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.