As Exciting as the 1930s

Doug Nolan

 
 
“One trouble with every inflationary creation of credit is that it acts like a delayed time bomb. 
 
There is an interval of indefinite and sometimes considerable length between the injection of the stimulant and the resulting speculation. Likewise, there is an interval of a similarly indefinite length of time between the injection of the remedial serum and the lowering of the speculative fever. Once the fever gets under way it generates its own toxics.” “The Memoirs of Herbert Hoover - The Great Depression 1929-1941”

There are few apt comparisons to today’s extraordinary backdrop. Late in the “Roaring Twenties” period offers the closest parallel – the global nature of vulnerabilities and the faltering boom; policymaker confusion and increasing ineffectiveness; fundamental deterioration in the face of impenetrable speculative impulses. It was by 1929 deeply embedded in speculator psyche that the enlightened Federal Reserve would never allow a market or economic collapse.

Top Federal Reserve officials (Yellen, Dudley, Bullard) this week suggested that Trump policies specifically target productivity. It must be a tough pill to swallow for the Fed to admit that their policies have succeeded in stimulating Credit growth and record securities prices, while coming up dreadfully short with respect to productivity gains.

By the late 1920s it had become an objective of the Federal Reserve to stimulate productive Credit. While there was deepening concern for market speculation, the weakened economic backdrop had the Fed determined to support ongoing Credit expansion.

An increasingly entrenched speculative Bubble had over years fomented financial and economic fragilities. Meanwhile, the Federal Reserve’s focus on the increasingly vulnerable economy worked to underpin speculator enthusiasm. Even as the fundamental backdrop turned alarming, a manic inflationary psychology grew only more powerful entrenched in the marketplace. In the end, efforts to promote productive Credit fatefully prolonged the life of “Terminal Phase” Bubble excess.

November 13 – Bloomberg: “China’s new home sales growth slowed in October from a year earlier, suggesting the push by policy makers to rein in runaway prices is getting traction. The value of homes sold rose 38% to 941 billion yuan ($138bn) last month from a year earlier… The increase compares with a 61% gain the previous month. Slower home sales have helped moderate credit growth. New medium- and long-term household loans, mostly residential mortgages, stood at 489.1 billion yuan in October, down from 571.3 billion yuan in September…”
Chinese policymaking – confronting the Fed’s late-twenties (Japan’s late-eighties) dilemma – badly flounders. Timid efforts to rein in its apartment Bubble were ineffective. This led to bolder moves to tighten mortgage Credit, which ironically spurred a speculative rotation and resulting equities Bubble. When the stock market Bubble burst, reflationary efforts then stoked spectacular real estate (mortgage Credit and prices) inflation. More recent efforts to cool the housing Bubble fueled major blow-off speculative excess throughout the Chinese bond market. Efforts to bolster a waning economic boom will see record Credit expansion this year approaching $3.0 TN.

It’s this global perspective of ongoing rapid Credit and unwieldy liquidity expansion in the face of waning economic prospects that helps explain the Trump Market Phenomenon. Only time will tell if President Trump is the second coming of Ronald Reagan. It’s worth noting that 10-year Treasury yields were around 12% for the Reagan inauguration (on the way to almost 16% by Sept. ’81). While starting to trend lower, CPI was still running about 10%. The S&P500 was trading at 135, just starting to crawl out of a prolonged bear market.

I’m all for responsible deregulation in the real economy. The financial sector is a different story. Count me skeptical that there will be some incredible wave of financial deregulation that will spur the golden age of financial stocks and a prosperity renascence. The Reagan era of deregulation coincided with momentous financial innovation.

We’re now into the third decade of what has been a period of monumental financial innovation. 
 
