Goldilocks goes short

At the core of much of our analysis is the contention that the ebb and flow of easy money injections—potentially stimulative in the short term, but ultimately destructive of economic co-ordination and rational capital allocation in the long—are the key variables.

Variations in the form of this money being provided (whether ‘inside’ the commercial banking system or ‘outside’ it and, hence, taking place through the actions of the relevant monetary authority) and in the volume and composition of the credit pyramided on top of it (whether public or private) are crucial both to an understanding of the dynamics of the business cycle and to the asset pricing it generates.

The vicissitudes of the rate of monetary growth, especially in real terms, are intimately related to cyclical swings in economic activity and, accordingly, to the binary, ‘Risk On’/’Risk Off’ nature of the response to these of our increasingly cross-correlated, non-discriminating, algo-corrupted financial markets.

As traders and investors undergo a programme of adaptive learning in reaction to this – however poorly articulated it is by the profusion of commentators and ‘cranks’ who cannot seem to grasp the workings of the underlying mechanism– this is serving to accelerate the iterative process of anticipation, over-commitment, and mass disappointment—of a hysteresis, if not a hysteria, of Greed giving way to Fear — which has characterised markets since the start of the Crisis.

This ’hog cycle’ of destabilization has, of course, been both made possible and exacerbated by the triggering of one or more strikes on the ladder of central bank ’puts’ which are implicitly held to stretch beneath current prices and macroeconomic growth rates.

All this is driven by a combination of several aggravating features of the modern world. First among them is that the policymakers’ dominant mindset is heavily biased to a crude Keynesian reflationism which sees the ‘euthanasia of the rentier’ as the answer to all imaginable woes. Compounding this error, there is the usual populist disinclination to clean house, once and for all, rife as such a politics is with the risk that one’s own turn at the top of the greasy pole will be prematurely curtailed by the inevitable pain such a curative will inflict on the voters, leaving one’s opponents gallingly to gather the plaudits and reap the electoral gain of any subsequent renaissance.

Thirdly, there is the insidious pressure exerted by various pressure groups to eschew a proper accounting for losses already made, but not openly realised, so that both the Too Big To Fail banks, insurers, and manufacturers and the Too Many to Fail mortgagees and student loan obligors can continue to ’extend and pretend’ in the hope that they will eventually earn their way out of trouble as progressive inflation and suppressed interest rates allow them both to set aside more of their current income and to mark up the nominal value of their assets while the count of their liabilities remains helpfully frozen in place.

Nor has there been any lack of will in trying to put Humpty Dumpty together again and restoring him to his pre-Crash vantage atop the wall.

Having already doubled in the five years prior to the Bust, the aggregate balance sheet of six of the more influential central banks has doubled again since that watershed. Foreign exchange reserves—clear evidence of Jacques Rueff’s ‘childish game of marbles’—have quadrupled since mid-2003, a period during which world trade has ‘only’ increased by 150%. As a consequence, our ‘Austrian’, M1+-type reckoning of money supply has gained 40% since the LEH-AIG debacle, as part of a tripling delivered in the long decade since the Tech Bust took place.

This is not to say that there have not been other developments which have shaped the way such an expansion has made itself manifest, outside of that brute application of a naïve quantity theory which is something of a straw man for monetary denialists of all stripes.

Not least of these shifts is that, since the Crash, growth in private sector credit in the US has been more subdued (with household and non-corporate business debt off by almost $1 trillion, though non-financial corporate debt up $500 bln as a partial offset), yet government debt has soared by a truly epic two-thirds or $5.3 trillion.

A second feature is that while ‘pig-on-pork’ financial borrowing has fallen a hefty $3.5 trillion, overall financial sector liabilities have eked out a modest increase, thanks largely to the direct and indirect impact of the Fed’s monster, $1.9 trillion expansion of base (’outside’) money.

Along with the Fed’s unusually weighty role in money creation, the troubled nature of the times—coupled to a number of extraordinary, ad hoc, regulatory shifts in the relative safety to be had in holding money rather than its nearer substitutes—has seen an unprecedented accumulation of the same in the unlikely shape of non-financial corporates.

So, where do we go from here?

Clearly, if corporates ever decide to mobilize that cash pile, if incomes stabilize and people tire of self-restraint, the fact of a supine Fed maintaining zero nominal and minus-2.5% real interest rates while gifting a mountain of excess reserves to banks with superficially adequate loan:deposit and capital:asset ratios suggests there is plenty of scope for mischief.

