Must Stop Digging

Doug Nolan

Amazon, Google, Microsoft, Intel and Draghi all handily beat expectations. Booming technology earnings confirm the degree to which Bubble Dynamics have become entrenched within the real economy. Draghi confirms that central bankers remain petrified by the thought of piercing Bubbles.

There is a prevailing view that Bubbles reflect asset price gains beyond what is justified by fundamental factors. I counter with the argument that the inflation of underlying fundamentals – revenues, earnings, cash-flow, margins, etc. – is a paramount facet of Bubble Dynamics (How abruptly did the trajectory of earnings reverse course in 2001 and 2009?).

With extremely low rates, loose corporate Credit Availability, large deficit spending, inflating asset prices and a glut of “money” sloshing about, there is bountiful fodder for spending and corporate profits. And with technology one of the more beguiling avenues to employ the cash-flow bonanza – and tech start-ups, the cloud, AI, Internet of Things, robotic, cybersecurity, etc. white-hot right now – the Gargantuan Technology Oligopoly today luxuriates at the Bubble Core.

By this time, expanding global technology capacity is a straightforward endeavor, while the industry for now enjoys booming demand and outsized margins. This confluence of extraordinary attributes provides “tech” the latitude to operate as a powerful black hole absorbing global purchasing power (throughout economies as well as financial markets). As such, it has been a case of the greater the scope of the Bubble, the more supply of “tech” available to weigh on overall goods and services pricing pressures. Central bankers continue to misconstrue this dynamic, instead perceiving irrepressible disinflationary forces that they are compelled to counter (with year after year after year of flagrant monetary stimulus).

The Nasdaq Composite’s 24.5% y-t-d gain has provided a fantastic windfall to fortunate investors as well as tens of thousands of extremely fortunate employees. This financial godsend will exacerbate wealth disparities along with housing inflation in select localities. Yet there will be little boost to reported wages (capital gains instead) and negligible impact on the overall CPI index. Is CPI these days even a relevant gauge of inflationary pressures or monetary instability?

As for Mario Draghi’s practice of beating market expectations, he is the present-day Alan Greenspan – the savvy operator that over the years has grown too comfortable wielding power over global markets (not to mention over central bankers at home and abroad). Headline from the Financial Times: “Draghi Pulls Off Dovish Trick with His QE ‘Downsize’ - ECB President Determined Not to Repeat Mistake of Premature Tightening.”

The ECB – right along with central bankers around the world – has replayed the fateful mistake of delaying for (way) too long the removal of monetary stimulus. Draghi refused to set a date to end the ECB’s “money” printing operations, ensuring at least several hundred billion of additional stimulus in 2018. And with the commitment to hold rates at the current negative level until well past the end of QE, a most inert “normalization” process will likely not even commence until well into 2019. Apparently, short rates likely won’t make it much past 1% for several years. Draghi’s central bank will continue to purchase large quantities of corporate debt next year. Moreover, with open-ended QE and assurances that operations could at any point be expanded, spoiled markets take great comfort that their beloved liquidity backstop is as unyielding as ever.

October 26 – Bloomberg (Alessandro Speciale and Mark Deen): “The European Central Bank should have decided on an end date for its asset-purchase program rather than retaining the option to extend it after September 2018, Bundesbank President Jens Weidmann said. ‘From my point of view, a clear end of net purchases would have been appropriate,’ Weidmann said in a speech… ‘The development of domestic price pressures shown in projections is in line with a trajectory that will take us toward our definition of price stability.’ Weidmann’s critique comes one day after the Governing Council extended quantitative easing until September at a monthly pace of 30 billion euros ($35bn), leaving the door open for further buying after that if needed. The Bundesbank president was among a handful of policy makers who didn’t support the decision, according to Germany’s Boersen-Zeitung.”

German stocks gained 1.7% this week, while French equities jumped 2.3%. German (38bps) and French (79bps) yields declined seven basis points to seven-week lows. Portuguese bond yields dropped 11 bps to a 30-month low 2.19%. Dropping nine bps, Italian 10-year yields traded back below 2%. And in a sign of these strange times, even Catalonia chaos couldn’t keep Spanish yields from declining eight bps to 1.58% (83bps below Treasuries!). Yet Draghi has company when it comes to assuring markets that central bank liquidity backstops are here to stay.

October 20 – Financial Times (Sam Fleming): “Janet Yellen… has warned that there is an ‘uncomfortably high’ risk that the central bank will have to deploy crisis-era stimulus tools again — even in the case of a less severe downturn than the Great Recession. Her comments come as President Donald Trump considers a sharp change of direction at the Fed which could see him install new leadership that is much more dubious about the Fed’s use of quantitative easing. Ms Yellen said in a speech that the US economy had made ‘great strides’ but that policymakers may be unable to lift short-term rates very far as the recovery proceeds. This could leave the Fed once again leaning on quantitative easing and forward guidance on the future rate outlook when the economy hits a downturn, she suggested… ‘Does this mean that it will take another Great Recession for our unconventional tools to be used again? Not necessarily. Recent studies suggest that the neutral level of the federal funds rate appears to be much lower than it was in previous decades,’ Ms Yellen said. ‘The bottom line is that we must recognise that our unconventional tools might have to be used again. If we are indeed living in a low-neutral-rate world, a significantly less severe economic downturn than the Great Recession might be sufficient to drive short-term interest rates back to their effective lower bound.’”
Apparently, there is an “uncomfortably high risk” that QE will be employed “in the case of a less severe downturn” because “policymakers may be unable to lift short-term rates very far as the recovery proceeds.” Does anyone believe that the Yellen Fed is less than comfortable with the prospect of restarting QE?

Q3 marked the second consecutive quarter of 3% U.S. growth; consumer confidence is the highest in years; stock markets are booming with record prices and “money” flooding into ETFs; debt issuance remains on record pace; leveraged lending and M&A are booming; a strong inflationary bias persists in housing; and the unemployment rate is down to 4.2%, lowest in 16 years. Why not begin a real normalization of monetary policy? Because some measures of core consumer price inflation remain slightly below 2.0%?

It has become increasingly apparent that central bankers recognize their predicament and have chosen not to risk piercing Bubbles. I suspect Draghi, Yellen and Kuroda (and others) fear the consequences of a destabilizing jump in global bond yields. I too fear the amount of leverage and range of distortions that have accumulated over the past nine years. The inescapable adjustment after such a prolonged boom will be quite difficult. Yet the analysis gets back to the “First Law of Holes:” Must Stop Digging. At this late (historic) Bubble stage, systemic risk is piling up exponentially.

October 24 – Financial Times (Robin Wigglesworth): “Inflows into exchange-traded bond funds have surged past last year’s record with several months to spare, as the seismic migration towards passive investing broadens out beyond the equity market. ETFs that track fixed-income benchmarks have attracted nearly $130bn so far this year, comfortably surpassing the record-breaking 2016, when almost $117bn gushed into bond ETFs… Bloomberg data puts this year’s inflows at more than $140bn. ‘It’s been a year of robust flows,’ said Steve Laipply, head of fixed income strategy at BlackRock’s iShares ETF business… ‘There has been accelerating institutional investor adoption of these products’… ETF providers such as Vanguard, State Street and BlackRock have rapidly grown their franchises, with BlackRock revealing in its latest quarterly earnings that it is currently taking in about $1.5bn a day.”

