!

I don’t know of anybody who has fully embraced the second option quoted above. Losing money slowly is very painful. It comes close to a Chinese torture. And you never know how long this orgy is going to last. It is discouraging, to say the least. We could have ten years to go!

Most investors try positioning their portfolios along the blurred line between the two options. It makes sense for its practicality but adds little conceptual value. Eclectic solutions sometimes add a new flaw to the ideological extremes they are trying to bridge.

I have tried a third alternative strategy, and it worked nicely since the GFC. Until it didn’t. I tried to game the CBs and did well for a decade -with only 2013 in the red. That is until I unknowingly stepped into a widow maker trade: shorting euro zone banks. I got massacred.

I know that European banks are still a recommendation by some analysts. I just think they do not know what they are talking about. It is not about their P&L account but their balance sheet and their shareholder structure. I don’t care if they make more money for a year or two! But nobody wants to look that deep. This year’s business is a lot better, the curve is steepening a bit, and Europe is out of the woods for good, or so they say. Wishful thinking is prevalent nowadays. God save the Queen!

So I lost big. In fact, it had to happen sometime. You cannot anxiously trade for your return every single year -without participating in the risk party with a stable beta exposure to risk- and expect not to be caught on the wrong foot at some point. Your problem is that wanting to avoid playing the CB game, either you trade markets for a living or you remain out -with a sluggish portfolio and close to inexistent yield. There are no good options left for dissidents!

The trillion dollar question is how long this goes on for. Bubbles always end with a bust -but this time might be different. This bubble has the market vigilantes none of the previous ones had. CBs existed in 2008 and 2000 but were hardly aware of the market risks involved. Market intervention by CBs was rare. Manipulation non-existent.

This time is different. The market scam is very well protected by a praetorian guard of POMO desks at major CBs. I do not see how they are going to lose control unless a recession puts them belly-up. And they can work to prevent excessive economic weakness printing some more, or even stimulating credit growth as needed. Playing against the CBs increasingly looks like a lose-lose proposition in the short run.

Hussman brilliantly summarizes it in the chart above. We are in a log-periodic Bubble with a finite-time singularity ahead. I just can’t see why the singularity is going to take place August 2017 -or any other date for that matter. We are left in the dark and have to patiently wait.

However fed up with this situation, I find myself unable to suggest a viable solution. Most likely it follows that physical decay is becoming a personal reality as well. You can see I don’t try to hide I am feeling “down” right now. But at least I don’t use lipstick or yearn for sex with Tadzio as an escape from my dreary financial day to day existence.

Okay, enough negativism for today. To end on a higher note, let me get my initial philosophical thread back. Believe it or not, this was initially meant to be a frivolous post to be read at the beach. I hope you enjoy it.

 

What makes Yellen so confident in her ability to tighten without disruption?

The latest fad in CentralBankville is market manipulation. It has been the inescapable follow up to a long string of increasingly stimulative monetary policies. Easy money can be traced all the way back to the maestro’s nomination. He began with low rates, then came QE (BOE), even more QE (FED), please take it up to extreme QE (ECB, BOJ), introduce negative nominal rates (Riksbank), then profoundly negative rates (SNB), add some yield curve control (BOJ), and all while increasingly tilting towards “forward guidance” policies. Outright manipulation was, in retrospect, the next obvious step in the Central Bank’s conspicuous seizure of power in the global village. 

Why do I say manipulation? Because it is clear to me that the only difference between intervention and manipulation is communication. CB’s have been increasing their market intervention for the last two decades. So far so good, even if I doubt it’s a healthy habit if we want to continue to pretend that markets ensure the optimum allocation of resources. But post the GFC, and led by Bernanke, they have increasingly switched over to price manipulation.

Only the BOJ continues to intervene in the open as opposed to manipulating. If they want to keep the long bond yield low, they tell market players to expect unlimited buying by the BOJ at a certain level. If they want to support equities, they go on the tape to affirm they are buying ETFs. The rest, with a special mention for Bernanke (reluctantly, his successor as well), and Draghi, have fully embraced the dark side of the force.

Sure enough, manipulation is now a methodology applied regularly at most Central Banks. It gives them a feeling of control, and they are in control! They are pleased with their success. It does help to keep other players in the dark and confuse them with price and volume signals that they perceive as market generated -when they are in fact CB cooked.

