Aldous Huxley brilliantly reminded us, quite some time ago, that the main lesson of history is that we, the “homo not so sapiens” species, never learn from it. Being a touch deterministic, and consequently agnostic about the real chances of single-handedly steering clear of a pervasive human mistake, I plan nonetheless to give it a fresh try once again.
Frankly, this last Central Bank coordinated intervention has confused me somewhat. Surprisingly enough, because it’s hardly the first time Central Bankers cost me serious money. I was indeed, well prepared for that (I had previously made it, in the downdraft preceding their intervention), so I have no real damage to report. But the downside to the confusion is not just two great trades (my stock market shorts/my credit spread widener) gone down the drain, for a meager profit (I am still positioned in both trades with a reduced profile). The real harm is allowing for the situation to affect my self-confidence and, furthermore, cloud my view of the actual financial landscape. That could easily cost me big.
In my last post, I allowed for defeat, with that “mea culpa” Latin wording repeated twice -in bold characters. I tried to remain focused on what really counts: overwhelming debt levels. Reading it once again, I stand by every word in it. But now, being critical of my own work, I think it is hardly worth the typing (never mind the reading) if it just serves the purpose of reminding everybody of our precarious debt situation. Even underlining Central Bank stealth PKO techniques, as I did, is all but evident now when looking back.
The good news is that Barron’s now dares label the US stock market as a “Bullard market”. Conspirationists like me, repeatedly bashed in the past, have somehow stolen the spotlight now -a strikingly fast transition! In a brief concession to my ego, I will take pride in the fact that just after the Bullard October 2014 low, I outspokenly described him as “the most inconsistent central banker in the world”, suggesting he was actually the head cheerleader for manipulation techniques. I was afraid to be denied future entrance in the US at the time! If Barron’s now nods to manipulation, the assertion must be as close to stating the obvious as one can ever get.
And, once the PKO (price-keeping operation) situation, and the Bullard rigging, are an accepted fact of life, it is easier to note that debt is, notoriously, the other elephant in the financial room. Unnervingly, we have no alternative options to keep living and investing in this environment, so it’s best to concentrate on getting the next elephant (Bullard and/or debt) moves right, beforehand. The timing of prospective events adds value, whilst market rigging and debt have become too self-explanatory to be further discussed to some avail.
The real added value comes when finding a path forward that enables us to survive the hurricane season that is constantly being delayed by the financial climate change perpetrated by Central Banks. We do not have a nature driven financial climate anymore. The Fed and its acolytes plan and implement the financial weather daily. So prospective weather patterns have to allow for plenty of behavioral science -in order to be meaningfully accurate. Finding that hurricane safe path implies having some homework to do. I feel compelled to sum up the most relevant lessons of recent history. And learn from them.
1.- Gradually, during the Greenspan tenure at the Fed, the developed world changed the economic model from a savings and investment, productivity growth enhanced, business model, to an easy money, consumption and credit-driven growth. Neoclassics, Keynesians, and Friedmanites converged to point at the monetary mistakes during the great depression as the sole reason for what happened then. The real economy was not at fault, it was just a question of insufficient monetary stimulus, they said.
They then set up wonderful econometric models, fostered Central Bank independence (from parliaments, not from banks and the elites), bought themselves some helicopters and printing presses, and firmly believed that Keynesian fiscal and monetary policies, well used, would make the business cycle something of the distant past. Econometric models would allow them to preview the future value of the main variables of the economic machine, and thus target the adequate stimulus for them in order to stabilize the economies along their, saddle-like, self-sustaining path to eternal prosperity (in earth as it is in heaven; Amen).
Well, it didn’t work as expected. By now most of the Keynesian and Neoclassical economists are belatedly admitting that the experiment was a failure. They are, however, still sustaining that excess money and credit at least did no harm. “Excusatio non-petita accusatio manifesta”. No further comment on that. University is where paradigmatic changes in scientific perception take place. We ought to welcome this gradual change of status of the economic doctrine. In due time, this increasingly-felt shift will become mainstream. More printing will be met with increased contempt and incredulity by financial pundits.
The politburo at the FED is smarter than mainstream economists (thank God for that), and they are already well aware (not Kuroda or Draghi that are still easy money believers) of the problems they face. I think I was right to say (I have been adamantly stating so for a time now) that they are done with easy money … But forgot to mention (big mistake), that normalization would only take place, provided they can find a window of opportunity to tighten us out of the mess. Wishful thinking is still one of the constant errors of emotionally contaminated thinking. I did not expect them to be that naive. Did they really think they could get away with four hikes and no printing, in a paradisiacal context of stable financial pricing, and low VIX? If not, what scared them enough to implement intervention after only an 11% stock market correction -in a stable USD environment?
