Doug Noland: Market Realities

Markets have grown well-versed at disregarding structural issues. I’m still amazed at what the marketplace was willing to ignore throughout the mortgage finance Bubble period: A doubling of mortgage Credit in just about six years; California’s housing market out of control by 2005; $1.0 TN of subprime CDS in 2006; the unprecedented growth in leveraged securities holdings and so on. Unrelenting Trade and Current Account Deficits. Didn’t the excesses of the cycle ensure a crash?

For those of us who have studied financial history, 2002-2008 financial follies pale in comparison to “Roaring Twenties” excess that unfolded without ramifications in the eyes of the securities markets – well, that is, until the Great Crash. What today’s markets have chosen to overlook – and what people have come to believe – are even more astounding.

Excesses over the past (almost) decade have been in the “Roaring Twenties” caliber: Prolonged, deeply structural and accompanied by epic misperceptions. And there’s no mystery why markets regress into a dysfunctional mechanism that hears no evil, sees no evil and speaks no evil. Given time (and ample “money” and Credit), asset inflation trumps worry; greed conquer fear.

Prolonged Bubble Dynamics ensure everyone eventually gets aboard the great bull market. Once on the ride, a myopic optimistic view takes on a life of its own, crushing dissent in the process. And the deeper the structural deficiencies – the more resolute central bankers will be with ongoing accommodation. Especially during periods of central bank activism (the current cycle and the “Roaring Twenties” topping the list), structural deficiencies over time turn bullish for asset prices and financial speculation.

Structural U.S. Trade and Current Account Deficits are a root cause of much that afflicts the world economy these days. At $57.6 billion, February’s U.S. trade deficit was the largest since 2008. At $154bn, Q4 ’17’s Current Account Deficit was the biggest going back to Q3 2008. Even in the depth of economic recession, the U.S. in 2009 ran a Current Account Deficit of $384 billion. Indicative of historic structural maladjustment, the U.S. has not posted a quarterly Current Account surplus since 1991. This was only possible because of Federal Reserve activism.

Incessant U.S. monetary inflation overwhelmed the world with dollar balances, with the process of inflating the world’s reserve currency unleashing synchronized monetary inflation and Bubbles around the globe. The U.S. has deindustrialized, shifting to a financial, consumption and services-based economic structure. These and related powerful forces have fomented intractable financial and economic fragilities, wealth inequality, social discontent and geopolitical instability.

Inflating securities markets have distorted perceptions. Just ignore President Trump’s blustering tariff rhetoric – it’s all an “art of the deal” negotiating tactic. They’ll get to the negotiating table and come to terms. Economic fundamentals are robust; a glorious earnings seasons starts soon. Trump will turn pragmatic and back down. China will make some concessions, enough for both sides to save face. The President surely won’t push this to the point of causing a problem for the great bull market.

In reality, the China issue goes far beyond trade. The Chinese have been working diligently for years now to attain superpower status – to supplant U.S. global hegemony and achieve their rightful destiny. With the extravagant assistance of U.S. trade and loose finance more generally, China has enjoyed essentially limitless resources to invest in world class manufacturing capabilities, global trade dominance, technological prowess and a formidable military complex. Is the U.S. to simply cede global power and influence to Beijing without even mustering a stab at countermeasures? The President and others believe strongly that something must be done after years of Washington neglect.

It’s no coincidence that the past decade has seen the parallel ascent of the strongman central banker (i.e. Bernanke, Draghi, Kuroda…) and the strongman autocrat (i.e. Putin, Xi, Trump, Erdogan, Sisi, Duterte – to name just a few). Putin and Xi, in particular, have gone to extraordinary measures to secure domestic power and global influence. Xi has taken firm control of Beijing, while Beijing has placed even tighter reins on domestic “markets,” finance and the overall Chinese economy.

China and Russia have solidified close economic and military bonds. They have also worked intensively to develop strategic trade, financial and economic institutions and relationships outside the purview of U.S. dominance. The U.S. has spent the past decade printing “money,” inflating asset prices, stoking consumption and reveling in quite a financial mania. Others – our principal competitors – have been in intense preparation. For what is not at this point clear.

I’ll assume China would today prefer the status quo. They’re in no hurry for a confrontation – economic or otherwise. It would suit their objectives to pursue the steady, disciplined execution of their long-term strategy. China be willing to make limited concessions – but there will be no backing down. Zero sign of weakness; no inclination to give in to Trump. Willing to fight “at any cost.” The strongman Xi, having recently accomplished an incredible power grab domestically, will not shy away from the opportunity to demonstrate his power on the global stage. And he’ll enjoy overwhelming domestic support when confronting the U.S. “bully.”