All clear then? Nope. In the long run, it ain’t going to cut it either. Manipulation has never been a viable long term strategy, and this time is not different. Manipulation is only feasible at critical turning points, in a context of very easy money. At some point, when easy money ebbs, manipulation will fail, and it is hardly reassuring to see that Yellen is oblivious to the fate that awaits us.

Undisputably though, manipulation is working, for now, therefore helping Yellen, Draghi, Kuroda, and Co feel safe. It is a foolproof medium term strategy -when simultaneously implemented by coordinated Central Banks in the right liquidity environment. And it can wreak havoc within the ranks of the dissidents. Let me disclose that I got severely hit by the surreptitious short squeeze in European Banks post the Italian and Spanish bank bankruptcies of the month of June. I had a very strong short in the Euro Stoxx bank index and was stopped out two weeks ago for the second time in a row this year.

In truth, nothing new under the sun. Preemptive strikes against the possible generation of negative momentum in any of the financial or economic variables they target had already become the norm. I knew they did that in the Eurex market for sovereign bond spreads -but was unaware of the extended scope of their manipulative interventions. They manipulate not only rates but also equities, gold or even commodities when required -with timely and stealthy interventions. Even bank share prices are a target now! POMO desks are all over the place and preemptively strike against possible systemic risks when denoted by price moves of critical assets.

They do it for a substantial reason. Interventions are suddenly not enough if investors are aware of them. They would point their finger at inconsistencies in pricing. So CBs come up with a plausible narrative for a forced market move -and make sure it is attributed to market forces. In this way, they manipulate the variables that they think are essential to generate a guide for investors. They use market price manipulation to induce momentum following thus guiding investors in the “right”, extend and pretend direction. Press narratives make me laugh heartily.

I am near certain that coordinated manipulation is one of the taboo (nobody dares touch the subject) causes of the low VIX numbers. Low realized volatility influences implied volatility in the pricing structure -if sustained long enough. Of late implied volatility, however low, is still above realized volatility! Not to mention the most likely direct manipulation of the VIX that takes place when required. Pavlovian instincts are alive and well, and investors respond instantly to guidance and its enforcement by POMO desks when needed. Manipulated, powerful market moves show the way. The quest for yield ensures the crowd’s approval. Think on your own at your peril. I can attest to that.

I have no doubts that monetary largesse warrants the long term bullish bias in equity markets, but, regardless of the underlying trend, I have never seen a succession of bullish turnarounds (against all technicals) in such reiterated, almost standard fashion. Some major, vertical turnarounds take place when the volume and price activity have signaled a strong down move in most of the time frames. I have been trading global markets for a long, long time; I know what I am talking about! POMO desks prevent any breaks before they could near a systemic risk qualification. BTFDippers are happy to cooperate. ETFs do not leave the party. Stop busting and “fear of missing out” finish the job. POMOs end up making lots of money. Our money. It is a criminal conduct.

Manipulation is also the ultimate cause for the ridiculous pricing of Euro zone banks. I stumbled into a new widow-maker trade and was inevitably stopped out. Not that the situation for European Bank shareholders is not dire. Most of their shares are held by customers that have been told that what they are holding is a near risk-free product. It is vital that they remain oblivious to the risks of their holdings or else an investor stampede would ensue. The ECB can not afford that to happen. Mario is doing whatever it takes once again. I understand the ECB’s concern, but the end never justifies the means.

It is not manipulation that provides the overall bullish impulse. Liquidity and the quest for yield take care of that. Both provide the necessary bullish support for the success of manipulative activity that surged post the first 1Q2016 financial market scare. But even in a bullish market, we should have ups and downs; not everybody is that complacent. The problem is no “downs” are allowed to happen. The Yellen put is “at the money” and is permanently rolled over regardless of the price. Precluding a tsunami of ETF outflows is paramount. Bearish headlines must be avoided at all costs.

It doesn’t cost them money (they make it back from other players while manipulating prices), and they play the game in size. CB balance sheets have infinite elasticity when needed. With the additional help of ETF induced reduction in the total price-sensitive free float, their interventions are more and more meaningful. CBs are now firmly in control of the downside. They even think there will never be another financial crisis in our lifetime -forgetting the need for incrementally accommodative monetary policy to keep things stable. Yellen’s assuredness is eerily reminiscent of Keynes’ assertion of confidence back in 1927.

