The Unwind

Doug Nolan

Too often it’s as if I’m analyzing an altogether different world than conventional analysts. My strong preference is to be viewed as an adept and determined analyst, as opposed to some wacko extremist. I have always tried to distinguish my analysis from the “lunatic fringe.”

It’s my overarching thesis that the world is in the waning days of a historic multi-decade experiment in unfettered finance. As I have posited over the years, international finance has for too long been effectively operating without constraints on either the quantity or the quality of Credit issued. From the perspective of unsound finance on a globalized basis, this period has been unique. History, however, is replete with isolated episodes of booms fueled by bouts of unsound money and Credit - monetary fiascos inevitably ending in disaster. I see discomforting confirmation that the current historic global monetary fiasco’s disaster phase is now unfolding. It is within this context that readers should view recent market instability.

It’s been 25 years of analyzing U.S. finance and the great U.S. Credit Bubble. When it comes to sustaining the Credit boom, at this point we’ve seen the most extraordinary measures along with about every trick in the book. When the banking system was left severely impaired from late-eighties excess, the Greenspan Fed surreptitiously nurtured non-bank Credit expansion. 
 
There was the unprecedented GSE boom, recklessly fomented by explicit and implied Washington backing. We’ve witnessed unprecedented growth in “Wall Street finance” - securitizations and sophisticated financial instruments and vehicles. There was the explosion in hedge funds and leveraged speculation. And, of course, there’s the tangled derivatives world that ballooned to an unfathomable hundreds of Trillions. Our central bank has championed it all.

Importantly, the promotion of “market-based” finance dictated a subtle yet profound change in policymaking. A functioning New Age financial structure required that the Federal Reserve backstop the securities markets. And especially in a derivatives marketplace dominated by “dynamic hedging” (i.e. buying or selling securities to hedge market “insurance” written), the Fed was compelled to guarantee “liquid and continuous” markets. This changed just about everything.

Contemporary finance is viable only so long as players can operate in highly liquid securities markets where price adjustments remain relatively contained. This is not the natural state of how markets function. The bullish premise of readily insurable/hedgeable market risks rests upon those having written protection being able to effectively off-load risk onto markets that trade freely without large price gaps/dislocations. And, sure enough, perceptions of liquid and continuous markets do create their own reality (Soros’ reflexivity). Sudden fear of market illiquidity and dislocation leads to financial crashes.

U.S. policymaking and finance changed profoundly after the “tech” Bubble collapse. Larger market intrusions and bailouts gave way to Federal Reserve talk of “helicopter money” and the “government printing press” necessary to fight the scourge of deflation. Mortgage finance proved a powerful expedient. In hindsight, 2002 was the fateful origin of both the historic mortgage finance Bubble along with “do whatever it takes” central banking. The global policy response to the 2008 Bubble collapse unleashed Contemporary Finance’s Bubble Dynamics throughout the world - China and EM in particular.

There are myriad serious issues associated with New Age finance and policymaking going global. The bullish consensus view holds that China and EM adoption of Western finance has been integral to these economies’ natural and beneficial advancement. Having evolved to the point of active participants in “globalization,” literally several billion individuals have the opportunity to prosper from and promote global free-market Capitalism. Such superficial analysis disregards this Credit and market cycles’ momentous developments.

The analysis is exceptionally complex – and has been so for a while now. The confluence of sophisticated finance, esoteric leverage, the highly speculative nature of market activity and the prominent role of government market manipulation has created an extremely convoluted backdrop. Still, a root cause of current troubles can be boiled down to a more manageable issue: “Contemporary finance” and EM just don’t mix. Seductively, the two appeared almost wonderfully compatible - but that ended with the boom phase. For starters, the notion of “liquid and continuous” markets is pure fantasy when it comes to “developing” economies and financial systems. As always, “money” gushes in and rushes out of EM. Submerged in destabilizing finance, EM financial, economic and political systems become, as always, overwhelmed and dysfunctional. And as always is the case, the greater the boom the more destabilizing the bust.

In general, reckless “money” printing has over years produced a massive pool of destabilizing global speculative finance. Simplistically, egregious monetary inflation (along with zero return on savings) ensured that there was way too much “money” chasing too few risk assets. Every successful trade attracted too much company. Successful strategies spurred a proliferation of copycats and massive inflows. Strong markets were flooded with finance. Perceived robust economies were overrun. Popular regions were completely inundated. To be sure, the post-crisis “Global Reflation Trade” amounted to history’s greatest international flow of speculative finance. Dreadfully, now comes The Unwind.

From individual trades, to themes to strategic asset-class and regional market allocations, speculative “hot money” flows have reversed course. Global deleveraging and de-risking has commenced. The fallacy of “liquid and continuous” markets is being exposed. Faith that global central bankers have things under control has begun to wane. And for the vast majority in the markets it remains business as usual. Another buying opportunity.

Whether on the basis of an individual trade or a popular theme, boom-time success ensured that contemporary (trend-following and performance-chasing) market dynamics spurred speculative excess and associated structural impairment. They also ensured latent Crowded Trade fragilities (notably illiquid and discontinuous “risk off” markets).

Crowded Trade Dynamics ensure that a rush for the exits has folks getting trampled. Previous relationships break down and time-tested strategies flail. “Genius” fails. When the Crowd decides it wants out, the market turns bereft of buyers willing and able to take the other side of the trade. And the longer the previous success of a trade, theme or strategy the larger The Crowd - and the more destabilizing The Unwind. Previous performance and track records will offer little predictive value. Models (i.e. “risk parity” and VAR!) will now work to deceive and confound.

Today, a Crowd of “money” is rushing to exit EM. The Crowd seeks to vacate a faltering Chinese Bubble. “Money” wants out of Crowded global leveraged “carry trades.” In summary, the global government finance Bubble has been pierced with profound consequences. Of course there will be aggressive policy responses. I just fear we’ve reached The Unwind phase where throwing more liquidity at the problem only exacerbates instability. Sure, the ECB and BOJ could increase QE – in the process only further stoking king dollar at the expense of faltering energy, commodities, EM and China. And the Fed could restart it program of buying U.S. securities. Bolstering U.S. markets could also come at the expense of faltering Bubbles around the globe.