October 22 – Wall Street Journal (Christopher Whittall): “Investors hungry for returns are piling back into securities once tarnished by the financial crisis. Complex structured investments developed a bad reputation during the credit crunch. Ten years later, investors seeking yield are overcoming their skepticism and buying into securities that rely on financial engineering to juice returns. Volumes of CLOs, or collateralized loan obligations, hit a record $247 billion in the first nine months of the year… Fueled by a wave of refinancings and nearly $100 billion in new deals, that far outpaces their recent full-year high of $151 billion in 2014 and the precrisis peak of $136 billion in 2006. The CLO boom is the latest sign of the ferocious hunt for yield permeating markets. Stellar performance over the past year has made CLOs increasingly hard to ignore for investors like insurance companies and pension funds.”

October 20 – Financial Times (Gillian Tett): “A decade ago, whenever I chatted to anyone at Switzerland’s Bank for International Settlements, I felt like I was hobnobbing with dissidents. The reason? Back then, most western central bankers and finance ministers were convinced that the global economy was in good shape: inflation was low, growth was steady, corporate and consumer optimism was high. In fact, the data seemed so benign that economists had labelled the first decade of the 21st century the ‘great moderation’. Not the BIS. Starting in 2003, officials at… institution, which aims to ‘promote global monetary and financial stability through international co-operation’, started to warn that the world economy was plagued by excessive levels of debt. This made the system dangerously distorted; so went the off-the-record murmurs from men such as William White… and Claudio Borio... Most central bankers dismissed these warnings — some even tried to silence the BIS… Earlier this month I travelled to Washington for an International Monetary Fund and World Bank meeting. There was a cheery mood in the air, just as there was in 2006… But now, just as before, those BIS dissidents are muttering in the wings. At the IMF gala, Borio (still at the BIS) told me that the pesky matter of debt has not disappeared. On the contrary, since the 2008 credit crisis, it has risen sharply: the level of global debt to gross domestic product is now 40% — yes, 40% — higher than it was in 2008. The world has responded to a crisis caused by excess leverage by piling on more, not less, debt.”
There are aspects of the current global Bubble that are reminiscent of pre-2008 crisis – though the amount of debt these days is larger, price distortions greater and misperceptions more perilous. Then: “Washington will not allow a housing bust.” Now: Global central bankers will not allow market dislocation. Unprecedented market distortions – including Trillions of mispriced “AAA” debt securities – back in 2008 look pee-wee when compared to today’s fiasco in perceived money-like instruments (fixed-income as well as equities)

At the same time, today’s “tech” party is more 1999 – just so much more expansive. Loose “money” coupled with government/central bank backstops have nurtured another epic sector mania – replete with more dangerous regional economic and housing Bubbles. Today’s EM backdrop has uncomfortable characteristics reminiscent of 1996, with the current “hot money” onslaught compounding already acute financial, economic, social and geopolitical fragilities from Asia to Eastern Europe to Latin America.

And there are elements of fixed-income excess that recall all the way back to 1993. The proliferation of leveraged derivatives strategies cultivates latent fragility. Meanwhile, the scope of flows into fixed-income ETFs at this late stage of the cycle is astonishing – yet, as they say, “par for the course.” It’s consistent with the flood of funds into passive U.S. equities indices and the emerging markets; the near-panic buying of European and U.S. corporate debt – the tsunami of “money” inundating virtually all risk assets via the ballooning ETF complex.

What most sets today’s Granddaddy of All Bubbles apart? Historic excess and distortion throughout the securities and derivatives markets – and asset markets more generally – on an unprecedented synchronized, systemic global scale. It’s become myriad powerful booms all packed into one killer Bubble unlike the world has ever experienced. History will not be kind to central banker fixation on arbitrary 2% annual CPI targets. Nasdaq inflated 2.2% in Friday’s session – the Nasdaq100 2.9%!


Globalisation’s losers

The right way to help declining places

Time for fresh thinking about the changing economics of geography



POPULISM’S wave has yet to crest. That is the sobering lesson of recent elections in Germany and Austria, where the success of anti-immigrant, anti-globalisation parties showed that a message of hostility to elites and outsiders resonates as strongly as ever among those fed up with the status quo. It is also the lesson from America, where Donald Trump is doubling down on gestures to his angry base, most recently by adopting a negotiating position on NAFTA that is more likely to wreck than remake the trade agreement.

These remedies will not work. The demise of NAFTA will disproportionately hurt the blue-collar workers who back Mr Trump. Getting tough on immigrants will do nothing to improve economic conditions in eastern Germany, where 20% of voters backed the far-right Alternative for Germany. But the self-defeating nature of populist policies will not blunt their appeal.

Mainstream parties must offer voters who feel left behind a better vision of the future, one that takes greater account of the geographical reality behind the politics of anger.

Location, location, vocation

Economic theory suggests that regional inequalities should diminish as poorer (and cheaper) places attract investment and grow faster than richer ones. The 20th century bore that theory out: income gaps narrowed across American states and European regions. No longer. Affluent places are now pulling away from poorer ones. This geographical divergence has dramatic consequences. A child born in the bottom 20% in wealthy San Francisco has twice as much chance as a similar child in Detroit of ending up in the top 20% as an adult. Boys born in London’s Chelsea can expect to live nearly nine years longer than those born in Blackpool.

Opportunities are limited for those stuck in the wrong place, and the wider economy suffers. If all its citizens had lived in places of high productivity over the past 50 years, America’s economy could have grown twice as fast as it did.

Divergence is the result of big forces. In the modern economy scale is increasingly important.

The companies with the biggest hoards of data can train their machines most effectively; the social network that everyone else is on is most attractive to new users; the stock exchange with the deepest pool of investors is best for raising capital. These returns to scale create fewer, superstar firms clustered in fewer, superstar places. Everywhere else is left behind.

Even as regional disparities widen, people are becoming less mobile. The percentage of Americans who move across state lines each year has fallen by half since the 1990s. The typical American is more footloose than the average European, yet lives less than 30 kilometres from his parents. Demographic shifts help explain this, including the rise in two-earner households and the need to care for ageing family members. But the bigger culprit is poor policies. Soaring housing costs in prosperous cities keep newcomers out. In Europe a scarcity of social housing leads people to hang on to cheap flats. In America the spread of state-specific occupational licensing and government benefits punishes those who move. The pension of a teacher who stays in the same state could be twice as big as that of a teacher who moves mid-career.

Perversely, policies to help the poor unintentionally exacerbate the plight of left-behind places. Unemployment and health benefits enable the least employable people to survive in struggling places when once they would have had no choice but to move. Welfare makes capitalism less brutal for individuals, but it perpetuates the problems where they live.

Welcome to the place age

What to do? One answer is to help people move. Thriving places could do more to build the housing and infrastructure to accommodate newcomers. Accelerating the reciprocal recognition of credentials across state or national borders would help people move to where they can be most productive. But greater mobility also has a perverse side-effect. By draining moribund places of talented workers, it exacerbates their troubles. The local tax-base erodes as productive workers leave, even as welfare and pension obligations mount.

To avoid these outcomes, politicians have long tried to bolster left-behind places with subsidies.

But such “regional policies” have a patchy record, at best. South Carolina lured BMW to the state in 1992 and from it built a thriving automotive cluster. But the EU’s structural funds raise output and reduce unemployment only so long as funding continues. California has 42 enterprise zones. None has raised employment. Better for politicians to focus on speeding up the diffusion of technology and business practices from high-performing places. A beefed-up competition policy could reduce industrial concentration, which saps the economy of dynamism while focusing the gains from growth in fewer firms and places. Fostering clusters by encouraging the creation of private investment funds targeted on particular regions might help.

Bolder still would be to expand the mission of local colleges. In the 19th century America created lots of public technical universities. They were supposed to teach best practice to farmers and factory managers in small towns and rural areas. They could play that role again today for new technologies, much as Germany already has a network of applied-research institutions. Politicians might even learn from Amazon, whose search for a home for a second headquarters has set off a scramble among cities hoping to lure the giant etailer. Governments could award public research centres—in the mould of America’s National Institutes of Health or Europe’s CERN—to cities which prepare the best plans for policy reform and public investment. This would aid the diffusion of new ideas and create an incentive for struggling places to help themselves.

