On December 18, ZeroHedge answered his own question wrongly with Russia Has Begun Selling Its Gold, According To SocGen.
I did not believe that when I saw it yesterday, and I sure don’t today after viewing a few charts from Nick at Gold Charts “R” Us.
Russia Gold Reserves Up 600,000 Ounces for November
In US dollar terms, Russia’s gold reserves are worth about $0.4 billion less.
Russia Gold Reserves in US Dollars
Of course, Russia may have started selling in December, but that’s not precisely what happened either.
Gold Chat Debunks Russia Selling Gold Rumor
Please consider this snip from the December 19 Gold Chat article ZH fail on Soc Gen fail on Russia selling its gold.
As is common in internet land, people pick up stuff by others without doing basic drilling down to the source. The reason you have to do this is because people often misinterpret the source. Other times the source is wrong.
ZH quote the following from Soc Gen: “It appears possible that the Central Bank of Russia has started to sell off some of its gold reserves in December, with some sources reporting that official gold reserves dropped by $4.3 billion in the first week of the month.”
Now that is a very specific figure, $4.3b. It seems that Soc Gen got it from this Business Insider republication of a Vesti Finance article which said “On Thursday, the Central Bank of Russia announced that gold reserves dropped by $US4.3 billion in just one week, reports Vesti Finance.”
However, if we check the [Vesti] source link [using Google Translate] we get the following:
“Russia’s international reserves for the week from November 28 to December 5, decreased from $ 420.5 billion to $ 416.2 billion, the central bank said on Thursday. … For the previous week, from 21 to 28 November, gold reserves increased from $ 420.4 billion to $ 420.5 billion. On November 14th the size of gold reserves stood at $ 420.6 billion, on November 7 – $421,400,000,000 rubles.”
Now the decrease they are talking about is $4.3b in total reserves but the headline mistakenly assumes it is all gold. The gold specific figures they mention show completely different numbers.
This is precisely what happens when you are sloppy with links.
My major criticism is not that ZeroHedge posted something inaccurately, but that he frequently fails to link to stories.
On many occasions ZeroHedge states things like “Bloomberg says” and I spend 15 minutes looking and cannot find anywhere Bloomberg said anything remotely close to what was being attributed.
I realize sometimes there is no link. On such occasions, I will say something like via email, no link available.
In this case it appears the source of this misrepresentation was Business Insider who also got the story amazingly wrong.
On December 12, Business Insider reported Russia Is Fighting Its Financial Problems By Selling The Gold They Have Been Hoarding.
Russia is finally using all that gold they have been hoarding.
On Thursday, the Central Bank of Russia announced that gold reserves dropped by $US4.3 billion in just one week, reports Vesti Finance.
Which isn’t all that surprising. ….
In the third quarter alone, Russia added more gold to its reserves than any other nation, according to the Telegraph. And over the last decade, Russia has tripled its gold stocks, according to data from the World Gold Council.
Until recently, Russia hasn’t dipped into these enormous reserves.
But now that the ruble is getting pummelled following the decline in oil prices and sanctions imposed on Russia’s economy by the West, Russia’s central bank is apparently selling off some of its gold reserves to fight inflation and the ruble’s decline.
Business Insider Sloppy Reporting
Russia is not selling gold, rather the US$ value of its international reserves fell by $4.3. Billion. Here is the opening sentence “Russia’s international reserves for the week from November 28 to December 5, decreased from $ 420.5 billion to $ 416.2 billion, the central bank said on Thursday.”
Gold Chat ended with …
“Editor’s Note: Earlier it was reported that the Central Bank’s gold reserves decreased by $4.3 billion, quoting Vesti Finance. However, in actuality, it is international reserves assets that have decreased — not gold. Appropriate changes have been made.”
Now how hard was that fact checking Soc Gen and ZH?
ZeroHedge messed up another gold story as well. Please consider the December 17 Gold Chat article Zero Hedge fail on undocumented gold supply story
This kind of nonsense is precisely why I am meticulous with links. I ask others to carry the same standard.
Bloomberg is also terrible. In fact, mainstream media is horrendous in general.
Many mainstream media news outlets only link to themselves. And when that happens there is no way to check the facts. Then nonsense like this happens. I rest my case.
Mike “Mish” Shedlock
With two reports a day, and often more, readers sometimes complain that keeping tabs on the thoughts of the various Gavekal analysts can be a challenge. So as the year draws to a close, it may be helpful if we recap the main questions confronting investors and the themes we strongly believe in, region by region.
1. A Chinese Marshall Plan?
When we have conversations with clients about China – which typically we do between two and four times a day – the talk invariably revolves around how much Chinese growth is slowing (a good bit, and quite quickly); how undercapitalized Chinese banks are (a good bit, but fat net interest margins and preferred share issues are solving the problem over time); how much overcapacity there is in real estate (a good bit, but – like youth – this is a problem that time will fix); how much overcapacity there is in steel, shipping, university graduates and corrupt officials; how disruptive China’s adoption of assembly line robots will be etc.
All of these questions are urgent, and the problems that prompted them undeniably real, which means that China’s policymakers certainly have their plates full. But this is where things get interesting: in all our conversations with Western investors, their conclusion seems to be that Beijing will have little choice but to print money aggressively, devalue the renminbi, fiscally stimulate the economy, and basically follow the path trail-blazed (with such success?) by Western policymakers since 2008. However, we would argue that this conclusion represents a failure both to think outside the Western box and to read Beijing’s signal flags.
In numerous reports (and in Chapters 11 to 14 of Too Different For Comfort) we have argued that the internationalization of the renminbi has been one of the most significant macro events of recent years. This internationalization is continuing apace: from next to nothing in 2008, almost a quarter of Chinese trade will settle in renminbi in 2014:
This is an important development which could have a very positive impact on a number of emerging markets. Indeed, a typical, non-oil exporting emerging market policymaker (whether in Turkey, the Philippines, Vietnam, South Korea, Argentina or India) usually has to worry about two things that are completely out of his control:
1) A spike in the US dollar. Whenever the US currency shoots up, it presents a hurdle for growth in most emerging markets. The first reason is that most trade takes place in US dollars, so a stronger US dollar means companies having to set aside more money for working capital needs. The second is that most emerging market investors tend to think in two currencies: their own and the US dollar. Catch a cab in Bangkok, Cairo, Cape Town or Jakarta and ask for that day’s US dollar exchange rate and chances are that the driver will know it to within a decimal point. This sensitivity to exchange rates is important because it means that when the US dollar rises, local wealth tends to flow out of local currencies as investors sell domestic assets and into US dollar assets, typically treasuries (when the US dollar falls, the reverse is true).
