[This piece can be seen at Sean’s blog here http://truesinews.com/2015/02/17/macro-market-update/]
More than half a century ago, in his role as an advisor to the men responsible for trying to set Taiwan on the road to prosperity, a redoubtable economist called Sho-Chie Tsiang argued that the monetary authorities should stop suppressing interest rates and directly rationing credit and should move instead toward a more market-oriented system where real rates were sufficiently elevated to encourage productive saving.
His reasoning was that the existing combination of what we might call Z(Real)IRP with ‘macro-prudential’ control was plagued with several significant drawbacks.
Firstly, rationed credit tended to be crony credit – with only the politically-favoured having any hope of persuading the banks to lend to them. Secondly, the erosion of purchasing power suffered by any one depositing money in the bank at the prevailing yields meant that savers looked for other outlets for their surpluses, such as property and precious metals, neither of which did much to augment the stock of productive capital. Thirdly, this lack of genuine saving meant that all extra funding had to rely on inflationary credit creation and thus necessitated even more macro-prudential monkeying with the price mechanism. Fourthly, anyone outside the charmed circle of accepted borrowers – which tended to mean anyone with a hint of genuine entrepreneurship – had to raise funds in a quasi-illicit and certainly non-transparent manner and so had to promise exorbitantly high ‘curb’ rates of interest to compensate their lenders for the extra hazards involved.
Tsiang argued – and was soon to be proved totally correct in his assertions – that by allowing the rate of interest to find a level where market for funds cleared – essentially where the impulse to thrift intersected the expectation of profit – not only would all these disadvantages be eradicated, but the funding rate applicable to the WHOLE economy, as opposed to that charged to the privileged few, would be lower on average, not higher, as the risk premia associated with the ‘shadow’ market were removed.
In the decades after the Second World War, Taiwan, not entirely coincidentally, transformed itself from a backward, low-value added, crisis-wracked basket case into the economic prodigy to which we still look for so many of our high tech gizmos today.
The reason for the history lesson should be obvious if we consider that much of the same reasoning is relevant to mainland China today, even if the scale of the problem is somewhat larger in a country of 1 1/3 billion people.
Beijing knows that it cannot afford to persist with ‘business as usual’, that the ‘three overhangs’ relating to past over-expansion and misdirected effort have to be overcome while moving to the ‘new normal’ of less force-fed growth-for-growth’s sake. The issues with this are twofold: will the authorities stick to their course, even when the waters get choppy and, if they do, can they then hope to bring the ship of state safely into harbour before the leaks springing from its every timber send it to the bottom?
On the monetary front alone, the issue is fraught. The PBoC, as everyone knows, was moved to cut the required reserve rate a week or so back and so sparked a renewed clamour for further, substantial easing even though the main reason for the reduction was technical: the traditional Lunar New Year cash squeeze was bumping up against the very substantial reserve drain occasioned by the last few months’ sizeable forex outflows.
[CLICK TO ENLARGE ALL GRAPHS]
Against such a backdrop, the monthly money and credit numbers were exceptionally hard to read. TSF rose, but less than it did in each of the past two years. Loan growth, however, was the second highest on record. On the other side of the balance sheet M2 slowed to a multi-year low increase of 10.2% (even though overall deposits jumped by the most on record!) and yet, within that total, M1 money remained unchanged in a month in which it often falls so its rate of climb therefore rose to a 20-month high of 10.6%. Confusion confounded, indeed!
What is key here is that Lui Lei of the central bank came out to argue that any intervention should henceforth only be aimed at alleviating liquidity shortages, not at fostering hothouse growth, while Xu Lin of the NDRC hinted that the latest Five-year Plan would insist on a ‘floor’ for growth of a mere 6.5% – a significant psychological climb down from the economy-doubling 7-handles to which the regime has heretofore grimly clung. Guan Tao of the SAFE next went so far as to make explicit reference to the parallels between his country today and its Asian neighbours back in 1997 on the eve of their great crisis (and he should know: $10 billion+ leaked out again in January, his employers had just revealed).
For all the worries, this was not enough to prevent the ChiNext from making a new high – taking its run to 233% these past two years. We suspect, however, that it will pay to sell a reversal somewhere in the next 10%. We are also intrigued by the similarity between the HK H-Shares chart and that for pre-collapse crude – or, for that matter, between the index and all manner of commodity-related indices in recent months.
It is also fascinating to watch sentiment start to dissolve among the US punditry. As the newsflow become more nuanced, market participants have become schizophrenic with regard to oil prices – lower is ‘a tax cut for the consumer’ but is also about to blow up the junk bond market, depending on who is talking. The Dow, for its part, has rallied on cheap energy, but also rallied on a rebound in oil prices which was said to signal continued demand. So long as it rallies, one supposes…
Amid a stretch of numbers which, aside from those concerning employment, were somewhat disappointing to a consensus only lately set four-square behind the thesis of US economic triumphalism, some unusual attention has been paid of late to the lacklustre retail and wholesale sales numbers – mainly becuase they, too, looked weak.
For our part, since these are the nearest thing we get to a timely measure of economy-wide revenues (and hence not just to an NGDP number, all you market monetarists and Neo-Hayekians out there, but to an NSOP – a nominal structure-of-production flow) we tend to pay close attention to them as a matter of routine. What is at issue here, however, is the very fact that these arenominal numbers and are therefore hard to interpret when large, supply-side price changes are underway, as is arguably the case in all things related to natural resources as well as, for the US with its persistently strengthening currency, to imported goods of a more general character.
Since it is the sales margin that ultimately counts for the success of an enterprise, the first thing we need to assure ourselves is that falling revenues need not be wholly bad, as long as costs fall commensurately alongside them. There are, as ever, several caveats to this broad pronouncement.
Firstly, we have to hope that the aggregate decline in selling and buying prices does not mask too great a disparity between conditions in one business and the next. We must also beware the fact that any resulting windfall for one is not ruined by the shortfall for another when the impact is not a simple matter of addition and subtraction but acts in a non-linear fashion – e.g., through its implications for the credit structure. Finally, we have to wonder how the necessary fall in nominal costs will be achieved when it comes to those associated with the payroll. We should all recognise that real wages are what determine our standard of living, but we must also bear in mind that it is the nominal ones over which we fight and for whose maintenance jobs are often sacrificed.
With that in mind, let us note three broad trends which are at work. Number one, inventory/sales ratios are rising to levels not seen (barring the Snowball Earth episode of the Lehman Crash) in anything up to thirteen years across manufacturing, wholesale, and retail. To what extent this just reflects a lag in marking down inventory values but having instantlyto recognise lower sale sprices, rather than something much more sinister, only time will tell. Nevertheless, the adjustment, when it comes, will have to be reflected in both a capital write down and a temporary reduction in profits in the relevant period, so there is scope for further anguish.
Number two, wage bills in relation to sales receipts have also been pushed to their least favourable in more than a decade and, again, while the marginal return on labour could come out unchanged if the margins are unaltered, lowered revenues could nonetheless serve to jeopardize employment levels. Number three is that the value of outstanding C&I loans is rising in relation to the stock it is financing i.e., collateral coverage is slipping to an extent which may soon start causing jitters among the lenders.
While bearing this wobble in mind, also consider that P/Es are back to where they were on the eve of the last crash as is price/book. Price/sales is where it was at the height of the Tech Bubble and returns on capital – measured using both cash flow and free cash flow – are at or approaching their lowest in five years. As ever, the main source of support for the stock market is the deliberately suppressed level of bond yields.
One way of illustrating this distortion of the bond market is to look at bond risk – such as modified duration – versus bond return, i.e., yield-to-worst. Off the scale, is the simplest way to describe it.
As unsustainable as all this looks – not to mention how perilous it all is – the key is to try to find a reversal clear enough to be played. A week or two back, we suggested that the T-bond might be headed to 2.20% and that, if such a level held, one should try to sell against it, scaling in above 2.45/50%. Well, 2.22% has been the low so far and we have had a smart 43bp, 8.3% price reversal since hitting it. So far, so good, so short.
As for the rest of the market, WTI is testing the top of a neat profile built at the bottom of the rout (and so, theoretically signalling much lower lows ahead). If it breaks the top of this band, it could swing up to a nice, round $60/bbl where the mid-point of the Thanksgiving Day massacre comes in. Brent looks a touch more positive, so signals are mixed and while not yet convinced we have seen the worst, we would hesitate just yet to position too aggressively as a result of the disparity.
Copper, too has seen a little cautious buying, taking it back to the bottom of the old range. On the one hand we have maximum spec shorts both outright and as a percentage of O/I: on the other, the recent, hefty cash premium has almost disappeared as LME inventories have built rapidly, rising 85% since Christmas to a 16-month high. Sell any identifiable failure here but stop out if it does build back above $6000
Likewise, gold – while below $1245/50 – stays negative, looking for a possible retest of $1180 and, one day, a break of the decade-old uptrend to usher in the opening up of a route back to the LEH crisis levels down around $800/oz.
If gold is to weaken further, that almost presumes that risk will not spike higher and also that dollar strength will continue at what is now an important technical level for the greenback – at the 50% retracement of the 2002-11 decline and at fairly overbought levels.
While below $1.450/00 the euro does not look like spoiling the party but rather giving it a boost by falling to the long-term linear mid at $1.0700 (and possibly, since the trend on this chart has already given way to the log one at $9275/00)
However it is espressed in the weakness of pair currencies, a continued USD advance should mean positive feedback with other US asset classes so it is worth noting that the MSCI US index is fast approaching its historic peak relative to the ROW equivalent. Bears will hope that top holds: bulls will be wishing for a full, swing pattern repeat of the 1988-2002 move and hence for much more upside to come.
The Nikkei, meanwhile, remains locked – once we peel back the veil of weak Yen money illusion – in the range which has contained it these last 18 months or so. the best hope is that this consolidation wil eventually move the longest line higher both on the medium term scale of the last 5 years of rebound and on the larger scale of the whole three decades of bubble-and-bust.
The sad fact remains that, if we adjust for changes in the yen’s international worth via the TWI, returns for the entirety of that period sweep out a quasi-normal, mean reverting distribution. Still, a push to the top of that formation’ s value area would be nothing to sniff at, were it to come about through the processes just discussed.
Finally to Europe, where NIRP is beginning to preclude even momentum-driven returns on bonds and is pushing people instead into the stock market. The DAX appears to have broken out against the REX as a result, meaning it has every chance to test the last cyclical highs, set back in 2007, in the weeks ahead.