Perhaps most of all, politicians need a different mindset. For progressives, alleviating poverty has demanded welfare; for libertarians, freeing up the economy. Both have focused on people.

But the complex interaction of demography, welfare and globalisation means that is insufficient. Assuaging the anger of the left-behind means realising that places matter, too.


Barron's Cover

Our Next Fed Chief

We weigh the choices in what will be President Trump’s most important financial decision to date.

By Randall W. Forsyth            
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Jerome Powell Andrew Harrer/Bloomberg
 

“In God we trust” is printed on the back of the dollar bill, and it is indeed a faith-based currency. The front of the bill says it is a “Federal Reserve Note,” an indication the faith is placed in that institution, not in any promise to redeem it for something tangible. While the strength of the dollar ultimately depends on that of the U.S.—political and military as well as economic—the central bank that issues the currency has become identified with the person at its helm.
Who will lead the Fed is a vitally important decision for any president, especially for Donald Trump, who has sought to fundamentally change Washington and the U.S. economy. And with Janet Yellen’s term set to end in February, the speculation of whether she gets a second four-year stint or is succeeded by somebody else has been looming large over Washington, Wall Street, and the global markets for weeks.

The candidates for central bank chief appear to be winnowed down to three: Fed Gov. Jerome Powell, Stanford University economist John Taylor, or Yellen herself, with reports on Friday that Trump has settled on Powell as his pick. The president played up the announcement in an Instagram post on Friday, promising to unveil details this coming week. Erstwhile candidates Gary Cohn, the National Economic Council head, and former Fed Gov. Kevin Warsh apparently fell out of the running earlier. (We also offer our own choice, a superstar central banker not on anybody’s short list, in “Our Pick to Head the Fed.”)

Notwithstanding all the buzz and speculation over who will win the competition for Fed chair, investors should realize that the course of monetary policy will not be altered much in the medium term.
 
John Taylor Tom Williams/CQ Roll Call/Getty Images;
 
 
Over the next year, the central bank will continue to raise its key short-term interest rates gradually, and those rates will remain at historically low levels. The Fed also will gradually reduce the size of its balance sheet, reversing some of the extraordinary liquidity it provided in the wake of the financial crisis of 2008-09.

The real change in Fed policy won’t be seen until the next bout of financial market turbulence or the next economic downturn, or both. Will the central bank under new leadership react to a decline in asset prices by slashing interest rates and pumping money into the financial system as aggressively as in the past? And perhaps more to the point, will a Fed led by Trump appointees follow a less restrictive regulatory tack and let markets function more freely? Will that mean profitability for banks and other institutions—but also greater risk when the financial markets encounter turbulence, as they inevitably do? As for the candidates, Yellen, a registered Democrat, was always a long shot to gain a second term, mainly because of politics, despite overseeing an economy with low unemployment and inflation—the Fed’s two main mandates—and a record stock market. Even so, there is ample precedent for her to be renominated by a GOP president. Indeed, each of the past three Fed chairs got nods for new terms after having been originally named by previous presidents of different parties.

Paul Volcker was named to a second term by Republican Ronald Reagan after having been nominated originally by Democrat Jimmy Carter. Alan Greenspan, originally named by Reagan to succeed Volcker, got a third term from Democrat Bill Clinton (after a second one from George H.W. Bush, Reagan’s successor). Finally, Ben Bernanke, who succeeded Greenspan after being named by Republican George W. Bush, secured a second term from Democrat Barack Obama.
 
 
Janet Yellen Andrew Harrer/Bloomberg
 
 
Precedent counts little for Trump, with personal relationships with appointees having far greater importance. On that score, the president remarked after meeting with Yellen that he liked her “a lot,” a reversal of his sharp criticism of Fed policy during the presidential campaign. Then, Trump charged Yellen was keeping rates low for political reasons—that is, to help the Democrats.

Trump also then criticized Yellen for creating “a false stock market” that would plunge as soon as interest rates rose. Now, of course, the president tweets as the stock market makes new highs—even after the Fed has raised short-term interest rates three times in the past year and is likely to hike them again another quarter percentage point this December.

But a record Dow Jones Industrial Average likely won’t be enough to gain Yellen another four-year term. (Her tenure as a Fed governor runs through 2024, but she would almost certainly step down if she doesn’t get reappointed as chair.) The Fed’s policies have lifted asset prices, not just stocks, but also corporate bonds, private equity, art, classic cars, and expensive houses. Presidents, however, typically prefer to nominate officials of their own party who are more in accord with their policy goals.

THAT MAKES POWELL the leading candidate to succeed Yellen, and the one who has the support of Treasury Secretary Steven Mnuchin, according to various reports. The stock market, for its part, climbed on Friday on reports that Trump was leaning toward picking him. A Republican who currently sits on the Fed Board of Governors, Powell has generally supported the Fed’s policies. But he also is likely to be more inclined to a lighter touch on regulation. Yellen, by contrast, emphasized the need to keep the postcrisis regulations in place in a speech last August at the Fed’s big Jackson Hole, Wyo., policy conference.

Taylor, meanwhile, is a favorite of GOP conservatives who want to curtail the Fed’s power and discretion.

The author of the eponymous Taylor Rule would have the central bank set interest rates according to a formula, which he argues would produce better results because of its consistency and transparency. More to the point, the Taylor Rule would signal substantially higher short-term interest rates—nearly two percentage points above the Fed’s current target range of 1% to 1.25% for federal funds.
 
 
 
 
The current betting is that Powell could get named chairman while Taylor could get the vice chairmanship, which also is open.

It’s not just about the leadership of the central bank. The president is in the unusual position of being able to virtually remake the entire seven-person Fed Board of Governors. Randal Quarles was just recently sworn in as vice chair in charge of supervision, a post that had been vacant. There are three other vacancies on the board to be filled as well. Lael Brainard could wind up the only holdover on the seven-person Fed Board.

Out of the running now is the previous favorite, Cohn, the former Goldman Sachs executive and head of the National Economic Council, who fell out of the president’s graces for criticizing his comments after the Charlottesville, Va., incident. Warsh, a former Fed governor, also fell out of contention, in part because of critics questioning his qualifications and Mnuchin’s opposition, according to published reports.

BEYOND PERSONALITIES, however, the assessment of Yellen’s Fed should come down to results. And those results are mixed.

As the chart above shows, her most prominent accomplishment has been the record stock market, which has been undeniably buoyed by the low level of short-term interest—near zero from December 2008 to December 2015—and historically low long-term bond yields.

But as the chart also shows, the real (that is, adjusted for inflation) median household income has only recently regained what it had lost in the Great Recession. The recovery has been helped by the decline in unemployment (by the narrow definition that gets the most attention) to 4.2%, which most economists define as full employment. But that has not been accompanied by a rise in inflation to the Fed’s inflation target of 2%. In turn, the growth of median incomes has lagged.

To be sure, the relatively lackluster economic recovery can’t be laid entirely at the Fed’s feet. Monetary policy can’t cure a litany of social issues like demographics, skill mismatches, inadequate education, or the scourge of drug addiction. Whether the buildup of debt at the household, corporate, and government levels has helped or hurt the recovery is a major point of debate.

The Fed’s critics charge that the central bank has held back growth by its interest-rate and regulatory policies. Chief among them is Taylor, who argues against both having held the federal-funds rate so low for so long and against the Fed’s asset purchases, or QE, for quantitative easing.