It has been amazing to witness the expansion of Credit default swap (CDS) markets to all crevices of international finance. To see China’s “shadow banking” assets balloon to $5 Trillion has been nothing short of astonishing. Then there is the explosion of largely unregulated Credit insurance throughout Chinese debt markets – and EM generally. I find it incredible that Brazil’s central bank would write $100 billion of currency swaps (offering buyers protection against devaluation). Throughout it all, there’s been an overriding certitude that policymakers will retain control. Unwavering faith in concerted QE infinity, as necessary. The fallacy of liquid and continuous markets persisted so much longer than I ever imagined.

I feel I have a decent understanding of how the Fed and global central bankers reflated the system after the 2008 collapse of the mortgage finance Bubble. The Federal Reserve collapsed interest-rates to zero, while expanding its holdings (Fed Credit) about $1 Trillion. Importantly, the Fed was able to incite a mortgage refinance boom, where hundreds of billions of suspect “private-label” mortgages were transformed into (money-like) GSE-backed securities (becoming suitable for Fed purchase). The Fed backstopped the securities broker/dealer industry, the big banks and money funds. Washington backed Fannie, Freddie and the FHLB, along with major derivative players such as AIG. The Fed injected unprecedented amounts of liquidity into securities markets, more than content to devalue the dollar. Importantly, with the benefit of international reserve currency status and debt denominated almost exclusively in dollars, U.S. currency devaluation appeared relatively painless.

These days I really struggle envisaging how global policymakers reflate after the multi-dimensional collapse of the global government finance Bubble. We’re already witness to China’s deepening struggles. Stimulus over the past year worked primarily to inflate a destabilizing stock market Bubble that has gone bust. They (again) were forced to backtrack from currency devaluation. Acute fragilities associated both with massive financial outflows and enormous amounts of foreign currency-denominated debt were too intense. Markets are skeptical of Chinese official signals that the renminbi will be held stable against the dollar. 

Market players instead seem to be interpreting China’s efforts to stabilize their currency as actually raising the probability for future abrupt policy measures (significant devaluation and capital controls) or perhaps a highly destabilizing uncontrolled breakdown in the peg to the U.S. dollar.

And as China this week imposed onerous conditions on some currency derivative trading/hedging, it’s now clear that Chinese officials support contemporary market-based finance only when it assists their chosen policy course. How long will Chinese officials tolerate spending international reserves to allow “money” to exit China at top dollar?

September 3 – Financial Times (Henny Sender and Robin Wigglesworth): “Lee Cooperman, the founder of Omega Advisors, has joined the growing chorus of investors blaming last week's stock market sell-off — and his own poor performance in August — on esoteric but increasingly influential trading strategies pioneered by hedge funds like Bridgewater. In a letter to investors…, Mr Cooperman and his partner Steven Einhorn said fundamental factors such as China's ructions and uncertainty over the US interest rate outlook ‘cannot fully explain the magnitude and velocity of the decline in equity markets last month’… ‘These technical factors can push the market away from fundamentals,’ Marko Kolanovic, a senior JPMorgan strategist, noted in a widely circulated report last week. ‘The obvious risk is if these technical flows outsize fundamental buyers. In the current environment of low liquidity, they may cause a market crash such as the one we saw on [August 24]. These investors are selling equities and will negatively impact the market over coming days and weeks.’”
I wholeheartedly agree with the statement “technical factors can push the market away from fundamentals.” Indeed, that’s been the case now for going on seven years. A confluence of unprecedented monetary inflation, interest-rate manipulation, government deficits and leveraged speculation inflated a historic divergence between securities markets Bubbles and underlying fundamentals. The global Bubble is now faltering. Risk aversion is taking hold. De-leveraging is accelerating.

The yen jumped 2.2% this week. Japanese stocks were hit for 7%. The Brazilian real sank 7.3%. The South African rand dropped 4.2%. The Turkish lira dropped another 2.9% and the Russian ruble sank 5.0%. China sovereign CDS surged, pulling Asian CDS higher throughout. 


The Hang Seng China H-Financials Index sank another 7.4% this week, having now declined 39% from June highs. From my vantage point, market action points to serious unfolding financial dislocation in China. It also would appear that a large swath of the leveraged speculating community is facing some real difficulty.

After a rough trading session and an ominous week for global markets, I was struck by Friday evening headlines. From the Wall Street Journal: “An Investor’s Field Guild to Bottom Fishing;” “Global CEOs See Emerging Markets As Rich With Opportunity.” From CNBC: “Spike in Volatility Creates ‘Traders Paradise.” And from the Financial Times: “Wall Street Waiting for Those Buy Signals;” “Time to Buy EM Stocks, History Suggests;” “Why I’m Adding Emerging Markets Exposure Despite China Wobble;” “G20 Defies Gloom to Forecast Rise in Growth.”

There still seems little recognition of the seriousness of the unfolding global market dislocation. 


It’s destined to be a wrenching bear market – at best.


Interest Rates and Bond Yields: Where are They Headed? September Hike Ideal? Is the Bond Bull Market Over?

By: Mike Shedlock

Thursday, September 3, 2015


With all the chatter about whether the Fed will hike on September 17 or not, let's do an interest rate and bond yield recap of where various rates are, where they have been, and where they are likely headed.


 Effective Federal Funds Rate
 
Effective Federal Funds Rate
 
As of yesterday, the effective federal funds rate was a mere 8 basis points. Since April, it has been swinging from a low of 6-8 basis points to a high of 14-15 basis points.
 
I suspect the odds of a hike are close to 50-50.
 
The CME Fed Watch has the hike odds at 27% as of September 2. However, the CME does not consider a move to 0.25% a hike.
 
I do, because it clearly is.
 
The current Fed stance is 0.00% to 0.25%. With the effective Fed Funds rate hovering between 8 and 15 basis points, a move to a firm 0.25% would be about an eighth of a point hike.
 
Why nearly everyone expects a quarter point hike is a pure mystery to me.
 
If the Fed delays until December, we may see such a move (if the economy stays reasonably firm), but even then, I believe the Fed will baby-step this in a Market May I approach, quite similar to the childhood "Mother May I" game.

Yellen vs. Greenspan
  1. Recall Greenspan's famous statement: Hikes will be at a "pace that's likely to be measured".
  2. The Yellen expected "pace" is half as often.
  3. The Yellen expected "measure" is half as much.

Moody's Seasoned Baa Bond Yield Detail

Moody's Seasoned Baa Bond Yield 1012-2015

Baa is Moody's lowest investment grade bond (one step above junk). It is a measure of risk taking appetite. The rise in yield from January is an effective tightening of rates, albeit from a low level. The following long term chart adds perspective.

