Pondering the Summers of 2012 and 2014
by Doug Noland
August 29, 2014
Meanwhile, global securities markets enjoyed rallies that were equally dramatic. Mustering a summer surge, U.S. equities disregarded geopolitics to post all-time highs (S&P 2000!).
Curiously, Treasury yields were in no way excluded from the frenzy. In the face of rallying stocks and generally positive U.S. economic data, Treasury yields surprised with a determined move to the downside. This latest “conundrum” saw 10-year yields sink to 2.34%, a 15-month low. While notably volatile, corporate Credit spreads ended August about where they began June.
Interestingly, European debt markets once again became a focal point – somewhat a mirror image of the drama-filled Summer of 2012. German 10-year bund yields sank this week to a record-low 0.89%, with French yields at an all-time low 1.25%. Incredibly, German sovereign yields turned negative all the way out to four year maturities. More amazing yet, yields across the spectrum of Europe’s basket-case periphery collapsed to at or near historic lows.
Spain’s 10-year yields traded to record low yields, ending August at 2.23%, down 62 bps in three months and a stunning 524 bps below July 2012 highs. Despite national public debt surpassing 130% of GDP (and rising!), Italian 10-year yields (briefly) traded below Treasuries before ending the month at 2.44%. Italian yields were down about 50bps in three months (down 470bps from 2012 highs). Portuguese yields dropped another 30bps this summer to 3.22%, increasing 2014’s y-t-d yield decline to almost 300 bps.
The global backdrop is absolutely fascinating, if not comforting. From an analytical perspective, the divergence between the troubling global fundamental backdrop and surging securities prices comes chock full of intrigue. An exuberant marketplace, especially in the U.S., perceives a virtually best-case scenario: an economic recovery having attained important momentum, with market yields pushed lower by global factors. The Jackson Hole central bank powwow, with a dovish Janet Yellen and hints of impending QE from the Draghi ECB, placed a bold exclamation point on the already emboldened bullish view.
This week I found myself reflecting back to that fateful summer of 2012 – a critical juncture for global policymaking and markets that forever changed the world. Back then Europe was the weakest link in a fragile post-crisis global financial and economic recovery. I remain convinced that the world was at the brink of what would have been a crisis more problematic than 2008/09.
Europe was facing a systemic crisis of confidence. With the periphery countries succumbing one-by-one to financial crisis, the euro currency was confronting an existential threat. In particular, the marketplace was rapidly losing confidence in a heavily indebted Italy. It was simply too big to bail out.
Italy along with the periphery began to suffer destabilizing financial outflows. And a crisis engulfing the Italian banks was poised to spark a crisis of confidence throughout the entire vulnerable European banking system. A crisis of confidence in Europe would have spread globally through various channels, certainly via the leveraged speculating community and the emerging markets (EM) that were both heavily dependent upon European bank finance.
Why would the Summer of 2012 occupy my mind? Well, in last week’s CBB I focused on how the Fed’s open-ended QE program fundamentally altered market perceptions, certainly including market faith that the Fed and global central bankers will ensure ongoing liquid securities markets. And this perception – the “Moneyness of Risk Assets” – has been fundamental to what I believe has evolved into speculative “blow-offs” in historic multi-decade Credit and securities Bubbles.
If not for a potentially dire European crisis, I don’t believe Bernanke would have so aggressively moved forward with “QE infinity.” It was never really about jobs; that was merely a feint. The whole focus on the unemployment rate, employment dynamics and such has been a ruse. And as far as I’m concerned, the current employment-fixation underpinning chair Yellen’s policy doctrine is a ploy. Jackson Hole 2014 – “Re-Evaluating Labor Market Dynamics” – was little more than policymaking subterfuge.