The Taylor Rule sets the fed-funds rates according to the economy’s potential growth, inflation, and how much slack exists in the economy. Under the formula, the Fed would have started the process of lifting the fed-funds rates much sooner, in 2010. (Importantly, the formula also would have dictated a negative rate target during 2009.) According to a Taylor Rule calculator from the Atlanta Fed, the fed-funds target would be 2.94% instead of the 1.15% it now is.

In past cycles, however, the Taylor Rule actually would have meant smaller changes in the fed-funds rate, according to the Atlanta Fed. During the past decade, when the Greenspan Fed raised the rate in small, predictable quarter-point steps and arguably allowed the mortgage bubble to inflate, the Taylor Rule would have started the rate increases sooner but also ended them earlier. During the 1990s, the Taylor Rule would have avoided the sharp rate jumps in 1994, which roiled the mortgage market and ended with a Mexican peso crisis, and wouldn’t have raised rates as much during the dot-com bubble.

EVEN IF TAYLOR wins the Fed chair, it seems unlikely he would apply his rule in a doctrinaire fashion. At a recent policy symposium at the Boston Fed, he commented: “I don’t think rules should be viewed as ways to tie central bankers’ hands. They are meant to help policy makers make better decisions.”

Still, a Taylor Fed would likely mean “a more aggressive” normalization of policy in terms of interest-rate increases and reduction in the central bank’s balance sheet than is envisioned by the Federal Open Market Committee, write Peter Hooper and Matthew Luzzetti, respectively chief economist and senior economist at Deutsche Bank. (The voting members of the policy-setting FOMC consist of the seven Fed governors and five of the 12 Fed district bank presidents, four of which rotate annually as voting members, with the New York Fed having a permanent vote.) A Taylor Fed also would likely mean a quicker move away from accommodation than the market expects.

That mightn’t be such a bad thing, comments John Brady, managing director at R.J. O’Brien & Associates in Chicago. After all, he says the Eurodollar futures market is discounting only two quarter-point rate hikes through December 2018, which would put the fed-funds rate in a range of 1.5% to 1.75%. The FOMC’s dot plot has a median year-end 2018 estimate of 2.1%.

Higher long-term bond yields would help boost returns for pension funds, Brady continues. In a yield-parched market, investors have resorted to options-selling strategies to earn premiums to augment low yields. That tends to depress volatility artificially, which in turn drags down yields. A somewhat higher bond yield—say, 2.75% on the benchmark 10-year Treasury note, versus 2.42% currently—would help normalize the bond market without imperiling stocks, he contends. So, Brady concludes, there’s little to fear from a Taylor Fed.

FOR THE GOP, Powell as Fed chairman and Taylor as vice chairman sizes up as a central bank dream team. Powell has experience at the Fed and as assistant secretary and undersecretary of the Treasury in the elder Bush’s administration as well as in private equity at the Carlyle Group. Taylor, while never having worked at the Fed, served as Treasury undersecretary for international affairs for the younger Bush. There’s plenty of government experience between them.

What could be a bigger change is how the Fed reacts to future swoons in the financial markets. To many observers, the central bank has paid increasing attention to the equity, corporate bond, and commodity markets. It amounts to “a third mandate,” as Eric Stein, co-director of global income at Eaton Vance, termed the central bank’s attention to financial market conditions, along with its official targets of full employment and stable prices.

At times, Fed heads have expressed caution about the level of stock prices, most famously when Greenspan warned about “irrational exuberance” in 1996, years before the 2000 peak of the dot-com mania. Yellen also warned prematurely in 2014 about valuations among biotechnology stocks being “substantially stretched.”

But more often, the Fed has been quick to ease policy when markets falter, beginning 30 years ago this month when the Greenspan Fed cut rates following the 508-point drop in the Dow on Black Monday. The Fed also cut rates in response to the market turmoil after the collapse of the Long-Term Capital Management hedge fund in 1998 and in early 2001 in the wake of the bursting of the internet bubble. This became known as the “Greenspan put,” a perceived option that protects investors in the event of market decline.

It was succeeded in turn by the “Bernanke put” and now the “Yellen put,” although the current chair hasn’t been put to such a test by a market plunge. But the current Fed chair has given the appearance of being sensitive to market conditions, notably early last year, by putting off expected interest-rate hikes when the stock, high-yield bond, and oil markets came under pressure.

A Fed led by Trump appointees may be less inclined to ride to the rescue of the financial markets, if and when the inevitable selloff hits, some market veterans suggest. In options terms, the Fed put is further out of the money, says Eaton Vance’s Stein, meaning it will take a far bigger hit to prices before the central bank reacts.

Under new leadership, the Fed also may see less unanimity and more independence. Building a consensus was seen as important under Bernanke and Yellen. But, says James Bianco, head of Chicago-based Bianco Research, more-independent-minded Trump appointees might be more inclined to dissent from policy decisions, as is typical at other central banks, such as the Bank of England and the Bank of Japan.

DESPITE TRUMP’S kind words for Yellen and his satisfaction about the stock market’s records reached on her watch, the president more than likely will prefer one of his own men at the Fed. Amid reports the president had settled on Powell, his odds of getting the Fed job jumped to 77% on betting site PredictIt.org Friday, with Taylor’s odds dropping to 20% and Yellen at 8%.

Even assuming six of the seven Fed Board members are named by Trump, monetary policy in the short and medium term is unlikely to deviate much from its anticipated course. The futures market is betting on an even smaller rise in rates than the modest increases the FOMC anticipates. The shrinkage in the Fed’s balance sheet is supposed to proceed so uneventfully that Yellen says it should be like watching paint dry.

(Don’t forget the European Central Bank and the Bank of Japan will still be buying and adding to global liquidity while the Fed redeems securities.)

The real test of Fed leadership will come when the winning streaks for the economy and the financial markets finally run out. In a speech the Friday before last, Yellen suggested extraordinary measures such as QE and zero interest rates may be needed in the next downturn, even if it is not nearly as severe as the 2008-09 crisis.

Would a Powell-Taylor Fed do likewise? And if not, would that be better or worse? That’s the uncertainty being introduced into the current placid markets. 


Getting Technical

FAANG Stocks Take a Bite Out of the Bears

Good earnings push Amazon, Alphabet, Microsoft, and others to technical breakouts.

By Michael Kahn              


Getty Images
 
 
Just when the bears thought it was safe to take a peek out from their dens, leading technology companies shred earnings estimates and their stocks leapfrog back into the lead. While the broad market was healthy enough to forge ahead without big tech as other sectors came into their own, it certainly doesn’t hurt to have them back in rally mode.

If we look at last week’s action in the group of leading tech stocks known as FAANGs or FAAMGs, we should be quite impressed. These acronyms include various combinations of Facebook (ticker: FB), Apple (AAPL), Amazon.com (AMZN), Netflix (NFLX), Microsoft (MSFT), and Google parent Alphabet (GOOGL). (I might substitute graphics chip maker Nvidia (NVDA) for Netflix based on its superior performance over the past two years.)

Thanks to great quarterly earnings results, both Amazon and Alphabet soared above resistance levels and back above the $1,000 share level (see Chart 1). In fact, Amazon shot the bears’ argument—that the stock was in the midst of a giant head-and-shoulders topping pattern—to pieces. If that were true, it was heading for at least an 11% drop from the bottom of the pattern near $935 to the $825 area. The stock traded at $1,108 Monday afternoon.

Chart 1



 
In technical analysis, failed bearish patterns are often bullish signals.

There is a caveat: All of these stocks are well into their bull runs. Amazon, for example, is up over 46% year to date.

Microsoft, which also beat its earnings expectations last week, leapt higher from what already were overbought conditions (see Chart 2). Up nearly 35% this year, the stock now trades well above its short-term moving averages, making it especially prone to a “reversion to the mean” snapback decline. That does not mean the bull run is over, but it could easily drop 5% before new buyers see any gains.