Moody's Seasoned Baa Bond Yield

Moody's Seasoned Baa Bond Yield 1985-2015

BB High Yield Bond Yield

BB High Yield Bond Yield 20-Year Chart

BB is the top junk bond rating. Is the yield bottom in?

10-Year Breakeven Rate

10-Year Breakeven Inflation Rate

Financial Times provides this Definition of Breakeven Rate.
The Break-even rate refers to the difference between the yield on a nominal fixed-rate bond and the real yield on an inflation-linked bond (such as a Treasury inflation-protected security, or Tips) of similar maturity and credit quality. If inflation averages more than the break-even rate, the inflation-linked investment will outperform the fixed-rate bond. If inflation averages below the break-even rate, the fixed-rate bond will outperform the inflation-linked bond.
The 10-year breakeven rate is about 1.63% as of August 31, 2015. Clearly the market is not expecting serious consumer price inflation for quite a long time.

Yield Curve as of 2015-09-01

Yield Curve as of 2015-09-01

I created the above chart in StockCharts. The chart shows US treasury yields from 2 years to 30 years.

2- and 3-year yields have been rising very slowly since the beginning of 2013 in anticipation of Fed rate hikes.

At the long end of the curve (30-year in red, 10-year in orange) rates made recent highs in late 2013 but are well below those highs now.

Let's compare rates across the entire curve now compared to a year ago.

US Treasury Yields Now vs. Year Ago

US Treasury Yields Now vs. Year Ago

Thanks to Doug Short at Advisor Perspectives for help with the above chart.

Note that between 6-months and 2-years, treasury yields are higher than they were a year ago. Meanwhile, from 5-years and out, rates are lower than they were a year ago.

September Hike Ideal?

Bloomberg has a curious article out today: One Reason Market Turmoil Might Actually Make September the Ideal Time to Hike Interest Rates.
Torsten Slok, Deutsche Bank's chief U.S. economist, sees a silver lining in this market turmoil that he figures actually makes a September liftoff look more attractive. 
"If anything, the narrative in markets at the moment is such that if the Fed does hike in September, then long rates and the dollar will decline because the market will think the Fed is hiking prematurely," Slok says in a research note. "Ironically, September may be the ideal time for the Fed to hike rates because given the way we currently talk about the economy in markets a Fed hike in September will likely be associated with an easing of financial conditions and not a tightening." 
He asserts that the central bank ought to "do the first hike exactly when there is a bearish narrative in markets" to ensure it doesn't prompt yields further out along the curve to jump, as was the case in the infamous bond selloff sparked by 1994's rate rise.
The Bloomberg article also mentions the "savings glut" thesis, a preposterous idea that I will rebut, in detail, later, in a separate post.

Mish Rebuttal of Slok's View

Other than general agreement over the unlikelihood of the long end spiking, Slok's reasoning seems flat out wrong.

The flattening of the curve is generally not good for bank profits and also reflects increasing recession possibilities.

A key reason the yield curve cannot invert now is the low end is at zero. Price in a couple hikes and portions of the yield curve could invert.

That's what happened in Canada earlier this year following a surprise cut in rates by the Royal Bank of Canada.

Canada Recession

On January 31, Based on an inversion in parts of the yield curve, I correctly proclaimed Canada in Recession.

Just yesterday, Canadian stats confirmed the recession. It remains to be seen if the US follows, but a flattening of the yield curve is not a good sign for growth.

For further discussion, please see Canada in Recession with Two Consecutive Quarters of Negative Growth.

How Big a Hike?

The debate still rages "will they, won't they". The correct answer is "It won't matter at all".

If the US does follow into recession, rest assured it will not be because of hike. With the global economy slowing rapidly, and with US equities and corporate bonds in huge bubbles, one hell of a payback is coming for the inane QE policies of this Fed.

Bubbles of Increasing Amplitude

Some defend the Fed, but I don't.

As noted in Fed Apologist Ritholtz Interviews Fed Apologist McCulley, Fed policy is precisely what's behind destabilizing bubbles of increasing amplitude over time.

Fed policy is also behind rising income inequality that Fed Chair Janet Yellen constantly whines about.

Is the Bond Bull Market Over?

Here's the question that's been on nearly everyone's mind for at least a decade: Is the Bond Bull Market Over.

I have two answers: Yes, and Perhaps Not.

Those answers are not contradictory. There are many bond bull markets to consider. Let's start with corporate bonds.

Near-Junk Corporate Bull Market Over?

Using Moody's Baa seasoned bonds as a good proxy for near-junk (the lowest investment grade bonds), let's take an even closer look at recent happenings.

Moody's Seasoned Baa Corporate Bond Yield 2014-2015

The Moody's Baa seasoned bond yield hit an all-time low of 4.29% on January 30, 2015. It is now 5.36%. That's over a 100 basis point tightening (one full percentage point) in a mere seven months.

I am willing to state that the bull market in near-junk bonds is finished.
  • At some point the market will question covenant-lite conditions in which corporations can pay back debt with more debt issuance.
  • At some point the market will questions corporations taking on debt to buy back shares.
  • At some point the market will question the ability of some of these near-junk companies to survive at all.
  • At some point the market will realize what a bubble the Fed has blown with QE and how it seriously affected junk bond rates.
That "some point" appears to be now.

The only question is how fast the air comes out of the enormous junk balloon. We have yet seen a slow release of air from a bubble. Will this be a first?

Junk Bond Bull Market Over?

Let's hone in on BB bonds, the top-tier on non-investment grade (junk) bonds.

BofA Merrill Lynch US High Yield BB Effective Yield

In April of 2013, the BofA Merrill Lynch US High Yield BB Effective Yield© hit an all-time low yield of 4.31%. The effective yield is now 5.62%.

That is a rise of 131 basis points (1.31 percentage points).

And for the same reasons noted in the above Baa discussion, I declare the end of the junk bond bull market.

Is the US Treasury Bull Market Over?

This question is amusing. Here is a pair of charts that shows why.

US 30-Year Bond Yield Monthly Chart
US 30-Year Bond Yield Monthly 2000-2015 Chart

The "death" of the US treasury bull market has been proclaimed so many times it's difficult to show them all. Let's hone in further.