It’s worth noting some key sector metrics from the now multi-decade financial inflation. When President Reagan came into office, the Fed’s balance sheet (from Z.1) was at $174 billion – compared to Q2 2016’s $4.524 TN. Money Market fund assets were only $76 billion (vs. $2.703 TN); Mutual Funds $656 billion (vs. $13.209 TN); Closed-End & Exchange-Trade Funds $7 billion (vs. $2.491 TN); GSE’s assets $175 billion (vs. $6.568 TN); Agency- & GSE-Backed Mortgage Pools $100 billion (vs. $1.844 TN); Asset-backed Securities $0 (vs. $1.285 TN); REITs $3 billion (vs. $1.021 TN); Security Brokers/Dealers $78 billion (vs. $3.117 TN); Funding Corps $3 billion (vs. $1.618 TN); Fed Funds & Security Repos $152 billion (vs. $3.769 TN).

Even more amazingly, Total Debt Securities have inflated from $2.0 TN to $40.581 TN. Outstanding Treasury Securities have grown from $736 billion to $15.385 TN. Agency- and GSE-Backed Securities from $191 billion to $8.324 TN. Total Mortgages have increased from $1.458 TN to $13.974 TN. Corporate & Foreign Bonds have expanded from $511 billion to $12.030 TN, with Corporate Equities ballooning from $1.495 TN to $36.112 TN.

Notably, Household Net Worth stood at $8.9 TN, or about 300% of GDP, to end 1980. By the end of Q2 2016, Household Net Worth had inflated to $85.3 TN, or near a record 463% of GDP. While continued craziness can be expected to dominate the prolonged Terminal Phase of this multi-decade Bubble, I highly doubt we’re at the cusp of some deregulation-induced financial resurgence. Been there; done that.

When analyzing today’s markets, we need to keep some things in perspective. One, global central bankers continue to provide market liquidity (QE) to the tune of about $2.0 TN annualized. Second, Chinese Credit is expanding at a record pace of about $3.0 TN annualized, with significant ongoing “capital” flight. Years of this unprecedented liquidity backdrop have fundamentally altered the way markets function (as we’ve again been reminded).

Over the past three months, 10-year Treasury yields have surged 82 bps (to 2.36%). UK yields have jumped 90 bps, and Canadian yields have advanced 54 bps (1.57%). German yields have risen 35 bps (27 bps), while French yield have jumped 62 bps (75bps). Italian yields have surged 102 bps (2.09%).

In the face of surging yields, U.S. stocks have run to record highs. Most global equities indices rallied as bond prices sank. However, without $2.0 TN of ongoing QE the world would be much less hospitable. Instead of the typical bond-induced de-risking/de-leveraging episode pressuring stocks and risk assets more generally, a very different dynamic has evolved: Rising bond yields instead spur a frantic rotation into equities. QE has numbed fear, while impelling speculation.

Let’s take this one step further. When it became apparent that a Trump win would not trigger the anticipated intense bout of “Risk Off,” markets immediately erupted into a speculative melee. Where were the shorts trapped? What stocks, sectors and markets? Where were the hedge funds over- and underweight? How were the long/short funds positioned? What about the quants and CTAs? Risk parity? What ETFs would be liquidated? Most importantly, how to quickly get in front of the wave of (self-reinforcing) finance that would be rotating out of the old favorites and into newly fashionable sector ETFs?

November 14 – CNBC (Jeff Cox): “On the day Donald Trump won the presidency and the two days after last week, investors poured the most money into stock-based exchange-traded funds that they have in nine years… In the week leading up to the election, short-term money was scrambling to hedge for a Trump victory, and the momentum hit a crescendo after the election and in the immediate aftermath. Equity-based ETFs took in $22.6 billion, or about 1.6% of total assets, from Tuesday through Thursday, according to… TrimTabs.”
November 16 – Bloomberg (Luke Kawa): “In the week following the election, the Financial Select Sector SPDR exchange-traded fund amassed $4.9 billion of inflows — a record, and more than it accumulated in the past three years. This ETF has stakes in major U.S. financial institutions… President-elect Donald Trump's victory has spurred a steepening of the yield curve fueled by rising term and inflation premiums, as investors move to price-in both his fiscal policies and the vast amount of uncertainty surrounding them.”
There’s an astounding amount of “money” on the move throughout the now colossal ETF complex. Inflows of $22.6 billion in three days? Three years of flows into a popular financial ETF in a single week? And the bull story holds that after Trillions flowed into bond funds (and bond proxies), the great rotation will now see at least a Trillion flow into popular equity ETFs. Buy now to ensure one gets ahead of the great wall of liquidity about to inundate the market.