2) A rapid rise in oil or food prices. Violent spikes in oil and food prices can be highly destabilizing for developing countries, where the median family spends so much more of their income on basic necessities than the typical Western family. Sudden spikes in the price of food or energy can quickly create social and political tensions. And that’s not all; for oil-importing countries, a spike in oil prices can lead to a rapid deterioration in trade balances. These tend to scare foreign investors away, so pushing the local currency lower and domestic interest rates higher, which in turn leads to weaker growth etc…
Looking at these two concerns, it is hard to escape the conclusion that, as things stand, China is helping to mitigate both:
- China’s policy of renminbi internationalization means that emerging markets are able gradually to reduce their dependence on the US dollar. As they do, spikes in the value of the US currency (such as we have seen in 2014) are becoming less painful.
- The slowdown in Chinese oil demand, as well as China’s ability to capitalize on Putin’s difficulties to transform itself from a price-taker to a price-setter, means that the impact of oil and commodities on trade balances is much more contained.
Beyond providing stability to emerging markets, the gradual acceptance of the renminbi as a secondary trading and reserve currency for emerging markets has further implications. The late French economist Jacques Rueff showed convincingly how, when global trade moved from a gold-based settlement system to a US dollar-based system, purchasing power was duplicated. As the authors of a recent Wall Street Journal article citing Reuff’s work explained: “If the Banque de France counts among its reserves dollar claims (and not just gold and French francs) – for example a Banque de France deposit in a New York bank – this increases the money supply in France but without reducing the money supply of the US. So both countries can use these dollar assets to grant credit.” Replace Banque de France with Bank Indonesia, and US dollar with renminbi and the same causes will lead to the same effects.
Consider British Columbia’s recently issued AAA-rated two year renminbi dim sum bond. Yielding 2.85%, this bond was actively subscribed to by foreign central banks, which ended up receiving more than 50% of the initial allocation (ten times as much as in the first British Columbia dim sum issue two years ago). After the issue British Columbia takes the proceeds and deposits them in a Chinese bank, thereby capturing a nice spread. In turn, the Chinese bank can multiply this money five times over (so goes money creation in China). Meanwhile, the Indonesian, Korean or Kazakh central banks that bought the bonds now have an asset on their balance sheet which they can use to back an expansion of trade with China…
Of course, for trade to flourish, countries need to be able to specialize in their respective comparative advantages, hence the importance of the kind of free trade deals discussed at the recent APEC meeting. But free trade deals are not enough; countries also need trade infrastructure (ports, airports, telecoms, trade finance banks etc…). This brings us to China’s ‘new silk road’ strategy and the recent announcement by Beijing of a US$40bn fund to help finance road and rail infrastructure in the various ‘stans’ on its western borders in a development that promises to cut the travel time from China to Europe from the current 30 days by sea to ten days or less overland.
Needless to say, such a dramatic reduction in transportation time could help prompt some heavy industry to relocate from Europe to Asia.
That’s not all. At July’s BRICS summit in Brazil, leaders of the five member nations signed a treaty launching the US$50bn New Development Bank, which Beijing hopes will be modeled on China Development Bank, and is likely to compete with the World Bank. This will be followed by the establishment of a China-dominated BRICS contingency fund (challenging the International Monetary Fund). Also on the cards is an Asian Infrastructure Investment Bank to rival the Asian Development Bank.
So what looks likely to take shape over the next few years is a network of railroads and motorways linking China’s main production centers to Bangkok, Singapore, Karachi, Almaty, Moscow, Yangon, Kolkata. We will see pipelines, dams, and power plants built in Siberia, Central Asia, Pakistan and Myanmar; as well as airports, hotels, business centers… and all of this financed with China’s excess savings, and leverage. Given that China today has excess production capacity in all of these sectors, one does not need a fistful of university diplomas to figure out whose companies will get the pick of the construction contracts.
But to finance all of this, and to transform herself into a capital exporter, China needs stable capital markets and a strong, convertible currency. This explains why, despite Hong Kong’s pro-democracy demonstrations, Beijing is pressing ahead with the internationalization of the renminbi using the former British colony as its proving ground (witness the Shanghai-HK stock connect scheme and the removal of renminbi restrictions on Hong Kong residents). And it is why renminbi bonds have delivered better risk-adjusted returns over the past five years than almost any other fixed income market.
Of course, China’s strategy of internationalizing the renminbi, and integrating its neighbors into its own economy might fall flat on its face. Some neighbors bitterly resent China’s increasing assertiveness. Nonetheless, the big story in China today is not ‘ghost cities’ (how long has that one been around?) or undercapitalized banks. The major story is China’s reluctance to continue funneling its excess savings into US treasuries yielding less than 2%, and its willingness to use that capital instead to integrate its neighbors’ economies with its own; using its own currency and its low funding costs as an ‘appeal product’ (and having its own companies pick up the contracts as a bonus). In essence, is this so different from what the US did in Europe in the 1940s and 1950s with the Marshall Plan?
2. Japan: Is Abenomics just a sideshow?
With Japan in the middle of a triple dip recession, and Japanese households suffering a significant contraction in real disposable income, it might seem that Prime Minister Shinzo Abe has chosen an odd time to call a snap election. Three big factors explain his decision:
1) The Japanese opposition is in complete disarray. So Abe’s decision may primarily have been opportunistic.
2) We must remember that Abe is the most nationalist prime minister Japan has produced in a generation. The expansion of China’s economic presence across Central and South East Asia will have left him feeling at least as uncomfortable as anyone who witnessed his Apec handshake with Xi Jinping three weeks ago. It is not hard to imagine that Abe returned from Beijing convinced that he needs to step up Japan’s military development; a policy that requires him to command a greater parliamentary majority than he holds now.
3) The final factor explaining Abe’s decision to call an election may be that in Japan the government’s performance in opinion polls seems to mirror the performance of the local stock market (wouldn’t Barack Obama like to see such a correlation in the US?). With the Nikkei breaking out to new highs, Abe may feel that now is the best time to try and cement his party’s dominant position in the Diet.
