The Smart Bird: In Case You Missed It

The “In Case You Missed It” series will include some of the more interesting articles and posts related to the financial environment that affects our investments.  First a little background.

The Smart Bird contends that the financial markets have been driven by a global credit cycle since 1987 instead of the business cycle.  It is not that the business cycle has disappeared, it has simply been amplified and globalized.

The easy money policies of the global central banks created a global credit boom that flowed into both rampant leveraged speculation and mal-investment that created global over-capacity and consumer price deflation.  All credit booms end the same, with a bust that can not be managed.  Today, the global credit cycle has turned and speculative forces are in retreat.

Debts do not go away when asset prices and income streams decline.   The losses have to be transferred to someone. Many contend the losses from the 2008 financial crisis were transferred to the Fed’s balance sheet and will be monetized away.

We add that American’s retirement security has paid dearly through interest rates set below inflation (and below the Fed’s own Taylor rule).  Interest income on savings to meet future liabilities (retirement accounts, pension plans, and life insurance companies) has been siphoned off to repair financial balance sheets and little went to “simulate the economy”.

Today, we start with Ambrose Evans-Pritchard’s writing from Davos quotes from William White.  Excerpts:

The situation is worse than it was in 2007. Our macroeconomic ammunition to fight downturns is essentially all used up,” said William White, the Swiss-based chairman of the OECD’s review committee and former chief economist of the Bank for International Settlements (BIS).

It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something,” he told The Telegraph on the eve of the World Economic Forum in Davos.

Mr White said Europe’s creditors are likely to face some of the biggest haircuts. European banks have already admitted to $1 trillion of non-performing loans: they are heavily exposed to emerging markets and are almost certainly rolling over further bad debts that have never been disclosed.

The European banking system may have to be recapitalized on a scale yet unimagined, and new “bail-in” rules mean that any deposit holder above the guarantee of €100,000 will have to help pay for it.

Mr. White said stimulus from quantitative easing and zero rates by the big central banks after the Lehman crisis leaked out across east Asia and emerging markets, stoking credit bubbles and a surge in dollar borrowing that was hard to control in a world of free capital flows.

The result is that these countries have now been drawn into the morass as well. Combined public and private debt has surged to all-time highs to 185pc of GDP in emerging markets and to 265pc of GDP in the OECD club, both up by 35 percentage points since the top of the last credit cycle in 2007.

In retrospect, central banks should have let the benign deflation of this (temporary) phase of globalisation run its course. By stoking debt bubbles, they have instead incubated what may prove to be a more malign variant, a classic 1930s-style “Fisherite” debt-deflation.

Mr. White said the Fed is now in a horrible quandary as it tries to extract itself from QE and right the ship again. “It is a debt trap. Things are so bad that there is no right answer. If they raise rates it’ll be nasty. If they don’t raise rates, it just makes matters worse,” he said.

Europe in their infinite wisdom decided the solution to the next banking crisis is to simply have the depositors pay for the bank’s irresponsible losses – this is called a “bail-in”.  It is the anti-FDIC rule.  FDIC insurance came about to stop bank runs when customers feared their bank was insolvent.

So how do the European bankers want to stop bank runs going forward.  Well one idea some bankers have been pushing is to outlaw cash so money can not leave the system.  The old fashion way is to continue to ensure depositors that everything is okay until you freeze their accounts.

For those who invest in the MSCI EAFE index (TSP I fund or IEFA ETF) it is important to know that 25% of its market capitalization is in financials (banks, etc.) compared to 16% for the SP500.  In Europe, governments are part owners of the banks and the banks lend to the governments.  A nice little relationship.

The banks are allowed to consider government debt as carrying no risk in determining their capital requirements.  Which leads us to the next article from Bloomberg Business, Forget Basel IV: Bundesbank Says Beware of Banks’ Sovereign Risk .

“Given the painful experience of the last six years, it has become more than obvious that sovereign paper is not risk-free,” said Dombret. “From my point of view, this is an issue which needs to be finalized, possibly after the Basel III reforms.”

Basel’s current rules give discretion to regulators to allow banks to treat their government-bond holdings as risk-free. In the European Union’s case, banks can rate all debt issued by the bloc’s 28 national governments as risk-free. There are also no limits as to how much a bank can lend to a single sovereign borrower, contrary to how other types of exposure are treated.