US 30-Year Bond Yield Daily Chart

US 30-Year Bond Yield Daily 2015 Chart

Where others saw massive price inflation coming (with the CPI as the determining measure), I called for deflation (as measured by credit marked to market and asset prices). In other words I expected monetary inflation to manifest itself in asset prices not consumer prices.

I stick with that call. For all of those who think consumer price inflation is just around the corner, I have some questions.

Questions for Inflationistas
  1. What happens when there is another asset bubble bust in the US?
  2. What happens if the US goes into recession later this year or early 2016?
  3. What happens to the long end of the curve if the market even thinks the Fed will hike the US into recession?
  4. What is happening to the long end of the cure relative to the short end?
  5. Do consumer prices soar when commodity prices collapse?
Bonus question: With the long end of the curve just 70 basis points away from a record low, and with a global growth slowing, is it inconceivable for another record low at the long end of the curve?


Is the Bond Bull Market Over?
  1. US Corporates: Yes - and with surprisingly little fanfare
  2. US Treasuries: Maybe - but with constant speculation and erroneous proclamations for what seems like forever.
By the way, junk bond bull markets and equity bull markets tend to go hand-in-hand. So do junk bond bear markets and equity bear markets.

Feelin' Lucky?
Question for the Fed: Do you have another bullet left in your gun if things head south, or not? "Well Do Ya Punk?"


Up and Down Wall Street

China: Sunshine Above, Stormy Markets Below

Beijing pulls out all stops to make the parade commemorating end of World War II a success and to try to end downturn in its stock market and economy.

By Randall W. Forsyth           

Updated Sept. 5, 2015 2:22 a.m. ET

 
Blue skies, smiling at me. Nothing but blue skies do I see.
 
And, lo, never was the sun shining so bright as it was above Beijing’s massive parade last week, to mark the 70th anniversary of the end of World War II. But while never were things going so right during the extravaganza to trumpet the absolute power and dominance of China’s leaders, the pall of their woes, environmental and economic, may be about to descend on them again.
 
By any means necessary, Beijing made sure the victory celebrations came off without a hitch. To ensure those blue skies, the government shuttered factories and curtailed automobile usage to lift, if only temporarily, the cloud of air pollution that normally hangs over the capital city, just as it had done for the 2008 Olympics.
 
And Beijing also took steps to quell the financial maelstrom that had enveloped the stock and currency markets. As part of those efforts, the authorities investigated brokerage analysts and the media for supposed insider trading and “rumor mongering” as culprits in the 40% collapse in the Chinese equity markets from their highs a few months ago.
 
A leading Chinese financial journalist confessed on state television to stirring up “panic and disorder” in the markets. That confession apparently was effective, as the Shanghai Composite’s rate of descent slowed markedly ahead of the shuttering of the mainland’s markets for the celebrations on Thursday and Friday.
 
And the notion that we in the media can actually influence the markets was bolstered by research by some academics, specifically in our use of what they seemingly saw as inflammatory words in news reports to describe market swings.
 
In a paper by Rajna Gibson Brandon and Christopher Hemmens of the University of Geneva and Matthieu Trepanier of Switzerland’s University of St. Gallen, an examination of market accounts by our corporate colleagues at Dow Jones Newswires from 1998 to 2012 found that a certain “lexicon” was linked to “irrational behavior” by equities. These words included the likes of “daft,” “hysterical,” “irrational,” “perplexing,” “stupid,” and even something as innocuous as “unusual.” The study, by the way, was reported by Bloomberg News, whose reports are wont to inform readers dryly that markets “fluctuate,” rather than inflame their passions unduly, as the academics found the DJ crew guilty of doing.
 
Specifically, the irrational behavior induced by such intemperate verbiage was found to depress stock prices for a few days. Eventually, however, the prices recovered, or reverted to their means. The lesson for investors then would be to use the media’s “panicking” and “paranoia”—to pick an alliterative pair of irrationality-inducing words in the lexicon assembled by the researchers—as a buying opportunity. But Chinese officials apparently are averse to leaving such things to chance.
 
As Anne Stevenson-Yang of J Capital Research wrote last week, in China “markets may only operate within the parameters specified by the government. In an oft-alluded metaphor, free markets are the bird; the government is the cage.”
 
Beyond the curbs on the media, Beijing is relying on administrative measures to prop up the market. Among them: “criminal penalties for failing to support the program of ‘buy high, hold indefinitely’ ” for brokers and major investors, she writes. So, even as the China Securities Regulatory Commission steps back from overt stock purchases, the government apparatus still is working to hoist the markets.
 
Beijing also wants to control China’s currency, the yuan or renminbi, which it recently devalued. The yuan’s exchange rate actually firmed, to 6.3559 to the dollar from 6.4128 on Aug. 25, in the lead-up to last week’s great parade. (Fewer yuan to buy a greenback means the Chinese currency is stronger.)
 
But there is a cost to keeping up appearances with a stable exchange rate as a backdrop to the grand celebrations in Beijing. That price, as Stevenson-Yang explains, is a tight rein on the supply of renminbi, or RMB. The Peoples’ Bank of China could refrain from lending new money to the interbank market, further tightening monetary conditions. A likely result: rising loan defaults by corporate borrowers, she says.
 
Or, the monetary authorities could buy up RMB by selling U.S. dollars to satisfy the demand for greenbacks that results from capital flight, which is ongoing despite government curbs on taking money out of country.
 
That capital flight is landing in high-end U.S. residential real estate, among other places. One clue: A multimillion house that sold in Gatsby country on Long Island was listed with “888” as the last three figures in the asking price, eight being a lucky number for those steeped in Chinese numerology.
 
The monetary mechanics are arcane but key. Selling dollars (actually, U.S. Treasury and agency securities) to slow the fall in the RMB shrinks the PBOC’s balance sheet. This is the opposite of the quantitative easing engaged in by other major central banks: the Federal Reserve, the European Central Bank, and the Bank of Japan, which all bought securities to inject liquidity (and were content or even eager to let their currencies thereby weaken, to boost their economies).
 
With the parade over, the Chinese authorities are unlikely to let tight money worsen strains on the banking system. “A financial crisis would necessitate a quick currency depreciation of at least 10% to 15%, enough to make buying U.S. dollars and moving money over the border seem unattractive. A depreciation of that magnitude would immediately impact currencies across emerging markets, from the peso to the real to the baht to the rupiah,” Stevenson-Yang concludes.
 
That would gain China relatively little, while continuing to batter other emerging economies. While mainland China’s markets remained closed for the parade at the end of the week, Hong Kong slumped Friday, along with most other emerging markets.
 
