No Mystery

Doug Nolan


January 30 – Financial Times (Sam Fleming): “After putting traders on notice six weeks ago to expect further increases in US interest rates in 2019, the Federal Reserve… executed one of its sharpest U-turns in recent memory. Leaving rates unchanged at 2.25-2.5%, Jay Powell, Fed chairman, unveiled new language that opened up the possibility that the next move could equally be down, instead of up. Forecasts from the Fed’s December meeting that another two rate rises are likely this year now appear to be history. Changes to its guidance were needed, Mr Powell argued, because of ‘cross-currents’ that had recently emerged. Among them were slower growth in China and Europe, trade tensions, the risk of a hard Brexit and the federal government shutdown. Financial conditions had also tightened, he added. Yet the about-face left some Fed-watchers wrongfooted and bemused. Many of those hazards were already perfectly apparent in the central bank’s December meeting, when it lifted rates by a quarter point and kept in place language pointing to further ‘gradual’ increases.”

The Wall Street Journal’s Greg Ip pursued a similar path with his article, “The Fed’s Mysterious Pause.” “Last December, Mr. Powell noted his colleagues thought they’d raise rates two more times this year, from between 2.25% and 2.5%, which was at the lower end of estimates of ‘neutral’—a level that neither stimulates nor holds back growth. On Wednesday, he suggested the Fed could already be at neutral: ‘Our policy stance is appropriate right now. We also know that our policy rate is in the range of the… committee’s estimates of neutral.’ If indeed the Fed is done, that would be a breathtaking pivot. Yet the motivation remains somewhat mystifying: What changed in the past six weeks to justify it?”

No Mystery. Don’t be bemused. The Fed Chairman was prepared to hold his ground, but the ground was suddenly giving way. Between the December 19th and January 30th FOMC meetings, acute systemic fragilities were revealed.

Not to dismiss economic weakness in China and Europe – or even tenuous U.S./Chinese trade talks and the government shutdown. But January 3rd was pivotal, not coincidently the wild market session ahead of Chairman Powell’s January 4th U-turn. Recall the currency market “flash crash” – with an 8% intraday move in the yen vs. Australian dollar, along with the dramatic widening of credit spreads (and a 19bps surge in Goldman Sachs CDS prices). Markets were careening toward dislocation.

Chairman Powell appeared somewhat downtrodden during his Wednesday press conference, a notable shift from his confident demeanor in December. We can assume Powell and other Fed officials have been alarmed by how swiftly booming securities markets succumb to instability and illiquidity. I believe Powell wanted to see markets begin standing on their own; that, in contrast with his three most-recent predecessors, he would be in no rush to come to the markets’ defense. He was content to see overheated markets commence the cooling process. A correction would actually be constructive for system stability. The predicament: Overinflated Bubbles don’t calmly deflate.

Circumstances forced the Fed’s hand. Old fears soon reemerged of escalating market instability getting ahead of the Fed. Better to act quickly before market/liquidity issues turned intricate and precarious. While not blatantly shock and awe, kind of along the same line. And responding to criticism of blurred messaging, the course of FOMC policymaking must appear coherent and decisive.

There will be no more rate hikes anytime soon. Now heeding market alarm, the Fed will also be reevaluating the runoff of its securities holdings. The Fed would prefer to convey that it remains “data dependent” in an environment of extraordinary uncertainties, while tepid inflation provides the Fed convenient cover for embracing “patience.” Well enough, but markets saw it for what it was: The Fed “caved” – just as the markets knew it would. No longer in doubt, the latest incantation of the “Fed put” is alive and well (irrespective of job or GDP growth). Indeed, the new Chairman’s hope for lowering the “put” strike price (Fed support not invoked before a significant market decline) was rather hastily quashed by acute market fragility.

There’s really nothing like a short “squeeze” to get market speculative juices flowing. How about a synchronized global squeeze across myriad asset classes? Only weeks ago, global markets were alarmingly synchronized to the downside. Now it’s everyone off to the races – lockstep (seemingly inebriated). Stocks and corporate Credit; EM currencies, stocks and bonds; Treasuries, bunds and JGBs; Italian bonds; crude and commodities and so on.

Here in the U.S., “Stocks Wrap Up Best January in 30 Years.” The DJIA surged 1,672 points (returning 7.2%) during the month. The S&P500 returned 8.0%, robust gains overshadowed by the broader market. The S&P 400 Midcaps jumped 10.4% in January, with the small cap Russell 2000 rising 11.2%. The average stock (Value Line Arithmetic) gained 11.2%. The Banks (BKX) rose 12.4%, with the Nasdaq Financials up 9.7%. The Nasdaq Composite also rose 9.7%. The Goldman Sachs Most Short index jumped 12.5%. The Philadelphia Oil Services index surged 19.3%.

