For those rich in assets, 2013 was a good year. Equity markets, especially in the US, rose substantially. Property markets continued their recovery. Even bonds, which lose value when interest rates rise, did well overall due to spread compression and the generous ‘roll-yield’ associated with steep yield curves. Indeed, declining risk premia and the associated fall in implied volatilities across all major asset classes was the single biggest financial market story of 2013. Why did this occur? Is it sustainable? In this report, I explain why it is not, and how, unseen by the economic mainstream, severe damage is being done to the global economy, in various ways, with the financial market consequences highly likely to be felt in 2014, and in the years to come.
THE PERILS OF FINANCIAL MARKET MANIPULATION IN THEORY AND PRACTICE
Other than a handful of economic officials and ivory-tower academics, few would argue that asset prices are where they are today independent of the unprecedented monetary and fiscal stimulus of recent years. Indeed, many economic officials openly admit that their actions have influenced financial market variables and that this is an important policy goal. Academic economists provide much theoretical although highly questionable support for this view.
Naturally, however, if asset prices are artificially supported by policy, then financial market participants will no doubt be concerned as to what happens when such policy is withdrawn. This is the single, best explanation for the recent, sharp correction in risky asset valuations around the world.
Economic officials, spooked by market developments, are thus now at pains to reassure all that they will only withdraw stimulus in a way that does not destabilise markets. While that sounds nice on paper, there is scant evidence that it can work in practice. Indeed, the entire modern history of economic officials managing financial market expectations has been an abject failure of economic boom and bust. In order to understand why, we need to revisit this history, beginning with the original ‘Maestro’ conductor of the financial orchestra…
BACK TO WHENCE IT ALL BEGAN: THE MAESTRO OF ‘FORWARD (MIS)GUIDANCE’
Alan Greenspan was at the height of his fame in 2003. Having already been the subject of a best-selling book, MAESTRO, by veteran Washington Post journalist (and Watergate sleuth) Bob Woodard, Mr Greenspan became ‘Sir’ Alan in 2002, receiving an honourary Knighthood from Her Majesty, Queen Elizabeth II. But it was in 2003 that Sir Alan claimed his special place in the annals of modern monetary history by introducing what is known today as ‘forward guidance’: explicit attempts to influence asset prices and, thereby, manage the economy to an even greater degree than that allowed by setting the level of interest rates, of bank reserve and other lending requirements, and through banking and financial regulation more generally. Announced to the world on 12 August 2003, for the first time in its history, the Fed included forward guidance (in bold) at the end of its policy statement:
The Federal Open Market Committee decided today to keep its target for the federal funds rate at 1 percent.
The Committee continues to believe that an accommodative stance of monetary policy, coupled with still-robust underlying growth in productivity, is providing important ongoing support to economic activity. The evidence accumulated over the intermeeting period shows that spending is firming, although labor market indicators are mixed. Business pricing power and increases in core consumer prices remain muted.
The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.
The minutes of this FOMC meeting were published just over a month later, on 18 September. The decision to include the statement was described thus:
The Committee also decided to include a reference in the announcement to its judgment that under anticipated circumstances policy accommodation could be maintained for a considerable period.
The minutes then documented the discussion which followed:
Several members commented that the nature of the Committee’s communications had evolved substantially over recent meetings and that it might be useful to schedule a separate session to review current practices. They agreed to do so prior to the next scheduled meeting on September 16.
Now, turning to that September meeting, we read in the minutes released later that year that:
The members also reviewed the further use of the reference concerning the maintenance of an accommodative policy stance “for a considerable period” that was included in the press statement issued for the August meeting. Given the uncertainties that characteristically surround the economic outlook and the need for an appropriate policy response to changing economic conditions, the members generally agreed that the Committee should not usually commit itself to a particular policy stance over some pre-established, extended time frame. The course of policy would be determined by the evaluation of the outlook, not the passage of time. The unusual configuration of already low interest rates and reservations about the strength of the expansion had justified the inclusion of the phrase “for a considerable period” in the statement issued in August. While changing circumstances would call for removal of that reference at some point, doing so at this meeting might suggest the members’ views on the economy had changed markedly. Accordingly, the Committee decided to release a statement after this meeting that was virtually identical to that used after the August meeting apart from some minor updating to reflect ongoing economic developments. (Emphasis added.)
In 2004, the Fed expanded on this precedent as it began to prepare financial markets for higher interest rates from the, at the time, unprecedented low of 1%.
