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).