Chart 2



 
Further, the odds that Microsoft’s gains were thanks to a final blow-off of buying, also known as capitulation of the bears, are not trivial. The jump, or gap, higher last week may turn out to be an exhaustion of demand. The problem is we can’t determine that right away.

If the stock holds its ground for a few days, then it is quite possible it is just resting before pushing even higher. But if it gives up a large chunk of its gains, then we have to think the stock is exhausted and in need of a long rest or pullback.

Even without specific earnings news, Facebook soared last week to break out from its own trading range (see Chart 3). The technicals are quite compelling, from getting back above the important 50-day average to very heavy volume on the breakout move to solid momentum readings. This is a welcome development for a stock already sporting a more than 54% gain on the year.

Chart 3



 
Emotionally, it may feel right to think that this market—and these big tech stocks in particular—are in dire need of rest. And after the bearish key reversals seen one week ago, it does seem that the time is right for a marketwide pullback. Events outside the market itself, including investigations in Washington and the specter of higher interest rates from the Federal Reserve, provide convenient excuses for stock declines.

But breakouts on the charts are breakouts. Plus, new highs Friday negated the big reversals we saw last week in the Standard & Poor’s 500 index and the Nasdaq Composite.

To be sure, no breakout is a guarantee of further gains. It is always possible for the market to change its mind on a stock or index. Indeed, Monday’s midday weakness a direct result of the disappointment over possibly not getting a swift and comprehensive tax cut. (The House reportedly may phase them in over a five-year period.)

While technical breakouts sparked by better-than-expected earnings are positive signs, we always have to be on the lookout for negative developments. I outlined some of them here last week, including the two-month trendline on the S&P 500, market breadth, and money flows.

Some of these indicators got dinged a bit last week, but all are still intact for the bulls. And even if they do fold and the market pulls back, there are still no signs yet that a major decline is in the works.


Michael Kahn, a longtime columnist for Barrons.com, comments on technical analysis at www.twitter.com/mnkahn. A former Chief Technical Analyst for BridgeNews and former director for the Market Technicians Association, Kahn has written three books about technical analysis.


Mnuchin’s Warning

by John Authers


Steve Mnuchin, the US Treasury secretary, says that stocks will fall if Congress does not pass tax reform. This manoeuvre is a little bit like a spoilt little girl threatening to cry unless she gets what she wants.




Should members of Congress be intimidated into giving Mr Mnuchin what he wants? He contends that there is “no question that the rally in the stock market has baked into it reasonably high expectations of us getting tax cuts and tax reform”.
 
It is debatable whether he is right about this. The most direct method to do this, comparing high-taxed companies to low-taxed companies, suggests that faith in a tax cut has dribbled away almost entirely.





If we look at US performance relative to the rest of the world, we see that it is lagging slightly since election day (when a corporate tax cut suddenly became a viable prospect). There is no sign here that anyone is banking on the US getting any advantage beyond the pick-up in global growth:





But if we look at the relative performance of smaller companies (seen as the greater beneficiaries of a tax cut), there is a clear improvement in hopes in recent weeks.




And it is plain that something other than earnings is driving share prices. Capital Economics last week published this assessment, which tends to support Mr Mnuchin's scare tactics:

Although the Republicans’ proposals would raise aggregate S&P 500 earnings, this boost may have already been largely priced into the market. After all, we estimate that the median effective tax rate paid by companies in the index last fiscal year was nearly 28%. If it had been 20%, operating earnings per share would only have been about 10% higher. The S&P 500 has already risen by more than that so far this year.

This “back of the envelope” calculation is clearly very simplistic. But we find it hard to see why the S&P 500 should continue to rise sharply, given that much of its strength so far in 2017 appears to have relied at various times on the prospect of tax reform, the passage of which remains uncertain.

 
Finally, stocks are being driven by more than earnings. This is how the historic price/earnings multiple has moved since election day.



As for prediction markets, where political wonks use real money to wager on an outcome, the outlook does not look good. This is how the Predictit market's estimation of the chance of a corporate tax cut by the end of the year has moved over the last three months:





There are different ways of looking at this, but I still concur with what a majority of people on the Street seem to think. The risks are broadly symmetrical; a successful tax cut would create as much upside as a failure would create downside. If anything, the implicit odds are less than 50 per cent.

Between BlackRock and a hard place



BlackRock have done their best to make the case that market-cap indexing is not distorting markets.

Most importantly, there is nothing new about high levels of correlation. They were higher in the 1930s, long before indexation was even thought of, than they are now. And indeed correlations have actually fallen post-crisis as money has flooded into passive funds.



BlackRock is also keen to point to the low turnover of passive funds compared to their active equivalents. This implies that they are not setting prices at the margin.



I would like to add one footnote to this, however: the total market cap of the US stock market is currently about $26.6tn. US ETFs hold assets of $3.075tn, according to ETFGI. So according to the data, trading volume of stocks is not quite triple that of ETFs, while the total value of stocks is more than eight times that of ETFs. The whole point of ETFs is that they can be traded through the day, which is not a traditional aim of "buy-and-hold" index investing, and it would appear that ETFs have, indeed, encouraged more people to trade through the day.

At least one of BlackRock's exhibits seems to me to argue against the notion that indexing is not distorting markets. It shows that the most successful active funds are still taking in money:



Thinking about this, I am not sure why BlackRock thinks this improves their case. First of all, there has always been a problem with returns chasing, with investors blatantly putting money into whatever manager or sector has been hot recently. We all know that indexing has been handily beating most active funds, and so a lot of the appeal of indexing is, I suspect, a sub-set of returns chasing, rather than a new sober approach to buy-and-hold investing, with no attempt to pick winners. These numbers emphasise that returns chasing continues.

Further, a net $108bn has been removed from poorly performing mutual funds, which were presumably somewhat more invested in losing stocks than were the index. That has substantially all gone into ETFs. That means, at the margin, that money has flowed from recent losers to the recent winners — which is the very definition of momentum. Also, the mutual funds that suffered outflows held far more cash than the ETFs they moved into — probably a good three percentage points more.

So that transition meant a net $3bn or so moving from cash to equities.

Momentum has always been around, and investors have always been inclined towards herding, and chasing the hottest recent performance. It looks to me from this data as though indexing is exacerbating these flaws.

Hawks, beige in tooth and claw

The Fed's Beige Book, its relatively subjective and anecdotal tour of conditions in the different Fed branches, is out. Big Data techniques, searching for words and patterns, make it easier than it used to be to discern a message.

What we can say about this Beige Book is that, first of all, perceptions of the overall strength of the economy continue to be upbeat, and have improved a little of late. This chart is from RBC:




Meanwhile, the Fed is as worried as ever about tightness in the labour market. This could in the long run, via the fabled Phillips Curve relationship, translate into inflation as workers are able to bid their wages higher. The degree of concern may have dipped in the latest edition of the Beige Book, but the trend remains firmly upwards. The Fed's governors are worried about a tight labour market:



In all, the Book tends to confirm the impression of a Fed predisposed, but not convinced, to err on the side of the tightening. The odds are still on a rate rise in December. Some surprisingly bad numbers for wage growth could still change that.

Dow 23k

The Dow Jones Industrials has passed another round number today. The landmarks come quicker as a smaller percentage gain is needed to reach them. How to remember this latest round number? Here is a good mnemonic for British readers:



And American readers, if you are not quite sure who David Beckham is, you probably do recognise this guy:



The number 23 associates itself with some great and successful athletes. Beyond that, there is no other reason to care about this landmark.