I am old enough to state that we always pay for past mistakes … sooner, or later. The economic and social price to pay for normalizing out of the easy money and credit spiral is a complete overhaul of risk pricing, and a more or less simultaneous, default driven meltdown. Gruesome, and possibly incompatible with global peace. Unfortunately, though, there is no sunny road from a debt and credit-driven consumption based economy, to one that works with Say’s law as the cornerstone of sound economic thinking. Abundantly more so after such a huge debt pile has been accumulated. In spite of that, obviously, the Fed still trying to get it done at no cost. I can only wish them good luck and lots of patience. In the meantime, the practical lesson to be learned is that, for now, they will not tolerate a financial market risk repricing in their desired tightening process.
2.- Inflation could come sooner than most expect. I have been saying it might happen for a couple of months, and recent data point firmly in that direction. Janet Yellen has recently dismissed the late rise in core inflation as transitory. She had no other option if she was to justify the sudden dovish shift at the Fed. Deep inside I do not think she is that confident, but she has to play the role of the super-dove right now.
More printing will thus not come for free, but with increasingly pernicious side effects. At an unpredictable point in time (and size of the monetary base), it will generate hyperinflation. They are playing with fire from now on, because economic actors, at some point, will cease to give the FED the benefit of the doubt. The next chart shows how money is entering the TIPS market (people that are actually paying a price for inflation protection).
For sure, traded goods are not likely to generate inflation, and talking demand led inflation is a non-starter with me -in both goods and services. But I would not be all that certain that inflation is not going to move up. Cost-push inflation is alive and well, because the service sector is lifting prices, and services are increasingly taking the lion’s share of the economy in developed countries. Shelter and education have been out of control for a long time now. Regulatory costs continue to mount everywhere, and Obamacare is a costly disaster in the US.
The best explanation for the inflationary tensions in the core readings has been provided, in my view, by “uber bear” Albert Edwards. He explains why, in the mature phase of a cyclical expansion, wage costs tend to increase more than prices of products or services sold. In a context of sluggish sales, unless something exceptional is taking place, productivity growth tends to sour. In a context of low productivity growth and low pricing power, profit margins decrease (there is that powerful universal phenomenon called regression to the mean pushing in the same direction as well). Near the end of the cycle prices initially grow slower than labor costs. Corporates try to play catch up as soon as possible, and push prices up to widen back their margins. Inflation is late, but it always comes.
Inflation numbers matter a lot in a “debt-cast” sky because inflation pressures yield and yield pressure adds to financial costs of the indebted. So the Fed finds itself in a scenario where if inflation doesn’t push prices up, profit margins collapse. And if it does appear, then future returns will have to be discounted at a higher rate, killing the few pockets of fundamental data supporting this market we are in. It is a situation where you cannot win. Yes, I know the market continues to move up. Tough luck, you can’t always hold winning trades!
The lesson of the distant past and the near-term data is that we should remain alert for late cycle cost push inflation. It is true that this is a deflationary environment, particularly in the manufacturing area. But the move from deflation to inflation, if and when it comes, should be fast. And we don’t need an enormous amount of inflation to spoil the party. We just need enough inflation to move yields up say 100 bps. The rest of the debacle would follow suit, with defaults spreading like a falling domino.
3- The FED wants to tighten because they feel the actual unemployment level in the US warrants a more precautionary stance, and also because they think this monetary orgy has gone too far for too long. But my hunch is that they are being blackmailed by different global actors with vested interests against it.
- The Chinese have most likely made it clear that further USD strength is unwelcome, and will propitiate a paradigmatic shift in their currency valuation policy (read substantial devaluation of the CNY). USD weakness (or stability at the very least) is a must from now on, if only for external systemic reasons. Things will get worse, not better, for China. Pressure is not likely to abate.
- Markets have also shown that there is only one way to go if easy money is to be finished. The FED will have to persevere at trying to fool everybody, all the time, for as long as it lasts. Players are increasingly aware that only continued easy money can help sustain actual market valuations. Hints of tightening will make financial players run for the exits every single time they do it.
- Multinationals pressure the Fed to allow for a currency driven (USD weakness-driven) improvement in their top line result and make it clear that they need to work at the eps level (with substantial buybacks) to help keep the show running. So they need low rates and high liquidity. Profits are unlikely to stage a comeback before regression to the mean (as a percentage of GDP) runs its course.
The FED is cornered by the powers that be. They are not data driven as they say, but blackmail conditioned. They want out of easy money, but that flies in the face of everybody else’s interest. So it turns out that in fact, they are opportunity driven, trying to tighten without disturbing their newfound enemies. Not that long ago, markets (with their postulated wealth effect, regardless of the Modigliani proving against it), China, with their endless US Treasury buying, and multinationals, with their debt-financed share buybacks, were the FED’s closest allies. Things can change fast in these last episodes of consumer and debt driven capitalistic model.
The lesson to be learned is that the Fed is aware (or being made aware), of their role as the Central Bank of the reserve currency. Together with keeping an eye on financial valuations, they have to take care of their newfound enemies in their quest for a normalization of monetary policy. That will influence their decisions severely for now. Something to consider in future trades.