Some of the problem-children EM currencies bounced strongly. The South African rand gained 8.2% in January, the Russian ruble 6.6%, Brazilian real 6.2%, Chilean peso 6.0%, Colombian peso 4.6%, Thai baht 4.2%, Indonesian rupiah 3.0% and Mexican peso 2.9%. The Chinese renminbi gained 2.7% against the dollar in January.

Over the past month, local currency bond yields were down 137 bps in Lebanon, 93 bps in the Philippines, 50 bps in Russia, 47 bps in Brazil, 34 bps in Cyprus, 33 bps in Hungary and 21 bps in Mexico. Equities gained 19.9% in Argentina, 14.0% in Turkey, 13.5% in Russia, 10.8% in Brazil, 9.6% in South Korea and 9.2% in Colombia. Dollar-denominated bond yields sank 124 bps in Argentina, 100 bps in Ukraine, 50 bps in Turkey, 34 bps in Indonesia and 35 bps in Russia.

January was also a big month for European equities. Major stock indices returned 8.9% in Portugal, 8.1% in Italy, 6.6% in Spain, 5.6% in France, 5.8% in Germany, 6.4% in Switzerland, 8.2% in Finland, 7.6% in Sweden and 8.7% in Austria. January saw 10-year sovereign yields drop 15 bps in Italy, nine bps in Germany, 15 bps in France, 22 bps in Spain, 10 bps in Portugal and 46 bps in Greece.

An overarching CBB theme over the years (debated compellingly generations ago): the problem with discretionary policymaking is that a policy mistake leads invariably to a series of mistakes. The Powell Fed coming quickly to the markets’ defense was a perpetuation of flawed policy doctrine. Moreover, it’s especially dangerous for central banks to so conspicuously buttress the securities markets at this late stage of historic speculative Bubbles. Calming language has an effect akin to electric shock therapy.

Clearly, such actions only further embolden a marketplace conditioned to reach for returns – adopting leverage while disregarding risk. Financial and economic stability are only further undermined. Blatant support of Wall Street will as well further erode public trust in such a critical institution. During the previous crisis, central bank measures were seen as vital to stabilization. I fear they will be viewed as fundamental to the problem in the coming crisis.

The delusion was the belief that zero rates and QE would over time support system stability.

The “buyer of last resort” function during a time of crisis should never have morphed into the buyer of first resort for years of booming markets and economies. We’re now a full decade into aggressive stimulus, and global finance is more fragile than ever. Policy rates remain at zero and the ECB only recently ended its historic balance sheet expansion (to $4.7 TN). Yet economies throughout the Eurozone appear in - or headed toward - recession. Amazingly, despite a QE-induced collapse in market yields, Italy faces a recessionary backdrop with its fragile banks hanging in the balance.

Meanwhile, troubling data runs unabated in China. The Caixin China Manufacturing PMI dropped 1.4 points during January to 48.3, the low since gloomy February 2016. It was also the first back-to-back months below 50 (contracting manufacturing activity) since May/June 2016. To see China’s economy weaken in the face of ongoing rapid Credit growth should be alarming to the entire world.

January 27 – Bloomberg: “The number of Chinese companies warning on earnings is turning into a flood, with no industry spared from worsening demand. Some 440 firms disclosed on Wednesday -- the day before a deadline to do so -- that their 2018 financial results deteriorated… Of the more than 2,400 mainland-listed firms that have announced preliminary numbers or issued guidance this season, some 373 said they’ll post a loss, the data show. About 86% of those were profitable in 2017.”

In a globalized, digitized and serviced-based economy, I never viewed consumer price inflation as the prevailing QE risk in the U.S. For the U.S. and the world more generally, zero rates and Trillions of fabricated “money” have fomented interminable Monetary Disorder (on full display during the past two months). Once unleashed, there was no controlling it. Yet with global markets in a synchronized rally, one easily assumes the Fed and central banks have again worked their magic. Stability has engulfed the world. Nothing could be more detached from reality.

The world is in the throes of a precarious period. Ill-advised central banking has ceded a historic global market Bubble additional rope. Meanwhile, until something snaps it is reckless fiscal policies accommodated by ultra-low rates, along with the precarious market perception that central banks will have no alternative other than reinstituting QE. Central bank-induced Monetary Disorder has completely distorted sovereign debt markets, granting Washington politicians the proverbial blank checkbook. And it is worse than merely a marketplace devoid of “bond vigilantes.” Treasury yields are pressured downward by the fragility of global Bubbles and the expectation of aggressive monetary stimulus as far as the eye can see.

Reckless global monetary management fuels reckless global fiscal mismanagement. Here in the U.S., trillion-dollar plus federal deficits until the market invokes some discipline. And it’s all passed off as business as usual. If I were a bond, I’d be tense. Bailing on “normalization,” the Fed has essentially committed to perpetual loose “money” and stock market support. And in the event the risk market rally turns crazier, there’s just not much slack in the U.S. economy. Ten-year Treasury yields jumped six bps Friday (to 2.68%), although the more interesting move was the 16 bps surge in Italian yields (to 2.74%). Under the circumstances, gold’s $38 January advance was rather restrained.

