A return to stop-go?

As the Fed’s QE-II programme was first announced and then implemented in the early autumn of last year, more and more elements of the investment world came to depend ever more closely upon its progress and on that of the renewed dollar weakness it entrained.

Over the 6 months to March, US business revenues shot up at a 19.3% annualized pace—their fastest in three decades—helping propel equity prices up by more than 1% a week to their May high (as measured by the Value Line index).

Nor did all-time record junk bond issuance of $309 bln over the past three quarters (including a monthly record of $50.6 bln in May alone) do much to satiate the appetite, as yields fell 2 full percentage points to regain their all-time lows of late 2004.

Commodities joined in the party with gusto, too, with the dollar value of non-commercial net positions (ex-natgas) expanding by a cool $73 billion, comparable to, but not quite matching, both the $76 bln jump from the Aug ’07 discount rate cut to the Bear Stearns rescue highs in March ’08 and the QE-I rebound which sucked in $78 bln. Still, the 8-month unbroken sequence of gains to the late April peak was enough to allow anyone long the DCI index to enjoy a near 40% total return – one which equalled the very best on offer for any similar spell since the first few months of the great commodity bull market, way back in 1999.

For much of this period, agriculture led the way on fears that cold, wet weather would adversely affect the harvest in North America, while drought would scorch the crops in Europe and China— you don’t buy into soft commodities by looking on the bright side of life, after all!

By the first quarter of the new year, however, as the turmoil associated with the ‘Arab Spring’ protest movement ignited a civil war in Libya and disaster struck the Fukushima reactor complex, medium-term oil supply fears combined with the more immediate challenge posed to European refiners to ensure that energy took over a lead it would not relinquish until the sharp-sell-off the sector suffered in the middle of May.

With base metals essentially trading sideways as a group so far in 2011 on worries relating to the Chinese economy and the suspect way it finances itself, the stage was then set for precious metals – those perennial storm petrels – to edge in front as the European sovereign crisis sapped risk appetites – and this despite silver’s spectacular reversal from a thirteen-week, 88% ascent to a headlong, two-week, 35% crash.

After a nasty few weeks of liquidation – unleashed in May as an overlong market began to receive less heartening macro-economic news at the very moment it was starting to fret about the imminent end of Chairman Bernanke’s asset inflation programme – the quarter ended on a note of renewed optimism in the form of a sharp, largely technical, short-covering bounce which served to add a certain artificial lustre to portfolios, conveniently in time for their official reporting date.

As events since have already begun to confirm, this switch may have been dangerously premature, not least because many of the key emerging markets whose growth – both of the spontaneous and state-induced varieties – has so far driven the recovery have since begun to falter under the effects of a growing inflationary threat and in response to the central bank tightening measures this has called forth.

Europe remains wracked by a degree of political and financial chaos which can only prolong its stagnation. With a collectivist elite determined to cling to the established form of their fledgling superstate, no matter what the cost, the threat must be that the only strategy to be pursued remains die Flucht nach vorne — that of pressing on ever deeper into the morass of complex bail-outs and fruitless refinancing packages which are trying to construct a quasi-fiscal union over the heartfelt wishes of the electorate.

Instead of decreeing a liberating seisacththeia and doing everything possible to reduce disincentives to private, entrepreneurial investment, the dead-end proposals emanating from the prevailing étatism has already encouraged markets to cast a critical—if very belated—look at economies beyond a ‘periphery’ rapidly beginning to be demarcated by the Alps and the Rhine.

Not just the PIGS, not even Italy, but Belgium is now trading wider to Germany than at any time since the ERM crises of the early-90s. France, too, has swept out to a sixteen-year high, and even the Netherlands are offering a pick up only beaten in recent history at the height of the LEH-AIG panic itself.