As he gets ready to face the voters, how should Abe attempt to portray himself? In our view, he could do worse than present himself as Japan Inc’s biggest salesman. Since the start of his second mandate, Abe has visited 49 countries in 21 months, and taken hundreds of different Japanese CEOs along with him for the ride. The message these CEOs have been spreading is simple: Japan is a very different place from 20 years ago. Companies are doing different things, and investment patterns have changed. Many companies have morphed into completely different animals, and are delivering handsome returns as a result. The relative year to date outperformances of Toyo Tire (+117%), Minebea (+95%), Mabuchi (+57%), Renesas (+43%), Fuji Film (+33%), NGK Insulators (+33%) and Nachi-Fujikoshi (+19%) have been enormous. Or take Panasonic as an example: the old television maker has transformed itself into a car parts firm, piggy-backing on the growth of Tesla’s model S.
Yet even as these changes have occurred, most foreign investors have stopped visiting Japan, and most sell-side firms have stopped funding genuine and original research. For the alert investor this is good news. As the number of Japanese firms at the heart of the disruptions reshaping our global economy – robotics, electric and self-driving cars, alternative energy, healthcare, care for the elderly – continues to expand, and as the number of investors looking at these same firms continues to shrink, those investors willing to sift the gravel of corporate Japan should be able to find real gems.
Which brings us to the real question confronting investors today: the ‘Kuroda put’ has placed Japanese equities back on investor’s maps. But is this just a short term phenomenon? After all, no nation has ever prospered by devaluing its currency. If Japan is set to attract, and retain, foreign investor flows, it will have to come up with a more compelling story than ‘we print money faster than anyone else’.
In our recent research, we have argued that this is exactly what is happening. In fact, we believe so much in the opportunity that we have launched a dedicated Japan corporate research service (GK Plus Alpha) whose principals (Alicia Walker and Neil Newman) are burning shoe leather to identify the disruptive companies that will trigger Japan’s next wave of growth.
3. Should we worry about capital misallocation in the US?
The US has now ‘enjoyed’ a free cost of money for some six years. The logic behind the zero-interest rate policy was simple enough: after the trauma of 2008, the animal spirits of entrepreneurs needed to be prodded back to life. Unfortunately, the last few years have reminded everyone that the average entrepreneur or investor typically borrows for one of two reasons:
- Capital spending: Business is expanding, so our entrepreneur borrows to open a new plant, or hire more people, etc.
- Financial engineering: The entrepreneur or investor borrows in order to purchase an existing cash flow, or stream of income. In this case, our borrower calculates the present value of a given income stream, and if this present value is higher than the cost of the debt required to own it, then the transaction makes sense.
Unfortunately, the second type of borrowing does not lead to an increase in the stock of capital. It simply leads to a change in the ownership of capital at higher and higher prices, with the ownership of an asset often moving away from entrepreneurs and towards financial middlemen or institutions. So instead of an increase in an economy’s capital stock (as we would get with increased borrowing for capital spending), with financial engineering all we see is a net increase in the total amount of debt and a greater concentration of asset ownership. And the higher the debt levels and ownership concentration, the greater the system’s fragility and its inability to weather shocks.
We are not arguing that financial engineering has reached its natural limits in the US. Who knows where those limits stand in a zero interest rate world? However, we would highlight that the recent new highs in US equities have not been accompanied by new lows in corporate spreads. Instead, the spread between 5-year BBB bonds and 5-year US treasuries has widened by more than 30 basis points since this summer.
Behind these wider spreads lies a simple reality: corporate bonds issued by energy sector companies have lately been taken to the woodshed. In fact, the spread between the bonds of energy companies, and those of other US corporates are back at highs not seen since the recession of 2001-2002, when the oil price was at US$30 a barrel.
The market’s behavior raises the question whether the energy industry has been the black hole of capital misallocation in the era of quantitative easing. As our friend Josh Ayers of Paradarch Advisors (Josh publishes a weekly entitled The Right Tale, which is a fount of interesting ideas. He can be reached at email@example.com) put it in a recent note: “After surviving the resource nadir of the late 1980s and 1990s, oil and gas firms started pumping up capex as the new millennium began. However, it wasn’t until the purported end of the global financial crisis in 2009 that capital expenditure in the oil patch went into hyperdrive, at which point capex from the S&P 500’s oil and gas subcomponents jumped from roughly 7% of total US fixed investment to over 10% today.”
“It’s no secret that a decade’s worth of higher global oil prices justified much of the early ramp-up in capex, but a more thoughtful look at the underlying data suggests we’re now deep in the malinvestment phase of the oil and gas business cycle. The second chart (above) displays both the total annual capex and the return on that capex (net income/capex) for the ten largest holdings in the Energy Select Sector SPDR (XLE). The most troublesome aspect of this chart is that, since 2010, returns have been declining as capex outlays are increasing. Furthermore, this divergence is occurring despite WTI crude prices averaging nearly $96 per barrel during that period,” Josh noted.
The energy sector may not be the only place where capital has been misallocated on a grand scale. The other industry with a fairly large target on its back is the financial sector. For a start, policymakers around the world have basically decided that, for all intents and purposes, whenever a ‘decision maker’ in the financial industry makes a decision, someone else should be looking over the decision maker’s shoulder to ensure that the decision is appropriate. Take HSBC’s latest results: HSBC added 1400 compliance staff in one quarter, and plans to add another 1000 over the next quarter. From this, we can draw one of two conclusions:
1) The financial firms that will win are the large firms, as they can afford the compliance costs.
2) The winners will be the firms that say: “Fine, let’s get rid of the decision maker. Then we won’t need to hire the compliance guy either”.
This brings us to a theme first explored by our friend Paul Jeffery, who back in September wrote: “In 1994 Bill Gates observed: ‘Banking is necessary, banks are not’. The primary function of a bank is to bring savers and users of capital together in order to facilitate an exchange. In return for their role as [trusted] intermediaries banks charge a generous net spread. To date, this hefty added cost has been accepted by the public due to the lack of a credible alternative, as well as the general oligopolistic structure of the banking industry. What Lending Club and other P2P lenders do is provide an online market-place that connects borrowers and lenders directly; think the eBay of loans and you have the right conceptual grasp. Moreover, the business model of online market-place lending breaks with a banking tradition, dating back to 14th century Florence, of operating on a “fractional reserve” basis. In the case of P2P intermediation, lending can be thought of as being “fully reserved” and entails no balance sheet risk on the part of the service facilitator. Instead, the intermediary receives a fee- based revenue stream rather than a spread-based income.”