To see securities markets – risk assets and safe haven alike – rally as they’ve done over recent weeks is something to behold. Sellers overwhelming the markets one month – buyers the next.

Legitimate fears of illiquidity supplanted by the utter fright of being on the wrong side of the market and missing a rally. The S&P500 recorded its strongest January since 1987. It’s an apt reminder not to place too much faith in the “January effect”- especially when global markets are acutely speculative. With Monetary Disorder and Dysfunctional Market Structure operating at full-force, no reason not to expect 2019 to be anything but a momentous year.

Capital raising by US oil companies falls sharply

Exploration and production sector has not had a single bond sale since November

Ed Crooks in New York


The US shale industry has relied heavily on debt to finance its growth, with exploration and production companies raising about $300bn from bond issuance over the past 10 years © AFP


Capital raising by US oil exploration and production companies has fallen sharply following the decline in crude prices that began last October, pointing to cutbacks in capital spending budgets and a continuing slowdown in activity.

Companies in the sector have not held a single bond sale since the start of November, according to Dealogic, while share sales have also slowed. The data suggest that after a record-breaking boom in US oil output in 2018, growth will be weaker this year.

The government’s Energy Information Administration has forecast that between December 2018 and December 2019, US crude production will rise by about 500,000 barrels a day. That would represent a sharp slowdown from growth of 1.8m b/d over the previous 12 months.

The US shale industry has relied heavily on debt to finance its growth, with exploration and production companies raising about $300bn from bond issuance over the past 10 years.

As crude prices started to slide last October, that source of capital was choked off, with just three bond sales by exploration companies that month, and none at all since November, according to Dealogic.




US benchmark crude dropped from a peak of about $76 a barrel in early October to about $42 at Christmas, before recovering to about $53 this week.

Ken Monaghan, co-head of high yield at Amundi Pioneer, the fund management group, said the rise in exploration and production companies’ debt yields had put off potential borrowers, with spreads over US Treasury bonds climbing from 3.9 to 7.5 percentage points at their peak before settling back to about 5.9 percentage points this year.

“No one wanted to issue debt unless they had to,” Mr Monaghan said. “At the peak, they would have been looking at yields of about 10.25 per cent. That’s awfully expensive.”

Henry Peabody of Eaton Vance, another fund management group, said that for the time being debt and equity investors were aligned in encouraging oil producers to pursue cash generation rather than borrowing more to pursue growth. “No one wants to get caught out over their skis,” he said.

Speaking on a panel at the World Economic Forum in Davos on Wednesday, Vicki Hollub, Occidental Petroleum’s chief executive, said US shale oil companies were being forced to react to an investor push for more spending discipline. “Not as much money is going to be pouring into the Permian basin,” she said.

John Hess, chief executive of Hess Corporation who was also on the same panel, said shale producers were now contending with a new financial climate. “The investor paradigm is changing.”

Weak share prices have also been a deterrent to capital raising. Share issuance by exploration and production companies has slowed sharply, with just $157m raised from equity sales in the past four months as the S&P oil and gas exploration and production sector index has fallen 29 per cent since October. There has not been an initial public offering of an oil and gas company for more than a year, and companies that were looking at possible flotations are expected to wait for markets to recover.

“We have a great IPO backlog, but not much IPO activity,” said Osmar Abib, co-head of energy at Credit Suisse. “We are getting ready, but owners are not going to go out at a substantial discount and give away value.”




With new capital constrained and cash flows squeezed by the weaker crude price, oil production companies are expected to rein in their plans for drilling and completing new wells. The number of rigs drilling oil wells in the US has already dropped by about 8 per cent since November to 889, according to S&P Global Platts Analytics.

Paal Kibsgaard, chief executive of oilfield services group Schlumberger, told analysts on a call last week that given a steady recovery in US crude prices to last year’s average of about $65 a barrel, it expected investment in onshore exploration and production in the US this year to be “flat to slightly down compared to 2018”.

The companies with the greatest access to capital are the big international oil groups, many of which have been building positions in shale oil and projecting steep production growth. Chevron said last month that about a quarter of its planned $20bn capital spending this year would go to the Permian Basin of Texas and New Mexico and other shale investments.

Merger and acquisition activity in the US exploration and production industry picked up sharply last year, with BP’s $10.5bn purchase of BHP’s shale assets the largest deal, and international oil companies could be buyers again this year, analysts and advisers say. Royal Dutch Shell has been reported to have been looking at buying privately held Endeavor Energy Resources, a leading holder of drilling rights in the Permian Basin.

Tim Perry, also of Credit Suisse, said he expected financial pressures to encourage further deals.

“Investors want bigger companies, so companies are looking for scale. Larger companies can get their development financed more efficiently,” he said. “There is a general recognition that the industry needs to consolidate.”