January (rates unchanged):
…the Committee believes that it can be patient in removing its policy accommodation.
May (rates unchanged):
…the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.
June (rates raised by 0.25%):
…the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.
This last forward guidance was then left in place as the Fed raised rates in steady 0.25% increments through the remainder of 2004 and into late 2005. Finally, in December that year, having raised interest rates in a long series of 0.25% baby steps to over 4%‑a level that could be considered in a normal range—the Fed changed the forward guidance yet again and concluded its policy statement thus:
The Committee judges that some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.
In other words, the Fed indicated three things: First, that additional rate rises were probably on the way. Second, that these rises would not exceed 0.25% each. Third, that the FOMC believed that it was now approaching the end of the rate hiking cycle.
So, when looking back on this period as monetary historians, what are we to conclude about the effectiveness of this forward guidance? Did it work?
Well, as we know, 2003-05 were the years in which the US housing market went from strength to steroids. Borrowing costs remained low, especially for long maturities, something that Sir Alan once described as a ‘conundrum’. With the Fed pointing out with forward guidance that rates would rise slowly, in predictable fashion, leveraged mortgages and home equity extraction were all the rage. And with house prices rising so steadily, lending standards were relaxed. Subprime lending exploded. Light-doc or even no-doc mortgages were easy to come by. Interest-only mortgages and the substantial leverage they offered were also increasingly common. Entirely new segments of the population (eg, those without steady jobs or income) were taking out mortagages for which they never would have qualified in normal circumstances. The bubble, as it were, was being blown to colossal proportions.
If the goal of Fed policy was to create a housing and credit bubble, then yes, forward guidance was a huge success. If the goal was to nuture the US economy back towards a path of balanced, sustainable economic growth, it was an abject failure. We learned this the hard way, as we know, in 2008.
2013: THE BIGGEST BUBBLE YET?
Subsequent to the financial fireworks of 2008, central banks around the world have made extensive use of forward guidance in order to influence a broad range of asset prices. What was once regarded as highly unusual has become the apparently necessary norm. Sir Alan set the precedent that time commitments could and, in unusual circumstances, should be used to try and influence interest rates. Now we are living through an aggressive, global campaign to micromanage not only interest rates but financial markets generally.
Following round after round of QE and other forms of generally unprecendented (and, in some cases, probably illegal) monetary and fiscal stimulus in the US and around the world, risky asset markets entered 2013 with substantial positive momentum. Many ascribe this in part to the aggressive reflationary policies—colloquially known as ‘Abenomics’–adopted by Japan following the 2012 election of Prime Minister Shinzo Abe. Others ascribe it to the ECB’s 2012 commitment to do ‘whatever it takes’ to keep the euro-area financial system liquid and intact. What no one can ascribe it to, however, is anything fundamental to the long-term profit outlook for non-financial corporations—the lifeblood of a developed economy. On every important measure, non-financial corporations have seen a deterioration in their long-term profit outlook since 2012:
- Headline revenue growth has been stagnant and below expectations;
- Profit margins have shrunk;
- Inventories have built up;
- Fixed investment has been weak.
There has, however, been a modest improvement in their collective financial condition:
- Liquidity ratios have improved;
- Balance sheet leverage has declined (if only rather modestly);
- Interest costs are low.
These financial factors, however, are insufficient to support higher valuations on their own because the long-term outlook for corporate profits has far more to do with investment rates, revenues and profit margins than with financial conditions, which are artificially and temporarily benign. That said, a generally rising interest rate environment is a clear negative, something that could certainly occur in 2014 given the low starting point for corporate borrowing costs.
John Hussman does an excellent job at summarising just why we should be so concerned about the current level of US stock market valuations in his recent weekly commentary, PUSHING LUCK, which you can find here. And here’s my former colleague Andrew Lapthorne’s recent take on the same subject:
US profits are not growing, companies are over not underinvesting (they may in fact have overinvested), and corporates are carrying more (not less) net debt than they were in 2009. It would appear that many believe the opposite to be true, yet corporate report and accounts data seems to say otherwise.” But hey- stocks are at record highs, right, and the market is never wrong (except when it is), so who cares. Indeed “Thank goodness equities went up in 2013, otherwise it might have been a rather depressing year.
When it comes to having a market view there are typically (at least) two sides to every argument. When it comes down to the state of US quoted sector profits and balance sheets there should be little argument, but even here there is a great debate, and several viewpoints with which we do not entirely agree.