Nor can the Continent’s more successful nations afford to rest too easily on their laurels: slowing domestic money conditions and renewed budgetary restriction will not make the surrounding markets any more welcoming at a time when a continuation of the miracle of their exports to the East is being placed in doubt not just by the aftermath of the tragedy suffered in Tohuko—to which the BOJ response has been muted, thus far—but by a growing sense that China’s wayward policy gigantism makes it just as great a peril to its global partners in the downswing as it has been a poster-child for the super-cycle crowd on the way up.

Laughably, there are (unconfirmed) rumours that China has begun to intervene in European debt markets: anxious, no doubt, lest the lack of credit among its customers there adds to the burdens being imposed at home. This is doubly risible in that China’s own parlous finances are finally receiving some overdue recognition, prompting no less august an institution than the PBOC to inveigh against its foreign critics in a blustering attempt to allay fears over the true state of the $1.6 trillion admitted (and $2.1 trillion conceivable) mountain of local government debt which fuels so much of the country’s febrile activity.

Whatever the exact numbers, their magnitude is clearly enormous and the rationale behind them highly suspect, especially since so much money is spent on generating output for its own sake and such a large percentage is so readily diverted into bribes, padded invoices, and various other sweeteners, along the way.

While the Schactian programme of forced saving and suppressed inflation may well help stir the standard macro-aggregate soup into a superficially more palatable form, it does not mean that the mix is not as heavily laced with harmful ingredients as a batch of Beijing baby formula.

Nor can we derive much comfort from the fact that the country is obviously subject to a vast surfeit of fixed investment of the kind that Roepke lampooned as a chicken farming boom (which temporarily raises the call for the chickens needed to stock the new breeding stations, before ultimately flooding the market with their progeny). More worrying still, it is apparent that this has been rolling over of late into the kind of funding requirement death-spiral that Hayek termed ‘investment that raises the demand for capital’.

Far from being a model for us all to emulate, then, China’s crony corporatism comprises perhaps the greatest exercise in sheer wastefulness in history – outside of total war, at least. As each passing day sees more of this profligate malinvestment and as the pyramid of mispriced plant, equipment, and infrastructure mounts ever higher, the more politically intractable its dismantling becomes, in much the same manner as is the case for the Occident’s unfinanceable, Bismarckian/Keynesian Provider State and its associated landfill of unproductive debt and misdirected effort.

Meanwhile, far across the Pacific, popular sentiment has swung significantly against a US establishment widely perceived to be both ineffectual and plutocratic, meaning that neither the Fed, nor the Obama administration will find it a trivial task to argue in favour of a further dose of ‘stimulus’ (whatever the currency cranks on the FOMC may say) – at least, not this side of a much steeper downturn than has so far been in evidence there.

Following on from the none-too cheery mix encapsulated in the ISM release, the index of small business optimism has also taken a fourth consecutive downward shift; the worst showing since the Crash and one which has sent it back 3-standards below its 30-year mean. Those same business revenues to which we earlier alluded have also abandoned their climb of late—something which, if it persists, must bode ill for profitability—and hence investment and employment—in the coming quarters.

In Britain, meanwhile, we have the outwardly paradoxical combination of rising consumer prices and a surging trade deficit—usually undeniable symptoms of overheating—with a renewed fall in the money supply which is even more pronounced when we deflate it in order to gauge the effectiveness of what stock there is.

The first point to make is that consumer price index component rises can often be accompanied by compensatory shifts in the prices of other goods as the productive structure changes and, in fact, MUST be so accompanied if the money stock is not increasing sufficiently to bear all boats higher on its tide. Not least of these are the ‘Johnny Foreigner ate my inflation target’ import prices on which the BoE is basing much of its hopes for exculpation.

In the absence of autonomous commercial bank money creation (and credit magnification) in order to accommodate private sector needs (as is arguably the case today), these banks—and, in spades, the Old Lady—can only create money by issuing demand liabilities and currency against the purchase of state sector liabilities. Even this resort, which may well serve to keep cash jingling in trouser pockets, has malign side-effects in that the trousers will be those worn by the importunate beneficiaries of the same overmighty spendthrift which has dragged the nation headlong into ruin and which is still throttling all hopes of restoring its fortunes.