Additional reporting by Anjli Raval


Why The Fed Did Not Go 'Risk On' And What To Do Now

by: DoctoRx

 
Summary
 
- The stock market has taken the Fed's statements and Chair Powell's Q&A bullishly.

- I rarely object to a bull move in stocks, but I'm back to seeing matters as justifying a risk-off posture to the markets.

- A rationale for interpreting the Fed's positioning more negatively is presented.

- Treasuries may again be positioned to outperform equities, as they have done since I proposed that outcome in October.


What the Fed did and said Wednesday
 
Facts first, interpretation second, trading and investing thoughts last.
 
Here is the key part of what the Federal Open Market Committee's statement said Wednesday:
...the Committee decided to maintain the target range for the federal funds rate at 2-1/4 to 2-1/2 percent. The Committee continues to view sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective as the most likely outcomes. In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes.
Commentators noted that "patient" is a new word, and Fed-watchers watch for any word change such as this to divine changes in the FOMC's point of view of the economy.
 
What was less discussed and therefore may be more important to traders was this phrase:
... global economic and financial developments.
Putting in the term 'global' is very good news for US-based investors in my view, as I'll get to later.
 
But the above is not a 'risk on' move by the Fed.
 
There were two other key related statements put out by the committee. One was regarding the ongoing shrinking of the balance sheet:
Decisions Regarding Monetary Policy Implementation 
...The Committee directs the Desk to continue rolling over at auction the amount of principal payments from the Federal Reserve's holdings of Treasury securities maturing during each calendar month that exceeds $30 billion, and to continue reinvesting in agency mortgage-backed securities the amount of principal payments from the Federal Reserve's holdings of agency debt and agency mortgage-backed securities received during each calendar month that exceeds $20 billion. Small deviations from these amounts for operational reasons are acceptable.
So they are continuing to shrink the money supply by the same $50B per month. This is an ongoing 'risk off' story. Here is the second related statement, a rare if not unprecedented ancillary commentary by the Fed. This is of great importance, so I reproduce all the important text in its entirety (emphasis added by me):
Statement Regarding Monetary Policy Implementation and Balance Sheet Normalization 
After extensive deliberations and thorough review of experience to date, the Committee judges that it is appropriate at this time to provide additional information regarding its plans to implement monetary policy over the longer run. 
Additionally, the Committee is revising its earlier guidance regarding the conditions under which it could adjust the details of its balance sheet normalization program.  
Accordingly, all participants agreed to the following:
  • The Committee intends to continue to implement monetary policy in a regime in which an ample supply of reserves ensures that control over the level of the federal funds rate and other short-term interest rates is exercised primarily through the setting of the Federal Reserve's administered rates, and in which active management of the supply of reserves is not required. 
  • The Committee continues to view changes in the target range for the federal funds rate as its primary means of adjusting the stance of monetary policy. The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.
Since everyone knew the Fed was on hold for some time regarding the Fed funds rate, this is what really got stock traders excited. I will discuss the above statement in the next section.
 
Why the balance sheet statement is important
 
The Fed is agreeing with its critics that its now-abandoned goal of normalizing monetary policy represented medicine that was harming the patient. To wit:
 
In the good old days, meaning from the Truman administration on to the Great Recession, the Fed handled its role in the economy by adjusting monetary reserves in the banking system.
 
There were normally no (or almost no) excess reserves; the banks preferred to lend them out or else invest them in higher-yielding opportunities. So, the Fed did not have to "print" or remove much money quantitatively to affect interest rates; the system was finely tuned. Quantitative easing, the famous (or infamous, if you prefer) policy that the Fed copied from Japan during and after the Great Recession, changed that, forcing the Fed to directly control interest rates as it has been doing rather than work indirectly on a system with minimal to no excess reserves by simply buying or selling relatively small amounts of Treasury bills. So it's going to stay with the current system that appeared to be working well.
 
That is not 'risk on' either.
 
The longer bolded section in the second bullet point basically implies that the Fed is open to ceasing its balance sheet normalization much sooner than it had previously indicated. That's more of a risk-on story. What's being interpreted as risk-on is the further clear implication that the Fed is willing to do QE again, i.e. "use its full range of tools" if lower rates did not revive the US (and global?) economy.
 
Is that really risk-on? I do not see it that way.
 
Didn't the Fed continue tightening, and isn't the market celebrating the wrong thing?
 
My answers to my questions: yes; yes.
 
Monetary policy works with a long lag; Chair Powell explicitly acknowledged that several weeks ago. The lag is more than a year. So the last 4 or 5 interest rate increases are still slowing the US and therefore the global economy and will tend to do so for approximately 12 more months. The US is not an isolated island, and these are some headlines from Thursday:
German retail sales slump at fastest rate in 11 years; Italy in recession amid sluggish eurozone and China says its manufacturing activity contracted for the second-straight month in January.
All this is consistent with an OECD-defined global recession that may be underway right now. Also consistent with a recession is the plunge to now-ridiculous interest rates on high-quality 10-year government bonds across the globe. These include, as of Thursday night:
  • Canada = 1.88%
  • UK = 1.21%
  • Australia = 2.23%
  • New Zealand = 2.19%
  • Germany = 0.15%
  • France = 0.55%
  • Portugal = 1.61%
  • Switzerland = -0.31%
  • Japan = -0.02%.
 