The bird may be caged in China, but markets elsewhere are flying—or fluttering—earthward.
 
EVEN WITH TRADING ON mainland China bourses suspended, U.S. stocks closed out the second-worst week of the year with losses on the order of 3%, trailing only the 5% drop of a fortnight earlier.
 
The temptation is to blame Friday’s 272-point drop in the Dow Jones Industrial Average on that day’s news—specifically the 173,000 rise in non-farm payrolls for August, which while below forecasts, doesn’t seem punk enough to forestall a liftoff in short-term interest rates at the Federal Open Market Committee’s Sept. 16-17 confab.
 
Without resorting to inflammatory prose, it should be noted that global markets were headed for a rout long before the U.S. jobs numbers were reported an hour before Wall Street equity trading started. Hong Kong and other Asian markets had fallen and European bourses already were diving, as Germany’s DAX entered the dreaded “death cross” (the 50-day moving average falling below the 200-day moving average).
 
We’re heading into a long holiday weekend in which the market is apt to be a major topic of conversation around barbecues, perhaps more so than Hillary and The Donald, Brady’s Deflategate suspension being lifted in time for the NFL season’ kickoff, the drop in gasoline prices, or Serena’s prospects of capturing the Grand Slam.
 
If anything, the hiatus until U.S. markets reopen Tuesday morning may have induced more angst than eagerness among investors ahead of the Labor Day break. China reopens Sunday evening U.S. time, while trading continues in the rest of the world, with Europe and Latin America continuing to be battered. It’s hard to enjoy your craft-brewed IPA as you steal glances at quotes on your phone.

IF YOUR PORTFOLIOS HAVE been lagging, at least you’re in good company, as my colleague Andrew Bary notes in the following report:
 
Big university endowments soon will be reporting their investment results for the year ended June and their performance likely will fall far short of that in the prior 12 months, during which Harvard, Yale, and other major schools had 15% to 20% gains.
 
The markets weren’t as cooperative in the latest year, with the S&P 500 returning 7%, the EAFE index of overseas developed equity markets falling 6% in dollar terms, while emerging markets also were weak. It’ll be interesting to see if the endowments, which tend to be light on U.S. stocks and heavy on alternatives such as private equity and hedge funds, are able to beat a 60/40 mix of U.S. stocks and bonds, which returned 5%. Our guess is that most didn’t do much better than that in the past year, and likely have fared worse since then, with the S&P 500 off about 7% since June 30.
 
Hedge funds generally have been disappointing, and natural-resources investments, which many endowments favor, likely fared poorly, thanks to the plunge in commodity prices.

Performance might hinge on private equity, a favorite of places like Yale. Some big winners, such as Uber, could help endowments’ private-equity results, but not enough to offset drags caused by conventional assets.
 
Endowments need 7% to 8% returns to meet spending requirements and to keep up with inflation. Many probably didn’t hit that target in the latest 12 months and will be hard-pressed to do so in the current year.
 
Public pension funds also are being forced to cut their return assumptions, as The Wall Street Journal reported Friday, to a still heroic 7.68%, the lowest projection since 1989. That’s a less obvious cost of ultra-low interest rates.


Buttonwood

With great power

Markets are dangerously dependent on central Banks

Sep 5th 2015 


WELCOME back from the holidays. After suffering their worst month in more than three years in August, American equities again fell sharply on September 1st, along with shares in Europe and Japan. This sudden bout of turmoil owes much to doubts about the continuation of two great economic experiments. And it also reflects the aftermath of a huge philosophical change about the role that governments should play in the markets.


The first experiment is the Chinese attempt to shift their economy away from an investment- and export-led model towards one based on consumption. The Chinese are also grappling with the consequences of a debt-fuelled boom and with the effect of volatility in their property, equity and currency markets. Many investors fear they will be unable to manage this transition successfully, and the impact on other economies (a sharp fall in South Korea’s exports, disappointing second-quarter growth in Australia) is becoming clear.

Quantitative easing (QE) in the developed world is the other great experiment. Holding down bond yields may have prevented the financial crisis from turning into another Depression. But interest rates have been at rock-bottom for six years now and, in America and Britain, central banks seem keen to tighten monetary policy. Investors appear nervous that the authorities are underestimating the damage premature tightening might cause, particularly given the upheaval in China. Whenever markets have reason to think that the Federal Reserve might postpone a rate increase, they rally.

Back in the 1980s, Margaret Thatcher argued that it was impossible to “buck the market”—that attempts by the authorities to interfere in the price-setting mechanism would eventually come unstuck. Since 2008 “You can’t trust the markets” has become the dominant philosophy. Central banks worried that, if they did not take action, bond yields would rise too fast, reducing the incentive for companies and consumers to borrow, and thus harming the economy. Furthermore, to the extent that lower bond yields boosted equities, that was good for consumer confidence; if QE pushed down the currency, that was good for exporters.

However, market support, once given, is hard to take away. When the Fed hinted at a slowdown in its asset purchases in 2013, bond yields rose sharply—an episode known as the “taper tantrum”. Even now, with unemployment having fallen dramatically and both the American and British economies growing at a 2-3% annual rate, neither the Fed nor the Bank of England has sold off any of the assets they acquired under their QE programmes.

With overall debt levels in developed economies still high, a big rise in borrowing costs would be a nasty shock to debtors. So central banks have emphasised that any tightening in monetary policy would be slow and steady, and that the “normal” level for rates may well be below those prevailing before 2007.

Central banks are clearly worried about the ability of the developed world to achieve pre-crisis levels of economic growth. That ought to be bad news for equities, since it should restrict profits. Until recently, however, American corporate profits had been remarkably strong, in part because of firms’ foreign sales and in part because margins had been boosted by subdued wages. The impetus from both factors seems to have faded. The earnings per share of S&P 500 companies were just 1.7% higher in the second quarter than they were a year ago; forecasts for the third quarter suggest a decline of 3.8%. Secular stagnation appears to be catching up with the stockmarket.

Meanwhile, investors are not the only people who have noticed the enormous power of central banks. Although central bankers may see themselves as disinterested technocrats, some politicians view them with suspicion. In Greece, the European Central Bank is part of the hated “troika” that is imposing austerity. In America, some Republicans think that QE is debasing the currency and will eventually lead to inflation. In Britain, Richard Murphy, an economic adviser to Jeremy Corbyn, Labour’s likely next leader, thinks that QE has been a handout to the banks and should be diverted to funding infrastructure. Central banks need to be brought formally back under democratic control, in his view.