There is another way we can look at it: finance today is an abnormal industry in two important ways:
1) The more the sector spends on information and communications technology, the bigger a proportion of the economic pie the industry captures. This is a complete anomaly. In all other industries (retail, energy, telecoms…), spending on ICT has delivered savings for the consumers. In finance, investment in ICT (think shaving seconds of trading times in order to front run customer orders legally) has not delivered savings for consumers, nor even bigger dividends for shareholders, but fatter bonuses and profits for bankers.
2) The second way finance is an abnormal industry (perhaps unsurprisingly given the first factor) lies in the banks’ inability to pass on anything of value to their customers, at least as far as customer’s perceptions are concerned. Indeed, in ‘brand surveys’ and ‘consumer satisfaction reports’, banks regularly bring up the rear. Who today loves their bank in a way that some people ‘love’ Walmart, Costco, IKEA, Amazon, Apple, Google, Uber, etc?
Most importantly, and as Paul highlights above, if the whole point of the internet is to:
a) measure more efficiently what each individual needs, and
b) eliminate unnecessary intermediaries,
then we should expect a lot of the financial industry’s safe and steady margins to come under heavy pressure. This has already started in the broking and in the money management industries (where mediocre money managers and other closet indexers are being replaced by ETFs). But why shouldn’t we start to see banks’ high return consumer loan, SME loan and credit card loan businesses replaced, at a faster and faster pace, by peer-to-peer lending? Why should consumers continue to pay high fees for bank transfers, or credit cards when increasingly such services are offered at much lower costs by firms such as TransferWise, services like Alipay and Apple Pay, or simply by new currencies such as Bitcoin? On this point, we should note that in the 17 days that followed the launch of Apple Pay on the iPhone 6, almost 1% of Wholefoods’ transactions were processed using the new payment system. The likes of Apple, Google, Facebook and Amazon have grown into behemoths by upending the media, advertising retail and entertainment industries. Such a rapid take- up rate for Apple Pay is a powerful indicator which sector is likely to be next in line. How else can these tech giants keep growing and avoid the fate that befell Sony, Microsoft and Nokia? On their past record, the technology companies will find margins, and growth, in upending our countries’ financial infrastructure. As they do, a lot of capital (both human and monetary) deployed in the current infrastructure will find itself obsolete.
This possibility raises a number of questions – not least for Gavekal’s own investment process, which relies heavily on changes in the velocity of money and in the willingness and ability of commercial banks to multiply money, to judge whether it makes sense to increase portfolio risk. What happens to a world that moves ‘ex-bank’ and where most new loans are extended peer-to-peer? In such a world, the banking multiplier disappears along with fractional reserve banking (and consequently the need for regulators? Dare to dream…). As bankers stop lending their clients umbrellas when it is sunny, and taking them away when it rains, will our economic cycles become much tamer? As central banks everywhere print money aggressively, could the market be in the process of creating currencies no longer based on the borders of nation states, but instead on the cross-border networks of large corporations (Alipay, Apple Pay…), or even on voluntary communities (Bitcoin). Does this mean we are approaching the Austrian dream of a world with many, non government-supported, currencies?
4. Should we care about Europe?
In our September Quarterly Strategy Chartbook, we debated whether the eurozone was set for a revival (the point expounded by François) or a continued period stuck in the doldrums (Charles’s view), or whether we should even care (my point). At the crux of this divergence in views is the question whether euroland is broadly following the Japanese deflationary bust path. Pointing to this possibility are the facts that 11 out of 15 eurozone countries are now registering annual year-on-year declines in CPI, that policy responses have so far been late, unclear and haphazard (as they were in Japan), and that the solutions mooted (e.g. European Commission president Jean-Claude Juncker’s €315bn infrastructure spending plan) recall the solutions adopted in Japan (remember all those bridges to nowhere?). And that’s before going into the structural parallels: ageing populations; dysfunctional, undercapitalized and overcrowded banking systems; influential segments of the population eager to maintain the status quo etc…
With the same causes at work, should we expect the same consequences? Does the continued underperformance of eurozone stocks simply reflect that managing companies in a deflationary environment is a very challenging task? If euroland has really entered a Japanese-style deflationary bust likely to extend years into the future, the conclusion almost draws itself.
The main lesson investors have learned from the Japanese experience of 1990-2013 is that the only time to buy stocks in an economy undergoing a deflationary bust is:
a) when stocks are massively undervalued relative both to their peers and to their own history, and
b) when a significant policy change is on the way.
This was the situation in Japan in 1999 (the first round of QE under PM Keizo Obuchi), 2005 (PM Junichiro Koizumi’s bank recapitalization program) and of course in 2013-14 (Abenomics). Otherwise, in a deflationary environment with no or low growth, there is no real reason to pile into equities. One does much better in debt. So, if the Japan-Europe parallel runs true, it only makes sense to look at eurozone equities when they are both massively undervalued relative to their own histories and there are expectations of a big policy change. This was the case in the spring of 2012 when valuations were at extremes, and Mario Draghi replaced Jean-Claude Trichet as ECB president. In the absence of these two conditions, the marginal dollar looking for equity risk will head for sunnier climes.
With this in mind, there are two possible arguments for an exposure to eurozone equities:
1) The analogy of Japan is misleading as euroland will not experience a deflationary bust (or will soon emerge from deflation).
2) We are reaching the point when our two conditions – attractive valuations, combined with policy shock and awe – are about to be met. Thus we could be reaching the point when euroland equities start to deliver outsized returns.
Proponents of the first argument will want to overweight euroland equities now, as this scenario should lead to a rebound in both the euro and European equities (so anyone underweight in their portfolios would struggle). However, it has to be said that the odds against this first outcome appear to get longer with almost every data release!
Proponents of the second scenario, however, can afford to sit back and wait, because it is likely any outperformance in eurozone equities would be accompanied by euro currency weakness. Hence, as a percentage of a total benchmark, European equities would not surge, because the rise in equities would be offset by the falling euro.
