Doug Noland: Market Structure

Financial conditions are much too loose. They remain too loose at home; they remain too loose abroad.

January 3 – (Heather Bell): “…ETF flows really blew away previous records. Flows into exchange-traded funds were going full blast throughout the year and finished on a particularly strong note. A whopping $51 billion in new money came into U.S.-listed ETFs during December, pushing inflows for the year to $476.1 billion. Total assets now top $3.4 trillion. The data, which comes from FactSet, includes flows for every trading day of 2017. The $476.1 billion figure was far and away a record for annual inflows, blowing past the previous all-time high from last year of $287.5 billion.”

Think of this: 2017 ETF flows surpassed the previous year’s record flows by 66%. And while U.S. equities attracted the strongest flows at $180 billion, international equities were not far behind at $162 billion. There’s never been anything comparable to this Market Structure.

The Nasdaq100 jumped 4.0% in 2018’s initial four sessions. The Nasdaq Computer Index surged 4.2%. The Semiconductors jumped 5.8%. The Nasdaq Industrials gained 3.1%, the NYSE Healthcare Index 3.2%, the Philadelphia Stock Exchange Oil Services Sector Index 5.1% and the S&P500 Index 2.6%. The mania is global. Germany’s DAX jumped 3.1% in four sessions, France’s CAC 40 3.0%, Spain’s IBEX 3.7%, and Italy’s MIB 4.2%. Japan’s Nikkei jumped 4.2%, Hong Kong’s Hang Seng 3.0%, and the Shanghai Composite 2.6%. Notable EM gainers included Brazil (3.5%), Russia (4.6%), Argentina (7.1%), Poland (2.5%), Czech Republic (2.5%), Romania (3.0%), Philippines (2.5%) and Pakistan (5.1%). Portending a wild year in the currencies, a number of EM currencies went nuts this week.

Bubbles are self-reinforcing but inevitably unsustainable inflations. Asset Bubbles are fueled by some underlying source of unsound monetary inflation. Major speculative Bubbles and manias are always propelled by key misperceptions and resulting monetary disorder. Bubble flows intensified in 2017, as misperceptions became only more deeply embedded in the Structure of Securities Market Pricing. Loose finance is ensured indefinitely.

The U.S. (Bubble) economy is energized. Strong earnings will be further inflated by lower corporate tax rates. Meanwhile, there’s a stimulus-fueled synchronized global economic boom. European growth is the strongest in years. China has set another 6.5% GDP growth target. Throughout Asia and with scores of other EM economies, things are booming. Whether on a U.S. or global basis, there is a broad consensus view that “fundamentals” are exceptionally constructive. Lost in all the euphoria is the critical issue of finance: global finance is alarmingly unsound.

The 10-year anniversary of the 2008 crisis arrives this year. Amazingly, a decade has passed yet global central banks continue with quantitative easing and ultra-low rates. At the onset, central bankers believed they could employ QE to goose inflation and risk-taking. Then, with inflation dynamics having regained normal traction, central banks would simply wind down “money printing” operations. Everything would settle nicely back to normal.

But it was all flawed. Inflationist doctrine failed. And as archaic as it sounds, the world is today trapped in the Scourge of Unsound “Money.” Central banks inflated a global securities market Bubble and have been incapable of extricating themselves from market domination. Each year sees the Bubble inflate to only more precarious extremes.

2018 will likely see (in the neighborhood of) an additional $1.0 Trillion of global QE. This amount, however, will be down significantly from 2017. The ECB slashes its monthly purchases in half starting this month (to about $36bn). The Fed has plans to reduce balance sheet holdings, while the BOJ has of late scaled back purchases. Markets have been conditioned to believe QE reduction doesn’t matter. This complacency will be tested in 2018. Last year’s concern for waning central bank liquidity operations has been supplanted by this year’s heady confidence that it’s not an issue.

From my analytical perspective, the global market boom has been financed by two extraordinary (interrelated) sources. First, Trillions of QE have directly financed inflated and over-liquefied global markets. Second, I believe leveraged speculation has played a major role in exacerbating liquidity excess. Importantly, QE-related liquidity coupled with the perception that open-ended QE is available to backstop markets has fostered an environment conducive to speculative leveraging. In short, the leveraging of central bank balance sheets has incentivized the aggressive expansion of speculative securities and derivatives leverage globally. And the bigger the Bubble inflates the less willing central banks will be to tighten financial conditions. This only further incentivizes risk-taking and leveraging throughout global markets that have over years become progressively too comfortable pushing the risk envelope.