4.- The FED is aware of the power of printing (altering the monetary base) and will resort to it -when pressed enough to do so. The assets in the Fed’s balance sheet are stable, but reverse-repos are a wild ride, moving the monetary base up and down in roller coaster mode. Quarter end window dressing certainly plays a role, but nevertheless, they are an excellent reminder of the power of printing (meaning expanding/modifying the monetary base sharply in short periods of time). Driving markets with sharp moves in the monetary base is still effective. They did not move their assets but used reverse repo to ease to the situation prior to the December tightening/quarter end window dressing. This is the second time the FED backpedals fast, on previously well publicized tightening measures (the taper tantrum was the first).
They cannot move GDP, but they are conscious of the power of a monetary aggregate variation to move financial market pricing. It is clear once again, that monetary aggregates still override valuation, the flow of funds, market technicals, and any other consideration. A sudden change in monetary aggregates immediately takes over the previous situation, as the most powerful and directly effective price driver.
I did emphatically say, that only printing could move the tide … and print they did, in a new subtle alteration of monetary aggregates, while keeping the CB balance sheet constant to fool us all (me included). Aren’t they smart! I had hoped they would stay the course, but they did not. Three possible motives come to mind:
- The situation was even worse than it seemed and they just couldn’t allow for the market to clean up naturally.
- Blackmail dissuaded them from following up on their previous course of action.
- Their desire to normalize policy is too weak.
I will go for a combination of the first and second line of reasoning because I think they are cognizant of the corner they have painted themselves in. In any event, the lesson to be drawn from this does not change. There will not be one last print, but many others, before the debt overhang is cleared meaningfully. They will be tempted to print when the going gets tough, and, just like a desperate drug addict goes for his dose, they will play with the money base when desperately needed (in their perception of things).
I know some readers might think that the debt overhang will never be disposed of. It’s just an illusion! The debt overhang will be cleared, one way or another, at some point. You can bet the ranch on that. We just don’t know how much they will print till then, and when it will happen. But if something can’t go on forever, it will stop.
5.- The reason for betting the ranch on that driver of future financial pricing, is that there cannot be any growth if the debt overhang subsists. Japan solidly proves that -after a quarter of a century experimenting with kicking the can forward. And Global GDP growth over the last couple of years does so as well.
To be honest, it not only my despised debt that impedes any meaningful growth. We have some other structural issues that reinforce that statement, and make me comfortable about pronouncing it emphatically. Yes, it will never be clear to what extent all the factors underneath contribute to a growth and productivity stagnation. But it is crystal clear, and it ought to be enough, that robust growth is something of the past, and the debt overhang is the last unwanted problem compounding the restraint imposed by the joint interaction of all the rest.
Of course I am talking long term, but anyway, the Atlanta Fed GDP prediction shows a near stagnation for the first quarter. FED estimates for growth have been overly optimistic for years now. What makes us think they are going to improve their accuracy from now on?
The second quarter growth figures will be massaged by the global central bank intervention, but we should expect near stagnation short term, and in the longer run, maybe stagflation, if monetary variables remain out of control for long. The lesson of Japan post-1990 and the lesson of the Bernanke-Yellen policies share common ground. We will not grow our way out of the debt overhang.
6.- Other factors will also slow economic growth to a near standstill. No history to check here, but hey, these trends are pretty obvious!
- Environmental constraints. We have to allocate a lot more resources to cover the externalities involved in the production process. One example is global warming concerns. But waste disposal, peak resources in some cases, and other similar considerations are coming up as relevant cost factors for the immediate future.
- Scant population growth in most countries, and the inversion of the population pyramid as a joint factor. Most likely, savings will have to increase, and not decrease in the medium term future due to an aging population. The turbocharged credit/consumption model is hardly compatible with this trend.
- Educational costs are surging, and the amount of knowledge to be acquired by the average worker is moving up fast. It is a challenge to set up a system that can educate most of the population, and be profitable when you consider the years of production to be obtained from that averagely trained worker.
- The combination os soaring life expectancy and NIRP ensures that nearly all entitlement schemes, private or public, will be bankrupt in the next five years. Aggregate demand will take a beating unless we print to pay unfunded liabilities.
To conclude: with no growth in sight, market manipulation, and subtle printing will only help us gain some additional time. Recent history proves it. We got lackluster growth in exchange for the most extravagant printing boom in worldwide history. Should we try the same policies again and expect different results?
- One lesson to be learned is that we should stick to value and avoid growth, particularly cyclicals, as an investment target for the following years. Only Biotech start-ups and similar new sector investments at reasonable prices should break this rule.
- The other lesson is that growth will not save the day. We will not grow our way out of debt. The end of the debt overhang cannot be far off, and it will be messy (hyperinflation or defaults)
Nevertheless, all of this does not point to a huge “short and hold” (the short) for the next years; if only because CB’s printing can kill you before you profit from the trade.
When trading we have to apply the knowledge contained in recent history. Recent history says that risk pricing will not move down direct, and it may never force financial prices down if we end up in stagflationary mode and debt is diluted via price increases or outright hyperinflation.
You have to feel bearish and remain apprehensive because of the need for a debt clean up. But you have to take your positions in the market considering the cards that are most likely to be played by our inestimable Central Banks. A wild ride, on the wild side. Not for the fainthearted!