Pity the upside is another matter and has them worried enough. You cannot control everything -fooling everybody all the time. By now investors are exultant and play happily to the BTFD script -but refuse to take a more cautious stance in their asset allocation. Central Bankers are surprised by market froth. They completely forgot that it is always difficult to put the genie back in the bottle -particularly if you suppress downside risk for years.

As for their increasingly erratic guidance, the truth is they have us all confused -and their reputation is further tarnished by recent events showing that they have lost control of the upside in equities and High Yield. As the bubble soars, macro managers and global strategists are all at a loss when trying to understand Janet Yellen’s latest flip-flopped statements. Consequently, we have all been whipsawed to some extent (that is, of course, unless someone has played by the rules and stuck to a long only, trust the Fed, investment strategy). It is my worst year ever.

How do you blend the following Yellen conceptual contradictory statements into a coherent narrative? Let’s synthesize a couple of them:

  • We will probably never have another financial crisis in our lifetimes. Has she joined the Irving Fisher- John Maynard Keynes school of predictions?
  • QT (quantitative tightening) will be a peaceful process. Something akin to watching the paint dry. Wow! Best wishful thinking in town.
  • Weakness in economic growth and inflation figures is only transitory and should not affect the interest rate hike calendar or the QT schedule. Of late, she has tempered that view.
  • Valuations are probably on the high side and implicitly allowing for some “minor” financial stability concerns. Only on the high side? Really?
  • The QT process should start relatively soon (meaning September in Fed-speak). Got you, Janet. But is it going to last? Will it be market dependent?
  • The Wicksellian rate of interest is very near current levels and (implicitly) requires few additional rate hikes. Good guess! Sure of that or the precise NAIRU level as well?

Believe it or not, she said all of that in the last two months. When trying to make sense of it, I feel like I am working to decipher Egyptian hieroglyphs. Finally, I think I have a comprehensive view that fits it all in nicely. Let me explain is what I think she and the core members of the FOMC mean:

  1. We have had low or nonexistent interest rates for too long, and side effects are killing us. We want out of the NIRP and ZIRP business asap. We also need a cushion to use in the next recession when it inevitably comes. Some of us (Yellen and Fisher) would also love to leave positive real interest rates without a market bust before we quit (next year). Oh my God, please help us out of this corner we have painted ourselves into. Low rates cannot go on forever!
  2. Because I cannot even hint at admitting the detrimental side effects of low rates (Yellen), I have to base rate increases in perceived economic strength, and I have to sell the idea that the economy is doing fine -regardless of the disappointing figures in the data from March onwards. Whenever I see strength ain’t good enough and lose confidence in the ability to raise rates repeatedly without real or financial economy disruption, I will come back to being concerned not about a recession but about not having enough inflation. What worries me (Yellen) though, is being able to get out of low rates, and stop the bubble without bursting it -or collapsing the economy.
  3. We are terribly scared about equity valuations, high yield spreads, VIX levels, commercial estate valuations and perspectives, unstoppable stock markets worldwide, house price levels and lease prices. We are aware of the risks involved where we sit now. But we cannot voice our concerns -or talk bubbles even in conditional mode.
  4. We think taking out some excess reserves (QT) might be more useful to stop the bubble than some additional rate hikes. And probably also less disruptive to the real economy. The financial bubble is the problem, but we can always pull back if we see too many cracks. We will adapt QT as it goes, if needed, monitoring markets carefully.  We will engage in market manipulation when necessary, and feel confident we have done well at that in the past. On a positive note, we are comforted by the fact that the real economy is unlikely to be affected by QT (it wasn’t directly affected by QE either) unless something breaks in the financial world. Manipulative guidance should help make sure QT is an orderly process.
  5. The potential growth of the economy has been severely hampered by the demographic and productivity trends (of course they do not think they have also contributed to lower our growth potential). Debt levels are breathtaking: no way we can raise rates that much more. The rate level we can achieve is not high enough to stop the bubble. We have no alternative but to take some chips (sorry, money) of the table. At this stage, QT is a must do.
  6.  A strong dollar is not as good as it seems (Trump) but a very weak USD doesn’t help either. We need tighter financial conditions in the least disruptive manner. No interest in a weaker dollar anymore (but let’s make sure The Donald doesn’t get to know this). At some point though we will have to make a stand. Where?