First is the notion that profits growth accelerated in the US last year. Yes, the pro-forma figures from popular providers such as I/B/E/S show EPS growth of around 6-7%, but pro-forma figures are whatever you wish them to be. Reported earnings growth slowed to almost zero in 2013 and EBIT is largely where it stood at the beginning of 2012.
Capital expenditure growth, the great hope for 2014, slowed throughout 2013 as did cash flow growth and sales growth. However, capex as a proportion of sales is at elevated (not depressed) levels. Why would a company step up investment when faced with contracting margins and lacklustre demand? Surely sales and profit growth recoveries lead investment and not the other way around?
US corporates do indeed hold lots of cash, which is currently at record levels, but they also hold record levels of debt. Net debt (so discounting those massive cash piles) is 15% above the levels seen in 2008/09. The idea that corporates are paying down debt is simply not seen in the numbers. What is true is that deleveraging has occurred through the usual mechanism of higher asset prices (no doubt an aim of central bank policy). This is the painless form of deleveraging. It is also the most temporary, for a simple pull-back in equities and rise in volatility will put the problem back on centre stage.
Financial market animal spirits being what they are, however, and encouraged no doubt by economic officials admitting their desire to support valuations, 2013 saw a relentless, prolonged compression of risk premia not only in US equities, but in most asset markets, and implied volatilities trended lower. At the start of 2014, the VIX volatility index had fallen to only 12, a level associated historically with what Sir Alan once called ‘irrational exuberance’ back in 1996.
The dramatic compression in risk premia and associated low implied volatility are but two major warning signs of a dangerously overinflated bubble in risky assets. Another is the resurgent growth of so-called ‘shadow’ banking activities, such as collateralised securities issuance, including the residential mortgage backed securities that helped to fuel the mid-2000s US housing bubble.
As reported recently in the Financial Times, these securities, and the entities investing in them such as Real Estate Investment Trusts (REITs), “enjoy lighter regulation, benefit from tax efficiencies and possess increasingly deep pockets that allow them to make aggressive loans to property developers… Their role in the market is growing—as is that of hedge funds and ‘business development companies’ that provide capital to middle-market companies, and a whole host of other specialty financiers.”
Also noted in the article cited above, regulators’ increasingly heavy hands on commercial banks are having the perverse affect of driving various risky activities into the shadows, obscuring them from regulatory view. There is also concern at the Bank for International Settlements (BIS) and among central bankers generally that the shadowy practice of so-called ‘collateral transformation’ could be a source of financial system fragility in future. Nor is such concern misplaced, as I wrote in a report last year, COLLATERAL TRANSFORMATION: THE LATEST, GREATEST FINANCIAL WEAPON OF MASS DESTRUCTION (link here). Here is a relevant excerpt from that report:
[I]f interbank lending is increasingly collateralised by banks’ highest quality assets, then unsecured creditors, including depositors, are being de facto subordinated in the capital structure and are highly likely to ‘run’ at the first signs of trouble. And if banks are holding similar types of collateral that suddenly fall in value, then they can all become subject to a run at the same time, for the same reason…
An obvious consequence of such collateral transformation is that it increases rather than decreases the linkages in the financial system and thus in effect replaces firm-specific, idiosyncratic risk with systemic risk, exactly the opposite of what the regulators claim they are trying to do by increasing bank regulatory capital ratios.
Financial regulators may believe that they are one step ahead of the next crisis, but then they also believed this in 2007, 2001, 1992, 1980, etc, etc. It would be highly naïve to trust them this time round when there is ample evidence of a global bubble in risky asset valuations quite possibly larger than that of 2007. The fact is the moral hazard associated with financial (mis)regulation and bail-outs only serves to increase the fragility of the system with each fresh application. Indeed, the boom-bust dynamic of the entire post-Bretton-Woods era is far easier to explain and understand as a policy-driven process rather than as a market-driven one. The growing activism of central bankers and other economic officials with each successive boom-bust clearly illustrates the point. (This is also the subject of chapter 3 of my book, THE GOLDEN REVOLUTION.)
MEA CULPA: I WAS WRONG
On two occasions in early 2013 I predicted that equity markets were due a correction or even a crash. I was wrong. There was a brief period over the summer when emerging markets and stocks began to roll over, but it was mild and short-lived. It did, however, demonstrate yet again the central role that Fed forward guidance plays in manipulating asset markets: The selloff was directly associated with the Fed’s initial ‘taper talk’; and the subsequent recovery in risk assets occurred when the Fed backed away from plans to imminently reduce the pace of QE. Later in the year, the Fed followed through with a very modest tapering plan that did not spook asset markets to the degree the initial talk did.