The Resistible Rise of Xi Jinping

China's president radically changed his country, and the Communist Party, through skill, determination — and a series of lucky breaks.

By Special Correspondent


 
China’s 19th Party Congress began Wednesday with a three-and-a-half-hour speech by Xi Jinping, a telling sign of a man who knows he has to be listened to. The general secretary of the Chinese Communist Party — usually referred to in English by his far less important title of “president” — is the heart of a weeklong love fest in Beijing as officials gather to determine the makeup of the leadership for the next five years and more.

But Xi’s power in office reaches far beyond the assembled delegates in the Great Hall of the People. Xi has near-absolute command over the ruling party and, through it, a state of 1.3 billion people, a 1.6 million-strong army, and an $11 trillion economy. The United States is still richer and stronger, but the office of the U.S. president — even when the officeholder is not deemed a “moron” by members of his own cabinet — is far more radically limited than the position held by his Chinese counterpart. Xi’s rule has tightened the grip of the party on his country and slashed away space for any opposition. While his predecessors, Hu Jintao and Jiang Zemin, struggled to make their authority felt, even before formally assuming office in 2013 Xi was purging his foes. Under the rules of the party, he’s about to reach the halfway mark of his term — but there’s a growing consensus that power in 2022 will stay in his hands, with no appointed heir in sight.

But Xi’s rise was not inevitable. The speed and range of his purges depended partially on his own political skills but far more critically on opportunities offered him by the rest of the party.

Xi arrived at the party’s highest echelon at a moment of growing paranoia — triggered by public discontent about rampant corruption, deepened by the revolutionary Arab Spring in 2010, and reinforced by the Ukraine rebellion of 2014. Xi represented the possibility of deliverance for China’s autocratic, but consensus-based, political system — and a promise to protect it against any opponent, including Xi’s main rival in the Communist elite, Bo Xilai. Bo’s fall in 2012 gave Xi the momentum he needed to create a rolling attack on his foes that left him the only man who mattered.

And so Xi managed to thoroughly change the party — imposing absolute security and receiving absolute control — largely, if paradoxically, because he did so in the course of allegedly preserving it. Absent the paranoia-inspired acquiescence of his party colleagues, and the opening provided by Bo’s unforeseen fall, Xi would almost certainly still be president of China — but hemmed in by political rivals, restricted in his use of the party’s security machinery, and limited in his ambitions.

Before we go on, a caveat. The party’s code of omertà is tight, and the outside world’s knowledge of what happens behind the palace moats of Zhongnanhai, Beijing’s Kremlin, minimal. Reliable information has become even harder to come by in the age of Xi, where the fear of talking to media, and especially to foreigners, has become more acute than ever. Tales of the leadership — including entire alternate histories promising supposedly hidden truths — circulate online and among the Chinese dissident diaspora, but most of them are fantasy. This account relies on private conversations with insiders, media accounts, and the opinions of foreign experts to create a rough first sketch of a history that may never be fully revealed. Yet the outlines of the story are clear, as is what they mean for the future direction of the world’s largest country.

China's President Xi Jinping delivers a speech at the opening session of the Chinese Communist Party's Congress at the Great Hall of the People in Beijing on Oct. 18. (Nicolas Asfouri/AFP/Getty Images)
                      

Xi’s ascent to the role of general secretary was fixed in 2007 at the 17th Party Congress, when his position as heir apparent was solidified. The horse-trading around this was part of a semicodified system of succession going back to 1989, when Jiang Zemin became general secretary following the Tiananmen massacre. Hu Jintao became Jiang’s heir apparent in 1997 and took on the role in 2002. Stability, as ever for the party, was paramount, but there was also a belief in rule by consensus and committee — at the top.

By the late 2000s, however, there was a strong feeling among the Chinese elite that Hu’s administration had been a failure. Despite the nominal ease of the succession, Jiang had never abandoned his desire to keep power in his hands, holding on to key military roles until 2005 and working through his political allies to hamstring his successor. Hu, once able to do a passable imitation of a human being, had become increasingly robotic, barely a presence in the public mind despite his constant unsmiling appearances on stage.

By 2007, Hu’s weakness had set up Xi’s strength; he was expected to be a more assertive, confident, and charismatic leader when he took over in 2012 — but still a party man to the core, one who had risen steadily through the system and was expected to serve it. By 2017 he’d pick a clear heir of his own, establishing a new generation of leadership to continue these traditions. But he would not be ruling alone; instead, he’d be guided, and constrained, by a range of other top figures on the Standing Committee, the seven to nine men who would make up the core leadership, and in the 25-seat Politburó.

Foreign observers often look for familiar patterns of “reformers” and “hard-liners” within authoritarian states. But the most important ties in the party at the time had very little to do with ideology. Instead, they were determined by affiliation: who you had come up with, served under, and were patronizing yourself. And so Xi’s new Politburo would be expected to include allies of Hu, Xi, and even the cadaverous Jiang.

The biggest challenge for the new administration would be rampant corruption, from the petty extortion of street vendors through to enormous payoffs for political influence and the wholesale ransacking of state resources. In percentage terms, Chinese corruption’s worst point had been the 1990s. But even if corruption had been slightly curbed since then in relative terms, in absolute ones China’s economic boom meant that the sums of money involved had become eye-bogglingly large, with scandals running into the billions of dollars.

From the party’s point of view, corruption was rotting the public’s faith and crippling the nation. From the point of view of most members of the party, however, if everyone else was getting rich, then why couldn’t they? Even a cursory glance at China’s new social media revealed that officials were seen as skinning the people, not serving them. Worst of all, the military itself was rotten — to the extent that a war, even a small one, could become a disastrous failure. The authorities were jailing 10,000 officials a year on corruption charges, but that was a droplet in a river. Helicopters were disappearing from bases, sold off to private firms; thousands of army license plates were flogged off to truckers so that they could avoid roadside tolls; and military officers — who had officially been told to get out of private business entirely a decade before — were running condom factories and Beijing nightclubs.

One reason why corruption was on everyone’s mind, though, was that the spaces available to talk about it had broadened. It can be hard to distinguish how much of the limited online and press openness of the late 2000s was deliberate policy and how much was laziness and indifference within an increasingly corroded system. But for some thinkers in the party, openness was seen as the solution to corruption. Online supervision of lower-level officials by the public, combined with more freedom of the press, would eliminate the rot at the bottom — while remaining carefully limited from going further. Chinese bloggers became adept at pointing out Rolexes on the wrists of city officials supposedly paid less than $1,000 a month.

Even those deeply embedded in the system felt the need to talk in this language: “We want democracy and an open press in China,” a prominent nationalist provocateur claimed in private conversation. “But we have to go slowly, slowly. China is a complicated country.”

The Arab Spring put an end to these ambitions. An already present paranoia about Western cultural infiltration was given new life by the scenes at Tahrir Square. “Color revolution,” already a concern after the Central Asian revolts, began to grip the Chinese leadership’s imagination. The country’s founding legitimacy rests on revolutionary martyrdom — but it’s also twice been threatened by passionate (and unemployed) youth taking to the streets, in the Cultural Revolution and in the Tiananmen protests. That gave the scenes from the Arab world an extra edge and made the threat posed by revolt a tangled one: It had to be both discredited as a Western-backed, insincere form of revolution and sincerely crushed.

A few posts by online exiles about a “Jasmine Revolution,” a call for protest that never materialized, prompted a massive upping of security in Beijing. Chinese officials were prone to exaggerating the capabilities and role of U.S. intelligence in these events. “The Green Revolution was just caused by CIA spies!” one yelled down the phone when his account of how much the Iranian people loved their government, based on a weeklong trip, was questioned. Yet Edward Snowden’s revelations about the extent of U.S. capabilities further escalated the sense of threat from the West — as did the discovery and elimination of an extensive CIA network between 2010 and 2012. A renewed urgency about the reach of the West, and the need to reassert the dominance of the party, began to seize the leadership.