At 2.64%, the US is a star, reflecting a good economy. Importantly, none of the above countries have active QE (bond-buying by the central bank) except Japan (to my knowledge). In fact, the European Central Bank spent last year tapering its version of QE and ended QE at the end of the year. Instead of rates increasing with the lack of the ECB as buyer, they have plunged.
 
When this is happening, the European economy is signaling some distress in my view. And when Canada, Australia and New Zealand, none of which ever did QE, are seeing such low and declining rates, I assume they are participants in a troubled global economy.
 
This is not a risk-on situation; neither is it an inflationary one. It bespeaks weakness, with risk aversion by banks that know much more than I and perhaps you do.
 
Even if the US economy is slowing, that is also not a risk-on status. What is risk-on is the opposite: the economy has slowed and troughed. and the Fed is stimulating it to do what it is ready to do without the stimulus, which is to expand again. This is different. The global economy may be in recession (which is not defined as absolute contraction on a global scale, just severe slowing in growth) and the Fed has neither lowered rates nor stopped (or even slowed) its pace of liquidity withdrawal.
 
So, what should investors do? Part 1, what I have done and why
 
Of course, I can't give investment advice, but as commentary, here's what I saw and laid out vociferously in October for anyone interested in my thoughts. I both criticized the Fed and switched my personal investment focus from both stocks and bonds to a heavy bond exposure.
 
For documentation and potential review by you, here are two of my Fed articles from October which criticized the rate hikes in conjunction with the reverse QE policy (which continues):
Yep, The Fed's Going Too Far, And Trump Has A Point: Analysis and Reign Of Error: What May Be Next Until, And When, The Fed Relents.
I continue to believe that the Fed erred in raising rates in December, that it erred in continuing to reverse QE, that it is erring in not lowering rates now, and that it is erring by not ending the reverse QE policy immediately.
 
As far what to do, I acted on this article from Oct. 12, where these were the key summary bullet points:
Why Lower Rates On Treasury Bonds Won't Be Good For Stocks
  • As shown, the reversal of QE now underway is taking hot money from the markets. 
  • While some think that lower rates on bonds are good for stocks, I believe that going forward, a bull market in one asset class means a bear move in the other. 
  • Thus as in 1999, I expect a stock bull market to coincide with rising rates (bear move in bond prices), and vice versa.

Since then, an ETF for the S&P 500 (SPY) has dropped from $277 to $270, a total return of about -2%. In contrast, a T-bond fund (TLT) with a long duration has risen from $114 to $122, a total return close to 8%. The delta in these 3 1/2 months has been 10 percentage points in favor of the long bond over the seemingly invincible SPY. And it required the help of the Plunge Protection Team beginning work over the Christmas holiday to get stocks back up this high. Absent the PPT, I think the outperformance of Treasuries would have been much higher.
 
If people ask me how I spent the second week of October, I would answer, selling stocks and buying long term bonds.
 
That was then.
 
What to do? Part 2, not going risk-on yet
 
What has fundamentally changed in the past several months?
 
It's the point the Fed made in its main statement, namely that the global economy has weakened and may be in recession. In that setting, the Fed has to either be on hold with rates or else cut them. If it does not cut short term rates, then the usual pattern would be for long term rates to decline. In one case or the other, high quality/safe haven US bonds tend to do well with price appreciation (lower yields) and the coupon. Accentuating that tendency is the ongoing fact that the Fed continues to force bank deposits and money market funds (which ultimately tie back to bank deposits) to buy $50 B per month of Treasuries and GSE debt that the Fed is unburdening itself of.
Here's an analogy for investors who think the Fed has gone risk-on, rather than just cooperating with the Plunge Protection Team. Let's look back at 2014, when the Fed was tapering QE 3. Everyone knew the stimulus was going to end, but the stock market still surged throughout the Taper, then stagnated as it ended.A 5-year chart of the SPY shows this:
Chart Data by YCharts

The SPY went nowhere from late 2014 to Q2 2016, with a downside bias. That's what happened when QE 3 ended.
 
Now think of today's reversal of QE 3 at full blast, a pace that only began in October last year, which not coincidentally in my humble opinion marked the top of the market. The very best I can say about the Fed's plans to retain a larger balance sheet than it had planned is that it might be analogous not to full-blown QE 3 (a 2013 event that sent the SPY straight up) but perhaps to the 2014 Taper.
 
Given this analogy along with the global economic situation, all the known worry points such as Brexit, US-China trade relations and the ongoing investigations of President Trump, I think the stock market has had a knee-jerk reaction and is vulnerable.
 