Where do we go from here?

I think they are trying to take money out of the system and raise rates. CBs are now aware of the need to end easy money, or as they put it, normalize monetary policy. They will decrease stimulus as rapidly as they dare to, but keep an eye on both financial markets and the underlying economy.

If the markets or the economy tank, they will cease tightening, or even reverse course. It is too late in the game to change their strategy -however wrong they are beginning to understand it is. If only the market falls, manipulation and more base money or credit will most likely contain the damage. But if it is the economy that takes a nose dive all bets are off.

Success at market manipulation makes them confident that they can handle market volatility and prevent any serious downside. They know ETF volume is dumb money that will only sell if frightened enough to do so. They will try to break asset bubble dynamics, get rates up a little bit higher, and make sure that they do not induce a market event or a recession.

The real economy is the variable they do not control entirely. Printing and pushing credit aggregates has helped the economy short term but they haven’t fixed anything structural. They know it. Every new massive intervention has added a new layer to the global debt overhang. Debt matters and at some point, it will sink the ship. The real economy will be the final arbiter of our fate.

Accordingly, I think we have to wait for an end of this artificially extended business cycle and sell only on real economic weakness. Financial market weakness will be aborted quickly with the same recipes they are using now. If this is a financial play, the game is rigged in their favor. More money and credit and lots of coordinated manipulation in a context of a mass of investors starved for yield make their success a sure thing.

I will take advantage of the time in between to lick my wounds and wait for the kill. Until the real economy breaks, they are the dark side of the force and still in control. I have learned that lesson the hard way. In the end, the real economy will implode crushed by the debt pile, the disastrous aggregate demand (inequality and wages will impede any improvement there), and the revolt of the have-nots. It is only a matter of time.

Timing is always the problem. Growth keeps slowing, and it is an ongoing process once the brutal 2016 stimulus has worn off. Only the BOJ and the ECB continue to prime the pump. But we should not expect financial markets to front run that event. Rather, capital markets might be late to react to a deteriorating real economy because it will take a severe jolt in confidence to erase the Pavlovian mentality now embedded into most fund managers.

I have been too greedy, and CB’s found my back. I’m short of ammo now, and I have to make the next/my last shot at shorting this bubble, count. In the meantime, I am standing aside and bidding my time, as I remind myself that this summer of 2017 is irreplaceable -and I can already feel it slipping through my fingers. Let’s make the best of it while we wait for the CB orchestrated financial genocide, to take place.

Holding-your-nose, or bidding-your-time. Pick your poison.

How long can this last...  After all, valuations are hugely stretched by any measure you can think of; there’s no disputing that. Not even the most steadfast bull could make a case that today’s market is cheap in some way. But does that matter? …

And that’s the thing; fundamentally, I think our market is absurdly priced. There are bubbles everywhere, … (but) extreme valuations can persist for a long time before something finally spooks investors into heading for the exits. And I’m not disputing that this is likely to happen at some point but I am saying that shorting the market or sitting in cash for years to wait for it is imprudent. …
 

Indeed, at this point, I’m not entirely sure what would actually bring about a sell-off and that is why, despite my bearishness on the fundamentals, I’m still in the hold-your-nose-and-buy camp.

Josh Arnold. Seeking Alpha (Emphasis mine)

 

“I’m having a hard time with this market because I can see what a powerfully stable social equilibrium is being established around this transformation of capital markets into a political utility. I’m having a hard time with it because, like any powerfully stable social equilibrium, to be truly successful in that world you must give yourself over to that world. You must embrace that world in your heart of hearts. …

I can’t do it. I can’t embrace the machines and the vol selling and the ETF parade and the central bankers’ “communication policy”. So I’m NOT happy. I’m 20+ pounds overweight. I don’t sleep well. I DON’T trust the Fed, much less love them, and I never will. …

So here’s my question. How do you survive, both physically and metaphysically, in a market you don’t trust but where you must act as if you do? How do you pass? How do you reconcile the actions and beliefs necessary to be successful in this market with the experiences and training of a lifetime that tell you NOT to act this way and believe in all this?