Note, however, that though the idea of European outperformance is becoming more widely shared – not least because of effects of the rapid growth in money supply even pre-QEuro – there is actually little in the graph of Germany v the USA in common currency to suggest this presentiment will be borne out in practice. If you do wish to play for a rise on the Continent, therefore, it seems as though you would be best advised to hedge up your forex exposure when you do so.
In his magisterial 1936 work, ‘A World in Debt‘, Freeman Tilden treated the business of contracting a loan with a heavy serving of well-deserved irony, describing how the debtor gradually mutates from a man thankful, at the instant of receiving the funds, for having found such a wise philanthropist as is his lender to one soon becoming a little anxious that the time for renewal is fast approaching. From there, he turns to the comfort of self-justification, undertaking a little mental debt-to-equity conversion in persuading himself that his soon-to-be disappointed creditor was, after all, in the way of a partner in their joint undertaking and so consciously accepted a share of the associated risks.
Next he adopts an air of righteous indignation at the idea that he really must redeem his obligation on the due date, before rapidly giving into a growing fury in contemplation of how this wicked usurer has duped him into contracting for something he cannot hope to fulfil, as so many poor fools before him have similarly been entrapped by this veritable shark.
Likewise, our author quotes the 19th century utilitarian, Jeremy Bentham, to much the same effect.
‘Those who have the resolution to sacrifice the present to the future are natural objects of envy’ for those who have done the converse, our sage declared, like children still with a cake are for those who have already scoffed theirs. ‘While the money is hoped for… he who lends it is a friend and benefactor: by the time the money is spent and the evil hour of reckoning is come, the benefactor is found to… have put on the tyrant and the oppressor.’
Here we should realise the pointlessness of trying to decide whether the Greeks or the Germans are at fault in the present impasse and press on toward the crux of the matter. As Tilden rightly argued about the consequences of a bust:-
‘It follows that any scheme looking towards the avoidance of panics and depressions must deal with this cause [viz., debt] and any plan that does not do so is not only idle, but may be a dangerous adventure.’
‘Hence, the way to deal with a collapse of exchange is not to pretend that “prosperity” is merely in a temporary eclipse, to return again if everybody will act optimistically; but frankly to acknowledge that conditions were unsound, and to permit the natural impulses of trade to rectify them. This prescribes a bitter medicine, which people do not like and politicians cannot collect upon, but quack remedies merely put off the final reckoning.’
Are you listening, Mario?
‘The natural remedies, if the credit-sickness be far advanced, will always include a redistribution of wealth: the further it is postponed, the more violent it will be. Every collapse of credit expansion is a bankruptcy and the magnitude… will be proportional to the magnitude of the debt debauch. In bankruptcies, creditors must suffer.’
The problem with our modern world is that the ‘quack remedies’ we most routinely favour are ones which involve adding another layer of ‘debt debauch’ on top of the still uncleared detritus of the previous one. If you doubt this, I must ask what else, pray, do you think is entailed by QE in all its many variants if not the attempt to find new, biddable debtors to take the place of the grumbling, undischarged old ones?
Even if you are loth to accept this line of reasoning, you surely must concede that a ‘putting-off of the reckoning’ comes with many disadvantageous features and several self-aggravating tendencies and that this should be obvious enough to anyone with sufficient intellectual honesty to consult the record of the past few years – if not decades – objectively.
Firstly, it encourages a wasting forbearance of dead or dying enterprises in a kind of lunatic refusal to recognise that the associated costs are well and truly sunk and that the only valid criterion for continued investment is the judgement that the undertaking will be viable from today, not whether we can thereby avoid booking the losses incurred by it yesterday. Such ‘zombification’ retards, if not prevents, the necessary reallocation of men, machinery, and financial means toward more profitable (and hence more socially beneficial) employment. By propping up the diseased trunks of the past, it prevents light and nutrients from reaching the thrusting saplings of tomorrow. Creative destruction is out and destructive continuation is in to the detriment of all.
Worse, yet, the feeble, ‘stimulus’-dependent manifestation of growth which does then occur leads to that dreadful, anti-Hippocratic impatience to which all our electoral cycle overlords are prone. Bad policy thus leads to more bad policy – whether by way of simple reinforcement of ineffective treatment or by jejune ‘innovation’. As more and more market signals become scrambled, as larger and larger swathes of the economy are turned over either to run-‘em-for-cash basket cases or to newly malinvested Bubble 2.0 entrants upon the stage, the space for genuine entrepreneurship becomes progressively restricted. Growth therefore slows, cycle after cycle, until men in authority – who really should know better – start to mutter rehashed 1930s pessimism about ‘secular stagnation’.
Compounding all this, of course, is the awful truth that practitioners of mainstream economics are in thrall to age-old underconsumptionist fallacies and so require – nay, demand – that no debt must ever be paid down in aggregate (or, as they like to put it, in order to give the idea a thin sheen of respectability, the total of outstanding credit must never fall). Thus, with each successive cycle, new strata of debt are laid down upon the barely eroded bedrock of stale, older ones. Thus it is that the burden of servicing such a growing mountain of claims – an orogenesis of obligation, we might say – can only ever go up. In turn, this results in the officially-imposed interest rate cycle becoming more and more truncated, with each peak lying below the preceding one and with each trough being pushed to – and lately through – the zero bound so that the income drain imposed by that tower of debt does not become too onerous or the old problems re-emerge with renewed venom.
As official rates trend downward, the private sector usually seeks to go one better. Knowing that the debt principal holds little place in the popular imagination but that the monthly payment is the true determining factor in the bargain, lenders start to push out maturities and/or forego the requirement that loans should be smoothly amortized. Not only does this allow the already-indebted both to refinance and then to add to the sums they owe, but it helps entice new cohorts of previously unwelcome borrowers to live beyond their means as well. A fifty-year mortgage or an eight-year car loan? Step this way, sir, we’ll see what we can do.
Soon so much income has been alienated – much of it for such entirely unproductive purposes that little extra earning potential has been acquired in the process – that what we call the intertemporal imbalances again become insupportable. In the current jargon, so much spending has been ‘brought forward’ to prop up today’s faltering system that ever more desperate measures are required to find new expenditures to accelerate and new prodigals to accelerate them when arrives that tomorrow whose fruits we have ‘brought forward’ and the orchard is seen to have been long since stripped bare of its bounty.
On top of this, the eradication of any appreciable opportunity cost in keeping money for its own sake in preference to owning one of the many recognisable claims on greater future money payments (loans, bonds, etc.) leads to a dilution of the principal source of demand for money, the one only transiently expressed in respect of its imminent use as the medium of exchange. This not only confuses the indicators by which we try to balance today’s thrift with tomorrow’s hopes of improved output, but it begins to poison the monetary manipulators’ own wells, to boot.
Accordingly, if money is seen as conferring no great disadvantage should one hold it in place of an ultra-low yielding bond, then the disingenuous assertion first made by Chairman Bernanke that QE is not inflationary because it comprises nothing more than an ‘asset swap’, starts to become all too true.
The central authority, desirous of creating just such an inflation out of a predominant fear of the effect of flat or falling prices on all those whom it has been ceaselessly exhorting to continue to overborrow, easily generates base or ‘outside’ money on which new loans could theoretically be pyramided. But, alas, the commercial banks passively book a good part of these reserves as the primary balance sheet counterparts to the largely inactive settlement deposits of the sellers of the bonds earlier ‘swapped’ for them. Thus, excess reserves do not induce the creation of many additional earning assets – and hence of ‘inside’ money deposits – on top of the original influx.
Moreover, where those same depositors do start to feel their trouser pockets heating up, they typically start to play pass-the-parcel with one another by engaging in a bidding war for bulk credits or listed equities on the financial market, inflating their values and further reducing yields below their optimum levels. What they do not do is rush out and make loans to small businessmen so that these latter earnest souls can improve their capital stock or expand their workforce, no matter what M. Sarkozy may have blustered in 2008 about wanting to ‘…put down the foundations of a capitalism of the entrepreneur and not of the speculator’ as a response to the ongoing financial apoplexy.
With barely a nod to the operation of the much vaunted ‘transmission channels’ so beloved of academia, real-side monetary ‘velocity’ is therefore seen to decline and before too long, the central bank is casting about again for new, more ‘unorthodox’ ways to engineer a perceived surfeit of money and hence to promote a more rapid transactional circulation of the stuff. The vicious circle takes another turn as it does: rates decline further across the curve and yet both borrowing and real-side activity are again only modestly excited.
Before long, men in authority – who really should know better – start to mutter freshly cooked forms of idiocy, claiming that the ‘natural’ rate of interest has fallen to a negative value – a state of affairs in which they must imagine that all of us intemperate, impatient, indulgent mortals have somehow switched en masse to a rare preference for the delayed, rather than the instant, gratification of our wants. Even worse, they find no paradox in supposing that the inexhaustible Horn of Plenty, without which no such unmitigated satiation can have been brought about, must have made its wondrous appearance in a period of mass unemployment and so, presumably, also one of mass want.
In the Looking Glass world of ‘secular stagnation’ and ‘negative real natural rates’ to which all this monetary accommodation has supposedly consigned us, can you guess what the prescription for a restoration of normality must be? Of course! A determined effort to swamp the world with yet more central bank money, to further suppress interest rates, to co-opt more of the decision-making to the central planners, and to annexe more of the economic realm to the fiefdoms of Frankfurt, Washington, and Threadneedle St.! Whatever it takes, don’t you know?
So, with all that said, we come today to yet another major confrontation between lender and borrower in the respective shape of Germany and Greece, one which has foolishly been delayed for more than seven years by the unshakable intransigence of those in power.
This all began with the early crisis vainglory that ‘no strategic bank will fail – and, yes, they are all strategic’. It continued into 2010 when M. Trichet pointed his metaphorical revolver of the refusal to continue with emergency support right at the head of the unfortunate Irish Finance Minister Brian Lenihan – a kind of financial Melian dialogue which the Greeks seem to have well taken to heart, now that such threats are being repeated once more. It rolled on and on with the efforts of the so-called Troika and with the ever-changing, but never truly effective programmes of the ECB itself. It mounted with the widespread abuse of Target2 – something that is, after all, supposed to be a clearing system, not a continent-wide credit wrapper – and with the inordinate strain placed on the balance sheet of the neighbouring SNB.
All the while, the insidious transfer of debt from the private sector to the state (or at least to banks which could not survive absent either explicit or implicit support from that state) has continued, so rendering the necessary resolution between creditor and debtor too diffuse, too indirect, and too legally undefined ever to achieve.