Alternatively, investors who are skeptical about either of these two propositions can – like us – continue to use euroland as a source of, rather than as a destination for, capital. And they can afford safely to ignore events unfolding in euroland as they seek rewarding investment opportunities in the US or Asia. In short, over the coming years investors may adopt the same view towards the eurozone that they took towards Japan for the last decade: ‘Neither loved, nor hated… simply ignored’.
Most investors go about their job trying to identify ‘winners’. But more often than not, investing is about avoiding losers. Like successful gamblers at the racing track, an investor’s starting point should be to eliminate the assets that do not stand a chance, and then spread the rest of one’s capital amongst the remainder.
For example, if in 1981 an investor had decided to forego investing in commodities and simply to diversify his holdings across other asset classes, his decision would have been enough to earn himself a decade at the beach. If our investor had then returned to the office in 1990, and again made just one decision – to own nothing in Japan – he could once again have gone back to sipping margaritas for the next ten years. In 2000, the decision had to be not to own overvalued technology stocks. By 2006, our investor needed to start selling his holdings in financials around the world. And by 2008, the money-saving decision would have been to forego investing in euroland.
Of course hindsight is twenty-twenty, and any investor who managed to avoid all these potholes would have done extremely well. Nevertheless, the big question confronting investors today is how to avoid the potholes of tomorrow. To succeed, we believe that investors need to answer the following questions:
- Will Japan engineer a revival through its lead in exciting new technologies (robotics, hi-tech help for the elderly, electric and driverless cars etc…), or will Abenomics prove to be the last hurrah of a society unable to adjust to the 21st century? Our research is following these questions closely through our new GK Plus Alpha venture.
- Will China slowly sink under the weight of the past decade’s malinvestment and the accompanying rise in debt (the consensus view) or will it successfully establish itself as Asia’s new hegemon? Our Beijing based research team is very much on top of these questions, especially Tom Miller, who by next Christmas should have a book out charting the geopolitical impact of China’s rise.
- Will Indian prime minister Narendra Modi succeed in plucking the low-hanging fruit so visible in India, building new infrastructure, deregulating services, cutting protectionism, etc? If so, will India start to pull its weight in the global economy and financial markets?
- How will the world deal with a US economy that may no longer run current account deficits, and may no longer be keen to finance large armies? Does such a combination not almost guarantee the success of China’s strategy?
- If the US dollar is entering a long term structural bull market, who are the winners and losers? The knee-jerk reaction has been to say ‘emerging markets will be the losers’ (simply because they were in the past. But the reality is that most emerging markets have large US dollar reserves and can withstand a strong US currency. Instead, will the big losers from the US dollar be the commodity producers?
- Have we reached ‘peak demand’ for oil? If so, does this mean that we have years ahead of us in which markets and investors will have to digest the past five years of capital misallocation into commodities?
- Talking of capital misallocation, does the continued trend of share buybacks render our financial system more fragile (through higher gearing) and so more likely to crack in the face of exogenous shocks? If it does, one key problem may be that although we may have made our banks safer through increased regulations (since banks are not allowed to take risks anymore), we may well have made our financial markets more volatile (since banks are no longer allowed to trade their balance sheets to benefit from spikes in volatility). This much appeared obvious from the behavior of US fixed income markets in the days following Bill Gross’s departure from PIMCO. In turn, if banks are not allowed to take risks at volatile times, then central banks will always be called upon to act, which guarantees more capital misallocation, share buybacks and further fragilization of the system (expect more debates along this theme between Charles, and Anatole).
- Will the financial sector be next to undergo disintermediation by the internet (after advertising and the media). If so, what will the macro- consequences be? (Hint: not good for the pound or London property.)
- Is euroland following the Japanese deflationary-bust roadmap?
The answers to these questions will drive performance for years to come. In the meantime, we continue to believe that a portfolio which avoids a) euroland, b) banks, and c) commodities, will do well – perhaps well enough to continue funding Mediterranean beach holidays – especially as these are likely to go on getting cheaper for anyone not earning euros!
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A recent report, The Annual Review of Public Health, summarizes the basic facts of firearm violence, a large and costly public health problem in the United States for which the mortality rate has remained unchanged for more than a decade. It presents findings for the present in light of recent trends. Risk for firearm violence varies substantially across demographic subsets of the population and between states in patterns that are quite different for suicide and homicide. Suicide is far more common than homicide and its rate is increasing; the homicide rate is decreasing. As with other important health problems, most cases of fatal firearm violence arise from large but low-risk subsets of the population; risk and burden of illness are not distributed symmetrically. Compared with other industrialized nations, the United States has uniquely high mortality rates from firearm violence.
1. The overall fatality rate from firearm violence has not changed in more than a decade.
2. Suicide is the most common form of fatal firearm violence (64.0% of deaths in 2012) and is increasing. Homicide is decreasing.
3. Homicide risk is concentrated to a remarkable degree among Black males through much of the life span. Mortality rates from firearm violence are very high and unchanged in this group.
4. Suicide risk is highest among White males beginning in adolescence. They also account for most fatalities from firearm violence and have increasing mortality rates.
5. As compared with other industrialized nations, the United States has low rates of assaultive violence…
…but uniquely high mortality rates from firearm homicide and suicide.
Blind faith in policymakers remains a bad trade that’s still widely held. Pressure builds everywhere we look. Not as a consequence of the Fed’s ineptitude (which is a constant in the equation, not a variable), but through the blind faith markets continuing to place bets on the very low probability outcome – that everything will turn out well this time around. And so the pressure keeps rising. Managers are under pressure to perform and missing more targets, levering up on hope. As we wrote last year, bad companies were allowed to push their debt up in order to pay generous shareholder dividends and director packages that are now (in an uninspiring turn of events) higher than their free cash flow. Buybacks are “all-in” at cycle-highs, funded with shareholder money while insiders continue to cash out their own. Individual investors pressured to pick up yield became their debt or equity holders – lured by higher returns, easy-to-use ETFs, and asking no questions. And so, just as Moody’s suggested a year ago would happen (and we presented in last year’s report), high yield spreads have widened all year – in stark contrast to the gains in stocks and one of the most supportive government Bond rallies in history. The default cycle doesn’t appear to be that far off anymore, and not just in U.S. markets. Credit markets have embarked on a new fundamental narrative – bills still need to be paid, and not everyone deserves to sell new paper at the same price. Markets are illiquid, fractured, and in many cases unable to sustain any real test of selling. Meanwhile it’s business as usual at the Fed, where credibility remains intact and market participants blindly expect another magic trick for Equities in the coming year.