Accommodation to the Hollow Market is a miserable experience for discretionary stock pickers (and the same is true for any security selectors, whether it’s bonds or commodities or currencies or whatever), and the higher your fee structure the more miserable it is, which is why hedge funds have been particularly hard hit. Why is accommodation so difficult? Because the point of discretionary stock picking is taking independent, idiosyncratic risk. …

For the past eight years, whenever you’ve stuck your neck out with idiosyncratic risk sufficient to differentiate yourself and move the needle, more often than not you’ve been slapped around brutally for your trouble. So you stop doing that. … you effectively lock in your underperformance and pray for the Old Gods to return and unleash their mighty wrath on global equity markets. Of course, you’ll be down 50% of the market in The Storm, just like you were in 2008, but hey … at least that would give you a reason to come into the office. Anything but this. …

Ben Hunt. Epsilon Theory (Emphasis mine)

Don’t we all (particularly us males) love to think we are smarter than the rest of the pack? We elaborate sophisticated reasonings for the most pressing issues at hand. And we do well at that. If we had to judge market players’ expertise according to their capacity to construct and replace narratives as needed, then the EMH would be indeed viable. Sadly though, players’ capacity for narrative cannot be inferred and transferred to data or conceptual analysis’ efficacy.

We need more profound and unbiased analysis, less narrative, and an effort to keep things simple. Sometimes they are. Like today. Three decades of easy credit, easy money, and permanent ultra low to hard negative real interest rates have generated something really ugly. Now dubbed the “everything bubble”, it is also known as the mother of all bubbles (Saddam-speak), the big fat ugly bubble (The Donald), a permanently high plateau for stock prices (I. Fischer), or … you name it. The result is, in plain wording, a scary, extremely dangerous price environment for investable assets.

And we asset managers have to live with that. Unfortunately for us, this extreme environment begs some very tough heads-or-tails decisions of the kind I really hate. In such a bubbly environment, only four relevant asset allocation decisions matter. That is of course if he/she can afford to decide because passive managers cannot. And most active managers can’t either because of that frequently forgotten concept called career risk.

But if you can decide, you have to take a stance on these four issues. Very much like Josh Arnold and Ben Hunt, all of us active independent asset managers have to pick our poison. The good, safe options dissipated in a central bank deceptive nebulous long ago (not to be confused by the technological cloud where things are supposed to be safely kept). Continue reading

The post-Keynesian paradise (hell): few viable options left.

Time always provides the final judgment on an issue. To quote Cameron Crowe, it is always “time” that puts things in proper perspective. It took humanity an unspecified amount of time to know the Mona Lisa was superb. In just a few decades we learned that María Callas was as close to unique as you can get in real life. But, regrettably, it took almost a century for most economists to realize that Keynesianism (monetary and fiscal policy) was not the solution. It was the core problem, to begin with.

A debt overhang was not going to be solved with more debt, however profusely lubricated with monetary aggregate largesse. Even back in 2008, it was crystal clear that it would only make things worse. It sure did. We bought ourselves some time (one decade), but at what cost? Much like in the perfect storm we find ourselves in the wrong place at the wrong time. Never mind the extraordinary debt pile. While postponing the day of reckoning we have synchronized a couple of worldwide social and economic trends that seriously endanger a peaceful future for our species.

Well-known facts first. A huge and relentless money and credit boom that began when Nixon closed the Gold window has taken our credit and monetary aggregates to unthinkable dimensions. Despite the CB engineered delay, we face the inevitable bust of the cycle -according to Mises. Okay, I know not few think that the Mises outcome can be avoided, but even the optimists concede some difficulty when trying to achieve just that. I will give you a couple of charts to illustrate the point. The first one is courtesy of the McKinsey Global Institute -the figures are largely worse two years later, particularly in China. Global Nominal GDP is 78 trillion for 2017. Do you really think we can we dilute this debt pile with no bust?

The second chart shows the monetary base growth implemented by the three main CBs since 2008. Staggering. BOJ and ECB are increasing their balance sheet in 2017 by a further two trillion! We are monetizing more than 7% of European GDP per year yet we are delighted to find out that we are achieving 1.5 to 2% growth at best. Does that sound like remotely sustainable to you?