Importantly, the Summer of 2012 saw international monetary policy come under the seemingly complete control of a quite small group of central bankers (see Hilsenrath’s “Inside the Risky Bets of Central Banks,” WSJ, December 11, 2012). Recall that shortly after Draghi declared “The ECB is ready to do whatever it takes… And believe me, it will be enough,” both the Bernanke Fed and Kuroda Bank of Japan (BOJ) commenced discussions to implement “open-ended” QE. The nucleus of the global central bank community quickly fell in line. This has profoundly impacted market perceptions, hence global securities markets dynamics and prices. The notion of a small cadre of central bankers dictating global monetary policy – irrespective of the views of various central bank committees – plays prominently in current market exuberance that only the views of uber-doves Yellen, Draghi and Kuroda really matter. Geopolitical strife, even war, along with global financial and economic fragility, even deflation, would undoubtedly be met with more open-ended monetary stimulus (and higher securities prices!).
It would be dangerous if global market Bubbles were inflating in the face of deteriorating fundamentals. If a deteriorating backdrop was specifically intensifying Bubble excesses, then I would argue strongly that such dynamics were fomenting catastrophe. Indeed, I see the recent rapidly widening gulf between inflating Bubbles and fundamental deterioration as creating the most precarious global backdrop in decades (going back to the late-twenties). And the situation now turns more alarming by the week.
Global markets were pleased with Yellen’s Jackson Hole dovishness. Market participants were tickled to hear BOJ’s Kuroda talk of extending aggressive monetary stimulus for “some time” to ensure the defeat of deflation. Yet the markets were downright giddy when the ECB’s Draghi noted heightened deflation risks while hinting at QE measures. Why such keen interest? Because Europe is once again the weak link in an increasingly fragile global system. And clearly, as bullish thinking goes, heightened European risks ensure that global central bankers will keep the monetary spigots running wide open. Buy stocks, bonds and risk assets.
So, from the standpoint of my analytical framework, I am confident in the global securities markets Bubble thesis. According to Bloomberg, the value of global equities this week rose to a record $66 TN. The S&P500 has now rallied 57% off of June 2012 lows. Over this period, the Nasdaq 100 (NDX) has gained 67%, the MidCaps 63%, the Semiconductors (SOX) 87% and the Biotechs (BTK) 131%. In Europe, European equities (Euro Stoxx index) have rallied 55% from 2012 lows, led by gains of 81% in Spain and 67% in Italy.
No doubt whatsoever that two years of unprecedented monetary stimulus have had a profound effect on global securities prices (and asset prices more generally). How about on global fundamentals? While the bulls would disagree, I believe the global economy is only more vulnerable these days. The Chinese economy is clearly weaker – arguably acutely vulnerable – than two years ago. Growth generally throughout EM is weaker (i.e. Brazil Q2 ’14 growth negative 0.6% vs. positive growth throughout 2012).
How about Europe, the catalyst for two years of reckless global monetary stimulus? Well, the prognosis is not good. A temporary stimulus-induced uptick in growth has of late given way to stagnation. At about 12.5%, Eurozone unemployment is essentially unchanged from 2012. And in the face of global liquidity abundance (and resulting booming securities markets), consumer price inflation has weakened. European “CPI” has declined from about 2.5% in 2012 to the recent annual rate of 0.3%. With “core” French and German economies slowing – and geopolitical risks rapidly escalating – European economic prospects are nothing short of abysmal.
I believed in 2012 that the euro currency regime was unsustainable – and I have seen little to alter this view. If anything, the past two years have provided additional confirmation that the experiment in European economic, financial and currency integration was a historic mistake. Today’s forces of disenchantment, acrimony and disintegration are too powerful. Public angst has become more engrained. Anti-euro/EU sentiment has only gained momentum, with troubling social and political ramifications. And I believe this unsettled and divisive backdrop has contributed greatly to Putin’s Ukraine gambit.