For the Chinese, the impetus of “Trump tariffs” goes way beyond trade. The Trump administration seeks to rein in China’s global superpower ambitions. China always claims it will “never succumb to external pressure.” At last, they have attained the power to back up the bravado. Better to move decisively to bloody Trump’s nose wrestling over trade. After all, there are bigger battles brewing on the horizon: Taiwan, the South China Sea, global resources, new technologies, military superiority, etc.

One could make the argument that the Chinese Bubble creates the type of acute financial and economic fragility that dictates a cautious approach from Beijing. The counterargument is that there are advantages domestically – and ample historical precedent – for villainizing foreigners. The great Chinese “meritocracy” has badly mismanaged key aspects of financial and economic development – the steep costs of which will surface when the Bubble finally succumbs. Why not pin blame on foreigners (the U.S. and Japan, in particular) determined to unjustly undermine China’s phenomenal progress?

President Trump, as well, has justification for not backing down. For years, China has abused its trading relationship with the U.S. (and others). The Chinese have in recent decades fragrantly stolen industrial and military secrets, technologies, and intellectual property. Comprehensive and sophisticated efforts to misappropriate have paid fantastic dividends – with meager cost and consequence. Akin to the North Korean situation, past administrations (of both parties) have talked tough, negotiated diffidently, acquiesced and, in the end, empowered serious threats to United States security. Stock prices notwithstanding, the President would not be a crazy lunatic for believing our country has been left with no other option: something must be done.

Both sides likely believe their adversary has more to lose. President Trump can bluster “my trade deficit is bigger than yours.” With his Thursday evening statement of “an additional $100 billion of tariffs,” the Chinese will rather quickly run out of U.S. imports to list for potential reciprocal treatment. The Trump administration likely sees the robust U.S. economy on stronger footing than China’s, and the U.S. banking sector relatively well positioned to deal with some adversity.

After taking extraordinary control measures over its financial system and economy, Beijing surely believes the U.S. has more to lose from the standpoint of securities markets tumult. Beijing also believes much of the world will have sympathetic ears to their protests against Trump’s overhanded threats of tariffs and trade wars. China can try to claim the moral high ground, which will not sit well in the Oval Office.

After opening Wednesday’s session down 500 points, the DJIA rallied almost 1,100 points in about eight hours of trading. Administration officials (notably Wilbur Ross and Larry Kudlow) adeptly walked back market fears of an unfolding trade war. It’s all a negotiating tactic. These efforts – along with the market rally – were crushed by the President’s Thursday evening “additional $100 billion…” pronouncement. Larry Kudlow said he learned of the new tariff list Thursday night. Friday afternoon from “The Hill”: “President Trump’s new top economic adviser Larry Kudlow joked Friday that he’s ‘gotta beat’ former communications director Anthony Scaramucci’s 11-day tenure in the White House.”

The markets have been willing to overlook structural issues along with White House chaos. Market participants have remained composed: Tax cuts coupled with conviction that the threat of sinking stock prices will keep the President from doing anything too destabilizing. Such remarkable composure appeared at risk during Friday trading. There was no attempt at walking back the President’s statement. The “additional $100 billion” may have been a negotiating tactic, but no longer can it be taken for granted that the President is fixated on stock prices. Was Trump incensed by the Chinese response, his team’s approach to damage control – or both?

This is a President increasingly willing to “go off script,” “call his own shots” and relish being “unhinged.” And rather suddenly the unpredictability and unconventionality of the President on matters of momentous importance do matter to the stock market.

Does President Trump believe the long-overdue confrontation against abusive Chinese trade and business tactics takes precedence over short-term stock market performance? For good reason, the markets are increasingly fearful he might.

The conventional view holds that the economy drives the securities markets. In reality, and after several decades of financial innovation and policy activism, the securities markets lead economic performance like never before. This is where structural issues can suddenly and unexpectedly play a decisive role.

Milton Friedman and others referred to the 1920s as the “golden age of capitalism.” Were financial and economic structural underpinnings robust in the late-twenties, only to be undercut by the failure of the Federal Reserve to respond (with money printing) forcefully to the 1929 stock market crash and associated bank capital shortfalls? Or, instead, had underlying structures become progressively impaired by a prolonged period of Terminal Phase (financial and economic) Bubble excess? Was the Great Crash inevitable – an historic inflection point marking the commencement of an unavoidable adjustment process: the fusing of what had become an epic divide between inflated market perceptions and deflating financial, economic, social and geopolitical prospects.

April 5 – MarketWatch (Mark DeCambre): “Vanguard founder Jack Bogle has been around the block. The 88-year-old investing titan, who is basically the father of passive investing, says this renewed regime of volatility in stocks is uncanny… ‘I have never seen a market this volatile to this extent in my career. Now that’s only 66 years, so I shouldn’t make too much about it, but you’re right: I’ve seen two 50% declines, I’ve seen a 25% decline in one day and I’ve never seen anything like this before.'”


Original Post  7 April 2018


TSP & Vanguard Smart Investor

Categories: Doug Noland, Perspectives