Pity then a Greece which is unfortunate enough to be stuck at Europe’s bottom-right corner instead of at Asia’s top-left, or an Iberian peninsula separated from its neighbours by the Pyrenees to the north rather than by the Atlas mountains to the south, for can we find it at all conceivable to think that they would both not have long ago have seen their debts meaningfully restructured, much of their dead wood cut away, and many of their people set back on the road to prosperity if they had been ‘emerging market’ nations and not satrapies subject to the reality-denying Canutes who run the EU?
For all the hand-wringing about ‘mindless austerity’ on the part of that economic luminary who occupies the Oval Office between golf rounds and for all the wailing conducted over ‘deleveraging’, the sorry truth, of course, is that neither a shrinkage of government outlays nor an overall reduction in debt levels is to be found in even the smallest corner of the globe.
To take one much quoted recent study, this month’s McKinsey report estimates that, since the start of the Crisis in 2007, global debt has risen by some $57 trillion (so, by around $8,000 for every man, woman, and child on the planet) with almost exactly half of the increase in the sub-total attributable to non-financial entities being the fault of those oh-so heartlessly austere governments who have run up an additional tab of a cool $25 trillion in that brief space of time! This means that, in the 6 ½ years of slump and reflation, Leviathan has treated himself to almost $11 billion a day in deficit spending, a sizeable deterioration of almost 2 ½ times the paltry $4.3 billion it was gobbling up during Pharaoh’s preceding seven years of plenty.
It may not be enough to satisfy a Krugman or a Lagarde, but for our taste that represents a dreadfully large quota of capital either frozen in place, shovelled (sometimes literally) into sub-marginal, make-work projects, or simply squandered on recipients of welfare – whether corporate, individual, or among the serried and largely sacrosanct ranks of the place-holding bureaucracy.
Looking instead to the subset represented by the BIS numbers for ‘global liquidity’ – i.e., the loans extended to and securities bought by banks from non-bank borrowers –we see a similar picture. Since Lehman fell, $25 trillion has been added to this particular pile, an increase of one-third from its starting point. Somewhat alarmingly, two-fifths of that increment has its origins in the Asia-Pacific combination of China, Taiwan, Indonesia, India, Korea, Malaysia, the Philippines, and Thailand. Indeed, the last twelve months’ 21.4% increase in cross-border lending to the region has capped off a nearly 80% rise in debt owed by this octet in the period under consideration. To gain some perspective on the magnitude of this, it should be noted that the $10.3 trillion which this involves matches the sums jointly accumulated by governments, households, and non-financial companies in the whole of Europe, the US, Japan, and Latam put together.
A sizeable proportion of that, it almost goes without saying, lies at the door of the Chinese and, coincidentally, the PBoC has been gracious enough this week to reveal its estimate of what it calls Total Social Finance (a hybrid of bank and non-bank credit, together with a smattering of non-bank equity issuance) – an inclusive agglomeration which the likes of Fitch would argue even so does not in any way account for the whole of the web of obligations being woven so densely across the Middle Kingdom.
Nevertheless, the totals we are given are impressive enough. As of the end of last year, the central bank reckons that TSF outstanding came to CNY124 trillion (around $20 trillion). Having pretty much been stable at a ratio of just over 120% of GDP in the prior six years, the massive stimulus programme unleashed in the immediate aftermath of the GFC and never truly attenuated since has seen the credit measure more than triple in absolute size the most recent six, pushing the ratio dangerously skyward to 193% of national income.
This is the legacy whose baneful influence makes up those ‘Three Overlays’ of debt overhang, surplus capacity, and urgent restructuring with which Beijing likes to remind us it has to tussle on the (Silk) road to its ‘new normal’ of slower, more rational growth, and more market-oriented, value-added activity.
So here we have both a major peril and a possible source of hope. The Chinese authorities appear to have recognised that, by following the practices preached by the execrable Western mainstream – albeit on a truly gargantuan, command-economy scale – it has gone beyond the bounds of merely diminishing to reach the Omega point of no return.
So far, as its economy has stuttered and stumbled along, it has resisted the temptation to add just one last, generous coup de whiskey in order to postpone the inevitable hangover (which does not mean it has been entirely abstemious since the new boys took over in 2013). But now not only is growth stuttering, but many prices are falling, too – principally, if not exclusively, those of the raw materials for which it has such a voracious appetite. However beneficial this discount may be to cash-strapped processing firms, it has nevertheless raised the bogey of so-called ‘deflation’ in the counsels of the wise
The question therefore presents itself: will Xi and Li stick to their guns and rely on broader micro-economic and institutional reform to foster a national renaissance – albeit one backed up with a little judicious concrete pouring ‘Along the Way’, i.e., along the route of the new trade routes being constructed to Europe? Or will the pressure to deaden the pain in the interim prove too intense and so unleash both indiscriminate policy easing and possibly an export-boosting devaluation of the yuan?
So far, all the signals are that they will resist the urge, despite a barrage of domestic commentary to the contrary, but a great deal hangs on the fortitude of Xi himself, that one lonely man, perched at the top of the CCP hierarchy – an organisation which itself sits uneasily at the very peak of a true Mount Olympus of debt.
“I don’t think there is a problem that this will fix. I think it will just continue to compress yields into negative territory. If that’s the objective it will achieve it. The question is: will we regain European growth momentum and will labour markets pick up in particular outside Germany if we have a programme that buys debt including German sovereign debt ? So the bigger issue is for me a comparison with the US programme. The US QE programme was effective because a large part of the surge of US unemployment towards 10% was cyclical and the Fed provided a federal instrument – there is no risk-sharing because it was federal debt – and intervened in the most liquid market from which everything is priced.
“In Europe we don’t have such a bond market for, say, Eurobonds because the instrument doesn’t exist. It would be a risk-sharing instrument. Europe is not at that stage of political and fiscal integration. So whatever the ECB does they will not have a big impact on unemployment because most of European unemployment, unlike in the US, is not cyclical. European unemployment is high because of structural reasons. It is high because of inflexible labour market and product market structures, of pension systems, of medi-care systems, of a huge amount of government expenditure related to an ageing population. And so the better issue for Europe is to say: ‘we can help buy time as a central bank – governments should do the right thing’. And we’re seeing too little action too late from governments; in my view we’re seeing too much action too much upfront by the central bank and I think they should really work very hard for governments to face their responsibilities rather than taking on ever larger and ever more demanding responsibilities themselves.”
– Axel Weber, former president of the Deutsche Bundesbank, interviewed on Radio 4’s ‘Today’ programme, 22 January 2015, just prior to Mario Draghi’s announcement of a €1.1 trillion ECB money-printing programme.
“The guy with the asset price bubble question.. he is not coming back.”
– Tweet from Zero Hedge during the ECB press conference.
“When you look at Mr Wolf’s background … it becomes clearer why he supports these policies. He’s never mortgaged his house to open a small business. He lives in the fairy land of academics that believe printing paper will somehow be a signal to Directors (that have a fiduciary duty to act in the best interest of shareholders) to invest in expanding capacity?! ..that only the omnipotent power of the central planners can save the private sector by artificially holding down the major price signal in a ‘market’ economy.”
– ‘Manfred’, responding to Martin Wolf’s FT piece, ‘Draghi’s bold promise to do what it takes for as long as it takes’, 22 January 2015.
“YOU KNOW THE BULL MARKET IS LONG IN THE TOOTH WHEN
“When….. Start-ups are being started and IPO’s being raised to hunt Bigfoot… Nope… this is not a joke…And nope, this is not something you would see anywhere near market lows.
Start-ups are famous for setting big, hairy goals. Carmine “Tom” Biscardi wants to catch Sasquatch—and is planning an initial public offering to fund the hunt.
Mr. Biscardi and his partners hope to raise as much as $3 million by selling stock in Bigfoot Project Investments. They plan to spend the money making movies and selling DVDs, but are also budgeting $113,805 a year for expeditions to find the beast. Among the company’s goals, according to its filings with the Securities and Exchange Commission: “capture the creature known as Bigfoot.”
Well, that was worth waiting for. Not. Future generations are unlikely to ask, ‘Where were you during the ECB’s announcement of QE, daddy ?’ Primarily because
a) Much of the detail of the stimulus was leaked the day beforehand, and
b) The real event of January was the Swiss National Bank’s capitulation in capping the franc’s peg to the euro.
Axel Weber’s assessment of the futility of euro zone QE is surely sufficiently articulate: a central bank is attempting to solve problems that can only be resolved through government action. A central bank by definition is limited in scope to the monetary sphere. What is required is tough love in the economic policy sphere – in France, in Greece, and elsewhere. Europe lacks the political and fiscal unity for Mario Draghi to do anything other than play games with the printing press and with a load of poor quality debt offering dubious yields. Central banks are not magicians, even if they behave like them.
And the ECB is coming late to the party in any case. In the words of Colin McLean, “the US and UK were dealing with a cyclical downturn, not deep-seated structural failure. In the euro zone, QE might further delay the need for structural reform..”
Financial historian Russell Napier last week discussed the Swiss National Bank’s surprise decision to abandon its own currency peg:
“The Swiss National Bank (SNB) failed to ‘fix’ the exchange rate between the Swiss Franc and the Euro. The simple lesson which investors must learn from this is – central bankers cannot fix very much. The inability of the Swiss National Bank to ‘fix’ the exchange rate will come to be seen as the end of the bull market in the omnipotence of central bankers.”
He went on to highlight some of the other things that investors erroneously believe central banks to have ‘fixed’:
“Central bank policy is creating liquidity. Wrong – the growth in broad money is slowing across the world.
“Central bank policy is allowing a frictionless de-gearing. Wrong – debt to GDP levels of almost every country in the world are rising.
“Central bank policy is creating inflation. Wrong – inflation in most jurisdictions is now back to, or below, the levels recorded in late 2009.
“Central bank policy is fixing key exchange rates and securing growth. Wrong – in numerous jurisdictions, from Poland to China and beyond, this exchange rate intervention is slowing the growth in liquidity and thus the growth in the economy.
“Central bank policy is keeping real interest rates low and stimulating demand. Wrong – the decline in inflation from peak levels in 2011 means that real rates of interest are rising. The growth in demand in most jurisdictions remains very sluggish by historical standards.
“Central bank policy is driving up asset prices and creating a positive wealth impact which is bolstering consumption. Wrong – savings rates have not declined materially.
“Central bank policy is creating greater financial stability. Wrong – whatever positive impact central banks are having on bank capital etc. they have failed to prevent the biggest emerging market debt boom in history. That boom is particularly dangerous because either the borrower or lender is taking huge foreign exchange risks and because a large proportion of that debt has been provided by open-ended bond funds which can be subject to runs.”
