Don't Buy This Dip: The Fed Is Not Your Friend

Aug. 4, 2014 9:49 PM ET

by: David Stockman

So yesterday’s 2% dip will undoubtedly be construed as still another buying opportunity by the well-trained seals and computerized algos which populate the Wall Street casino. But that could be a fatal mistake for one overpowering reason: The radical monetary policy experiment behind this parabolic graph is in the final stages of its appointed path toward self-destruction.

In fact, this soaring index reflects the most artificial, unsustainable and dangerous Fed created financial bubble ever. That’s because its was the untoward product of a completely busted monetary mechanism. What has happened is that the Fed’s historic credit expansion channel of monetary transmission has been frozen shut ever since day one of the massive Bernanke monetary expansion which began in August 2007, but went into warp-drive in the weeks after the Lehman event a year later.

Yet this madcap money printing campaign was a drastic error because it failed to account for the immense roadblock to traditional monetary stimulus that had been built up over the last several decadesnamely, “peak debt” in the household and business sector. This condition means that monetary easing and drastic interest rate cuts have not elicited a surge of consumer borrowing and business capital spending and hiring as during past business cycle recoveries.

Instead, the entire tsunami of monetary expansion has flowed into the Wall Street gambling channel, inflating drastically every asset class that could be traded, leveraged or hypothecated. Stated differently, 68 months of zero interest rates had virtually no impact outside the the canyons of Wall Street. But inside the casino, they provided virtually free money for the carry trades, causing an endless bid for leveragable and optionable financial assets.

But now that the monetary flood is cresting, financial asset values hang in mid-air like Wile E. Coyote. Stranded there, they are nakedly exposed to market discovery any moment now that the real economy and sustainable corporate earnings dwell in a region far below.

That the credit channel of monetary expansion is busted and done is patently obvious in the data on the household sector. Below is both the current track of total household debt since the December 2007 peak, and the prior Greenspan housing bubble track. The latter turns out to be the last hurrah for the essential Keynesianstimulusgambit of the last several decades, which is to say, the one-time LBO of household balance sheets.

During the 78 months since the last peak, household credit has shrunk by 5%. Nothing like this has ever happened before. Not even remotely close. And in truth, the relevant shrinkage has been even greater, since more than 100% of the slight up-tick in borrowing shown in the graph for recent quarters is owing to the explosion of student debt. By contrast, the traditional source of household borrow and spend”—-mortgage borrowings and credit card debt—-is still below its 7-year ago peak.

Needless to say, this contrasts dramatically with the 78 month path after the 2001 cycle peak. During the Greenspan housing and credit bubble, household debt soared by nearly 90%, providing a robust, if temporary, boost to the consumption component of GDP.

The reason for the sharp difference in the most recent cycle is that Keynesian stimulus was always an economic trick, not an permanently repeatable exercise in enlightened monetary management. Quite simply, the US household balance sheets—-as measured by outstanding credit market debt relative to wage and salary incomegot used up during the decades after the nation’s fiat money debt binge incepted at the time of Camp David in August 1971.

Now, in fact, the household leverage ratio has rolled over and is slowly retracing toward the still dramatically lower and more healthy levels that prevailed prior to 1971. In this context, it is surely the case that household leverage will continue to fall—-zero interest rates notwithstanding—– because it is a demographic given. The 10,000 baby boomers retiring each and every day between now and 2030 will not be adding to household debt; they will be liquidating it.

What this means is that the motor force of traditional Keynesian expansion is gone. Household consumption spending, perforce, can now grow no faster than household income and economic production, and likely even more slowly than that. The coming funding crisis of the social insurance entitlementsMedicare and Social Security—will surely jolt the American public into a realization that higher private savings will be essential to retirement survival. Accordingly, the household savings rate has nowhere to go but up in the years just ahead.