Are you missing the PBOC’s assets in the previous chart? It is not relevant to include the PBOC in global monetary base growth. The PBOC has resorted primarily to credit growth instead of base money growth because they control the banking sector. Sex is taking place behind not fully closed doors, in the Total Social Financing variable. Quarterly figures are breathtaking (chart: Zerohedge).Nevertheless, you pay a price for everything, even in China. Liquidity constraints at financial institutions have become serious by now, and the need to handle them is one of the reasons to “de facto” suppress free market pricing for the USDCNH. They need their USD reserves to provide some credible backing to the amount of renminbi they have to print to keep their financial system alive.

The next chart (hat tip: Kevin Muir) shows that monetary base growth keeps accelerating, demonstrating that this is not a stable macroeconomic model. We need incremental amounts of new money to remain afloat.

Let’s not become too fixated on debt. Sadly, the obvious debt overhang is no longer our sole relevant concern. Things have deteriorated sharply in the last decade. Social trends and CB policies have bought time at the cost of fostering major impediments to growth, the traditional recipe in order to dilute excess debt creation. It is difficult to grow yourself out of debt past a certain point. It is impossible to do so after ten years of disastrous neglect of the supply side -favoring instead financial market speculation. The reflationary trade is dead in the water and I have been saying so for months. I am betting the farm on that. Growth will not put a blanket over our accumulated credit excesses this time around. Why? We have messed up our supply side. Growth is a simple matter. It depends on the number of hours worked, and productivity increases. The number of hours worked depends on the working-age population growth. Productivity has two drivers: education and CAPEX.

A multiplicity of reasons suggests population growth is a non-starter in the developed countries. And we do not want to take on some people from the underdeveloped world to fill the void. It won’t be easy to change that because we need more than the addition of new souls to the production process. We need “educated souls”, and it would help if they were spiritually educated as well. I don’t care the underlying religion or lack of it, provided the ethic code shows some consistency. No way we can achieve those educational standards soon enough.

Productivity will not fare much better in the short term. The CB orchestrated money flood, and financial repression has lured savers to play the “everything bubble” -destroying CAPEX expenditure and, consequentially, productivity growth.

Money has been diverted from the real economy to fuel credit and financial market excess. Zero rates have grossly added to discounted cash flow values simultaneously providing “faux” valuation support (the Fed model is a sophism), and animal spirit backing for all the speculative activity taking place. In the meantime, our supply side barely invests to cover depreciation of our current capital infrastructure. With insufficient CAPEX, and decreasing standards of education, productivity is a mess, and it will also take a long time to fix that. US figures are unnerving. It’s just as bad, or even worse, elsewhere.

Our supply side is hardly ready to take a leap forward. It shows some serious additional flaws. Zero and negative interest rates have endangered the stability of corporations in the US, taking the ratio of corporate debt to EBITDA to historic heights. Much less so in Europe and Japan, but China is another leveraged corporate monster. And our global supply side has maneuvered successfully to avoid taxation and convert competitive markets into oligopolistic structures. In most sectors, the winner takes it all, creating a spiral of increasingly oligopolistic global markets. The “FAAMGs” are the paradigmatic example. Nothing that can’t be fixed if we want to (the establishment does not), but this is not a supply side that can spring to efficient, widespread growth instantaneously.

At this point in history, we are fast running out of luck. There seems to be no limit to our woes. Robotics is endangering a meaningful percentage of our global workforce, adding to the problem of unemployment, and the increasingly inefficient distribution of wealth. It will be difficult to build a solid aggregate demand if we cannot put most people to work and pay them reasonable salaries. By raising the complexity of jobs that are left for humans (the rest will be taken over by robots or software), technology is compounding our educational problem. We not only need to recover previous educational levels. We have to increase them markedly, and steadily, over the next decade or more.

Lastly, the population is growing older as we combine falling natality with the extension of life expectancy. The population dependency ratio deteriorates as I write -and this is a secular trend. That does not bode well for entitlement pressures, never mind the undeliverable promises that have been sold by our politicians to the masses. Even if we had no accumulated debt, entitlement promises and pensions were a chimera. Add debt and life expectancy expenses (medical and pension costs) to the problem, and there are very few viable options left. A lot less than in 2008.

In fact, whatever growth we have been able to squeeze out of the system since 2008 has always been based on debt, money printing, or currency devaluation. Healthy, productivity-driven growth has only been found in a few small countries.