Central banks have done the lion’s share of steering the global economy through the financial crisis. Markets everywhere depend on them more than ever. Should they appear to falter, they will face an enormous backlash.


Stephen Schwarzman of Blackstone Feels the Agony of Victory

By LANDON THOMAS Jr.

SEPT. 4, 2015

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Stephen A. Schwarzman, Blackstone’s chief executive, has spent at least half of each year since 1985 flying around the world, wooing clients. Credit Todd Heisler/The New York Times       


Stephen A. Schwarzman ought to be a satisfied man.
 
The Blackstone Group, the investment firm he helped found 30 years ago, is hauling in cash at a dizzying pace. His name graces the New York Public Library building at 42nd Street and Fifth Avenue as well as a new complex to be built at Yale. And last year he made $690 million, one of the biggest paydays ever for a chief executive of a public company.
 
But instead of taking a victory lap, Mr. Schwarzman, who will turn 69 in February, has spent countless hours over the last year struggling to convince investors that Blackstone’s shares are drastically undervalued when compared with those of its peers. His message: Blackstone’s extraordinary run of asset growth and profitability is no mere fluke.
 
“It is ridiculous empirically, but psychologically, people want to believe that it might never happen again,” Mr. Schwarzman told an investment conference in New York this spring, making little attempt to disguise his frustration over Blackstone’s stock price. “Is it a miracle when LeBron James scores 37 points? Not really, he is the best basketball player. The guy scores more than anybody. Each shot is unique, but over time, some teams win and they score and that’s like performance fees for us.”
 
LeBron James? Well, no one has ever accused Mr. Schwarzman of selling himself short.
 
Mr. Schwarzman, Blackstone’s chief executive, was speaking before a packed conference hall at the Waldorf Astoria, surely not unaware that he commanded the coveted 9 a.m. speaking slot ahead of Michael L. Corbat, the chief executive of Citigroup.
 
The scheduling could be seen as a sign of how profits — and power — on Wall Street have shifted from the global banking giants to asset-gathering machines like Blackstone. Since the financial crisis, Citigroup and other large commercial banks have had their profits and ambitions shrink, while nimbler investors like Blackstone have generated sky-high returns by cashing in on investor demand for riskier investments.
 
Nonetheless, Mr. Schwarzman seemed to be on the defensive. He had gone to the Sanford C. Bernstein Annual Strategic Decisions Conference to dispel doubts that Blackstone could keep up its great performance. Those concerns have only increased since the recent stock market slump. Private equity firms need buoyant stock and real estate markets to sell off their holdings and earn performance fees.
 
But as he responded to investors’ questions, Mr. Schwarzman took offense at the suggestion — put to him by the conference moderator — that Blackstone’s profits may not be repeatable.
 
“I don’t accept that observation or that conclusion, which is based on nothing, actually,” he said, a slight edge creeping into his voice. “It’s the same thing as a basketball player who is great, taking a shot and never going to the basket again. That’s not how it works.”
 
From Mr. Schwarzman’s childhood in suburban Philadelphia to his years at Yale and through all his professional conquests, he has been driven to accumulate more. More money, more power, more status. But one ambition has trumped them all: to create a financial enterprise that will stand the test of time.
 
Since Mr. Schwarzman started out as a junior analyst at Donaldson, Lufkin & Jenrette in 1969, roughly 25 Wall Street names have disappeared (D.L.J. among them), having either imploded or been swallowed up in various financial mergers.
 
Blackstone, in turn, has survived and prospered, and now Mr. Schwarzman is demanding respect in the form of a higher stock price. Of course, the fight may be futile. One of the core principles of investing is that, over the long term, the stock market is supremely efficient in terms of incorporating all that needs to be known about a company’s worth.
 
Conceived as a buyout shop that lived from one big deal to the next, Blackstone in recent years has broadened its business mix. While the bulk of the company’s profits still come from leveraged bets, Blackstone is pushing hard to present itself to investors as a fast-growing asset manager and not a boom-and-bust deal maker.
 
Through its stakes in luxury hotels, office buildings and rental homes, Blackstone owns more real estate than any other private-sector entity. It has also emerged as a dominant shadow banker, extending loans or buying up the distressed debt of a wide range of companies through its credit division. And the $68 billion in hedge fund assets that it oversees makes it one of the biggest players in the sector.
 
From these business units, Blackstone collected more than $7 billion in revenue last year, with the majority coming from profits recouped from home-run investments in the Hilton hotel chain and the timely offloading of real estate positions.
 
Few companies have raised as much money in as short a time or been as profitable as Blackstone has.
 
Since 2007, when the company sold shares to the public, Blackstone’s assets under management have soared to $330 billion from $102 billion, and profits have leapt to $4.3 billion from $348 million. In the last 12 months alone, it raised close to $100 billion — an amount that roughly equals all the assets under management of its archcompetitor, the private equity company Kohlberg Kravis Roberts & Company.
 
But the real secret to Blackstone paydays comes from those LeBron-like performance fees that the company collects when it unloads private equity and real estate stakes.
 
Consider this: Of the $4.3 billion Blackstone earned in 2014, 71 percent came from performance fees. That sum equals the combined net income of the asset management giants BlackRock and T. Rowe Price, which together preside over $5.4 trillion in assets, more than 15 times the size of Blackstone’s.
 
It also exceeds the $3.6 billion earned last year by the investment banking giant Morgan Stanley, which employs 55,000 people, compared with Blackstone’s 2,300.
 
Blackstone’s profits, it should be said, are flattered by a minuscule tax rate of 4.3 percent. That is because the bulk of these performance fees is so-called carried-interest gains, which — with much political controversy — are taxed at a much lower rate than standard corporate profits.
 
Charles D. Ellis, a longtime financial consultant and the author of a comprehensive study of Goldman Sachs, pinpoints two elements that set Blackstone apart: a laser focus on raising capital and Mr. Schwarzman’s obsessive drive.
Indeed, when it comes to banging on the doors of wealthy institutions for money, be it a major pension fund in California or Abu Dhabi’s enormous sovereign wealth fund, there is arguably no one on Wall Street who rivals Mr. Schwarzman.
 