In any event, it is no mystery as to why business capital spending remains stuck on the flat-line. During the most recent quarter, real spending for plant and equipment was still 4% below its late 2007 peak——an outcome that is not even remotely comparable to the 10-25% surges that have occurred during comparable periods of prior business cycles. Business is not rushing to the barricades to add to capacity because it is plainly evident that consumer demand is not growing at traditional recovery cycle rates; and that it will never again do so given the constraints of peak debt and the baby boom retirement cycle ahead.

As shown below, in fact, real net investment in CapExafter allowance for depreciation of assets currently consumed—- is on a declining trend. Not only does this reflect the drastic downshift in the growth potential of the US economy that has set-in during the era of monetary central planning, but it also underscores that the current stock averages are capitalizing a future that is a pure chimera.

At 19.5X reported LTM earnings, the S&P 500 is at the tippy top of its historical range, and at the point that it has invariably stumbled into a deep correction. Yet why is it rational to capitalize at even historic average PE multiples the earnings of an economy that is clearly locked into a low/no growth mode for as far as the eye can see? In truth, the market’s PE multiple should be well below the historic average generated during recent decades when Keynesian policy-makers were busy using up the nation’s balance sheets on a one-time basis in a nearly continuous campaign to stimulate credit-fueled growth.

At the end of the day, even the heavily massaged data from the Washington statistical mills cannot hide this reality. Setting aside the short-run inventory swings which cloud the headline GDP numbers each quarter, and which accounted for nearly half of the 4% gain reported for Q2, real final sales tell the true story. Notwithstanding the Fed massive balance sheet expansion since its first big rate cut in August 2007—-that is, from $800 billion to $4.4 trillion—–real final sales have grown at less than a 1% CAGR since then.

There is nothing like this tepid rate of trend growth for any comparable period in modern history. Indeed, given the clear bias toward under-reporting inflation in the BEAs GDP deflators, it is probable that during the last seven years the real economy has grown at a rate not far from zero.

All of this means that the financial markets are drastically over-capitalizing earnings and over-valuing all asset classes. So as the Fed and its central bank confederates around the world increasingly run out of excuses for extending the radical monetary experiments of the present era, even the gamblers will come to recognize who is really the Wile E Coyote in the piece.

Then they will panic.

August 4, 2014 5:19 pm

Arab turmoil makes Israel reckless and complacent

The political shifts that help Israel look much more ominous in the long run

illustration: Arab turmoil and Israel

When last week I saw a White House spokesman say that Israel’s bombing of a UN school was totally indefensible, I briefly thought that I had witnessed something new. Surely the Americans had never before been that strong in condemning Israel? But a colleague with a longer memory reminded me that Israel’s siege of west Beirut in 1982 had provoked President Ronald Reagan (yes, Reagan) to telephone Menachem Begin, the Israeli prime minister, and accuse him of perpetrating a “holocaust”. 

There is nothing new about Israeli military action killing hundreds of civilians. There is also nothing new about the international outcry it provokes.

In the 32 years since Reagan called Begin, the Berlin Wall has fallen, the Soviet Union has collapsed, China has been transformed, apartheid has ended and the internet has revolutionised communication. But the Israeli-Palestinian conflict has rolled ever onwards – with two intifadas, three invasions of Gaza, further wars in Lebanon and innumerable failed peace initiatives.

While the Israelis and the Palestinians remain locked in bloody conflict, however, the region around them is changing fast. For the moment, those changes are actually making Israel less vulnerable to international condemnation. In the longer term, shifts in global power suggest that Israel’s future will be bleak, particularly if it does not make peace with the Palestinians.

For now, Israel is benefiting from the fact that the Arab world, which has acted as the chief advocate for the Palestinians in previous conflicts, is ripping itself apart. Syria and Iraq are engulfed by conflict, and Libya is in turmoil. The Egyptian government itself has killed hundreds of supporters of the Muslim Brotherhood in Cairo and regards Hamas as an offshoot of the Brotherhood. Saudi Arabia, the other big power in the Arab world, is also deeply hostile to Hamas.