We have already shown the consequences of printing and growing debt aggregates. Devaluation of currencies is another traditional way to grow. But, globally speaking it is a zero sum game. You can devalue your currency against the rest, but not everybody can devalue at the same time. Some countries can opt for this, but it will never be a global solution to what has become a pervasive planetary problem: growth!

Think about it. We have simply been shifting growth around with currency market moves. A strong yen transferred growth abroad. A weaker yen took it back to Japan. Euro weakness last year stimulated the euro area and euro strength will sap growth if kept up.The Chinese would love to devalue if allowed to, Trump wants a weak dollar, Swiss and Swedes want weak currencies, the Bank of Canada allows bubbles to form when trying to keep rates low to protect the Loonie, New Zealand tries desperately to temper Kiwi appreciation. The minute the problem is global, currency devaluation is out of the question for most. We will not collectively devalue our way to growth either.

Sooner or later things will have to change … big! It is thus crucial to find out faster than the rest what road we are going to take -as these problems explode and provoke a new era for society and financial investments. It is not difficult to envisage the problems we are up against. It is near impossible to know what the CBs will do when pressured by future events, or the calendar of such events. Yet therein lies the reward in financial terms. We won’t get paid for outlining the problems. But we can make a killing if we are the first to guess what our establishment will do when confronted with reality. There is also great value in pinpointing the time more precisely. An unlikely feat unless luck helps.

What can CBs and governments possibly do? Well, let’s start by looking into what they are actually doing right now.

Muddle through: Austerity and Financial Repression.

From a macro-financial perspective, initially, I don’t care much if austerity is imposed reducing government expenses or increasing taxes. Of course, I have a view, but I think the relevant issue is to assume or not that millennials will accept to pay for our excess, either diminishing public services or allowing for a higher taxation that does not provide them with additional services.

In the long run, I am positive that the new generations will revolt against paying for our excesses. They don’t hold most of the financial assets endangered by a global reset. It is in their interest to bust the system and write off debt -and as a side effect they will devalue real estate prices and enable access to ownership of their homes. They cannot afford them now. Healthcare and educational costs are also pressuring them. At some stage, they are going to say enough is enough.

Austerity comes together with financial repression. We have done this in the past, in the aftermath of WW II. Investors help dilute debt if CBs impose negative or barely positive real rates on debt. It takes a long time but it can dilute debt significantly if maintained. It also helps public perception of the sustainability of a high debt load.

It is morally repugnant. Money is transferred from prudent savers to people and institutions that overspent or overindebted themselves. Old people are affected most because it impacts the return on the accumulated savings of a lifetime. Sublime unfairness!

But it works, at least for some time. The main problem is not just the moral underpinnings of such strategy,  but the significant side effects we explained in previous paragraphs. Zero rates destroy propensity to save, generate asset bubbles, bankrupt insurance companies, and pension funds if kept for too long, decrease CAPEX feeding bubbly speculation instead, augment wealth concentration, stimulate further leverage etc etc. Low rates are unsustainable in the long run, particularly in economies that need substantial CAPEX investments due to the complexity of the installed productive capacity on the supply side. If kept low for too long, productivity stalls, creative destruction subsides (no cleaning up of economic zombies) and growth languishes.

The key issue is: can you perpetuate austerity and financial repression? The answer could very well be yes. Acknowledged, you can’t be sure of anything nowadays, regardless of the fact that even CBs themselves see obvious stability risks (ECB chart released last month shows it clearly). Yet my own view is that, before long, the have-nots will denounce austerity. Even if that doesn’t happen, over time, financial repression will stymie our residual growth potential, taking the global economy to a standstill and a global recession. It’ll be curtains for markets after that. When that happens, if it happens, is anybody’s call.

The nuclear option: Debt defaults.

A plain global default of the unserviceable levels of debt is the free market’s choice. Most active independent Asset Managers are desperate to get there. Put me on that list. No matter how painful, we need to move ahead, and the sooner the better for the new generations. Defaulting is not something to look forward to, but the alternative options are even less palatable. Governments should print only what’s needed to protect bank deposits “strictu sensu”. All other financial assets should teach their holders the true meaning of risk and fake valuations. We ought to leave moral hazard behind before we engage in a new economic model that precludes credit and monetary induced growth.