What to do? Part 3, bonds may still have more fun
 
Here's the dynamic I was pointing to in the Oct. 12 article about having finally flipped to favor bonds over equities:
 
When the Fed reverses QE, it shrinks the basic money supply of the US. Initially, this puts pressure on all financial asset prices, as there is less "hot money" around than there was due to full-blown QE. So it's anyone's guess as to what asset class would be in favor, but one thing I was pointing out almost all of last year was that cash was no longer trash. Cash was hated but it was getting scarcer and therefore more valuable. Thus I was not surprised that cash outperformed almost every other major asset class last year.
It could happen again for cash, but Treasury bonds are "cash-like." That is to say that they are guaranteed to turn into cash via revenues from taxation or from the magical electronic printing press of the Federal Reserve. They will turn into cash and they will pay interest as promised.
 
You can take that to the bank. But cash has limits as an investment. And by cash, I mean high-yield insured bank deposits, typically Internet-accessed, or money market funds. The general principle is that any investment that is virtually interchangeable with dollar bills that just sit in your wallet earning no interest is not really a good investment; it's just a placeholder. Interest rates might drop, and you have nothing. So, a Treasury bond becomes - in my thinking - the next asset to come into favor if cash strikes investors as played out, i.e. short term rates may stabilize and may drop.
 
What about the SPY? I think it's a tougher call with it back near $270. That puts it at 18X GAAP projected P/E based on consensus around $150/share for S&P 500 earnings this year. This is high given that after-tax margins in 2018 were the highest for any year since at least 2006, and by a good deal. If one adjusts for more normal after-tax margins, I get a P/E well above 20X. Given a global economy that may already be in recession, I find that unattractive.
 
But, on a trading basis, anything can occur, as we all know.
 
Summary
 
I disagree with the market's reaction that the Fed has caved to the stock market and has gone risk-on. Rather, I give a golf clap to Chair Powell and the FOMC for being alert enough to see that the global economy has weakened, and therefore the Fed needed to take a softer tone. It's only a golf clap, though, because I believe the Fed is already too tight, that it should not have raised rates in December and should never have engaged in reverse QE to anywhere near the $50 B/month level. Thus I'm keeping to a generally risk-off investment strategy until I have a clearer picture of the numerous moving parts to the current economic and financial scene.

As always, I am sharing my own thoughts and plans, expressing opinions and projections that may not work out well. Nothing herein represents investment advice of any sort; different points of view make for good two-way markets.


Canada: Caught in the Crossfire of the US-China Trade War

Canada’s arrest of a top Chinese executive landed Ottawa in the middle of a feud it wanted to avoid.

By Jacob L. Shapiro

 

Canada has found itself in the middle of two diplomatic spats over the past five months. In August, Saudi Arabia took exception to a Canadian Foreign Ministry tweet urging Saudi authorities to release jailed women’s rights activists. In response, Saudi Arabia withdrew its ambassador in Ottawa and suspended all trade and investment with Canada. A few months later, Canadian authorities arrested Meng Wanzhou, a top executive of Chinese telecom firm Huawei, at the United States’ request. After Meng’s arrest, China detained two Canadians, including former diplomat Michael Kovrig, accusing them of threatening China’s national security. This week, another Canadian was sentenced to death in China after a brief retrial for allegedly organizing a methamphetamine smuggling ring.

Canada probably didn’t intend to provoke a conflict in either situation. It’s hardly the first country to accuse Saudi Arabia of violating human rights – under normal circumstances the Foreign Ministry’s tweet would have been quickly forgotten. But these weren’t normal circumstances. Canada publicly criticized the kingdom in the midst of Crown Prince Mohammed bin Salman’s consolidation of power and ambitious drive to transform Saudi society – which hinged on cultivating an image of the crown prince as a reformer. In that sense, the tweet was inadvertently prescient. Canada had no way of knowing it would enrage the Saudi political establishment as much as it did or that Saudi agents would kill a Saudi journalist in a Turkish consulate and bring global attention to the kingdom’s human rights record just two months later.

As for China, Canadian authorities detained Meng not at Ottawa’s directive but because a New York court issued a warrant for her arrest on Aug. 22. While the U.S. hasn’t yet produced an indictment or formal request for Meng’s extradition (it has until the end of the month to do so), Canadian prosecutors said last month she was being charged with conspiracy to defraud banks. Meng is accused of not disclosing to banks Huawei’s links to another tech firm called Skycom, which was doing business in Iran that violated U.S. sanctions. Canada has plenty of reasons to be suspicious of Huawei, but on Meng’s arrest, it’s simply fulfilling its treaty obligations to the U.S. That this justification is unconvincing to China is a subtle reminder of the very real differences between Chinese and Western legal systems.