Since 1985, when the firm was founded, Mr. Schwarzman has spent at least half of each year flying around the world, wooing clients. Even now, pushing 70, he spends the majority of his time meeting with large institutional investors.
 
And while it may well be that Blackstone’s next generation, like the real estate guru Jonathan D. Gray and the head of private equity, Joseph Baratta, are doing much of the work, at the root of it all is Mr. Schwarzman’s refusal to be satisfied.
 
“It is the Steve phenomenon,” Mr. Ellis said, “his unrelenting push for more and better.”
 
While he can be a punishing micromanager when the firm’s capital or reputation is at stake — on one occasion he cursed out an investment partner over a bet gone bad, according to the book “King of Capital” — for years he has given top executives the space to build and run their businesses.
 
Blackstone executives compare their brand on Wall Street to Goldman Sachs’s. Mr. Schwarzman likes to brag about the 15,000 job applications the company gets each year for 100 analyst spots, and there is no doubt that from the client’s perspective, investing in a Blackstone fund carries a cachet similar to that of a company board’s hiring Goldman to advise it on a merger.
 
But Mr. Ellis stops short of saying that Blackstone has reached the point at which its culture of success has become institutionalized, like that of Goldman Sachs. He wonders whether the company can sustain its pace without Mr. Schwarzman at the helm.
“Can they continue without him?” he asked. “I just don’t know.”
   

Stephen A. Schwarzman, chief executive of the Blackstone Group, is famous for his ambition. Credit Alex Wong/Getty Images

 
Although he has ceded the operating reins to the company’s president, Hamilton E. James, and has a line of succession in place, with Mr. Gray the early favorite, Mr. Schwarzman has no plans to retire anytime soon and continues to work full time as Blackstone’s cheerleader in chief.
 
But skepticism over the company’s stock price continues to haunt him. And the burning issue now is whether Blackstone can keep generating the profit-pumping performance fees once interest rates go up, as they are expected to this year or next.
 
The fee bonanza of the last few years has attracted the attention of regulators concerned that the secrecy in private equity deals is masking hidden fees. Blackstone and other private equity companies have disclosed that government officials are investigating how they charge their clients for their services.
 
In Blackstone’s filing, it reported that the Securities and Exchange Commission was investigating practices “relating to the application of disparate vendor discounts to Blackstone and to our funds.”
 
Even without regulatory inspection, investors have started to become wary of the opaque and pricey fee structure of hedge funds and private equity firms.
“The real question is whether the Blackstone business model will hold up in the future,” said Roy Smith, a former Goldman Sachs partner and professor of finance at New York University.

“Returns on hedge funds and private equity have been disappointing, and as such, the fee structure is hard to justify.”
 
“Investors don’t have to buy alternative assets — they can go back to the old ways and maybe do just as well with E.T.F.s, but save a lot of money on fees,” he said, referring to exchange-traded funds.
 
For now at least, the cumulative returns on Blackstone’s main private equity and real estate funds have been impressive — around 20 percent.
 
And while the recent bout of market volatility may hit short-term profits, Blackstone, unlike mutual and hedge funds, has an advantage: The majority of its capital is locked up for 10 years.
 
It’s a point that Mr. Schwarzman hits on time and again when making the case that Blackstone deserves a stock market premium.
 
Take a look at the travails of the bond giant Pimco, he said at the investor conference, referring to the mass exodus of investor cash from its funds last year because of management turmoil.
 
“I feel sorry for these people,” he said. “But they had the largest bond fund in the world. And what happened? Somebody decided to take their money out and then somebody else decided and then lots of people.”
 
With most of Blackstone’s funds, he continued, “you can’t take your money out.”
 
In Mr. Schwarzman’s pitches to investors, he frequently reminisces about the firm’s early days as a start-up. Mr. Schwarzman and the company’s now retired co-founder, Peter G. Peterson, had their desks, a couple of secretaries and about $400,000 in the bank between them.
 
Now Blackstone presides over companies generating close to $90 billion in sales and effectively employing 616,000 people through its private equity operations.
 
Perhaps its biggest bet is on the notion that Americans will move from owning homes to renting them. Since 2011, Blackstone has spent close to $10 billion buying nearly 50,000 homes in beaten-down real estate markets, including Arizona, Florida and Nevada.
 
Through its newly formed company, Invitation Homes, it fixes up homes and rents them to families. The idea is to create a nationwide landlord by providing better service than local alternatives.
 
Blackstone executives have said that they plan to take Invitation Homes public next year, although that could change if markets continue to decline.
 
As Blackstone’s profits have grown, so has Mr. Schwarzman’s compulsion to secure the company’s legacy. This cannot be truly achieved, in his view, until it rids itself of its “doggy multiple,” as Mr. Schwarzman has taken to describing Blackstone’s valuation on the stock market.
 
What bothers him is that Blackstone has a price-earnings ratio of just 8.5, compared with a multiple of around 13 for BlackRock and T. Rowe Price, despite sitting on more substantial profits. That is because the market considers so-called alternative investment companies like Blackstone to be riskier, given the volatility of their performance fees. While the profits of classic money managers may be lower, they are seen as more consistent, and thus deserving of a higher rating.
Blackstone’s stock certainly has not been stagnant. Over the last five years, the share price is up over 200 percent, more than double the return of mutual fund firms.
 
But for Mr. Schwarzman, that is not enough.
 
In a way, an undervalued stock undervalues him — which is an unacceptable state of affairs for a man who, in 2007, gave himself a 60th birthday party in which a part of the vast Park Avenue Armory was redesigned as his living room.
 
This year, Blackstone reported its most profitable quarter ever. As he usually does, Mr. Schwarzman led off in presenting the company’s highlights during its earnings call with Wall Street analysts.
 
He touched on the company’s growth (few other large businesses in America were growing as fast) as well as its cachet (getting a job at Blackstone was six times as hard as getting into Harvard).
 
Perhaps, he suggested, the company might even have a higher calling than minting money for its partners.
 
“Blackstone is not really a business per se,” Mr. Schwarzman said. “It’s a mission to be the best.”
 
And with that, he turned the call over to his chief financial officer.


Brazil’s disastrous budget

All fall down

Brazil is in an economic hole—and still digging

Sep 5th 2015
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PLENTY of countries run deficits. And when recessions occur, loosening the public purse strings makes sense for many of them. But Brazil is not most countries. Its economy is in deep trouble and its fiscal credibility is crumbling fast.