Central bankers confront a historic dilemma. They perpetuated a prolonged major Bubble inflation. Despite a strengthening global economy and conspicuously speculative markets, central banks in 2017 failed to move forward with “normalization.” Financial conditions further loosened when they needed to have tightened. At this point, when it comes to monetary tightening central bankers lack credibility. The view that central bankers will avoid any actual tightening of financial conditions has become deeply embedded in a extremely distorted marketplace.

At this phase in the cycle, markets would typically fret central banks “falling behind the curve.” These days, however, markets see zero possibility that the Fed (or any central bank) would resort to “slamming on the brakes.” At this point, it would appear only a significant change in the inflation backdrop would have the markets fretting the prospect of a true tightening cycle.

The general backdrop is increasingly supportive of U.S. headline CPI moving above the 2% threshold in 2018. Labor markets are tight, and the growth in manufacturing employment has attained decent momentum. With an increasing number of sectors overheated, companies will be forced to pay up for talent. And with sales strong and inventories slim, expect further acceleration in housing prices and construction. Crude prices have surpassed $61, with the weaker dollar stoking commodities prices generally.

It’s no coincidence that securities markets have succumbed to speculative Bubble Dynamics in the face of economic, financial, social, political and geopolitical unrest. For several decades now, unstable finance has fostered serial boom and bust dynamics. Central bank intervention has only increased the scope of Bubbles, their duration and the severity of consequences. Wealth inequality, disillusionment and anxiety reached a crisis stage. In the face of upheaval, decisions have been made to let the “money” flow.

Speculative markets welcome fragile underpinnings, confident that central banks will continue to goose the markets. Markets relished the Trump administration’s chaotic first year. The more unnerving the Washington backdrop the more likely it became that the President and the Republicans would throw all their energy into must-have tax legislation. One and done?

With all the tax reform hype and market euphoria, it’s easy to disregard longer-term ramifications for about the most partisan tax legislation imaginable. The powerless big “blue” states have taken one on the chin. And when all is said and done, I doubt Republicans will win the PR battle on this one. Taxes will be going up for many; an election promise broken to many. This will be seen as yet another gift to the wealthy and corporate America. Come November, the Republicans hope to receive credit for a booming economy. Expect Democrats to be the more energized party.

Exuberant markets are numb to political dysfunction. And with stock prices setting daily records, there’s no difficulty dismissing the Washington Spectacle. Tax legislation was likely an aberration. Republicans were desperate for a win, so they came together and passed legislation. The pendulum will now swing back. The dismal fiscal backdrop will have the so-called “deficit hawks” spooked. Attention will turn to reelection. Fixated on Tuesday, November 6th, Democrats have no incentive to play ball. Trump’s 2018 agenda could be DOA.

Pundits will trumpet earnings, earnings and more earnings. After receiving the gift of big corporate tax cuts to end 2017, talk will shift to “politics don’t matter.” Politics could matter greatly in 2018. There’s the ongoing Mueller investigation. An investigative shift to past financial issues (and potential money laundering) could spark a constitutional crisis. Many are raising questions as to the President’s mental fitness for the highest office. Some Democrats will look for an opportunity to move on impeachment proceedings. In summary, this is one big, ugly unfolding mess that doesn’t matter – until it does.

There are extraordinary political uncertainties, including the mid-terms. The Republicans could very well lose the power to push through legislation. And while bullish equities strategists extrapolate lower taxes and higher earnings years into the future, there’s a scenario where the repeal of Republican tax (among other) legislation commences in about three years.

Geopolitical risks are even more unnerving. Perhaps North Korea backs down. Trump and the U.S. military may not, arguing this problem has been left to fester to the point that action must be taken. On multiple fronts, relations with China have been cooling. The President has said, “I want tariffs. Bring me some tariffs!” It’s worth noting the U.S. November trade deficit surpassed $50 billion for the first time since March 2012. Especially if other agenda items face resistance, the President may lean more aggressively on administration trade policy. A tougher stance toward China will see little pushback – except from Beijing.

The prevailing view has inflation dead and buried. The current backdrop is ripe for an upside surprise. If focus turns to boom-time labor tightness, a manufacturing renaissance, and a fledgling housing construction boom and attendant bottlenecks – prospects for rising import costs could be enough to arouse a secular shift in inflation psychology.