Up until the crash, foreign central banks (‘diversifying’ their risks!) did a great deal to plug the UK’s serial Micawberism, delivering both a ‘deficit without tears’ and the means to fuel the housing boom far beyond the capacity of the local banks to self-finance. Then, in 2009, Threadneedle St. monetized the government’s appalling deficits: last year, the commercial banks took up the cudgels in their turn. Despite an interim resumption of sterling accumulation by EM central banks in particular, it seems as if this is no longer enough to offset the paydown coming from debt repudiation and redemption elsewhere.

In that context, this week’s ‘surprise’ dip in CPI and RPI were not really so inexplicable, after all — nor, sadly, is the ongoing rise in unemployment claims – whatever the confusion to the macroherd’s blindly extrapolated estimates.

To the extent that Britons are price takers in terms both of the substantial surplus of imported goods they consume and in the buying (often involuntarily) of an overlarge quotient of government-supplied pseudo-goods, the purchase of these at elevated prices using a sluggish trickle of new money must mean that either VOLUMES are falling or that money is being diverted here from elsewhere in the system. Neither of these offers a positive outlook for a nation presently swilling in a rather inappropriate schadenfreude at Europe’s equally self-inflicted traumas.

To sum up: short of some form of unexpected volte face on the part of the fiscal and monetary authorities of one of the Big Four economic groupings—however ill-advised the enactment and however short-lived the effect of this would likely be—it is difficult to envisage what might instead recharge the speculative instinct and so push ‘risk’ assets higher in time to rescue a rather lacklustre 2011 for all those whose livelihoods depend not so much on business itself improving, as on the disembodied tickers loosely associated with its undertaking flashing reassuringly green on their screens come Christmas time

We are therefore left with the reflection that we find ourselves, fast approaching the third anniversary of Lehman’s collapse and well over four years since the first thunderclouds began to gather on the fringes of the late boom, forlornly clinging to the wreckage of yet another New Deal, and still steadfastly stopping our ears to the Austrian advice that no disease was ever cured by treating its symptoms not its causes and no addiction broken by prescribing more of the addictive substance as means of lessening the pain of withdrawal.

As a result, far too many balance sheets still lie tainted by the legacy of the poor decisions made at the height of our earlier madness and far too much of the effort since has been devoted to frustrating rather than facilitating the widespread reordering of the political, industrial, and commercial landscape which will be necessary to achieve a more lasting and equitably-distributed prosperity than the shoddy, ersatz, narrowly-focused version we financially-engineered out of too much credit and too little critical thinking in the new millennium’s first decade

With the heat temporarily being taken out of much fiscal and monetary mischief-making, the immediate risks of igniting another bout of galloping inflation, much less a holocaust of hyperinflation, are presently somewhat dampened, however much such an inference will jar with the more lurid fantasies of the Monetary Rapture crowd.

But, alas, while we continue to refuse to put owners of bad assets through bankruptcy without fear or favour and while we stubbornly resist the shrinkage of state expenditures to a level far, far reduced from the prevailing scale of profligacy, we seem set for a weary alternation of episodic reinflation—each more frenzied than the last—to as a palliative for those repeated phases of slowdown which will inevitably arise through a process of ‘stimulus toleration’ – i.e., because of the actual and expectational adaptation of relative prices to any given level of stimulus, by which means the underlying real constraints again make themselves bind against the monetary fictions with which we attempt to escape them.

Each cycle of such hysteresis which we endure is likely to reach its individual end more and more quickly, as the behavioural response becomes conditioned, while each turn of the screw will also bring us closer and closer to that point of no return at which either rapid, overt inflation or a police-state suppression of its consequences becomes utterly unavoidable.

This bleak switchback of ‘Stop-Go’—to use the old British phrase—may not be driven by union militancy pushing up wages beyond the marginal value of employed labour in quite the same predominant fashion as it was in the 1970s , but the syndrome from which we seem foredoomed to suffer will be otherwise similar in all too many respects and may culminate in just as dire an outcome by the time it has run its course.