Markets continued to rally subsequent to the formal ‘taper’ announcement late last year, in what I would consider to be a classic ‘buy the rumour, sell the fact’ response. Underlying market momentum was strong and, on the surface at least, economic data appeared to confirm that the economy was growing, if only moderately.
Underneath the surface, however, the data were deteriorating. Specifically, the quality of growth was poor. Most growth was not due to business fixed investment or household income, but rather an extended inventory build. Real final sales, a measure of ‘core’ GDP that strips out inventories, was stagnant at under 2% last year. Meanwhile, the modest improvement in headline labour market data obscured a continuing decline in the work-force participation rate, something that normally only occurs during and in the aftermath of recessions.
More recently, even the headline data have begun to show reason for worry and I’m not the least surprised that the hugely overvalued US stock market has taken notice. Prices have declined sharply, if by a modest amount overall, and the VIX volatility index has spiked to above 20. Bulls will argue that this is but a necessary consolidation before the bull market resumes. They may be right. But their momentum arguments are increasingly removed from valuation reality, as discussed above. Momentum can carry the airplane into thin air, yes, but it can’t prevent the subsequent stall and possible crash. Risk-reward now strongly favours a defensive stance.
HOW TO PLAY IT FROM HERE
For those still overweight equities or risky assets generally, now is a good time to cash in your chips. To the extent that your portfolio guidelines and benchmarks require you to hold equities, then it is time to rotate into defensive, deep-value, income-generating shares. These could include, for example, infrastructure, consumer non-discretionary and well-capitalised mining shares, including gold miners. That may seem an odd combination, but it so happens that even well-capitalised miners are trading at distressed levels at present, offering unusually good value.
Another oddity is that, following a three-year bear market, global commodity prices in general are low. Yes, in the event that equity markets decline sharply, commodity prices are also likely to decline. However, the decline is likely to be relatively modest, in particular for what I consider to be ‘defensive’ commodities: those with little if any correlation to the business cycle. These include grains, other agricultural products and precious metals. Grains prices are currently very depressed following bumper crops and associated excess inventory. Coffee has only just begun to recover from a multi-year bear market. Sugar prices are also depressed. If stagflationary conditions set in during 2014 and beyond—as I expect and explain why in a moment—defensive commodities are the best place to be, as was also the case in the stagflationary 1970s.
In contrast to other defensive commodities, however, livestock prices are unusually expensive, in particular cattle. This is due in large part to extreme weather in North America. So high prices may be justified but their potential to rise further seems constrained at this point, in part due to the potential for substitution effects as cash-poor consumers gradually switch to more affordable protein sources, such as poultry or dairy products, for example.
Turning to precious metals, I remain a long-term gold and silver bull for a variety of reasons. Economic officials may claim their policies are succeeding at reducing deficits and thus future debt burdens but the truth is in fact the exact opposite. Yes, by blowing asset bubbles they can artificially reduce public sector deficits for a time, as much of the tax-base is asset-price-related in some way. But with the inevitable bust in asset prices comes the inevitable bust in tax revenues. And as Arthur Laffer and others have showed, beyond a certain point, inflationary marginal tax bracket creep no longer increases but rather decreases revenues, as a number of high-tax economies figured out during the 1990s and 2000s. Some countries, such as France, are still figuring this out, and increasingly suffering for it.
Faced with intractable future debt burdens, economic officials will continue to favour inflationary over deflationary economic policies. Rates of money creation are likely to remain elevated and populist, price-fixing economic policies purporting to support middle-class incomes—minimum wage increases or socialised health care come to mind—are highly likely to be stagflationary in their future effects. Combined with various forms of so-called ‘financial repression’, limiting the ability of savers to protect themselves from inflation, merely preserving existing wealth will be a challenge. As precious metals can be neither arbitrarily devalued as fiat currencies can, nor defaulted on as with corporate securities, they should now play an unusually important role in every defensive investor’s portfolio.
TOWARD A BRIGHTER FUTURE
These can be depressing times for those of us who don’t trust in the effectiveness of modern, neo-Keynesian economic micromanagement. Indeed, for those who believe that such micromanagement in fact misallocates resources, turning the economy’s capital stock into a deformed, mangled mess over time, it is difficult to remain at all optimistic for the future. However, while a great bust (or Misean ‘crack-up boom’) is an inevitable part of the global financial system reset that lies in the future, perhaps the near future, once that is out of the way there are reasons to be not just optimistic, but highly so.