We think 2015 could mark a turning point in the narrative – and for the first time in eight years we’ve begun deploying capital, albeit still conservatively, in areas with the largest potential for significant dislocations—without risking much if we are wrong.
Without further delay we present our slightly unconventional annual list. Instead of the usual what you should do, we prefer the more helpful (for us at least) what we probably wouldn’t do. Five fresh new contenders for what could become some very bad trades in the coming year. As usual this is not intended as an exhaustive list. In fact we had to leave out some rather compelling candidates on this go-around. To further complicate things, some bad trades from last year happen to be sneakily carrying over as we mentioned before. We’ll discuss these and others in the next section.
Five Bad Trades To Avoid Next Year – 2015 Edition
BAD TRADE #1 For 2015: “Leaked” Research.
In March of this year one of the biggest Emerging Markets-focused macro funds in the world leaked a 100+ page slideshow for why EM, and specifically Brazil and China, were going to implode (and bring down the world with them). Around the same time the head of macro research for a major fund published an article in a top newspaper warning of an imminent systemic calamity in Emerging Markets, and specifically China. We spoke with some managers at the time and they said: “Our team went to [insert country name here] with a bearish view, and came back even more bearish”. This statement probably deserves a whole section/discussion for itself. What followed is now history.
Long ago, there was a time when professional money managers on average possessed an informational advantage over the average market participant – as well as the ability to translate this advantage into superior performance. Some may attribute that edge to a combination of better data, research departments, experience, portfolio construction, and risk control. We don’t necessarily disagree. But a sixth factor may have been the most important of all – patience to let high-conviction, asymmetric bets pay off. Whatever the weights one assigns to each factor or edge, most have been in irreversible decline for over a decade. Data is free. Research departments are increasingly rigid. Average experience keeps falling as the industry contracts. Six years and a rising market have forced portfolios to ignore probabilistic outcomes and focus only on the past trend. Risk control is modeled so it doesn’t have to be understood. Patience has been cut to zero.
The result of this – October 2014 a prime example, is that major developed equity markets can now easily decline nearly 10% in a period of only 3-4 days, without any new or significant information released from news or government sources at the margin. And some individual stocks (which appeared liquid not even a day before) can now effectively stop trading as if the market were closed.
Valuable and timely research doesn’t come in a polished easy-to-flip format. It is planted and cultivated over time and with great care. It doesn’t copy-and-paste what is happening, but drives an ever-changing discussion of what may happen in the future. It is exchanged with clients as part of a broad conversation on future investments, goals, and strategy. Sometimes it may not even aim to recommend a specific course of action. It may simply conclude that different information is needed, and outline the paths to get there. Good research should include alternate scenarios. It should guide towards the most likely outcomes, not shut the door on everything else. Keeping an eye on the vault labeled “won’t open” can sometimes be much more rewarding. Next year should be no different.
BAD TRADE #2 For 2015: It’s A Bull Market, If Markets Rise Then Volatility Will Fall.
We’ll save the bit about “It’s A Bull Market” for Bad Trade #3. In this section we’ll discuss “Volatility Will Fall”.
Volatility used to be regarded as a highly-specialized tool for risk management. Hedgers used it to hedge, and every few years or so a levered speculator (read: seller) blew up. Today, six years of rising markets have turned every yield-starved investor and performance-chasing fund manager into a volatility seller.
Selling volatility has become a casino floor bleeping with offerings of ETFs, leveraged structures, swaps and futures. Every table offers its own brand of excitement and adventure. Yet unlike a real casino where some patrons know they’ll lose money – and consciously play small to enjoy a free drink on a getaway with friends – no one selling volatility today thinks they can lose at this game.
Let’s step back for a moment. The biggest monetary experiment in history has just (possibly) ended. From 2008 to 2014, the Fed was the largest synthetic seller of volatility in financial history. Following smartly along, countless asset managers and even the world’s largest Bond fund came out as proponents of selling volatility. That is, until the founder of said fund left to manage a smaller fund he could actually trade without the whole market knowing about it. Two weeks after his departure, the market collapsed and volatility briefly doubled. So the two biggest volatility sellers in history have just left the casino floor and are sitting down to eat at the complimentary buffet, while everyone else is doubling down on a new deck.
But let’s ignore all of that. It’s a bull market, you know, Mr. Partridge. So stocks will rise and volatility will fall. Well it turns out… not really. Six years into this bull market, calling this environment Mid Cycle would be very, very generous. More likely, we just ended the first year of a two-year Late Cycle phase.
Take a look at the picture below. In over a century, U.S. Equities on a year-on-year basis have made gains with falling volatility about one-third of the time, and made gains with rising volatility about a quarter of the time. In total, U.S. Equities have made gains roughly 60% (one third plus one quarter) of the time on a year-on-year basis.
As it turns out, the long-term averages are trumped by the specifics of the stage in the cycle. Very strong trending returns with rising volatility, both of which are firmly observed today, are the hallmark of late cycle bull markets with very few exceptions. In late stage bulls, the market and volatility rise together well over double the long-term average. Not very good odds. This is one of those cases where one doesn’t have to be right about the underlying trend in stocks to make a thoughtful, truly hedged bet. We wish the brave few hedgers luck.
BAD TRADE #3 For 2015: It Didn’t Work The First Two Times, So Let’s Go All-In On The Third.
We could spend all day on the previous comment – “It’s A Bull Market”. But the fundamental truth, at least for us, is that it doesn’t really matter what animal this is. Market participants devote too much time to this discussion and usually with little benefit other than satisfying their need for confirmation bias. We believe in watching risk instead – and letting the returns take care of themselves.
One way we define risk is price acceleration in any direction. Two of the ways we estimate this are by monitoring market conditions and assessing the equity cycle. What has become increasingly clear is that more parts of the market now behave as if we are in Late Cycle, while others have transitioned to a new Bear Market. These conditions have been developing all year.
To our surprise this late cycle pricing (and risk) had not yet started to show up in our Core Risk guidelines. So in our view, throughout most of the year we were dealing with a normal extension of prior conditions, with brief periods of elevated risk.