2018 is set up for a Historic Year. Global Bubble markets are dominated by the dangerous misperception that central bankers have it all under control. I believe the extraordinary liquidity backdrop is acutely vulnerable to an unanticipated bout of de-risking/de-leveraging dynamics. The expectation is that 2018 will be a stable continuation of 2017: financial conditions will remain loose – or, why not, even looser. But unless global central bankers are completely reckless, there will be heightened pressure in 2018 to commence “normalization.” The Powell Fed will have its hands full.

Why do Bubbles burst? At some point, Bubble Finance turns unmanageable. On the upside, Bubbles create their own self-reinforcing liquidity and momentum. Things turn crazy near the end. It’s just so easy to make money. Everyone should be wealthy, and nothing causes angst like watching your neighbor get rich (thank you C.P. Kindleberger).

It’s the parabolic speculative blow-off that seals a Bubble’s fate. A “melt-up” in prices is sustained by only progressively larger speculative flows. The higher prices inflate the greater the amount of finance required sustain the Bubble. In the heart of the mania, these flows are sustained by extreme speculative leveraging. Finance becomes deranged. Such a Market Structure creates latent fragilities – manic speculative leveraging and the rapidly elevating risk of a bout of destabilizing “Risk Off.”

I see overwhelming support for my view that we are witnessing history’s greatest financial Bubble. Things turned crazy in 2017 and, if the first four sessions of 2018 are any indication, markets are taking “crazy” up a notch.

Can bond markets avoid trouble for yet another year – avoiding the comeuppance one would expect after years of loose finance? With fiscal deficits and inflation likely on the rise, when will bond holders finally demand a semblance of reasonable risk premiums? When will bond holders focus on long-term risk-adjusted real returns rather than short-term funding costs and rate differentials? Global bond markets are in the greatest Bubble in history, yet worry of Market Structure is nonexistent.

The ETF industry recently surpassed $3.4 Trillion. Do 2018 flows again surpass the previous year’s? Here again, Market Structure is a serious issue. “Money” has flooded into “the market” through perceived safe and liquid ETF instruments. A surprising bout of “Risk Off” would test market liquidity and perceptions.

Central bank liquidity; faith in central banker monetary management; seemingly unshakable global bond markets; and the bubbling ETF complex have been integral to the global collapse in market volatility/risk perceptions (i.e. VIX). Shorting “volatility” has for years now been a huge money-maker. Amazingly, selling market risk “insurance” during a central-banker ensured drought has become one massive Crowded Trade on a global scale. This is a huge accident in the making, and this Epic Structural Market Flaw could easily become a major Issue in 2018.

Forecasting a catalyst for a bursting Bubble is risky business. There are any number of potential accidents in this now tightly integrated global economy and financial Bubble. China’s Bubble is a historic accident in the making. Like global central bankers, Beijing appears for now to have everything under control. They also have no experience with the downside of an unparalleled Credit Cycle.

Massive 2017 financial flows gave EM Bubbles a further lease on life. The weak dollar in 2017 helped devalue their still mounting dollar-denominated debt problem. A global “Risk Off” would see an abrupt reversal in their liquidity position. One of these days – perhaps even in 2018 – there might be some worry about Chinese and EM financial institutions. It’s been such a long cycle. How much bigger did the fraud issue inflate during 2017’s Credit bonanza?

I expect the cryptocurrency Bubble to burst in 2018. Seems like we’re set up for major cyber security issues. Will there be even more damaging weather disasters?

There will be numerous surprises and unexpected developments. I just wish I could share in all the optimism. But Bubbles are just so destructive. Markets continue to grossly misprice risk. Resources – real and financial – are being poorly allocated. Too many uneconomic enterprises are lavishing in boom-time finance. Real economic wealth is being redistributed and destroyed, while asset price Bubbles ensure wealth illusion and a perilous lack of discipline. Speculation doesn’t matter; deficits don’t matter; excess doesn’t matter; and debt doesn’t matter. Market Structure doesn’t matter.

Because of the unprecedented globalization of Bubble Dynamics during this protracted cycle, I have special concern for geopolitical risks. Pondering what might unfold this year leaves me uncomfortable.


Original Post 6 January 2018


Categories: Doug Noland, Perspectives

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