The ongoing disaster that is the euro zone is tedious beyond words, so let’s change the subject. The Washington Post last week published a piece on Venezuela (different circus; same clowns) by Matt O’Brien. This is another cautionary tale of what happens to economies when bureaucrats insist on messing around with the price function. Having “defaulted on its people”, Venezuela may now be on the verge of defaulting on its debts.
“It shouldn’t be this way. Venezuela, after all, has the largest oil reserves in the world. It should be rich. But it isn’t, and it’s getting even poorer now, because of economic mismanagement on a world-historical scale. The problem is simple: Venezuela’s government thinks it can have an economy by just pretending it does. That it can print as much money as it wants without stoking inflation by just saying it won’t. And that it can end shortages just by kicking people out of line. It’s a triumph of magical thinking that’s not much of one when it turns grocery-shopping into a days-long ordeal that may or may not actually turn up things like food or toilet paper.
“This reality has been a long time coming. Venezuela, you see, has the most oil reserves, but not the most oil production. That’s, in part, because the Bolivarian regime, first under Chavez and now Maduro, has scared off foreign investment and bungled its state-owned oil company so much that production has fallen 25 percent since it took power in 1999. Even worse, oil exports have fallen by half. Why? Well, a lot of Venezuela’s crude stays home, where it’s subsidized to the you-can’t-afford-not-to-fill-up price of 1.5 U.S. cents per gallon. (Yes, really). Some of it gets sent to friendly governments, like Cuba’s,in return for medical care. And another chunk goes to China as payment in kind for the$45 billion it’s borrowed from them.
“That doesn’t leave enough oil money to pay bills. Again, the Bolivarian regime is to blame. The trouble is that while it has tried to help the poor, which is commendable, it has also spent much more than it can afford, which is not. Indeed, Venezuela’s government is running a 14 percent of gross domestic product deficit right now, a fiscal hole so big that there’s only one way to fill it: the printing press. But that just traded one economic problem — too little money — for the opposite one. After all, paying people with newly printed money only makes that money lose value, and prices go parabolic. It’s no wonder then that Venezuela’s inflation rate is officially 64 percent, is really something like 179 percent, and could get up to 1,000 percent, according to Bank of America, if Venezuela doesn’t change its byzantine currency controls.
“Venezuela’s government, in other words, is playing whac-a-mole with economic reality. And its exchange-rate system is the hammer. It goes something like this. The Maduro regime wants to throttle the private sector but spend money like it hasn’t. Then it wants to print what it needs, but keep prices the same like it hasn’t. And finally, it wants to keep its stores stocked, but, going back to step one, keep the private sector in check like it hasn’t. This is where its currency system comes in. The government, you see, has set up a three-tiered exchange rate to try to control everything — prices, profits, and production — in the economy. The idea, if you want to call it that, is that it can keep prices low by pretending its currency is really stronger than it is. And then it can decide who gets to make money, and how much, by doling out dollars to importers at this artificially low rate, provided they charge what the government says.
“This might sound complicated, but it really isn’t. Venezuela’s government wants to wish away the inflation it’s created, so it tells stores what prices they’re allowed to sell at. These bureaucrat-approved prices, however, are too low to be profitable, which is why the government has to give companies subsidies to make them worthwhile. Now when these price controls work, the result is shortages, and when they don’t, it’s even worse ones. Think about it like this: Companies that don’t get cheap dollars at the official exchange rate would lose money selling at the official prices, so they leave their stores empty. But the ones that are lucky, or connected, enough to get cheap dollars might prefer to sell them for a quick, and maybe bigger profit, in the black currency marketthan to use them for what they’re supposed to. So, as I’ve put it before, it’s not profitable for the unsubsidized companies to stock their shelves, and not profitable enough for the subsidized ones to do so, either..
“.But just like Venezuela has defaulted on its most basic obligations to its people — like, say, laundry detergent — it might also default on its financial ones. It can’t afford anything, not food, not diapers, and not bond payments, if oil stays around $50 a barrel. Now, investors have assumed that they’d be able to seize Citgo, which is owned by Venezuela’s state-owned oil company, as payment if the country ever defaulted on its debt. But now it looks like that’s not true. That, together with falling oil prices, is why credit default swaps, basically debt insurance, on Venezuela’s 5-year bonds haveexploded the past few months. The fiscal situation is so dire that Citgo, which, remember, supposedly wouldn’t count as a part of the Venezuelan state, is planning on taking out $2.5 billion in debt to give to its parent company, which would presumably pass it along to the government. This makes sense, as much as anything does in Venezuela, because Citgo has a higher credit rating than the government, so it canborrow, and if it defaults, it will just be as if the country sold it.
“It’s a man-made tragedy, and the men who made it won’t fix it. Maduro, for his part, blames the shortages on the “parasitic” private sector, while the food minister doesn’t get what the big deal is since he has to wait in line at soccer games.
“So it turns out Lenin wasn’t just right that the best way to destroy the capitalist system is to debauch the currency. It’s also the best way, as Venezuela can tell you, to destroy the socialist one.”
At last week’s press conference to announce the ECB’s first iteration of QE (if history is any guide, there will be more), Mario Draghi claimed to see no evidence of inflation whatsoever. Perhaps Mario Draghi lets someone else manage his property, stock and bond portfolio.
The European Central Bank (ECB) is planning to pump 1.1 trillion euro’s into the banking system to fend off price deflation and revive economic activity. The ECB president and his executive board are planning to spend 60 billion euro’s a month from March 2015 to September 2016.
Most experts hold that the ECB must start acting aggressively against the danger of deflation. The yearly rate of growth of the consumer price index (CPI) fell to minus 0.2% in December last year from 0.3% in November and 0.8% in December 2013.
Many commentators are of the view that the ECB should initiate an aggressive phase of monetary pumping along the lines of the US central bank. Moreover the balance sheet of the ECB has in fact been shrinking. On this the yearly rate of growth of the ECB balance sheet stood at minus 2.1% in January against minus 8.5% in December. Note that in January last year the yearly rate of growth stood at minus 24.4%.
Why is a declining rate of inflation bad for economic growth? According to the popular way of thinking declining price inflation sets in motion declining inflation expectations. This, so it is held, is likely to cause consumers to postpone their buying at present and that in turn is likely to undermine the pace of economic growth.
In order to maintain their lives and well being individuals must buy present goods and services, so from this perspective a fall in prices as such is not going to curtail consumer outlays. Furthermore, a fall in the growth momentum of prices is always good for the economy.
An expansion of real wealth for a given stock of money is going to manifest in a decline in prices (remember a price is the amount of money per unit of real stuff), so why should this be regarded as bad for the economy?
After all, what we have here is an expansion of real wealth. A fall in prices implies a rise in the purchasing power of money, and this in turn means that many more individuals can now benefit from the expansion in real wealth.
Now, if we observe a decline in prices on account of an economic bust, which eliminates various non-productive bubble activities, why is this bad for the economy?
The liquidation of non-productive bubble activities – which is associated with a decline in the growth momentum of prices of various goods previously supported by non-productive activities – is good news for wealth generation.
The liquidation of bubble activities implies that less real wealth is going to be diverted from wealth generators. Consequently, this will enable them to lift the pace of wealth generation. (With more wealth at their disposal they will be able to generate more wealth).
So as one can see a fall in price momentum is always good news for the economy since it reflects an expansion or a potential expansion in real wealth.
Hence a policy aimed at reversing a fall in the growth momentum of prices is going to undermine and not strengthen economic growth.
We hold that the various government measures of economic activity reflect monetary pumping and have nothing to do with true economic growth.
An increase in monetary pumping may set in motion a stronger pace of growth in an economic measure such as gross domestic product. This stronger growth however, should be regarded as a strengthening in the pace of economic impoverishment.
It is not possible to produce genuine economic growth by means of monetary pumping and an artificial lowering of interest rates. If this could have been done by now world poverty would have been erased.
Summary and conclusion
The European Central Bank (ECB) is planning to pump 1.1 trillion euro’s into the banking system to fend off price deflation and revive economic activity in the Euro-zone. Most experts are supportive of the ECB’s plan. We question the whole logic of the monetary pumping.
A fall in the growth momentum of prices either on account of real wealth expansion or on account of the demise of bubble activities is always good news for wealth producers.
Hence any policy that is aimed at preventing a fall in prices is only likely to strengthen bubble activities and undermine the process of wealth generation.
Washington finally shows signs of coming to grips with the importance of money to politics. This is not about mere campaign finance. Recently there was a breakthrough in bringing the money policy issue out of the shadows and to center stage … where it belongs.
The real issue of money in politics is about the Fed, not the Kochs. The Fed’s political impact is orders of magnitude greater than all the billionaires’ money, bright and dark, left and right, combined.
There was a real breakthrough in the discourse last week. This breakthrough deserves far more attention than it yet has received.
The arc of the political universe is long, but it bends towards monetary policy.
That’s the boring truth that nobody wants to hear. Forget about the gaffes, the horserace, and even the personalities. Elections are about the economy, stupid, and the economy is mostly controlled by monetary policy. That’s why every big ideological turning point—1896, 1920, 1932, 1980, and maybe 2008—has come after a big monetary shock.
Think about it this way: Bad monetary policy means a bad economy, which gives power back to the party that didn’t have it before. And so long as the monetary problem gets fixed, the economy will too, and the new government’s policies will, whatever their merits, get the credit. That’s how ideology changes.
O’Brien’s column may, just possibly, represent a watershed turn in the political conversation. Game on.
O’Brien demolishes not one but two myths. The first myth is of the Fed as politically independent. The second is that monetary policy properly resides outside the electoral process.
Although they strained to portray themselves as nonthreatening, nonpartisan technician-managers of the status quo, central bankers, like proverbial Supreme Court justices reading election returns, used their acute political antennae to intuit how far they could lean against the popular democratic winds. “Chairmen of the Federal Reserve,” observes ex-Citibank Chairman Walter Wriston, “have traditionally been the best politicians in Washington. The Fed serves a wonderful function. They get beat up on by the Congress and the administration. Everyone knows the game and everyone plays it. But no one wants their responsibility.”
Moreover, as to the political delicacy of this position, I wrote:
To consistently be in what iconic Fed Chairman William McChesney Martin called “the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up” is just asking too much of most mere mortals. It asks too much even of officials of such admirable integrity, intellect, and heart as Janet Yellen (and Chair Yellen’s deeply admirable Vice Chair Stanley Fischer, most recently seen talking with protestors at Jackson Hole).
Monetary policy has been relegated to the Fed and largely excluded from the formal electoral process for almost two generations. This is, at it happens, and as O’Brien states forthrightly, a historical anomaly.