Conversely, the growth in corporate earnings— outside the energy sector—has been markedly slower this quarter, perhaps as a result of poorer conditions offshore, adding to the translation effects of a mildly stronger dollar. Trade flows also seem to have ground to a halt as the Asian malaise spreads.

Adding to the plus column is the undoubted fact that the real value of that dollar is also historically depressed. Moreoever, America does seem to have wrested back some its labour cost advantage in recent years and its latest blessing – one that we can all share in, if not so directly as the natives – is that it is also doing its bit for the global supply-demand balance on the energy front.

Shale gas exploitation has driven real domestic prices to 20-year lows and has begun to bring forth plans to export some of the glut, while the production of associated liquids, together with more conventional drilling success, has cut oil & product imports by a quarter; has quadrupled exports; and has thereby reduced the net call on world oil by almost a half – to a two decade low – in less than six years.

Taking all this into account—and acknowledging that it may not be the most unqualified endorsement—it does appear as if the States is the least sick of all the major countries at the moment.

Conversely, after an initial burst of good, old-fashioned, outright inflation from Aug’08-Aug’10 which saw a €215 billion increase in the ECB’s monetary base call forth a three-times-greater, 23%, €654 bln rise in ‘inside’, bank money, the wheels first started slipping—with the next ten months seeing a €28 bln MB reduction to the accompaniment of a €133bln, 3.8% ‘inside’ money gain (half the pace of the earlier period)—then spin furiously and helplessly in place—as a massive, 60%, €665 bln ECB injection barely countered an alarming, 18%, €658 bln drop in the banks’ own, autonomous contribution to the money stock.

Not entirely coincidentally, this latter was a period when PIIGS TARGET2 debits soared by no less than €500 bln, over 90% of that thanks to the flight from Spain and Italy into (mostly) the perceived safe havens of Germany and the Netherlands.

To this point, what money supply growth there has been (and to the extent we can truly draw meaningful internal borders within the single currency area), has taken place in a Germany where, thanks to the influx of flight capital, the less binding debt constraints, and the admirable marketability of the country’s high value-added goods—not least among the Asian powerhouses—the woes of its neighbours have been a long while in diffusing into the Heimat.

However, faced with an intensification of the slump in the rest of Europe at the same time that the Pacific Basin is decelerating, this aura of invulnerability is starting to wear thin. Production numbers have been spotty, orders weaker—if erratically so—and revenues are beginning to slip. Surely, profits, investment, and employment cannot be far behind, though the aggregates might just mask this if the criminally lax monetary conditions work their corrosive effect on the traditional Teutonic virtues of thrift and so ignite a consumer and housing boom across the Länder, as some surveys suggest may indeed be occurring.

Until this logjam is broken—whether that requires the simultaneous fracture of the euro or merely the wholesale abandonment of the limits to centralisation which accompanied its introduction—nothing good can be expected from the region for some time to come.

The longer the clock ticks before a resolution is achieved, the more likely it is that particularism and populism take the place of the cosy, Brussels-centric consensus and the less enthusiasm there will be for what can easily be portrayed as externally-mandated belt tightening. We can see this already in the tenor of the French presidential campaign, in the fall of the Dutch government, the woes of the Czech regime: ‘austerity’ is fast losing whatever hold it had on the minds of the political elite and, should the German economy really start to stutter, the last bulwark against a more overt monetization of recidivist deficit spending will surely crumble.

Turning to that nexus of the new global economy—Greater China and its satellites—the market is still trying to peddle two, more optimistic scenarios—somewhat incompatible, though they be.

The first is that China has already achieved the mythical ‘soft landing’ and that, absent a certain legacy of weakness in what we might call the ‘non-affordable’ property sector (a label we append out of respect for the unavoidable Aristotelian distinction with the state’s much vaunted ‘affordable’ segment), it will be all sweetness and light from here on as the All-knowing mandarins astutely steer the country to a rapidly restored prosperity.

The alternate spiel is that the worse things look now, the more readily—and the more forcefully – the PBoC will intervene to administer a shot of adrenalin, not just to China, but to all of its trade partners across the world.

To believe in the first is to display a laughable ignorance of both economic fundamentals and business history. When and where, exactly, was such a gossamer-light atterrissage ever achieved? How, indeed, can it be engineered in a top-heavy, sur-investing, crash-industrialising, debt-fuelled malinvestment boom once the credit spigots begin to close?