The Saudi issue is ultimately a minor one – Saudi Arabia represents less than 1 percent of Canadian trade, and whether Canada will continue to sell military equipment and vehicles to the kingdom will be based on domestic political considerations in Canada more than anything else. The China issue, however, is more complicated and potentially more consequential. Canada might have hoped to avoid getting involved in the U.S.-China spat. The Canadian economy is overwhelmingly dependent on the U.S. economy, and though Canada can’t eliminate that dependence, it can try to reduce it – in part with China’s help. Indeed, as recently as last November, Canada’s trade minister said a free trade deal between Canada and China was posible.

 


 
That might not be the case anymore, however. Unlike the U.S., Canada has elected to remain in the revamped Trans-Pacific Partnership, which was designed in part to limit China’s expanding global economic influence. In December, it was reported that spy chiefs from the “Five Eyes” intelligence alliance met in July in Canada to coordinate efforts to prevent Chinese-made equipment from being used in 5G mobile networks. (The U.S., Australia and New Zealand have banned Huawei equipment from being used in 5G networks, and the U.K.’s largest telecom company announced its intention to avoid Huawei last month. Canada is likely not far behind.) In November, Canada deployed the HMCS Calgary to the Western Pacific to participate in anti-China drills and has signaled its intention to keep up to two ships in the region year-round.

Canada is, therefore, already part of an emerging U.S.-led alliance to constrain Chinese power. China is seeking a temporary trade deal with the U.S., so it can’t afford to confront Washington directly right now, especially not while its economy is under increasing pressure. But Canada is a much smaller and weaker country than the U.S., and Chinese power might have more of an effect there. From China’s perspective, it was already facing an escalating trade conflict with the U.S. and a concerted campaign to block Chinese companies like Huawei from the global economy. Now Canada, of all countries, is arresting Chinese nationals. The excuse that it was merely operating under the rule of law doesn’t make it any easier for China to accept. China has responded that it, too, has laws, not to mention roughly 200 dual Canadian-Chinese citizens in custody. If the West wants to play hardball, China will show it can play, too.

Unfortunately for China, its retaliation against Canada is somewhat self-defeating. China needs foreign investment and has been working hard to keep foreign businesses in China and attract more foreign companies that have the capital and technology to help Beijing manage its ongoing economic transition. Arresting Western nationals will only deter foreign companies from wanting anything to do with China. On the other hand, Beijing can’t afford to look weak, especially in the eyes of its own people. The potential impact on the Chinese economy of the U.S. trade war is so great that Beijing has no choice but to try to spin the situation as much as it can. (Chinese censors are already doing so.) The arrest of a Chinese national – the daughter of the founder of a globally recognized Chinese company no less – is much harder to spin. If the Chinese government can’t protect its own people when they’re abroad, the motherland is not nearly as strong as the Communist Party insists it is.
Canada didn’t intend to set off an altercation with China any more than it meant to offend the Saudi crown prince’s self-styled image as a feminist icon, but as is sometimes the case in geopolitics, intentions are irrelevant. From Ottawa’s perspective, Canada is simply observing the rule of law. China has a different interpretation – according to its ambassador to Canada, “the detention of Ms. Meng is not a mere judicial case, but a premeditated political action.” When China retaliates by detaining Canadians who it says are threats to its national security, and Canada and its Western allies decry this as a violation of the rule of law, China can’t help but express anger at what it sees as “double standards due to Western egotism and white supremacy.” But the Canadian government is obligated to honor a U.S. extradition request, and as a result, it’s now mired in a confrontation it didn’t want. Complicating matters, Prime Minister Justin Trudeau has ample political reasons not to appear weak on China, considering the 2016 around Chinese contributions to the Pierre Elliott Trudeau Foundation.

In the end, this diplomatic spat will come down to whether the United States is willing to drop the charges against Meng in light of its broader negotiations with the Chinese government. Earlier this week, China signaled it may be open to a face-saving resolution – Meng’s father and Huawei’s founder made a rare public appearance during which he described U.S. President Donald Trump as “a great president” and Huawei as “only a sesame seed in the trade conflict between China and the U.S.” If, however, the two countries, who will continue trade talks at the end of the month, do come to an understanding, it will only defuse the current problem. In the long term, the U.S. and the West are behaving in ways China can interpret only as hostile to its development, and China is behaving in ways the U.S. and the West can interpret only as hostile their interests. It’s looking increasingly doubtful that the two sides can break out of this spiral. In the meantime, Meng, Kovrig and Canadian foreign policy remain caught in the crossfire.


The Three Revolutions Economics Needs

The silence of most economists on the underlying causes of the political ructions erupting throughout the West – and on what, if anything, can be done to restore economic vigor – has been deafening. And it provides further evidence of the profession's refusal to acknowledge the need for change.

Edmund S. Phelps

students auditorium


PARIS – The West is in crisis – and so is economics. Rates of return on investment are meager. Wages – and incomes generally – are stagnating for most people. Job satisfaction is down, especially among the young, and more working-age people are unwilling or unable to participate in the labor force. Many in France decided to give President Emmanuel Macron a try and now are protesting his policies. Many Americans decided to give Donald Trump a try, and have been similarly disappointed. And many in Britain looked to Brexit to improve their lives.