Monetary policy was a white hot topic at the Constitutional Convention of 1787. Thereafter, it was crucial to the success of George Washington’s administration, one of the few matters in which cabinet members Thomas Jefferson and Alexander Hamilton concurred.
Monetary policy — in the North, “Greenbacks” — was a huge (and later litigated) issue during and after the Civil War.
Monetary policy was a fundamental issue for Grover Cleveland.
Monetary policy was the issue that propelled the young William Jennings Bryan to national prominence and three presidential nominations, beginning with his famous “cross of gold” speech.
Monetary policy was a, perhaps the, prime issue on which William McKinley campaigned (and won).
After the Panic of 1907 monetary policy was a central issue for U.S. Senator Nelson Aldrich, then called America’s “General Manager.” Aldrich chaired the National Monetary Commission. He wittily noted, in a 1909 speech, that “[T]he study of monetary questions is one of the leading causes of insanity.”
Thereafter — with the creation of the Fed — monetary policy became a key issue for Woodrow Wilson. As recorded in Historical Beginnings. The Federal Reserve by Roger T. Johnson, (published by The Federal Reserve Bank of Boston, revised 2010)
On December 23, just a few hours after the Senate had completed action, President Wilson, surrounded by members of his family, his cabinet officers, and the Democratic leaders of Congress, signed the Federal Reserve Act. “I cannot say with what deep emotions of gratitude… I feel,” the President said, “that I have had a part in completing a work which I think will be of lasting benefit to the business of the country.”
FDR’s revaluing gold, on the advice of agricultural economist George Warren, was crucial to lifting the Depression. This was a matter so politically dramatic as to land Warren on the cover of Time Magazine.
As (conservative economic savant Jacques) Rueff observed in The Monetary Sins of the West (The Macmillan Company, New York, New York, 1972, p. 101):
“Let us not forget either the tremendous disaster of the Great Depression, carrying in its wake countless sufferings and wide-spread ruin, a catastrophe that was brought under control only in 1934, when President Roosevelt, after a complex mix of remedies had proved unavailing, raised the price of gold from $20 to $35 an ounce.”
As investment manager Liaquat Ahamed wrote in his Pulitzer Prize winning history Lords of Finance: The Bankers Who Broke the World (The Penguin Press, New York, 2009, pp. 462-463):
“But in the days after the Roosevelt decision, as the dollar fell against gold, the stock market soared by 15%. Even the Morgan bankers, historically among the most staunch defenders of the gold standard, could not resist cheering. ‘Your action in going off gold saved the country from complete collapse,’ wrote Russell Leffingwell to the president.”
“Taking the dollar off gold provided the second leg to the dramatic change in sentiment… that coursed through the economy that spring. … During the following three months, wholesale prices jumped by 45 percent and stock prices doubled. With prices rising, the real cost of borrowing money plummeted. New orders for heavy machinery soared by 100 percent, auto sales doubled, and overall industrial production shot up 50 percent.”
Of course, FDR did not take the dollar off gold. He revalued. That FDR did not have a firm grasp on the implications of his own policy is evidenced by his Treasury’s sterilization of gold inflows, arguably a leading factor leading to the 1937 double dip back into Depression.
Monetary policy figured more than tangentially in President Nixon’s “New Economic Policy,” announced in a national address on August 15, 1971. The inflationary consequences of Nixon’s closing of the gold window — and the easy money policy he bullied out of the Fed — figured prominently in the Ford and Carter administrations. The symptom of bad monetary policy — runaway inflation — was a major contributing factor in the election of Ronald Reagan.
A period that has been called the Great Moderation — under Fed Chairman Paul Volcker and the first two terms of Chairman Greenspan — followed. This saw the creation of almost 40 million new jobs, and economic mobility. This tookmonetary policy largely off the political agenda for almost two generations.
Then, of course, came the unexpected financial meltdown of 2008. That event — and the ensuing soggy recovery — helped propel monetary policy back into the realm of electoral politics.
The Republican Party national platform of 2012 called for the establishment of a monetary “commission to investigate possible ways to set a fixed value for the dollar.” This is something for which American Principles in Action (which I professionally advise) was and is a leading advocate.
This plank, widely noted around the world, directly led to the introduction, by Joint Economic Committee chairman Kevin Brady (R-Tx), of Centennial Monetary Commission legislation, which attracted 40 House and two Senate co-sponsors. It is expected to be reintroduced early in the 114th Congress.
The monetary commission legislation meticulously is bipartisan in nature. It includes ex-officio commissioners to be appointed by the Fed Chair and Treasury Secretary. It has been widely, and universally, praised in the financial press … including the FT, the Wall Street Journal, and Forbes.com. It is purely empirical in intent and has attracted the public support of many important civic leaders in the policy and political arena.
Last winter the commission received a unanimous resolution of support from the Republican National Committee. Democrats and progressives, of the kind of progressive Democrat President Cleveland, also well can support it.
There are a number of things about which one might quibble in O’Brien’s column. (O’Brien, for instance, reflexively opposes the gold standard. Yet the facts and analysis on which he rests his objections are incomplete.)
That said, O’Brien gets the big thing right: “The arc of the political universe is long, but it bends towards monetary policy.” Such an important columnist for the Post getting the big thing right is in and of itself a Big Thing.
Good money — and how to make our money good — is a matter that belongs at the center of our national, and, especially, presidential, politics. Good money is central to restoring job creation, economic mobility, equitable prosperity, the integrity of our savings and the solvency of our banks.
We are in what trenchantly has been called “uncharted territory.” Among issues which deserve a “national conversation” good money deserves the place at the head of the line. Fed Chair Yellen has been described, astutely, by Politico as having the Toughest job in Washington. It is high time for our elected officials — and presidential aspirants — to shoulder more responsibility. It is high time for monetary policy, after being in political near-hibernation for almost two generations, to enter the 2016 presidential debate.
Ralph Benko is senior advisor, economics, for American Principles in Action, in Washington, DC, specializing in the gold standard and advisor to and editor of the Lehrman Institute's The Gold Standard Now. He is editor-in-chief of thesupplyside.blogspot.com. With Charles Kadlec, he is co-author of The 21st Century Gold Standard: For Prosperity, Security, and Liberty available for free download here. Benko and Kadlec are co-editors of the Laissez Faire Books edition of Copernicus's Essay on Money. He also manages the Facebook page The Gold Standard. Follow him on Twitter as TheWebster. | Contact us
28 January 15 | Tags: Central Banking, deflation, Federal Reserve, Inflation, monetary policy, Sovereign Debt | Category: Money | Comments are closed
Greece is back in the spotlight amid renewed fears of a break-up of the Euro as the Syriza party show a 3.1% lead over the incumbent New Democracy in the latest Rass opinion poll – 4thJanuary. The average of the last 20 polls – dating back to 15th December shows Syriza with a lead of 4.74% capturing 31.9% of the vote.
These election concerns have become elevated since the publication of an article in Der Spiegel Grexit Grumblings: Germany Open to Possible Greek Euro Zone Exit -suggesting that German Chancellor Merkel is now of the opinion that the Eurozone (EZ) can survive without Greece. Whilst Steffen Seibert – Merkle’s press spokesman – has since stated that the “political leadership” isn’t working on blueprints for a Greek exit, the idea that Greece might be “let go” has captured the imagination of the markets.
In its policies Syriza represents, at best, uncertainty and contradiction and at worst reckless populism. On the one hand Mr Tsipras has recanted from his one-time hostility to Greece’s euro membership and toned down his more extravagant promises. Yet, on the other, he still thinks he can tear up the conditions imposed by Greece’s creditors in exchange for two successive bail-outs. His reasoning is partly that the economy is at last recovering and Greece is now running a primary budget surplus (ie, before interest payments); and partly that the rest of the euro zone will simply give in as they have before. On both counts he is being reckless.
In theory a growing economy and a primary surplus may help a country repudiate its debts because it is no longer dependent on capital inflows.
The complexity of the political situation in Greece is such that the outcome of the election, scheduled for 25th January, will, almost certainly, be a coalition. Syriza might form an alliance with the ultra-right wing Golden Dawn who have polled an average of 6.49% in the last 20 opinion polls, who are also anti-Austerity, but they would be uncomfortable bedfellows in most other respects. Another option might be the Communist Party of Greece who have polled 5.8% during the same period. I believe the more important development for the financial markets during the last week has been the change of tone in Germany.
The European bond markets have taken heed, marking down Greek bonds whilst other peripheral countries have seen record low 10 year yields. 10 year Bunds have also marched inexorably upwards. European stock markets, by contrast, have been somewhat rattled by the Euro Break-up spectre’s return to the feast. It may be argued that they are also reacting to concerns about collapsing oil prices, the geo-political stand-off with Russia, the continued slow-down in China and other emerging markets and general expectations of lower global growth. In the last few sessions many stock markets have rallied strongly, mainly on hopes of aggressive ECB intervention.
A couple of years ago the prospect of a Syriza-led government caused serious tremors in European markets because of the fear that an extremely bad outcome in Greece was possible, such as its exit from the Euro system, and that this would create contagion effects in Portugal and other weaker nations. Fortunately, Europe is in a much better situation now to withstand problems in Greece and to avoid serious ramifications for other struggling member states. The worst of the crisis is over in the weak nations and the system as a whole is better geared to support those countries if another wave of market fears arise.
It is quite unlikely that Greece will end up falling out of the Euro system and no other outcome would have much of a contagion effect within Europe. Even if Greece did exit the Euro, there is now a strong possibility that the damage could be confined largely to Greece, since no other nation now appears likely to exit, even in a crisis.
Neither Syriza nor the Greek public (according to every poll) wants to pull out of the Euro system and they have massive economic incentives to avoid such an outcome, since the transition would almost certainly plunge Greece back into severe recession, if not outright depression. So, a withdrawal would have to be the result of a series of major miscalculations by Syriza and its European partners. This is not out of the question, but the probability is very low, since there would be multiple decision points at which the two sides could walk back from an impending exit.
German chancellor Angela Merkel in a New Year’s address deplored the rise of a rightwing populist movement, saying its leaders have “prejudice, coldness, even hatred in their hearts”.
In her strongest comments yet on the so-called Patriotic Europeans Against the Islamisation of the West (Pegida), she spoke of demonstrators shouting “we are the people”, co-opting a slogan from the rallies that led up to the fall of the Berlin Wall 25 years ago.
“But what they really mean is: you are not one of us, because of your skin colour or your religion,” Merkel said, according to a pre-released copy of a televised speech she was to due to deliver to the nation on Wednesday evening.
“So I say to all those who go to such demonstrations: do not follow those who have called the rallies. Because all too often they have prejudice, coldness, even hatred in their hearts.”