The rules encourage so-called carry trades, whereby lenders borrow at low cost from the European Central Bank and plow the money into state debt that offers higher returns, which contributed to the chain of events that triggered Europe’s sovereign-debt crisis.

The carry trade is not limited to states in Europe.  Ultra-low interest money is borrowed in one country and invested in another paying higher interest rates and this is especially attractive in countries that pegged their currency like China to the US.  With China’s peg removed, the currency risk becomes unbearable and this speculative money rapidly is withdrawn as reported by Bloomberg Business in JPMorgan: Potential Capital Outflows From China Have Become ‘Practically Boundless’ .

China has seen nearly $1 trillion in capital leave the nation since the second quarter of 2014, and according to analysts at JPMorgan Chase, the sky’s the limit for outflows going forward.

“The Chinese capital outflow picture appears to have entered a new phase in [the third quarter], broadening to include foreign direct investment and portfolio instruments, something that could make future capital outflows practically boundless,” writes the JPM team.

And about that 282% debt to GDP in China, they just need the courage to print like the Ben Bernanke:

Bernanke also said the $28 trillion debt pile facing China was an “internal” problem, given the majority of the borrowings was issued in local currency.

$28 trillion doesn’t matter – Really!  While Ben Bernanke is out defending his record, other Fed officials tell it like it is or was when they were decision makers.  While we knew this, I was somewhat astounded that Richard Fisher would be so blunt in his statements.  But before we get to his statements let’s look at what Wikipedia says about the “wealth effect”.

However, according to David Backus, a NYU economist, the wealth effect is not observable in economic data, at least in regards to increases or decreases in home or stock equity. For example, while the stock market boom in the late 1990s (q.v. dot-com bubble) increased the wealth of Americans, it did not produce a significant change in consumption, and after the crash, consumption did not decrease.

Got that, stoking the stock and bond market does not improve the economy and the only wealth effect comes to those who own most of the financial assets – for awhile.  Now for Fisher’s take:

I spent 10 years (through last March) as a participant in the deliberations of the Federal Open Market Committee, setting monetary policy for the U.S. The purpose of zero interest rates engineered by the FOMC, together with the massive asset purchases of Treasury’s and agency securities known as quantitative easing, was to create a wealth effect for the real economy by jump-starting the bond and equity markets.

…The addition of a third round of QE, which had the Fed buying $85 billion per month of securities to ultimately expand its balance sheet to over $4.5 trillion, juiced the markets.

I voted against QE3 but the majority of the committee embraced it. One could argue — as I did — that QE3 and its predecessor rounds front-loaded the equity market. Stated differently, I believe we engineered a version of the “Wimpy philosophy”: We gave stock-market investors two hamburgers today in exchange for one or none tomorrow. We pulled forward the price-reaction function of markets.

If that is a correct assessment, then there may well be a payback period of lesser movement in stock prices to follow… It would not be unreasonable to expect subdued returns this year given that stocks are still richly priced by historic standards.

We will see what ensues. But one thing to bear in mind is that the Fed is focused on the real economy looking out to the intermediate term, not necessarily on sustaining the stock market today. In an effort to revive the economy, it floated all boats with its hyper-accommodative monetary policy. The real economy has been extensively repaired. And the easy money in investing has been made.

I agree with all the bolded statements, not the policy, but the effects the policy had on the stock market.  I do not agree with “The real economy has been extensively repaired”.  What are they looking at?  Real Median Household Income declined 7% from 1999 to 2014 – not much wealth effect here.

They just pulled the stock market off the QE life support in October 2014 and it is not looking so good.  In our monthly Current Situation Reports we track those few economic indicators that lead the stock market.   Here is a sample of what matters after cutting through all the noise:

  • Four consecutive quarters of corporate revenue declines.
  • Three consecutive quarters of corporate earnings declines.
  • GAAP corporate profits below the 4th quarter 2011 level!
  • The US Industrial Production Index is now below its level in July 2014
  • CSX’s CEO: “We’re in a freight recession”  13 January 2016 Jacksonville Business Journal

The question is not whether two years from now some official board will determine that we are currently in a recession or not, it is whether the fundamentals support the extremely high equity valuations – they don’t.  We also know that valuations don’t matter until investors become averse to holding risk assets – they have.  And once investors become averse to holding risk, history tells us monetary policy has little effect.


Cut through the bull and focus on what matters with us at TSP & Vanguard Smart Investor where our goal is to make informed allocation decisions.

Categories: Perspectives, The Smart Bird

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