The end of the global commodity boom and a confidence-sapping corruption scandal, after years of economic mismanagement, have extinguished growth. Brazil’s GDP is expected to contract by 2.3% this year. Fast-rising joblessness, together with falling real private-sector pay and weak consumption, are squeezing tax receipts. Meanwhile rising inflation, allied to a free-falling currency, means investors demand higher returns on government debt. The result is a budgetary disaster. This year a planned primary surplus (ie, before interest payments) has vanished. Once interest payments are included, the total deficit this year is projected to be 8-9% of GDP.

Faced with the prospect of public finances slipping out of control, Brazil’s policymakers have stuck their heads in the sand. The 2016 draft budget sent to Congress this week by the president, Dilma Rousseff, builds in a primary deficit for the first time in the post-hyperinflation era. The very legality of a budget with a primary deficit has been questioned: a fiscal-responsibility law passed in 2000 has long been interpreted as banning spending that outstrips receipts. But whatever the legal debate, the budget is calamitous.

First, Brazil would have to borrow to cover all its interest payments—a risk for a country with by far the highest real interest rates of any sizeable economy, at a time of recession and wider emerging-market jitters. Second, a primary deficit sends a bleak message about Brazilian economic management. Since the turn of the century Brazil’s government has been guided by three principles: a credible inflation target, a floating currency and primary surpluses, ideally large enough to bring public debt down. This “tripod” allowed it to move away from its hyperinflationary past, convinced ratings agencies to grant it an investment-grade badge and underpinned growth that propelled millions out of poverty. All this is now in jeopardy.


Ms Rousseff is not the only one to blame. She had hoped to run a primary surplus, despite the recession, by resurrecting a tax on financial transactions that was abolished in 2007. But her political weakness put paid to that plan. At just 8%, her public-approval rating has hit depths unplumbed by any previous Brazilian president, undermining her authority in Congress.

Lawmakers are also angered by her finance minister’s attempts to rein in pork-barrel spending, and alarmed by a wide-ranging investigation into corruption at the state-controlled oil giant, Petrobras. Knowing that the new tax would be unpopular—and hoping to weaken Ms Rousseff further—they made it clear that they would block it.

Congress, Ms Rousseff’s advisers say, must now find a way to pay for the spending it refuses to cut. But it is stuffed with short-termists who are more concerned with lining their pockets than securing Brazil’s future. Many, both in the opposition and among her supposed allies, are wasting their energy trying to impeach Ms Rousseff, rather than finding a way to fix the budget. Unless this impasse is resolved quickly, business and consumer confidence will fall further and foreign investors will pull out. Brazil will be headed for a multi-year slump and a ratings downgrade.

Heaven can wait
 
So how might Brazil reach a primary surplus? By far the best solution would be to cut public spending, which accounts for more than 40% of GDP, much more than in other middle-income countries. Ms Rousseff has scaled back some discretionary spending, for example by promising to merge some ministries. But the 2016 budget includes plans to raise the minimum wage and many welfare payments by a whopping 10%. Congressional gridlock and a constitution that is chock-full of unaffordable spending commitments mean that only rarely have Brazilian governments managed to trim outgoings—and only under presidents endowed with remarkable political and leadership skills. Ms Rousseff falls far short of that ideal.

That leaves the sticking-plaster. The proposed financial-transaction tax would be, like so many Brazilian taxes, poorly designed and hard on growth. But it would still be better than ramping up spending with no way to pay for it. If not this tax, then some other is needed—and after that, the business of reforming Brazil’s greedy and profligate government.


A Banker Beat Down That Could Hurt Housing

Banks are likely to keep pulling back from making FHA loans

By John Carney

Sept. 4, 2015 2:41 p.m. ET

A house in Oradell, N.J., this past May. Some banks are pulling back on FHA lending. A house in Oradell, N.J., this past May. Some

Dreams of reconciliation between big banks and the Federal Housing Administration got a rude awakening this week.

On Tuesday, the agency sought to entice banks into making more of the kind of loans the FHA says it will insure. That appears to have backfired.

The Mortgage Bankers Association and nonpartisan policy research group the Urban Institute warned that lenders may continue to pull back on FHA lending. Wells Fargo WFC -2.65 % said it would actually tighten its standards on FHA loans. J.P. Morgan Chase JPM -2.39 % announced its retreat from FHA loans last year and has largely stopped making such loans.

FHA loans are a small part of the overall U.S. mortgage market. Even so, if not resolved, this conflict between banks and the FHA could crimp banks’ mortgage operations and prove a longer-term headwind for housing. That, in turn, isn’t good for the wider economy given housing’s importance as well as the fact that this has been one area that is doing well despite fears over how slowing global growth could ripple through the U.S.

At issue are the additional protections against defaults, known as “credit overlays,” that banks impose on top of the 580 credit score and 3.5% down payment the FHA requires to insure home loans. Most lenders require a minimum credit score of 640, according to Jim Parrot of the Urban Institute. That excludes about 13 million potential borrowers.

Why would banks seek to reduce credit risk on loans in which the FHA agrees to assume that risk? Lenders fear they might wind up on the hook for up to three times the size of an FHA-backed loan’s outstanding balance should the loan sour.




In the wake of the financial crisis, federal prosecutors began to use the False Claims Act to penalize banks for troubled loans. Under the act, banks can be held responsible not just for the loss to the FHA arising from a default but for up to three times the outstanding loan amount.

So a bank could be asked to pay $600,000 on a $200,000 loan.

Because the FHA can’t prevent prosecutors from seeking penalties, lenders and housing policy advocates asked the agency to limit lender liability to serious errors that were otherwise avoidable. This is where lenders and housing policy advocates say the FHA fell short. The new proposal still leaves banks with too much uncertainty about what might incur a penalty.

While FHA lending tends to be just a small part of a bank’s business, the overlays can have outsize effects. Real-estate agents and home builders often seek relationships with lenders who can support their full line of business, so banks can lose more than just the FHA loan business to nonbank competitors. Similarly, loan officers can defect in favor of nonbank lenders willing to make the loans.

But even with nonbank lenders stepping in, large gaps remain. Many of those who wind up on the wrong side of the overlays are would-be first-time home buyers. Preventing or delaying their purchases is a long-term drag on the housing market and mortgage lending, making it harder for existing homeowners to trade up.

While the latest proposals will likely be revised at the end of the 30-day comment period, hopes for anything aligning bank and FHA standards are now much dimmer.