Concern about domestic politics in Germany and rising support for the ultra right-wing Pegida party makes the prospect of allowing Greece to leave the Euro look like the lesser of two evils. Yet a Greek exit and default on its Euro denominated obligations would destabilise the European banking system leading to a spate of deleveraging across the continent. In order to avert this outcome, German law makers have already begun to soften their “hard-line” approach, extending the olive branch of a potential renegotiation of the terms and maturity of outstanding Greek debt with whoever wins the forthcoming election. I envisage a combination of debt forgiveness, maturity extension and restructuring of interest payments – perish the thought that there be a sovereign default.
Total outstanding US dollar-denominated debt of non-banks located outside the United States now stands at more than $9 trillion, having grown from $6 trillion at the beginning of 2010. The largest increase has been in corporate bonds issued by emerging market firms responding to the surge in demand by yield-hungry fixed income investors.
Within the EZ the quest for yield has been no less rabid, added to which, risk models assume zero currency risk for EZ financial institutions that hold obligations issued in Euro’s. The preferred trade for many European banks has been to purchase their domestic sovereign bonds because of the low capital requirements under Basel II. Allowing banks to borrow short and lend long has been tacit government policy for alleviating bank balance sheet shortfalls, globally, in every crisis since the great moderation, if not before. The recent rise in Greek bond yields is therefore a concern.
An additional concern is that the Greek government bond yield curve has inverted dramatically in the past month. The three year yields have risen most precipitously. This is a problem for banks which borrowed in the medium maturity range in order to lend longer. Fortunately most banks borrow at very much shorter maturity, nonetheless the curve inversion represents a red flag : –
Over the same period Portuguese government bonds have, so far, experienced little contagion:-
Greece received Euro 245bln in bail-outs from the Troika; if they should default, the remaining EZ 17 governments will have to pick up the cost. Here is the breakdown of state guarantees under the European Financial Stability Facility:-
Guarantee Commitments Eur Mlns
Assuming the worst case scenario of a complete default – which seems unlikely even given the par less state of Greek finances – this would put Italy on the hook for Eur 43bln, Spain for Eur 28.5bln, Portugal for Eur 6bln and Ireland for Eur 3.8bln.
The major European Financial Institutions may have learned their lesson, about over-investing in the highest yielding sovereign bonds, during the 2010/2011 crisis – according to an FTinterview with JP Morgan Cazenove, exposure is “limited” – but domestic Greek banks are exposed. The interconnectedness of European bank exposures are still difficult to gauge due to the lack of a full “Banking Union”. Added to which, where will these cash-strapped governments find the money needed to meet this magnitude of shortfall?
The ECBs response
In an interview with Handelsblatt last week, ECB president Mario Draghi reiterated the bank’s commitment to expand their balance sheet from Eur2 trln to Eur3 trln if conditions require it. Given that Eurostat published a flash estimate of Euro area inflation for December this week at -0.2% vs +0.3% in November, I expect the ECB to find conditions requiring a balance sheet expansion sooner rather than later. Reuters – ECB considering three approaches to QE – quotes the Dutch newspaper Het Financieele Dagbad expecting one of three actions:-
…one option officials are considering is to pump liquidity into the financial system by having the ECB itself buy government bonds in a quantity proportionate to the given member state’s shareholding in the central bank.
A second option is for the ECB to buy only triple-A rated government bonds, driving their yields down to zero or into negative territory. The hope is that this would push investors into buying riskier sovereign and corporate debt.
The third option is similar to the first, but national central banks would do the buying, meaning that the risk would “in principle” remain with the country in question, the paper said.
The issue of “monetary financing” – forbidden under Article 123 of the Lisbon Treaty – has still to be resolved, so Outright Monetary Transactions (OMT) in respect of EZ government bonds are still not a viable policy option. That leaves Covered bonds – a market of Eur 2.6trln of which only around Eur 600bln are eligible for the ECB to purchase – and Asset Backed Securities (ABS) with around Eur 400bln of eligible securities. These markets are simply not sufficiently liquid for the ECB to expand its balance sheet by Eur 1trln. In 2009 they managed to purchase Eur 60bln of Covered bonds but only succeeded in purchasing Eur 16.9bln of the second tranche – the bank had committed to purchase up to Eur 40bln.
Since its inception in July 2009 the ECB have purchased just shy of Eur 108bln of Covered bonds and ABS: –
These amounts are a drop in the ocean. If the ECB is not permitted to purchase government bonds what other options does it have? I believe the alternative is to follow the lead set by the Bank of Japan (BoJ) in purchasing corporate bonds and common stocks. To date the BoJ has only indulged in relatively minor “qualitative” easing; the ECB has an opportunity to by-pass the fragmented European banking system and provide finance and permanent capital directly to the European corporate sector.
Over the past year German stocks has been relatively stable whilst Greek equities, since the end of Q2, have declined. Assuming Greece does not vote to leave the Euro, Greek and other peripheral European stocks will benefit if the ECB should embark on its own brand of Qualitative and Quantitative Easing (QQE):-
Source: Bloomberg Note: Blue = Athens SE Composite Purple = DAX
It is important to make a caveat at this juncture. The qualitative component of the BoJ QQE programme has been derisory in comparison to their buying of JGBs; added to which, whilst the socialisation of the European corporate sector is hardly political anathema to many European politicians it is a long way from “lending at a penal rate in exchange for good collateral” – the traditional function of a central bank in times of crisis.
Conclusion and investment opportunities
European Government Bonds
Whilst the most likely political outcome is a relaxation of Article 123 of the Lisbon Treaty, allowing the ECB, or the national Central Bank’s to purchase EZ sovereign bonds, much of the favourable impact on government bond yields is already reflected in the price. 10 year JGBs – after decades of BoJ buying – yield 30bp, German Bunds – without the support of the ECB – yield 46bp. Aside from Greek bonds, peripheral members of the EZ have seen their bond yields decline over the past month. If the ECB announce OMT I believe the bond rally will be short-lived.
Given the high correlation between stocks markets in general and developed country stock markets in particular, it is dangerous to view Europe in isolation. The US market is struggling with a rising US$ and collapsing oil price. These factors have undermined confidence in the short-term. The US market is also looking to the Europe, since a further slowdown in Europe, combined with weakness in emerging markets act as a drag on US growth prospects. On a relative value basis European stocks are moderately expensive. The driver of performance, as it has been since 2008, will be central bank policy. A 50% increase in the size of the ECB balance sheet will be supportive for European stocks, as I have mentioned in previous posts, Ireland is my preferred investment, with a bias towards the real-estate sector.
Whilst the EUR/USD rate continues to decline the Nominal Effective Exchange Rate as calculated by the ECB, currently at 98, is around the middle of its range (81 – 114) since the inception of the currency and still some way above the recent lows seen in July 2012 when it reached 94. The October 2000 low of 81 is far away.
If a currency war is about to break-out between the major trading nations, the Euro doesn’t look like the principal culprit. I expect the Euro to continue to decline, except, perhaps against the JPY. Against the GBP a short EUR exposure will be less volatile but it will exhibit a more political dimension since the UK is a natural safe haven when an EZ crisis is brewing.
Colin has worked in the financial and commodity markets since 1981. He started his career in physical commodities moving on to a futures and options brokerage in 1987. Here he focused on servicing bank proprietary traders, global macro and relative-value fixed income hedge funds together with managed futures advisors. He was also instrumental in the development of interest rate and credit default swaps businesses.
In December 2013 he launched a macroeconomic newsletter – In the Long Run – focussing on macroeconomics and financial markets.
He has recently became a director of AAIN - Asian Alternative Investments Network – a non-profit industry group with which he has been involved since its inception in 2007. | Contact us
18 January 15 | Tags: Economic Cycles, Economics, Financial Stability, Markets, Sovereign Debt | Category: Economics | Comments are closed
2014 ended with two ominous developments: the strength of the US dollar and a collapse in key commodity prices.
It is tempting to view both events as one, but the continuing fall in oil prices through December reveals they are sequential: first there was a greater preference for dollars compared with other currencies and this still persists, followed by a developing preference for all but the weakest currencies at the expense of raw materials and energy. These are two steps on a path that should logically lead to a global slump.
Dollar strength was the first warning that things were amiss, leading to higher interest rates in many of the emerging economies as their central banks sought to control investment outflows. Since this followed a prolonged period of credit expansion these countries appear to be entering the bust phase of the credit-driven boom-and-bust cycle; so for them, 2015 at a minimum will see a slump in economic activity as the accumulated malinvestments from the past are unwound. According to the IMF database, emerging market and developing economies at current prices account for total GDP of over $30 trillion, compared with advanced economies’ GDP totalling $47 trillion. It is clear that a slump in the former will have serious repercussions for the latter.
As the reserve currency the dollar is central to the exchange value of all other currencies. This is despite attempts by China and Russia to trade without it. Furthermore and because of this dependency, the global economy has become more geared to the dollar over the years because it has expanded relative to the US. In 2000, the US was one-third of global GDP; today it is about one-fifth.
The second development, falling energy and commodity prices, while initially driven by the same factors as dollar strength, confirms the growing likelihood of a global slump. If falling prices were entirely due to increased supply of the commodities involved, we could rejoice. However, while there has been some increase in energy and commodity supply the message is clear, and that is demand at current prices has unexpectedly declined, and prices are now trying to find a new equilibrium. And because we are considering world demand, this development is being missed or misread by economists who lack a global perspective.
The price of oil has approximately halved in the last six months. The fall has been attributed variously to the west trying to bankrupt Russia, or to Saudi Arabia driving American shale production out of business. This misses the bigger picture: according to BP’s Statistical Review 2014, at the beginning of last year world oil consumption comfortably exceeded supply, 91.3million barrels per day compared with 86.8. This indicates that something fundamental changed in 2014 to collapse the price, and that something can only be a sudden fall in demand in the second half.
Iron ore prices have also halved over the last six months, but other key commodities, such as copper which fell by only 11% over the period, appear to have not yet adjusted to the emerging markets slump. This complies with business cycle theory, because in the early stages of a slump businesses remain committed to their capital investment plans in the vain hope that conditions will improve. This being the case, the collapse in demand for energy can be expected to deepen and spread to other industrial raw materials as manufacturers throw in the towel and their investment plans are finally abandoned.
Therefore the economic background to the financial outlook for the global economy is not encouraging. Nor was it at the beginning of 2014, when it was obviously going to be a difficult year. The difference a year on is that the concerns about the future are more crystallised. This time last year I wrote that we were heading towards a second (to Lehman) and unexpected financial and currency crisis that could happen at any time. I only modify that to say the crisis has indeed begun and it has much further to go this year. This is the background against which we must briefly consider some of the other major currencies, and precious metals.