 Then-Chongqing Municipality Communist Party Secretary Bo Xilai attends a meeting during the annual National People's Congress at the Great Hall of the People on March 6, 2010 in Beijing, China. (Feng Li/Getty Images)

                
A security state demands a strongman to lead it. Yet by early 2012, it wasn’t Xi who worried the country’s liberals most but one of his rivals — the consummate politician Bo Xilai. Like Xi, Bo was a scion of red aristocracy; their fathers, Bo Yibo and Xi Zhongxun, had helped forge the revolution, fell in the chaos of the 1960s, re-emerged under Deng Xiaoping, and then worked hard to promote their sons’ careers. Both had divorced their first wives and made advantageous marriages: Xi to the celebrity army singer Peng Liyuan and Bo to Gu Kailai, the daughter of a revolutionary general and a prominent lawyer.

Bo’s campaigning for higher office had initially been seen as gauche, but his publicity skills proved better suited to the 2000s, as the internet and the rise of a less controlled media opened up new means of campaigning that eluded most of Bo’s peers. Bo’s TV-friendly good looks and smooth talk were as winning to foreign politicians as they were to Chinese crowds.

As party chief of Chongqing, one of the country’s largest cities, Bo was in the national papers almost daily — a rarity for a provincial leader. He arrived in 2008 with a blaze of furious activity, running a highly publicized anti-gangster campaign that purported to have ended organized crime in the city. Bo followed that cleanup with an extensive cultural campaign, ordering “frivolous” shows off the air in prime time to be replaced with party propaganda (and crashing ratings) and organizing mass singalongs to “red songs” — a mix of revolutionary classics and modern patriotic numbers. It inspired imitations throughout the country — and won lengthy praise from Xi himself on a Chongqing visit in 2010. In 2011, it became an official part of the party’s 90th anniversary celebrations.

Alongside the cultural campaign, a simultaneous expansion of public services, new parks, and urban housing made Bo genuinely popular in the city. Journalists, academics, and other officials rushed to praise the “Chongqing model,” incentivized both by a belief that Bo was the coming man and by the all-expense-paid (plus a few red envelopes) trips that the city administration offered. Even Henry Kissinger, a national hero in China for his role in Richard Nixon’s 1972 visit, blessed Bo at a red songs event before a crowd of 100,000 people.

All of this worried both China’s embattled liberals and Bo’s rivals within the party. Dissidents and intellectuals saw the red songs as an unhealthy reminder of Cultural Revolution fervor. His peers saw him as dangerously charismatic and ambitious and a potential threat to the established consensus-based order, where politicking was supposed to be a matter of backroom deals, not open campaigning. There were hints that Bo might even be able to overturn Xi’s succession. At 63 in 2012 — four years older than Xi — he wasn’t able to wait for a chance at the top job. “Bo would almost certainly have been elevated into the standing committee and then he would have been untouchable.… That was a very frightening prospect for his rivals, who thought of him as a Hitler-like figure,” a senior Chongqing official told the Financial Times in 2012.

At that year’s 18th Party Congress, fixed as usual for the autumn, the stage seemed set for Bo to join the ranks of China’s most powerful men in the Politburo and to provide a permanent counterweight to Xi. And then it all came crashing down — and opened up a chance for Xi to rule unchallenged.

A screen shows a video of Gu Kailai, wife of ousted Chinese Communist Party Politburo member Bo Xilai at the media room for Bo Xilai's trial on August 23, 2013 in Jinan, China. (Feng Li/Getty Images)
 
 
On Feb. 2, 2012, Wang Lijun, Bo’s brash police chief, was suddenly demoted to a minor position. On Feb. 6, he turned up at the American consulate in Chengdu, 200 miles away from Chongqing, begging to be given political asylum. Bo’s wife, Gu Kailai, had, Wang claimed, murdered a British businessman and fixer, Neil Heywood. The Americans were firm, though; there was no way they could give Wang refuge — especially with Chinese police surrounding the consulate. A day later, he was on a first-class flight back to Beijing, accompanied by the vice minister of state security.

Whatever really happened, Wang’s very public flight gave Bo’s rivals, especially Xi, a golden chance to take him down. By March 15, he was out as party chief; by April 10, he was officially under investigation. He languished in detention for more than a year before charges were officially brought the next July, culminating in public show trials for him and his wife alike.

Tens of thousands of people had hitched a ride on Bo’s bandwagon, and now the scrabble to get off left many of them trampled underfoot. Ambitious underlings sent clippings of their bosses’ praise of Bo to the authorities. Regular pundits disappeared from the opinion pages for a while, like expert sycophant and “top journalism educator” Li Xiguang, who had made the mistake of praising Bo too loudly. (Like many others, Li would re-emerge a couple of years later with his tongue ready for Xi’s broad posterior.)

Gu Kailai became “Bogu Kailai” in reports, a linguistic aberration something along the lines of saying “Mrs. Bill-Hillary Clinton.” There were wide speculations that this was a deliberate attempt to remind everyone of Bo’s culpability. But the real answer lay in the desperation to prove that you were on the right side — especially among journalists who had heaped fulsome praise on the Chongqing model. “It was a misprint in a piece of Xinhua [the state news agency] copy,” an experienced Xinhua reporter claimed. “And then everybody imitated it because they thought it must mean something — and then nobody could stop.”


A screen shows the picture of the sentence of Chinese politician Bo Xilai (Center) on September 22, 2013 in Beijing, China. (Feng Li/Getty Images)
                      

Bo’s purge had been technically initiated under Hu’s auspices. But that made it the perfect cover for Xi to move against other potential opponents — and to carry out his own version of Bo’s policies at the same time, putatively in service of the party’s integrity rather than his own personal ambition.

Even as the “Chongqing model” was officially discredited (and Xi’s own praise for it erased from media archives), Xi was imitating his former enemy’s techniques. He entered office with a promise of national cleanup, sparing neither the great (“tigers”) nor the petty (“flies”). Unlike previous campaigns, retired officials, civilian and military alike, were in the crosshairs despite being theoretically out of the game. Like Bo’s gang crackdown, the anti-corruption campaign was broadly popular among a public increasingly fed up with the vagaries of bribery — although it was hard to distinguish genuine enthusiasm from the mandatory praise of the leader’s schemes. And, at least at first, it was also popular among a party establishment desperate for a renewed sense of order and public legitimacy.

Perhaps the most significant scalp claimed by Xi in his early years was that of Zhou Yongkang, a powerful deal-maker under Hu who had retired from his post on the Standing Committee in 2012. After Bo’s fall, rumors about his ties to Bo circulated widely, possibly prompted by Xi himself. “Bo and Zhou were nowhere near as close as claimed,” the daughter of one of Zhou’s fallen allies said.

“But Xi wanted to link the two of them together so that he could go after Zhou.” In the year before Zhou’s own arrest was announced, his appointees were systematically accused of corruption and removed from office. Ling Jihua, a close ally of Hu’s, was another early victim, rendered particularly vulnerable when his son died in a Ferrari crash the same month that Bo fell — another stroke of luck for Xi. Senior army officials, once thought untouchable due to the military’s fierce resistance to any inquiry into its own ranks, were also hit — one literally arrested in his hospital bed.

Xi’s weapon in this campaign was the Central Commission for Discipline Inspection (CCDI), the party’s internal watchdog. He put his close ally Wang Qishan in charge of it, a friend since childhood and former colleague. Before the arrival of Wang, the CCDI had been much more limited in who it could target, wary of offending the powerful and circumscribed, in particular, by the feared Ministry of State Security. But it had been closely tied to Zhou, and several of its former ministers and vice ministers were among the first to be reaped. It was the CCDI that now gave officials bad dreams.