Even more risibly, the ‘inventor’ of that superlative, if ultimately fatuous, marketing tag—the ‘BRICs’—wants us to believe that the resounding weakness displayed by these very same economic sub-divisions (‘higher order’ to us Austrians), by dint of ensuring they fell proportionately more in the last official GDP release than did the normally etoliated end-consumption components whose relative increase is an avowed government aim, is not a cause for concern, but a triumphant manifestation of just how successful not just the ‘landing’ has been, but how far advanced the hoped-for ‘rebalancing’ is, too!

Presumably, Mr. O’Neill, were the Chinese all to abandon their capital-destroying, resource-burning, debt-addicted industries en masse, and return to their ancestral paddy fields, there to subsist only on what they themselves can sow and spin and slaughter, you would consider that the total collapse of the upper orders of the economic superstructure this would entail and the resulting arithmetical predominance of ’consumption’ in the data count would mark a victory for central planning not seen since the end of the Great Leap Forward!

But, if the first scenario is unlikely , the second seems to be politically tone-deaf. How else can one trust in the delivery of a sudden, massive, re-inflation effort by the central bank when the inner sancta of the CCP are themselves being publicly riven with the same discord and dissatisfaction being expressed by hundreds of millions of less privileged citizens over the creation of those glaring inequalities which are always created by a sustained bout of inflation; an unfair advantage compounded in China’s case by the fact that most of the first-user ’winners’ of that inflation are already beneficiaries of the significant advantages which accrue to membership—and a quasi-dynastic membership, at that—of a narrow political elite?

If we take anything at all from the confused web of rumour and counter-rumour surrounding the downfall of Bo Xilai and his Chongqing cronies, it is surely that regime is terrified by the fact that a man whose powerbase was built partly by a massive exploitation of easy money (whether raised under the aegis of the local government itself or extorted from the nouveaux riches who also borrowed themselves to the top of the pile) could slyly appeal to the popular discontent engendered by the behaviour of China’s execrable, Gucci-wearing apparatchiks and Ferrari-driving princelings, among whose number could be found some of the man’s own family!

In such circumstances, it is hard to do other than take the authorities at their word and assume that any relaxation of the current squeeze will be desultory and case-by-case, rather than overwhelming and indiscriminate, as in early 2009. We may not be so biddable as to believe that the grant of any extra credit can really be confined to use solely in the pursuit of the aims for which was intended—money is the ultimate fungible good, after all—but that does not preclude us from the belief that its release will be piecemeal and its recirculation therefore more tortuous.

Summing this up, we can only operate on the premise that while China’s Götterdämmerung moment may not yet have arrived, neither are we about to be ushered over the coruscating walkway of the Bifröst bridge to the shiny, new Asgard of resumed boom-time, faux-prosperity

Nor do the other darlings of the Lumpen Investoriat offer too rosy a prospect, at present.

Brazil is struggling between the twin horns of a property bubble and stagnant industrial production. Argentina seems to be heading inexorably into yet another crisis of misrule. Turkey is facing a current account gap of truly terrifying dimensions. India is desperately trying to tame inflation and rein in its own vast external deficit without snuffing out growth, even as the government resorts to a series of crude, ad hoc policy moves.

Far from being the saviours in the way they are being touted by the Herd, it seems as though they have been following the same old, weary cycle of flattering to deceive, just not one exactly in synch with ours.

Since both EM macro and EM equities have risen and fallen pretty much in tune with commodity prices over this cycle, if they do succumb to their self-cultivated weaknesses, what does that mean for us in the commodities business?

Nothing too cheery for now, we would argue.

Rather, we think that the market is starting to bear out our predictions of last Christmastime, when we sketched in a picture of prices being driven upward throughout QI via the restoration (required by the prevailing imperatives of investment-by-numbers) of weightings drastically reduced during the liquidation of mid-2011—a blind need for conformity which continues to be greatly aggravated by the painful opportunity cost of doing nothing when ’riskless’ interest rates are so wilfully depressed.

We said back then that the positive news emanating from America’s monetary laxity would couple with the belief in Chinese omniscience, the effectiveness of big-battalion, European ’war finance’, and the Federal Reserve’s much–bruited readiness to put a floor under the market to build in just about all the good news imaginable in the early months of the year. We also said back then that any subsequent discovery that the porridge was still too cold in some countries to generate much in the way of organic growth and too hot in others to allow for it to be put straight back on the stove would leave poor little Goldilocks a very hungry girl, indeed, by the time QII arrived.

So, watch out, Blondie! Methinks you may have had your best crack at it for a while. It’s time to give the guys with the fur coats and the sharp claws their turn at the cooking pot instead. We do find ourselves as uninvited guests in their house, after all.


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