Japan and the yen
The complacency about Japan in the economic and investment communities is astonishing. Japan is committed to a scale of monetary inflation that if continued can only end up destroying the yen. The Bank of Japan is now financing the equivalent of twice the government deficit (¥41 trillion) by issuing new currency, some of which is being used to buy Japanese equity ETFs and property REITs. By these means pricing in bond, equity and commercial property markets has become irrelevant. “Abenomics” is about financing the government and managing the markets under the Keynesian cover of stimulating both the economy and animal spirits. In fact, with over ¥1.2 quadrillion of public sector debt the government is caught in a debt trap from which it sees no escape other than bluff. And since Abenomics was first embarked upon two years ago, the yen has fallen from 75 to the US dollar to 120, or 37%.
Instead of learning the lessons of previous hyperinflations, mainstream economists fall for the official line and ignore the facts. The facts are simple: Japan is a welfare state with an increasing and unsustainable ratio of retirees to tax-paying workers. She is the leading advanced nation on a debt path the other welfare nations are closely following. Consensus forecasts that the Japanese economy will be stimulated into recovery in 2015 are wide of the mark: instead she is destroying her currency and private sector wealth with it.
Eurozone and the euro
In the short-term the Eurozone is being revisited by its Greek problem. Whether or not the next Greek government backs off from confronting the other Eurozone members and the ECB remains to be seen. The problems for the Eurozone lie considerably deeper than Greece, made worse by politicians who have been reluctant to use the time bought by the ECB to address the structural difficulties of the 19 Eurozone members. The result is the stronger northern bloc (Germany, Netherlands, Finland and Luxembourg) is being crippled by the burden of the Mediterranean states plus Portugal plus France. And Germany and Finland have suffered the further blow of losing valuable export business from Russia.
In the coming months the Eurozone will likely face gas shortages from Russia through the trans-Ukrainian pipeline, and price deflation driven by energy and other commodity prices. Price deflation spurs two further points to consider, one false and the other true: lower prices are deemed to be recessionary (false), and falling prices increase the burden of real debt (true). The consequence is that the ECB will seek ways to expand money supply aggressively to stop the Eurozone from drifting into an economic crisis. In short, the Eurozone will likely develop its own version of Abenomics, the principal difference being the Eurozone’s timeline is behind Japan’s.
US and UK
Japan and the Eurozone account for total GDP of $18.3 trillion, slightly more than the US and added to the emerging and developing economies, gives a total of $48 trillion, or 62% of global GDP for nations leading the world into a slump. So when we consider the prospects for the US and the UK, together producing $20.4 trillion or 26% of the world’s GDP, their prospects are not good either. The UK as a trading nation exposed to the Eurozone has immediate risk, while the US which is not so dependent on international trade, less so.
The foregoing analysis is of the primary economic drivers for 2015 upon which all else will ultimately depend. The risk of a global slump can be called a first order event, while the possibility of a banking crisis, derivatives default or other market dislocation brought on by a slump could be termed a second order event. There is no point in speculating about the possibility and timing of second order events occurring in 2015, because they ultimately depend on the performance of the global economy.
However, when it becomes clear to investors that the global economy is indeed entering a slump, financial and systemic risks are certain to escalate. Judging this escalation by monitoring markets will be difficult because central banks, exchange stability funds and sovereign wealth funds routinely intervene in markets, rendering them misleading as price signals.
Precious metals are the only assets beyond the long-term control of governments. They can distort precious metal markets in the short term by expanding the quantity of derivatives, and there is a body of evidence that these methods have been employed in recent years. But most price distortion today appears to have come from bullion and investment banks who are fully committed to partying in bonds, equities and derivatives, and for which gold is a spoiler. This complacency is bound to be undermined at some point, and a global economic slump is the likely catalyst.
The dangers of ever-inflating currencies are clearly illustrated by the Fiat Money Quantity, which has continued to expand at an alarming rate as shown in the chart below.
FMQ measures the amount of fiat currency issued as a replacement for gold as money, so is a measure of unbacked monetary expansion. At $13.52 trillion last November it is $5.68 trillion above the long-established pre-Lehman crisis growth path, stark evidence of a depreciating currency in monetary terms. Adjusting the price of gold for this depreciation gives a price today the equivalent of $490 in dollars at that time and quantity, so gold has roughly halved in real currency terms since the Lehman crisis.
There is compelling evidence that 2015 will see a global slump in economic activity. This being the case, financial and systemic risks will increase as evidence of the slump accumulates. It can be expected to undermine global equities, property and finally bond markets, which are currently all priced for economic stability. Even though these markets are increasingly controlled by central bank intervention, it is dangerous to assume this will continue to be the case as financial and systemic risks accumulate.
Precious metals are ultimately free from price management by the state. Furthermore, they are the only asset class notably under-priced today, given the enormous increase in the quantity of fiat money since the Lehman crisis.
In short, 2015 is shaping up to be very bad for fiat currencies and very good for gold and silver.
“Sir, John Authers, in Loser’s Game (The Big Read, December 22), could have delved deeply into the flaws in the asset management business as it has evolved in recent decades, rather than accepting the industry’s own terms or focusing on tweaks to “active” management that might improve results..
“Mr Authers could also have challenged the bureaucratic thinking and methods asset management has adopted in the course of chasing its “bogeys”, starting with the Big Ideas.. Then there are the model portfolios, relative-weightings, “style drift”, investment committees, the requirement to be fully invested and so on — all bog down decision-making and most have nothing to do with genuine investing. In adopting these practices the fund management business has created a recipe for mediocrity.
“In investing, it is never a good idea to do what everyone else is doing. Piling into passive index funds during a year of decidedly poor relative results for active managers, and especially after a long period of rising security prices is likely to lead to future disappointment, just as it did in 1999. This leads us to another line of inquiry for Mr Authers: even assuming “beating” an index is worthwhile, why must we do it all of the time? It is a paradox of investment that in order to do well in the long run, you sometimes have to do “poorly” in the short run. You have to accept the fact that often you will not “beat” an index; sometimes you don’t even want to — think of the Nasdaq in 1999, for example..”
– Letter to the FT from Mr. Dennis Butler, December 30, 2014.
A happy new year to all readers.
For historians, there are primary sources and secondary sources. Primary sources are the original documents that point to the raw history, like the original Magna Carta, for example. Secondary sources are effectively historical derivatives – they incorporate interpretation and analysis. In financial markets, the equivalent of primary sources are prices – the only raw data that speak unequivocally of what occurred by way of financial exchange between buyer and seller. Everything else amounts to interpretation and analysis, and must by definition be regarded as subjective. So-called fundamentals, therefore, are subjective. There is the price – and everything else is essentially chatter.
It says much for the quality and depth of our mainstream media that one of the most insightful and thought-provoking pieces of social and cultural analysis of the last year came in the form of a 5 minute essay within a satirical news review of 2014. The piece in question was by the cult documentary maker Adam Curtis and you can watch it here. The following extracts are taken directly from the film:
“So much of the news this year has been hopeless, depressing, and above all, confusing. To which the only response is to say, “oh dear.”
“What this film is going to suggest is that that defeatist response has become a central part of a new system of political control. And to understand how this is happening, you have to look to Russia, to a man called Vladislav Surkov, who is a hero of our time.
“Surkov is one of President Putin’s advisers, and has helped him maintain his power for 15 years, but he has done it in a very new way.
“He came originally from the avant-garde art world, and those who have studied his career, say that what Surkov has done, is to import ideas from conceptual art into the very heart of politics.
“His aim is to undermine people’s perceptions of the world, so they never know what is really happening.
“Surkov turned Russian politics into a bewildering, constantly changing piece of theatre. He sponsored all kinds of groups, from neo-Nazi skinheads to liberal human rights groups. He even backed parties that were opposed to President Putin.
“But the key thing was, that Surkov then let it be known that this was what he was doing, which meant that no-one was sure what was real or fake. As one journalist put it: “It is a strategy of power that keeps any opposition constantly confused.”
“A ceaseless shape-shifting that is unstoppable because it is undefinable..
“But maybe, we have something similar emerging here in Britain. Everything we’re told by journalists and politicians is confusing and contradictory. Of course, there is no Mr. Surkov in charge, but it is an odd, non-linear world that plays into the hands of those in power.
“British troops have come home from Afghanistan, but nobody seems to know whether it was a victory or whether it was a defeat.
“Ageing disk jockeys are prosecuted for crimes they committed decades ago, while practically no one in the City of London is prosecuted for the endless financial crimes that have been revealed there..
“..the real epicentre of this non-linear world is the economy, and the closest we have to our own shape-shifting post-modern politician is [U.K. Chancellor of the Exchequer] George Osborne.
“He tells us proudly that the economy is growing, but at the same time, wages are going down.
“He says he is reducing the deficit, but then it is revealed that the deficit is going up.
“But the dark heart of this shape-shifting world is Quantitative Easing. The government is insisting on taking billions of Pounds out of the economy through its austerity programme, yet at the very same time it is pumping billions of Pounds into the economy through Quantitative Easing, the equivalent of 24,000 Pounds for every family in Britain.
“But it gets even more confusing, because the Bank of England has admitted that those billions of Pounds are not going where they are supposed to. A vast majority of that money has actually found its way into the hands of the wealthiest five percent in Britain. It has been described as the biggest transfer of wealth to the rich in recent documented history.
“It could be a huge scandal, comparable to the greedy oligarchs in Russia. A ruthless elite, siphoning off billions in public money. But nobody seems to know.
“It sums up the strange mood of our time, where nothing really makes any coherent sense. We live with a constant vaudeville of contradictory stories that makes it impossible for any real opposition to emerge, because they can’t counter it with any coherent narrative of their own.
“And it means that we as individuals become ever more powerless, unable to challenge anything, because we live in a state of confusion and uncertainty. To which the response is: Oh dear. But that is what they want you to say.”
The start of the New Year is traditionally a time for issuing financial forecasts. But there seems little point in doing so given the impact of widespread financial repression on the price mechanism itself. Are prices real, or fake ? The cornerstone of the market structure is the price of money itself – the interest rate. But interest rates aren’t being set by a free market. Policy rates are being kept artificially low by central banks, while the term structure of interest rates has been hopelessly distorted by monetary policy conducted by those same central banks. Inasmuch as ‘real’ investors are participating in the bond market at all, those institutional investors have no personal skin in the game – they are economic agents with no real accountability for their actions. Other institutional players can be confidently assumed simply to be chasing price momentum – they likely have no ‘view’ on valuation, per se. The world’s bond markets have become a giant Potemkin village – nobody actually lives there.