Then over the last 2 weeks something truly remarkable happened.
We track a number of late cycle fundamental data series that we call our Core Risk framework. Our primary concern in running these long-term price series is risk-management. The bigger the dislocation in our long-term data, the larger the risk. Further, in our experience risk is also non-linear. Historically, above certain levels of risk the probability and magnitude of severe drawdowns follow patterns similar to a power law.
The chart below offers an example. In almost thirty years, the highest value (risk) ever achieved in our Late Cycle Equity Pricing Model was during May 2008. It also led to the largest drawdown. The occasional failure such as 2005 produced a flat market, but in the process gave us valuable information that High Risk dynamics were not yet in play. Even then, caution and patience were highly rewarded.
As can be seen above, the last few weeks have finally produced what we call an “All-In” Late Cycle risk dynamic. Historically this has transitioned to very high volatility and very large drawdowns for U.S. equity markets. We can’t control how the market will respond to this. All we can do is recognize the problem and manage the risk accordingly.
Also “Going All-In”, another one of our Core Risk monitors:
We hope this drives the point that debating a Bull or Bear case is particularly irrelevant here. Yes, it could be either one. But the risk of one’s bias being wrong has almost never been higher. And going “All In” this third time around doesn’t look right either.
BAD TRADE #4 For 2015: I’ll Worry About It Tomorrow.
We live in a world where long-term thinking has been thrown out the window. Stock traders have decried this on a daily basis for over a century and yet it still rings true. Nowhere is this clearer than in the below chart. It starts at the inception of the SPY ETF in January 1993. We break out the market’s cumulative price return into overnight (which we’ll call “investors”) and cash-session (which we’ll label “day traders”) components.
During its first few years of existence, the Cumulative Return of holding the SPY overnight vs. the cash session was roughly equal. The market advance was being driven by both. Then in 1997 something changed. Day trader returns peaked and became a headwind. Overnight returns started to accelerate and overtook the Market return. Even more fascinating, this outperformance was maintained with lower volatility and lower drawdowns. None of this factors in transaction costs or taxes. Regardless, it’s an extremely powerful visualization of what we think is a key structural change in stock investing.
Recent years have been even more fascinating. Zooming in since 2009, the SPY has gained +195%, with the investor component gaining +60% and day traders gaining +84%. The chart below shows their normalized returns anchored at the March 2009 bottom:
While it may seem like day traders have collectively beaten the pants out of investors, individually today each group has only been able to reach where the broad market was roughly in 2010. As was the case since 1997 a great deal of money has been left on the table by those unwilling to hold positions past the close – which in this day and age is an ever-growing chunk of market participants. In this bull market (like the ones before it) a significant and steadily reliable component of returns came from thinking more like an investor.
As with every year before it, 2014 produced several periods of worrisome economic and geopolitical news. Sooner or later one of these hit close enough to a portfolio manager’s “sell button”, and panic ensued. In a market increasingly dominated by automated HFT day trading, speed-based market-making strategies, and generally ultrashort-term thinking, those who preferred to “Worry About It Tomorrow” instead of accepting overnight risk were accordingly giving up risk premium.
Worse, over the past year short-term thinkers have given up even more of this risk premium. And along with it, much of their performance lead. The next chart illustrates this interesting trend. Since the 2009 advance started, the Ratio of Cash to Overnight Cumulative Returns has been broadly stable between 1.10 and 1.20. This meant the cash session was maintaining a 10-20% lead. Since May 2013 however, day traders started to underperform overnight returns – giving up nearly half their previous lead. At one point in October they nearly gave it all back:
This unfolding weakness is quite significant. The S&P gained 25% since May of 2013. The overnight return was 15.3% and the cash session return was only 8.7%. Heading into next year, there is little reason to expect this gap to shift back in favor of short-term thinking. In fact, it peaked in late 2009. And then failed again in 2011. If history is our guide and late cycle dynamics become even more entrenched, investors seem more likely to outperform – and intraday returns to drift relatively lower. For those taking this to mean a strong market environment ahead, we look back to 2002-2007 when the Cash/Overnight Ratio finally fell below 1.10 for good, after a 2+ year drift lower in nearly identical fashion to what we observe today:
BAD TRADE #5 For 2015: It’s the only game in town.
Much of this section has been covered in the other four trades. Nevertheless we think a separate mention is important. Increasingly, investors are riding trends without understanding their fundamentals. We see this philosophy particularly prevalent in volatility, inflation expectations, and the Dollar. We see it mentioned alongside the Fed, with QE frequently hailed as “the only game in town”. Its siblings Abenomics and Draghinomics now compete for the same label. It’s become a well-worn phrase. We heard it in 2011 when some described the Gold market, in mid-2012 on Bonds, in mid-2013 on Japan, to name a few. Meanwhile pressure continues to build as market prices dislocate further from underlying driving forces.
This year almost no market has been spared the deadly phrase. Leaders became losers and vice-versa, in a particularly nasty game of musical chairs. Mean-reversion doing its dirty work. At one point this year European Equities were the only game in town. So were high-flying U.S. momentum stocks. Then Japan again. Then Emerging Markets. Then China. Then the Dollar, followed by U.S. Equities. These last two, along with a few others, still stand unchallenged.
We worry about the velocity of price adjustment required to close the wide gap between momentum investors extrapolating trends and what fundamentals can truly support. The consensus reasoning is that price adjustment won’t happen because markets are permanently supported by central bankers. Unfortunately in every year since 2009, despite massive coordinated central bank intervention, price adjustment did happen in virtually every major market and often with very painful knock-on effects. So when something is hailed the only game in town we’ve decided to quietly agree, pack our bags, and move to a different town.
While the current episode of Russian geopolitical and economic turmoil may seem significant, the following chart from Goldman Sachs shows the tempestuous time the nation has had over the past 150 years…
click image for large legible version
And here are Goldman’s thoughts on Russia and The West now and into 2015…
Where we stand now:
Currency distress has taken center stage in Russia, with the ruble down 40%+ against the US dollar since early August. Already under fundamental pressure from sanctions and lower oil prices, the currency experienced a sharp sell-off this week in what we would characterize as a crisis of confidence. After the USD/RUB exchange rate depreciated by 10%+ on December 15 alone, the Central Bank of Russia (CBR) responded with a 650bp midnight rate hike. Despite the unexpected move, the ruble has remained weak. The currency’s high volatility – part of which was likely driven by retail deposit outflows – and the sharply higher interest rate environment introduce risks to the health of Russia’s banks.