Understandably, CB’s try to prevent this outcome. It was a long time ago that central banking was an honest profession. Bernanke is still arguing that he did the right things in spite of assuring in 2008 that subprime risks were “contained”. Amazingly he kept the job for another seven long years.

The Zimbabwean way. Currency debasement using inflation.

This is the traditional method to destroy debt. You can still opt to inflate away your debts. But you have to generate inflation in the real economy for that end. And go ask Mario, Janet, or Kuroda-san, it ain’t easy. Somehow the money is always finding its way into physical or financial assets. Even if you succeed at stoking inflation, you have a new problem: keeping long-term rates low (you can anchor short-term rates, but to anchor long-term rates as inflation grows, you need some kind of permanent QE).

If inflation becomes the preferred option and it takes hold, you want to convert your money to equities and physical assets fast enough. An inflationary environment is the only way to prevent a stock market bust. All shorts would be exterminated.

The existence of this option is what makes things so difficult for a fund manager. Equities are grossly overpriced but would be the asset of choice in an inflationary scare. We just had one. And you never know what CBs might do. It CBs fail to generate inflation, intentionally or not, debt defaults are forthcoming and prices could be cut in half. If they succeed, equities will soar as the asset that best protects you in that environment. An extreme binary option between both tails of the normal distribution. Buying index puts and calls makes a lot of sense, particularly with current levels of implied volatility. Only the difficulty of the timing puts me off.

Tough times ahead -but you have to believe in humanity.

We have painted ourselves into a corner with no easy way out. However, the choices that will be made greatly condition the optimal investment strategy. Impossible to know well in advance. I will do my best, but can’t help a feeling of despair when I think about what we are up to. Preserving wealth in this context is a vast undertaking. When faced with something we don’t know, and can’t possibly know for certain, you have to remember Mark Twain’s prescient advice. It ain’t what you know, but what you think you know, but don’t, that will get you into trouble.

Remaining humble and adaptable is key to surviving this future, Mauldin denominated, “Global Reset”. While we wait we can lift our spirits remembering some of the highlights of the human species. If Donizetti and Pavarotti could write and sing this piece, there is at some point a bright future for us. I always run out of tears when listening to it.

The crux of the matter

“Every time the economy stops slowing or contracting, people seem to become irrationally hopeful that means something truly radical and positive even though all experience since 2007 has demonstrated that there actually is no rational basis for that hope. The road to Japanification is surely paved with so much disbelief. It’s completely understandable in a sense since it has been almost eight years of all the “experts” constantly claiming that things were definitely going to get better.”

Jeffrey P. Snider

So much for the Hopium apex of H1 2017. Hope has never been a viable investment strategy, and if you base ten investment decisions on hope, on average you are going to turn out as a loser. But if you do it just once, maybe you can pull it off. Not because hope helped your chances of success (it sure didn’t), but because what you were hoping for just happened.

So right now, this is a binary risk. Like tossing a coin for heads or tails. After ten years extending and pretending (in fact a couple more if you take into account some pre-GFC central bank practices), we are about to find out which side of the intellectual divide of our economics profession got it right. Can we reignite a credit cycle without cleaning up the previous excess, or is it correct to state that Japanification is our course, and no sustainable recovery can take place in this context?

Everything I read or hear points to a state of mind where investors have decided that the time has come for an economic take off after the crisis. This must be it, everybody thinks. Yeah, lots of risks looming, but experience has taught them that BTFD is the thing to do. Central Banks will prevail. And it has unsurprisingly become a self-fulfilling, self-reinforcing, prophecy. Investors keep on buying the tiniest dip in spite of nuclear war threats, or even a couple of FOMC members coming out “en masse” to suggest that the time has come for the Fed to shrink its balance sheet. Nothing can stop this train.

Monetary Policy started this last tranche of the bubble (the “everything bubble”) when credit growth flopped in 2007. Ironically, this last 2017 bull market blow off comes at a time when monetary policy is being accepted as nearly exhausted everywhere. Isolated and pretentious as they are, even CB politburo members have begun to realize the long-term dangers of shoring up monetary and credit aggregates. Not only The Fed openly suggests it is going to reduce its balance sheet, but the Dutch parliament gives Draghi a warm welcome with a beautiful tulip -to remind him of one of the best bubbles of all times. Very subtle. I’ve got more examples, but I feel these two suffice. Confidence in monetary policy has declined markedly, at least in academia.

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