Yet economists have been largely mute on the underlying causes of this crisis and what, if anything, can be done to restore economic vigor. It is safe to say that the causes are not well understood. And they will not be understood until economists finally engage in the task of reshaping how economics is taught and practiced. In particular, the profession needs three revolutions that it still resists.

The first concerns the continuing neglect of imperfect knowledge.

In the interwar years, Frank Knight and John Maynard Keynes launched a radical addition to economic theory. Knight’s book Risk, Uncertainty, and Profit(1921), and Keynes’s thinking behind his General Theory of Employment, Interest, and Money(1936) argue that there is no basis – and could be no basis – for models that treat decision-makers as having correct models with which to make decisions.

Knight injected an uncertain future, Keynes added the absence of coordination. But subsequent generations of economic theorists generally disregarded this breakthrough. To this day, despite some important work on formalizing Knight’s and Keynes’s insights (most notably by Roman Frydman and his colleagues), uncertainty – real uncertainty, not known variances – is not normally incorporated into our economic models. (An influential calculation by Robert J. Barro and Jason Furman, for example, made predictions of business investment resulting from Trump’s corporate profits tax cut without bringing in Knightian uncertainty.) The Uncertainty Revolution still has not succeeded.

Second, there is still a neglect of imperfect information.

In what has come to be known as the “Phelps volume,” Microeconomic Foundations of Employment and Inflation Theory, we brought to light a phenomenon overlooked by economists. Overestimation by workers of wage rates outside their towns brings inflated wages and thus abnormally high unemployment; underestimation brings bargain pay levels and thus abnormally low unemployment. When workers lose their jobs in, say, Appalachia they have little idea – no well-based estimate – of what their wage would be outside their world and how long it might take to find a job; so they might remain unemployed for months or even years.

There is a deficiency of information, not “asymmetric information.”

More than that, the volume sees every actor in the economy as being thrown back on whatever sense he or she can make of it, as Pinter depicted, and to do the best they can, as Voltaire urged. But theorists at the University of Chicago created a mechanical location model in which unemployment is merely frictional and thus transitory – the so-called island model. As a result, the Information Revolution has not yet been absorbed.

The last great challenge is the utter omission from economic theory of economic dynamism.

While economists have come to recognize that the West has suffered a massive slowdown, most of them offer no explanation for it. Others, wedded to Schumpeter’s early thesis on innovation in his classic 1911 book The Theory of Economic Development, infer that the torrent of discoveries by scientists and explorers has shrunk to a trickle in recent times. Schumpeter’s theory operated on the explicit premise that the mass of people in the economy lack inventiveness. (He famously remarked that he never met a businessman with any originality.)

This was an extraordinary premise. One can argue that the West as we know it – the modern world, we might say – began with the great scholar Pico della Mirandola, who argued that all mankind possesses creativity. And the concerns of many other thinkers – the ambitiousness of Cellini, the individualism of Luther, the vitalism of Cervantes, and the personal growth of Montaigne – stirred people to use their creativity. Later, Hume stressed the need for imagination, and Kierkegaard emphasized acceptance of the unknown. Nineteenth-century philosophers such as William James, Friedrich Nietzsche, and Henri Bergson embraced uncertainty and relished the new.

As they reached a critical mass, these values produced indigenous innovation throughout the labor force. The phenomenon of grassroots innovation by virtually all sorts of people working in all sorts of industries was first perceived by the American historian Walt Rostow in 1952 and described vividly and voluminously by the British historian Paul Johnson in 1983. I discuss its origins in my 2013 book Mass Flourishing.

So it was by no means clear that the Schumpeterian thesis would be incorporated into economic theory. But when MIT’s Robert Solow introduced his growth model, it became standard to suppose that the “rate of technical progress,” as he called it, was exogenous to the economy. So the idea that people – even ordinary people working in all industries – possess the imagination to conceive of new goods and new methods was not considered. And it would have been dismissed had it been mooted. The Dynamism Revolution in economic theory was put on hold.

With the great slowdown and a decline of job satisfaction, however, there now appears to be a chance to introduce dynamism into economic modeling. And doing so is imperative. The importance of understanding the newly stagnant economies has sparked an effort to incorporate imagination and creativity into macroeconomic models. I have been arguing for a decade or more that we cannot understand the symptoms observed in the Western nations until we have formulated and tested explicit hypotheses about the sources, or origins, of dynamism.

That theoretical advance will give us hope of explaining not only the slow growth of total factor productivity, but also the decline of job satisfaction. America cannot be America again, France cannot be France again, and Britain cannot be Britain again until their peoples are once again engaged in thinking of better ways to do things and excited at embarking on their voyages into the unknown.


Edmund S. Phelps, the 2006 Nobel laureate in Economics, is Director of the Center on Capitalism and Society at Columbia University and the author of Rewarding Work.