Consider, for example, the great price deflation that has taken place in recent years across a broad range of technology goods. Cutting-edge research, entrepreneurial spirit and business acumen have completely transformed the ways in which we communicate, do business, transact and entertain, and the prices for such services have plummeted. The positive economic productivity shock provided by the full spectrum of what we call ‘tech’ is as if not more profound than that of mechanised agriculture; railroads; assembly line mass-production; antibiotics; plastics, synthetics and petrochemicals; air travel; intermodal container shipping; you name it.
Most regard our amazing modern capital stock as just a given, something that spontaneously came into existence. But no, it would never have come into existence without the tireless work of countless innovators, most of whom are and will remain essentially unknown, unlike past celebrities such as Thomas Edison, Henry Ford or Steve Jobs.
Just as important, there is a critical role for the state in all of this dynamism, to provide for the rule of law and the enforcement of property rights. Without those robust parameters, spontaneous entrepreurial activity cannot respond efficiently to information and thus will be suboptimal, as George Gilder’s best-selling new book, KNOWLEDGE AND POWER (find it here) convincingly demonstrates. Highlighting the crucial role of information in a capitalist economy, he argues compellingly that a market-based economy is at base a highly efficient if necessarily chaotic information system that cannot possibly be understood by any person or group of persons.
Central economic planning, by contrast, is highly counterproductive as it not only cannot use information efficiently; it distorts the flow of all economic information in countless if largely unseen ways. The more technologically advanced an economy, therefore, the more damaging central planning becomes.
This is one way to understand why the failed Anglo-Saxon financial system and associated economic micromanagement is such a drag on growth everywhere. It is sucking vital resources out of potentially highly dynamic regional and global industries and distorting the flow of information everywhere, to the detriment of job creation and income growth. Sure, shrinking the financial sector would require those workers to be re-trained to some extent to move into new industrial directions, but this sort of ‘creative destruction’ at the micro level is part and parcel of the dynamic nature of real, sustainable, qualitative economic advancement at the macro level. The sooner we bring it on the sooner the exponential economic progress associated with an information economy can resume.
Fortunately, in the coming financial market bust lie the seeds of such renewal. It will soon become painfully obvious to those in power that the financial system is beyond repair and, once they get out of the way, creative destruction will create a new one through the implementation of new technologies imbued with entrepreneurial spirit. Say what you will about Bitcoin, crowdfunding and other recent financial innovations; they provide examples for how new technologies may one day completely displace the archaic, ossified, ‘Too Big To Fail’ financial behemoths of our time.
A FINAL OBSERVATION
Those familiar with my book and following the relevant news flow around gold and central bank reserve policies may have noticed that the de-rating of the dollar and remonetisation of gold continues to take place in the dark background of international economic and monetary relations. (A superficial treatment of the topic was recently published in the Financial Times.) But much as astronomers can observe black holes indirectly, by the distortions they create in nearby space, so the remonetisation of gold can be inferred from keen observation of gold flows and economic policy shifts taking place around the world. The strongest such signals may be emanating from China at present, but there are others: in Germany, Russia and Nigeria, for example. (For a more thorough discussion on this topic, please see Cognitive Dollar Dissonance: Why a Global Rebalancing and Deleveraging Requires the De-Rating of the Dollar and Remonetisation of Gold, The Gold Standard Journal, issue 34, October 2013. The link is here.)
Care to comment on this report? Please send me a note: firstname.lastname@example.org
And if you like you can follow me on twitter: @butlergoldrevo
 The link to this FOMC statement is here.
 This research from Societe Generale was featured here.
 COMPETITION FOR SHADOW BANKING LURKS IN THE SHADOWS, Financial Times, 17 January 2014. The link is here.
 The most recent of these predictions was made in March. The link to the relevant report, ASSUME THE BRACE POSITION, is here.
 For a more thorough discussion of this episode from last year, please see my previous report, WILL THE FED RE-ARM THE BOND MARKET VIGILANTES? Amphora Report vol. 4 (July 2013). The link is here.
 George Gilder is hardly the first to have made this point, however. Among others, Friedrich von Hayek, Immanuel Kant, Confucius and innumerable quantum physicists have also explored the necessary limits to knowledge, in their various ways. One particularly poignant example is Leonard Read’s famous assay, I, PENCIL.
 The article, by veteran FT columnist Gillian Tett, can be found at the link here.
This article was previously published in The Amphora Report, Vol 5, 07 February 2014.