The CCDI’s procedural tool was shuanggui, the rapid seizure and isolation of suspects in order to prevent them from contacting their own networks of power. It literally means “double designation,” referring to the official notice to appear at a “designated time and designated place.” In practice, it was quasi-legal kidnapping, carried out under the authority of “party discipline.” A CCDI team would turn the wing of a local hotel into an improvised detention center, where they would force confessions — and information on other targets — out of their subjects using every means possible, including torture. By 2013, the purges had become so widespread that the major state-owned oil enterprises established a routine of calling senior staff in the early morning to check that nobody had disappeared into detention overnight.

In ordinary times, those targeted would have been able to fight back, drawing on the wealth of personal friendships, mutual blackmail material, and institutional loyalties that every Chinese leader accumulates on the way up. But back-footed by Bo’s fall, and their networks disrupted by the numerous retirements, changes in title, and prosecutions that had followed, they were never able to mount any kind of resistance. Chinese political plotting requires getting people from across a vast country together in the same room — surveillance makes communications too risky to use. But the very act of getting high-ranking officials together, outside of approved occasions, could now be taken as evidence of a conspiracy. Previous purges, although frequent, had been followed by a cooling-down period, an ebb and flow that gave the chance for recovery and resistance. But the shock and awe of Xi’s campaign never let up.

Xi’s crackdown did curb much of the mid-level corruption and especially the wild banqueting and brothel culture that had become the norm among officials and businessmen. But referring to it solely as an anti-corruption campaign misses the point. There was no doubt that many — virtually all — of those who had fallen had been corrupt. But so had everyone. Chinese government salaries had fallen far behind inflation, so even with the packages of benefits that came with the post it was impossible to keep up one’s neighbors without taking something on the side. And an official who insisted on being clean would be seen as either dangerously naive or up to something, a Frank Serpico among dirty cops. Xi’s own family had accumulated billions of dollars.

Perhaps the fallen had been a little dirtier than most. But those picked for sacrifice in the campaign, however, tended to come from areas where Xi’s rivals had strong power bases: the southern provinces, especially Sichuan; the energy sector; and the army. Not that the inequities of Xi’s approach made any difference to the public, which was pleased to see high officials receive any comeuppance at all. “Oh, they all sing the same tune,” a guard at the Tangshan Prison said wearily, describing the fallen party officials he now oversees. “‘Everyone was doing it. Everyone was taking money. I was just unlucky, poor me.’”

People walk past a poster featuring Chinese President Xi Jinping with a slogan reading "Chinese Dream, People's Dream" in Beijing on Oct. 16. (Greg Baker/AFP/Getty Images)
 
                      
The other plank of Xi’s new program was the reassertion of total party dominance over all sectors of public life, especially over policing its own people. When Xi arrived, there had been the usual wide-eyed speculations that he could be a new Mikhail Gorbachev. His Western enthusiasts pointed to his time in Iowa as a sign that he must be eager to embrace the wonders of freedom. But it turned out that a lifetime spent as the heir to a Leninist party was more influential on Xi’s thought than two weeks among the cornfields. The paranoia of Western infiltration and rebellious youth prompted by the Arab Spring gave Xi unrestrained access to the full possibilities of China’s security state, turned against both his foes inside the party and the party’s potential rivals in civil society.

Again imitating Bo’s Chongqing techniques, he began a mass roundup of potential critics and a freeze of civil society. 2012 immediately saw an assault on Weibo, the country’s most popular microblogging platform, which had become a way for journalists to call out (suitably minor) corrupt officials and for thinkers to post calls for reform. The “big Vs” of Weibo (the equivalent of Twitter’s blue-checked “verified accounts”) were silenced, either banned from the service or scared off after several of them were forced into televised confessions of wrongdoing. Human rights lawyers, once given a limited space to operate, were shut down or arrested. A new NGO law was introduced, modeled on Russia’s, that limited the ability of organizations to receive foreign funding and scared many into closing. Foreign textbooks were forced out of Chinese universities. The newspapers became an endless drumbeat of praise for Xi mixed with territorial jingoism.

Each of the campaigns fed into the other. Since the primacy of the party was at stake, resisting Xi’s purges could be framed as treason. Meanwhile, the fall of the great was rupturing local networks and kicking the brutally Darwinian political economy of Chinese officialdom into high gear. Ideological vehemence was necessary, not just to show allegiance to the new leader but to prove that you were doing something, anything, to justify your post. And the easiest thing to do was to pick on acceptable targets, like feminists, fans of yaoi, churches, and ethnic minorities — and remind them just who was in charge.
 

A paramilitary policeman stands guard in front of the portrait of China's late communist leader Mao Zedong in Tiananmen Square during the opening ceremony of the 19th Communist Party Congress in Beijing on Oct. 18. (Greg Baker/AFP/Getty Images)
                      

Both these campaigns are still going on. Fresh scalps of public officials were culled just before the Party Congress. The political situation remains frozen, the language of media and academia stilted and sycophantic. Unauthorized contact with foreigners is understood to be dangerous for anyone in a position of power. Sources who would once go on record now speak anonymously; those who always preferred cover now won’t speak at all. The government is doubling down on big data, offering the possibilities of a surveillance state that can trace every purchase, movement, and online posting — or claim to, at least.
 
In the run-up to the Party Congress, Xi has been given a prominence far exceeding any Chinese leader since Mao Zedong. Even when he was general secretary, it was very easy to forget that Hu Jintao existed; late at night, Hu himself might have had doubts. But Xi is everywhere — slogans, posters, daily television. The contrast in visual imagery between the blank-faced Hu, never allowing an iota of emotion to slip, and the easily confident, in-command Xi is startling.

New slogans now circulate with Xi’s name attached in a way that Hu’s own effort, the “harmonious society,” never managed. “Xi Jinping’s Chinese dream.” “Xi Jinping’s Belt and Road Initiative.” Some of this was mandated, but much of it is voluntary, eager signaling by everyone from academics to businesses that they are on board. Xi’s name can be crammed into anything, no matter how irrelevant or insignificant.
 
What will Xi do with this power? There are still a few optimists who believe that economic reform is the next step, now that he has the power to override resistance. But all indications so far have been of the primacy of the party-state in the economy, just as in every other aspect of life — a fact reiterated by Xi in his opening speech at the Party Congress. As Americans have found since 9/11, it’s harder to wind down a security state than it is to crank it up.
 
As for how popular Xi genuinely is, it’s hard to judge; he certainly seems to have a strong base with the middle-aged homeowners who make up the central pillar of party support. Inside the party, things seem far less certain. One of the underappreciated achievements of Xi’s earlier predecessor, Deng Xiaoping, was to break the country out of the cycles of political revenge that had begun in 1949. Part of that bargain was the collective leadership system, upheld even by those temporarily at the top in the knowledge that the winds could change. Xi has snapped some, if not all, of the links that kept things from getting out of hand.
 
So now, even as they smile and grovel to survive, many inside the party are nurturing private hatreds — which means that Xi can ill-afford to let go of the power he’s taken into his hands, even if he gives up his official titles in 2022. In Chongqing and Dalian, nobody will criticize Xi directly — but they’ll still speak fondly of Bo, a coded indication of their feelings about the man who built his rule off their former favorite’s fall.
 
 
Top photo; China’s President Xi Jinping delivers a speech at the opening session of the Chinese Communist Party’s Congress at the Great Hall of the People in Beijing on Oct. 18. (Nicolas Asfouri/AFP/Getty Images)