Outside the region, geopolitical shifts are taking the edge off the anti-Israel backlash. The governments of Russia, India and China are deeply concerned about the threat of radical Islam at home. Last week more than 100 people were killed in the Chinese province of Xinjiang, after fighting provoked by Muslim separatists. Russia also has 20m Muslim citizens and, after waging two brutal wars in Chechnya, is paranoid about Islamist militancy. Narendra Modi, India’s prime minister, is a Hindu nationalist, who himself is accused of connivance in anti-Muslim violence.

These political shifts are not reflected in official diplomacy. China, Russia and India voted in favour of an investigation of possible Israeli war crimes in Gaza, at the recent session of the UN Human Rights council. (EU countries abstained and the US voted against.) But there is something formulaic about the condemnation. An Israeli official says that in high-level meetings between Israeli and Chinese leaders, the Chinese spent roughly 20 seconds” on Palestine. Benjamin Netanyahu, the Israeli prime minister, and President Vladimir Putin of Russia get on famously.

Yet while Israel’s traditional enemies are becoming less hostile, its allies are becoming less friendly. The relationship between Mr Netanyahu and US President Barack Obama is chilly – and some Israeli officials are openly contemptuous of John Kerry, the US secretary of state. 

Opinion polls in the US also suggest that young people are much less sympathetic to Israel than older groups are. However, such shifts may take decades to filter through into US policy. Israel’s position in Washington is deeply entrenched. The US Senate voted unanimously to support the Gaza assault and the Obama administration has combined its condemnation of Israeli actions with continued aid and arms sales.

Many European leaders are openly appalled by Israel’s actions in Gaza and Europe’s large Muslim population has been at the forefront of anti-Israel demonstrations. But Europe’s Muslims are an often marginalised and unpopular group. Manuel Valls, the French prime minister, has condemned anti-Semitic demonstrations which he says have fused the “Palestinian cause, jihadism, the detestation of Israel and the hatred of France”. Any such fusion helps Israel because it reduces sympathy for the Palestinians.

Israel has long been concerned about the possibility of EU sanctions. But the measures under discussion, for example banning imports from illegal Israeli settlements, would be largely symbolic in their impact. Surveying this global picture, Israel seems to have decided that it can afford to ignore international condemnation of the Gaza war. That calculation may prove correct, as far as the current conflict is concerned.

But the political shifts that are now helping Israel look much more ominous in the long run. Turmoil in the Arab world may briefly have produced a constellation of forces that is helpful to Israel. But that situation could easily change. And some of the rising forces in the regionmost obviously Isis in Iraqmake Hamas look moderate.

More broadly, a relative decline in US power is bad news for a country that is, in cultural terms, an outpost of the west. America’s willingness to entangle itself in Middle Eastern conflicts is declining. That means that, long term, Israel’s security can only be guaranteed by achieving peace with its neighbours. Reducing Gaza to rubble and killing hundreds of civilians every few years makes that prospect ever more distant.

But a security-obsessed Israeli government, backed by an ever more rightwing public, seems to have given up thinking about the long term.

08/04/2014 03:37 PM

After the Arab Spring

The Return of the Generals

By Shadi Hamid

Photo Gallery: Rise of Strongmen in Arab World

After the uprisings of 2011, the Arab world seemed to be moving towards democracy, but the recent resurgence of strongmen have illustrated just how deep certain divides still are -- and how desperate people are for stability.

In the tense build-up to the 2011 uprisings, Arabs seemed to be turning away from dictatorship. Poll after poll showed that more Egyptians, Jordanians and Moroccans believed democracy was the best form of government than did Americans or, say, Poles. But "democracy" in the abstract could mean just about anything as long as it was positive. It was one thing to believe in democracy and quite another to practice it.

In Egypt, the loss of faith in not just democracy, but in the very notion of politics, was particularly striking. A not insignificant number of Egyptians backed the military coup of July 3, 2013, and then turned away from -- or, worse, embraced -- the mass killing of their countrymen on August 14, 2013

More than 600 were killed in mere hours, as security forces moved to disperse Muslim Brotherhood supporters from two protest camps in Cairo. This happened exactly a year ago -- and will remain a dark blot on the country's history. It, in a sense, is what the Arab Spring had managed to unleash -- not just chaos but something darker.