Incredibly, weak bond prices have become key to the equities bull story. And with equities bubbling, monetary policy now arouses little angst. The market almost celebrates that the Fed will raise rates next month. Fears of a Fed-rate hike induced EM tantrum are these days nonexistent.

With $2.0 Trillion of QE greasing the wheels of speculation, market participants glare at faltering EM bonds and see a more terrific rotation to “core” (king dollar) equities. Yields are recently up more than 100 bps in Mexico and Brazil, and only somewhat less in Turkey, Malaysia, Indonesia, Poland, Hungary and elsewhere. Yields were up another 20 bps this week in Malaysia, 28 bps in the Philippines and 13 bps in Mexico. EM currencies have been under intense pressure. This week saw the Colombian peso drop 4.7%, the Turkish lira 3.6%, the Polish zloty 2.9%, the Malaysian ringgit 2.8%, the Czech Koruna 2.5%, the Hungarian forint 2.5%, the Bulgarian lev 2.5% and the Romanian leu 2.4%. And few these days see any reason not to pile into U.S. financial and industrial stocks.

Not only have U.S. equities become firmly detached from reality, market participants are clearly in the mood to disregard risk. Look beyond the near-term and one sees a very different world upon the conclusion of the QE experiment. At the minimum, it’s a highly uncertain global financial and economic backdrop. Not only will bubbling equities be pulling “money” from faltering bond funds. Booming stocks would also likely accelerate what has been a slow-motion “tightening” cycle. In the meantime, king dollar will spur the next phase of the EM bursting Bubble. There is simply way too much complacency with regard to troubling developments unfolding in global bond markets, China, Japan, Europe and EM.

November 18 – CNBC (Berkeley Lovelace Jr.): “Donald Trump's controversial top advisor Steve Bannon said the Trump administration would build an entirely new political movement, one greater than the ‘Reagan revolution’… ‘The conservatives are going to go crazy,’ Bannon said. ‘I'm the guy pushing a trillion-dollar infrastructure plan. With negative interest rates throughout the world, it's the greatest opportunity to rebuild everything. Ship yards, iron works, get them all jacked up. We're just going to throw it up against the wall and see if it sticks. It will be as exciting as the 1930s, greater than the Reagan revolution — conservatives, plus populists, in an economic nationalist movement
If “negative interest rates throughout the world” is the key to the new Administration’s plans, they’d better not waste any time. Many would surely like to call a mulligan on the previous eight years of experimental QE. There’s endless things to spend near-zero interest borrowings on – new infrastructure among them. Rebuild everything – like China.

But too much was borrowed and spent on stock buybacks, M&A and all varieties of financial engineering. The experiment has left the global economy maladjusted and vulnerable. Bonds have been the centerpiece of a historic speculative Bubble throughout global securities markets. It would be comforting to believe that inflation is dead and buried, and that global QE can expand $2.0 TN annually forever, and that Chinese Credit expansion can grow year-after-year to eternity.

Yet that’s just not the way unsound finance works. We’ve experienced a multi-decade Credit inflation of epic proportions. At this juncture, I would bet on consequences coming home to roost - rather than unending free money (to finance economic renaissance) as far as the eye can see. And, while we’re pondering the future, let’s hope for something other than “as exciting as the 1930s.” 

0 comentarios:

Publicar un comentario en la entrada