Yet all of this is viewed as “bullish”. Clearly, the economic, financial, social and military risks are so high on the European continent that Mr. Draghi will have no alternative than to pursue Federal Reserve style QE. This, apparently, will ensure another shot of monetary fuel to further inflate global securities Bubbles. And a weak euro will provide another reliably weak currency for speculative “carry trade” riches. Moreover, Draghi’s compatriots at the Fed, BOJ, Bank of England, Swiss National Bank and elsewhere will surely lend support both to help Europe and to fight the “scourge of deflation.”
Bloomberg’s Caroline Connan: “The ECB president Mario Draghi is calling for more help from governments in terms of fiscal policy. What could Germany do to help France?”
Germany Finance Minister Wolfgang Schaeuble: “What Mario Draghi is saying again and again is that what is needed are structural reforms. That is not to the ECB to implement, because monetary policy can’t. It’s up to national governments and parliaments. In this regard, we agree 100%: monetary policy has to take its responsibility. But monetary policy can only buy time. To solve the underlying problems is a matter of fiscal policy and especially of economic policies – structural reforms. It’s a globalized economy. We have to work for – ongoing, again and again – to enhance competitiveness. Because markets are changing very fast. And if you look at what’s going on with the global economy, it’s very important that we all know in Europe – every member state – that we have to stick on structural reforms again and again to enhance competitiveness. If we will be complacent, even in Germany, we are fine actually, but if we would not continue to enhance our competitiveness in coming years, we would lose our position.”
Connan: “…One more comment on the Eurozone. We are going to get the latest inflation numbers…, it’s going to be much below the 2% target. Should the ECB do more to fight deflation?”
Schaeuble: “I don’t think that the ECB’s monetary policy has the instruments to fight deflation, to be very frank. Interest-rates are on a historical level low. You can’t solve the problem in lowering interest rates. The liquidity in markets is not too low; it’s even too high. Therefore we have the problems. I think monetary policy has come to the end of its instruments. Therefore, what we urgently need is investment, regaining confidence – by investors, by markets, by consumers. In Germany, of course our economy faces geopolitical risks in the given situation… But our growth is driven by internal demand, because we have high confidence of consumers – investors as well. And the main reason we have such high confidence, I think, is our public finance is sustainable, we will stick to what we have promised; and we will continue to stick on investments… And of course we have to raise our expenditure for research and development. That is what the French government is also deciding to do. I think this is the right direction.”
I’d been awaiting a German response to all the Draghi QE jubilation. It is notable that it came from Finance Minister Schaeuble and not Bundesbank President Weidmann. Expectations for aggressive ECB monetary inflation do come at the same time as the anti-German “austerity” movement becomes increasingly clamorous. At the end of the day, I still don’t see how the French, Italians and Germans (among others) share a common currency. The cultures – the views on so many things, including how wealth is created (and shared), how economies should function, and how monetary and fiscal affairs must be managed – are inconsistent and often conflicting. At some point, somebody – the “periphery” countries, the French and Italians, or perhaps the German people - will say “enough is enough – this is not sustainable.”
In this age of monetary inflationism, the Germans provide a veritable oasis of sanity. At its best, “monetary policy can only buy time.” At its worst – the current reality – over time it buys problematic out-of-control Bubbles. Why would European banks partake in higher risk lending for business investment when they can make seemingly risk-free profits buying sovereign bonds? For that matter, why would American CEOs invest in plant and equipment at home when so much “wealth” is created buying back their stock? Meanwhile, two years of massive global monetary stimulus has prolonged historic investment booms in China and throughout much of Asia. This has exacerbated Bubbles, while only worsening the global pricing backdrop and capital investment environments elsewhere. Global imbalances have worsened.
Monetary policy promised way too much back in 2012. As I’ve written repeatedly, at this stage of a most spectacular and protracted Credit cycle, monetary inflation can only make things worse. Where does it end? And not for a minute do I believe the alarming rise in geopolitical risk and instability is unrelated to years of prolonged global monetary disorder. Mismanagement of the world’s reserve currency is replete with huge consequences. Mismanagement of all the world’s major currencies is a complete fiasco.