Before they began to falter, the region's autocrats, whether in Tunisia, Syria or Yemen, were fond of reminding Westerners that despite their brutality -- or perhaps because of it -- they were the ones keeping the peace and ensuring stability. As Egyptian President Hosni Mubarak said in a televised address just 10 days before he was ousted, "The events of the last few days require us all as a people and as a leadership to choose between chaos and stability." In a sense, he and his fellow autocrats were right -- there was a tradeoff. These, after all, were weak states, divided by religion, ideology, sect and clan.

With little warning, the uprisings pushed these internal tensions and conflicts that had always simmering in the background to the fore. Before the uprisings, Arab strongmen had governed unwieldy countries with arbitrary borders and uncertain identities. They promised stability at the expense of liberty -- and it was a bargain that held for decades.

Questions of Identity

In Eastern Europe, democratic transitions became possible when the dominant ideology was discredited by the demise of the Soviet Union. Meanwhile, in Latin America, the primary cleavages were largely economic in nature. During transitions in Brazil, Chile and Argentina, the leftist opposition could reassure regime elites that their financial interests would be protected. In the Middle East, there was, and could be, no such resolution.

While economic grievances were at the fore for ordinary Tunisian and Egyptian protesters, they were quickly overshadowed by questions of identity. The major parties and movements, whether Islamist or liberal, had little to say about the economy beyond the self-evident. Who, after all, could take issue with fighting unemployment and combating poverty? Ideological divides over Islam dominated an increasingly raucous debate among the secular intelligentsia, on one hand, and an aspiring Islamist counter-elite, on the other.

The foundations of society and state were still very much in doubt, and the Arab uprisings only made these questions more difficult to answer. There was a basic lack of consensus over the meaning and purpose of the modern nation-state and, relatedly, the role of religion in political life.

The sheer ferocity of this confrontation led a growing number of so-called "liberals" and "democrats" to embrace the military -- and particularly a charismatic general named Abdel-Fattah el-Sissi -- as protector and savior of the Egyptian state. And Sissi filled the role quite well. He was weaned in and by the military, rising through the ranks under the Mubarak regime to become head of military intelligence. In his public appearances, he presented himself as the stern patriarch caring for his wayward children. Many Egyptians -- too many -- returned the favor. They longed for the return of a strongman.

'This Is Something We Live'

When I, as an American researcher, would talk to my friends in the region about the importance of respecting democratic outcomes even if you disagreed with them, there was a basic gap. As a journalist friend told me once: "This is something you study; this is something we live." They were the ones who had to live with the consequences of elections. In Egypt, the sentiment was particularly jarring considering how recent the experience under military rule had been -- a troubled year and a half where the army woefully mismanaged the country.

But during the Muslim Brotherhood's one year in power, those memories began to fade. Liberals, leftists and even revolutionaries looked to the army to reset the political process and start over. They opposed what they saw as a creeping Islamist takeover of the Egyptian state -- from its courts and newsrooms to its labyrinthine bureaucracy -- all, apparently, in the service of forcibly reshaping Egyptian society. With so much at stake, the dangers of military coups seemed beside the point.

The risks were simply too high, and for those actually living under "democracy," it didn't seem nearly as exciting as Western observers made it sound. It was, instead, deeply frightening.

The return of the generals -- culminating in Abdel-Fattah el-Sissi's rise to the presidency -- was most striking in Egypt, but elsewhere too, the disillusion with democracy, and its attendant messiness, spread. In Libya, Syria, Egypt and Tunisia, the fall of a dictator meant a weakened state and a gaping power vacuum, which radical Islamist groups, such as Libya's Ansar al-Sharia, were all too willing to take advantage of. Meanwhile, Libya's democratically elected General National Congress struggled to make its authority felt amidst heavily-armed militias, which would, on occasion, surround the parliamentary building to swing votes in their favor.