So of the four asset classes to which we allocate, three of them offer at least some protection against the material depradations and endless price distortions of the State. ‘Value’ listed equities give us exposure to the source of all fundamental wealth – the actions of the honest entrepreneur. Systematic trend-following funds are the closest thing we can find to truly uncorrelated investments – and we note how 2014 saw a welcome return to form. The monetary metals, gold and silver, give us Stateless money that cannot be printed on demand by the debt-addicted. We are slowly coming to appreciate the counsel of a friend who suggested that the merit of gold lies not in its price so much as in its ownership. What matters is that you own it. (It also matters why.) Which leaves debt. Objectively high quality debt – a small market and getting smaller by the day.
The practice of sensible investment becomes difficult when our secondary information sources (“fundamentals”) are inherently subjective. It becomes almost impossible when our primary information sources (prices) can’t be trusted because they have politicians’ paw-prints all over them. “Nothing really makes any coherent sense.. We live with a constant vaudeville of contradictory stories.. We live in a state of confusion and uncertainty.” If the pursuit of certainty is absurd, the only rational conclusion is to acknowledge the doubt, and invest accordingly.
According to the ECB’s Bank Lending Survey for October banks eased their credit standards in the last quarter, while their risk perceptions increased.
This apparent contradiction suggests that the 137 banks surveyed were at the margin competing for lower-quality business, hardly the sign of a healthy lending market. Furthermore, the detail showed enterprises were cutting borrowing for fixed investment sharply and required more working capital instead to finance inventories and perhaps to cover trading losses.
This survey follows bank lending statistics since the banking crisis to mid-2014, which are shown in the chart below (Source: ECB).
It is likely that some of the contraction in bank lending has been replaced with bond finance by the larger credit-worthy corporations, and Eurozone banks have also preferred buying sovereign bonds. Meanwhile, the Eurozone economy obviously faces a deepening crisis.
There are some global systemically important banks (G-SIBs) based in the Eurozone, and this week the Financial Stability Board (FSB) published a consultation document on G-SIBs’ capital ratios in connection with the bail-in procedures to be considered at the G20 meeting this weekend. The timing is not helpful for the ECB, because the FSB’s principle recommendation is that G-SIBs’ Tier 1 and 2 capital should as a minimum be double the Basel III level. This gives operational leverage of between 5 and 6.25 times risk-weighted assets, compared with up to 12.5 times under Basel III.
The FSB expects the required capital increase to be satisfied mostly by the issue of qualifying debt instruments, so the G-SIBs will not have to tap equity markets. However, since Eurozone G-SIBs are faced with issuing bonds at higher interest rates than the returns on sovereign debt, they will be tempted to scale back their balance sheets instead. Meanwhile bank depositors should note they are no longer at the head of the creditors’ queue when their bank goes bust, which could affect the non-G-SIB banks with higher capital ratios.
If G-SIBs can be de-geared without triggering a bank lending crisis the world of finance should eventually be a safer place: that’s the intention. Unfortunately, a bail-in of a large bank is unlikely to work in practice, because if an important bank does go to the wall, without the limitless government backing of a bail-out, money-markets will almost certainly fail to function in its wake and the crisis could rapidly become systemic.
Meanwhile, it might appear that the ECB is a powerless bystander watching a train-wreck in the making. Businesses in the Eurozone appear to only want to borrow to survive, as we can see from the October Bank Lending Survey. Key banks are now being told to halve their balance sheet gearing, encouraging a further reduction in bank credit. Normally a central bank would respond by increasing the quantity of narrow money, which the ECB is trying to do despite the legal hurdles in its founding constitution.
However, it is becoming apparent that the ECB’s intention to increase its balance sheet by up to €1 trillion may not be nearly enough, given that the FSB’s proposals look like giving an added spin to contraction of bank credit in the Eurozone.
Spring 2010: A gradual recovery
Autumn 2010: A gradual and uneven recovery
Spring 2011: European recovery maintains momentum amid new risks
Autumn 2011: A recovery in distress
Spring 2012: Towards a slow recovery
Autumn 2012: Sailing through rough waters
Winter 2012: Gradually overcoming headwinds
Spring 2013: Adjustment continues
Autumn 2013: Gradual recovery, external risks
Winter 2013: Recovery gaining ground
Spring 2014: Growth becoming broader-based
Autumn 2014: Slow recovery with very low inflation.. ”
European Commission economic headlines, as highlighted by Jason Karaian of Quartz, in ‘How to talk about a European recovery that never arrives’.
“Well we know where we’re going
But we don’t know where we’ve been
And we know what we’re knowing
But we can’t say what we’ve seen
And we’re not little children
And we know what we want
And the future is certain
Give us time to work it out
We’re on a road to nowhere..”
‘Road to nowhere’ by Talking Heads.
In 1975, Charles Ellis, the founder of Greenwich Associates, wrote one of the most powerful and memorable metaphors in the history of finance. Simon Ramo had previously studied the strategy of one particular sport in ‘Extraordinary tennis for the ordinary tennis player’. Ellis went on to adapt Ramo’s study to describe the practical business of investing. His essay is titled ‘The loser’s game’, which in his view is what the ‘sport’ of investing had become by the time he wrote it. His thesis runs as follows. Whereas the game of tennis is won by professionals, the game of investing is ‘lost’ by professionals and amateurs alike. Whereas professional sportspeople win their matches through natural talent honed by long practice, investors tend to lose (in relative, if not necessarily absolute terms) through unforced errors. Success in investing, in other words, comes not from over-reach, in straining to make the winning shot, but simply through the avoidance of easy errors.
Ellis was making another point. As far back as the 1970s, investment managers were not beating the market; rather, the market was beating them. This was a mathematical inevitability given the over-crowded nature of the institutional fund marketplace, the fact that every buyer requires a seller, and the impact of management fees on returns from an index. Ben W. Heineman, Jr. and Stephen Davis for the Yale School of Management asked in their report of October 2011, ‘Are institutional investors part of the problem or part of the solution ?’ By their analysis, in 1987, some 12 years after Ellis’ earlier piece, institutional investors accounted for the ownership of 46.6% of the top 1000 listed companies in the US. By 2009 that figure had risen to 73%. That percentage is itself likely understated because it takes no account of the role of hedge funds. Also by 2009 the US institutional landscape contained more than 700,000 pension funds; 8,600 mutual funds (almost all of whom were not mutual funds in the strict sense of the term, but rather for-profit entities); 7,900 insurance companies; and 6,800 hedge funds.
Perhaps the most pernicious characteristic of active fund management is the tendency towards benchmarking (whether closet or overt). Being assessed relative to the performance of an equity or bond benchmark effectively guarantees (post the impact of fees) the institutional manager’s inability to outperform that benchmark – but does ensure that in bear markets, index-benchmarked funds are more or less guaranteed to lose money for their investors. In equity fund management the malign impact of benchmarking is bad enough; in bond fund management the malign impact of ‘market capitalisation’ benchmarking is disastrous from the get-go. Since a capitalisation benchmark assigns the heaviest weightings in a bond index to the largest bond markets by asset size, and since the largest bond markets by asset size represent the most heavily indebted issuers – whether sovereign or corporate – a bond-indexed manager is compelled to have the highest exposure to the most heavily indebted issuers. All things equal, therefore, it is likely that the bond index-tracking manager is by definition heavily exposed to objectively poor quality (because most heavily indebted) credits.
There is now a grave risk that an overzealous commitment to benchmarking is about to lead hundreds of billions of dollars of invested capital off a cliff. Why ? To begin with, trillions of dollars’ worth of equities and bonds now sport prices that can no longer be trusted in any way, having been roundly boosted, squeezed, coaxed and manipulated for the dubious ends of quantitative easing. The most important characteristic of any investment is the price at which it is bought, which will ultimately determine whether that investment falls into the camp of ‘success’ or ‘failure’. At some point, enough elephantine funds will come to appreciate that the assets they have been so blithely accumulating may end up being vulnerable to the last bid – or lack thereof – on an exchange. When a sufficient number of elephants start charging inelegantly towards the door, not all of them will make it through unscathed. Corporate bonds, in particular, thanks to heightened regulatory oversight, are not so much a wonderland of infinite liquidity, but an accident in the secondary market waiting to happen. We recall words we last heard in the dark days of 2008:
“When you’re a distressed seller of an illiquid asset in a market panic, it’s not even like being in a crowded theatre that’s on fire. It’s like being in a crowded theatre that’s on fire and the only way you can get out is by persuading somebody outside to swap places with you.”
The second reason we may soon see a true bonfire of inanities is that benchmarked government bond investors have chosen collectively to lose their minds (or the capital of their end investors). They have stampeded into an asset class historically and euphemistically referred to as “risk free” which is actually fraught with rising credit risk and systemic inflation risk – inflation, perversely, being the only solution to the debt mountain that will enable the debt culture to persist in any form. (Sufficient economic growth for ongoing debt service we now consider impossible, certainly within the context of the euro zone; any major act of default or debt repudiation, in a debt-based monetary system, is the equivalent of Armageddon.) As Japan has just demonstrated, whatever deflationary tendencies are experienced in the indebted western economies will be met with ever greater inflationary impulses. The beatings will continue until morale improves – and until bondholders have been largely destroyed. When will the elephants start thinking about banking profits and shuffling nervously towards the door ?
Meanwhile, central bankers continue to waltz effetely in the policy vacuum left by politicians. As Paul Singer of Elliott Management recently wrote,
“Either out of ideology or incompetence, all major developed governments have given up (did they ever really try?) attempting to use solid, fundamental policies to create sustainable, strong growth in output, incomes, innovation, entrepreneurship and good jobs. The policies that are needed (in the areas of tax, regulatory, labour, education and training, energy, rule of law, and trade) are not unknown, nor are they too complicated for even the most simple-minded politician to understand. But in most developed countries, there is and has been complete policy paralysis on the growth-generation side, as elected officials have delegated the entirety of the task to central bankers.”
And as Singer fairly points out, whether as workers, consumers or investors, we inhabit a world of “fake growth, fake money, fake jobs, fake stability, fake inflation numbers”.
Top down macro-economic analysis is all well and good, but in an investment world beset by such profound fakery, only bottom-up analysis can offer anything approaching tangible value. In the words of one Asian fund manager,
“The owner of a[n Asian] biscuit company doesn’t sit fretting about Portuguese debt but worries about selling more biscuits than the guy down the road.”
So there is hope of a sort for the survival of true capitalism, albeit from Asian biscuit makers. Perhaps even from the shares of biscuit makers in Europe – at the right price.