Libya's Egyptianization

Libya was supposed to be different -- ideological divides were less pronounced. It seemed unlikely that the Muslim Brotherhood would be able to repeat the feat of other Islamist parties across the region, which had quickly risen to power. There hadn't traditionally been a secular elite as in Egypt or Tunisia, and even "secular" parties like Mahmoud Jibril's National Forces Alliance were more than comfortable speaking the language of religion and sharia. 

Groups like the Muslim Brotherhood simply had less traction because they weren't as distinctive -- regional and tribal divides took precedence. But that was then. As the Libyan Muslim Brotherhood, which could claim an organizational coherence that others couldn't, grew more powerful, the fears of Islamist takeover of the state grew along with it.

The "Egyptianization" of the Libyan conflict brought yet another general, Khalifa Heftar, to newfound prominence. Heftar claimed to speak for something called the "Supreme Council of the Armed Forces," sharing a name with the military body that had ousted President Mohammed Morsi just a year before

Taking another cue from Egypt, Heftar appeared on television in February to announce a "roadmap" for saving Libya from Islamist militias and politicians. In May, after gathering more support, forces loyal to Heftar attacked the General National Congress building.

Like Sissi, Heftar is the new face, and voice, of the post-Arab Spring era, fashioning himself as a strongman savior bearing good tidings of stability and security after a destabilizing democratic process. In this respect, Egypt has been an inspiration to its neighbors, but not necessarily in the way one might have hoped.

Increasingly Regional Divide

The "Islamist-secular" divides were real before, but they at least seemed to be localized. The role -- and relative strength -- of Islamist parties varied widely across North Africa. But the defining breach of the coup in Egypt -- backed by Saudi Arabia and the United Arab Emirates -- has given these conflicts an increasingly regional cast, reflecting a lopsided proxy battle with an increasingly isolated Qatar and Turkey on the other side. Before the July 3, 2013 coup, the leaders of Tunisia's Ennahda party were keen to distinguish and distance themselves from their counterparts in Egypt, whom they saw as damaging the Islamist brand. Yet, after the military's ouster of Morsi, the outrage of Tunisia's Islamists became palpable -- they sympathized, of course, with the Brotherhood's plight, particularly after the mass killings of Morsi supporters in August 2013. But they also feared an Egypt scenario at home, with the secular opposition threatening more mass protests if Ennahda didn't step down.

Today, the Brotherhood's affiliates and descendants have coalesced in a way that they haven't for decades. Numerous meetings and conferences have been held in Doha, Istanbul and other capitals to discuss strategy, tactics, lessons learned and, more generally, what's next for an Islamic "project" seemingly in decline. Movements that have long been committed to peaceful political participation now must contend, as in Egypt, with a minority of members -- and a larger minority of supporters who are turning to the use of anarchic, low-level violence against repressive regimes, in the form of lobbing Molotov cocktails, burning police cars and attacking security personnel. In the Syrian and Libyan theaters, violence is itself a form of politics, and Brotherhood affiliates there have either allied themselves with armed groups or formed their own militias.

There is now a sense of shared Islamist solidarity and struggle in the face of a hostile regional and international environment. Each local Brotherhood branch has faced existential moments before, but this is the first time that the challenge has extended to so many of them at the same time

This is what the Arab Spring made possible, for both better and worse. Having succumbed to the temptations of prominence and power, Islamists across the region are thinking again, and anew, about the long game

They've been here before. Just two months before the Arab uprisings began, I spoke to Hamdi Hassan, head of the Egyptian Brotherhood's parliamentary bloc, during an election in which the Mubarak regime wouldn't permit the movement to win even one seat.

They seemed resigned to their fate, but, at the same time, they believed that history, and God, moved with them. "In the lifespan of mankind," Hassan told me, "80 years isn't long; it's like eight seconds."