The sharp currency movements come on the back of shocks to the Russian economy from geopolitics (Russian capital outflows and sanctions that limit foreign inflows), falling oil prices, and sharp tightening of domestic financial conditions. Russian economic growth in the first three quarters of the year nevertheless stood at 0.8%yoy, indicating the economy’s resilience. The weakening of the ruble served as an important channel for the macroeconomic adjustment, keeping ruble-denominated oil prices relatively stable and shielding local balance sheets from more intense stress. However, the CBR’s large rate hike now makes it likely that FX distress migrates to domestic balance sheets.
The conflict in Ukraine remains far from resolved. The eastern Donetsk and Luhansk regions are still under rebel control, having declared independence on the back of controversial referendums held in May. Presidential elections later brought pro-Western Petro Poroshenko to power, though voting did not take place in parts of the east. Large-scale violence subsided after a ceasefire in September, but sporadic clashes have continued.
Diplomatic relations between Russia and the West remain strained, and economic sanctions against Russia appear likely to remain in place in 2015. President Obama is due to sign into law new sanctions legislation, although this is unlikely to result in any meaningful escalation of sanctions, in our view. In fact, there have been growing signs in the past several weeks of a renewed push toward diplomatic negotiations over the conflict in Ukraine. Meanwhile, deals between Moscow and Beijing on natural gas and currency-swap lines have reinforced expectations for the Kremlin to pivot eastward.
In response to Western sanctions, Russia introduced bans on food imports from the United States, Europe, Canada, Australia, and Norway for one year. This ban has had greatest effect on fresh product exports from Europe but little impact on the more tradable and storable agriculture products, such as wheat (of which Russia is a large exporter). As expected, the ban triggered a sharp rise in Russian food inflation. Of course, the worst-case scenario of Russia halting energy exports to Europe has not come to fruition, and exports of base metals and palladium have also been maintained. Following an agreement over gas debt payments, Russia also reportedly restarted gas flows to Ukraine on December 8.
Despite limited direct exposures to Russia, increased uncertainty resulting from the conflict weighed on investor sentiment in Europe and was one of several factors behind a deterioration of European economic indicators in 2Q14.
What to look for in 2015:
A highly uncertain Russian economic picture. Since the CBR’s decisive rate hike, we have placed our forecasts for rates, FX, growth and inflation on hold. There is a high likelihood of further measures to arrest the ruble’s fall – including a tightening of liquidity that leads to higher front-end rates, FX interventions and, in more extreme scenarios, there could be a risk of capital controls and bank holidays. Meanwhile, sustaining the CBR’s current policy stance for some months is likely to come at the cost of a sharper economic contraction, forcing pain onto local corporate and household balance sheets. The domestic banking system is now the most important place to watch for signs of broadening stress. And in the event that contingent liabilities in the banking sector are taken onto the sovereign balance sheet, pressure could migrate to sovereign credit.
Persistent tensions between Moscow and the West, with a highly uncertain path to resolution of the conflict over Ukraine.
Subsiding negative influences on the European economy, contingent on the conflict being contained.
Still little impact on Russian commodity production and exports. Russia may be able to keep oil production flat during 2015: lifting costs for conventional projects are low, and the cost structure is more resilient than that of other producers as Russia has a local service industry that generates ruble-denominated operating costs. Further out, Western sanctions combined with weaker market conditions may pose a downside risk to oil production. In terms of natural gas, a 2009-style disruption to European gas flows appears unlikely this winter, but in the current tense geopolitical climate there is still a risk that the deal breaks down. And as far as agricultural commodities, we continue to believe that sanctions impacting Russian agricultural exports are unlikely given their large size and the potential humanitarian aspect of such a move.
First comes production. Then comes income. Spending and savings follow. All the rest is debt…….unless you believe in a magic Keynesian ether called “aggregate demand” and a blatant stab-in-the-dark called “potential GDP”.
I don’t. So let’s start with a pretty startling contrast between two bellwether data trends since the pre-crisis peak in late 2007—debt versus production.
Not surprisingly, we have racked up a lot more debt—notwithstanding all the phony palaver about “deleveraging”. In fact, total credit market debt outstanding—-government, business, household and finance—-is up by 16% since the last peak—from $50 trillion to $58 trillion. And that 2007 peak, in turn, was up 80% from the previous peak (2001); and that was up 103% from the business cycle peak before that (July 1990).
Yes, the debt mountain just keeps on growing. It now stands 4.2X higher than the $13.6 trillion outstanding just 24 years ago.
As a proxy for “production” I am using non-durable manufactures rather than the overall industrial production index for three good reasons. The former excludes utility output, which incorporates a lot of weather related noise, and also excludes oil and gas production, which, as we are now learning, embodies a whole lot of debt. Besides, if the US economy has any hope of growing, non-durables should not still be migrating off-shore at this late stage of the global cycle; nor are they subject to fashion or lumpy replacement cycles like cars and refrigerators.
Moreover, the virtue of the industrial production index is that it is a measure of physical output, not sales dollars which reflect inflation. And unlike indicators that are deflated into “real” terms, it is not distorted by Washington’s fudging and finagling of the prices indices.
So how are we doing on production of things the American economy consumes day-in-and-day out? Well, at the most recent data point for November, production had soared…….all the way back to where it was in January 2003!
That’s right. Domestic output of food and beverages, paper, chemicals, plastics, textiles and finished energy products (e.g. gasoline), to name just a few, has experienced no net growth for nearly 11 years.
Now that’s a lot more informative than the Keynesian GDP accounts, which presume that government output is actually worth something and that do not know the difference between current period “spending” derived from production and “spending” funded by hocking future income, that is, by borrowing.
Stated differently, the current capitalism suffocating regime of Keynesian central banking and extreme financial repression has created systematic bias and noise in the so-called “in-coming data”. These distortions are the result of mis-allocations and malinvestments reflecting artificial, sub-economic costs of debt and capital. The resulting bubbles and booms, in turn, cause highly aggregated measures of economic activity to be flattered by the unsustainable production, spending and investment trends underneath at the sector level.
Thus, during the peak-to-peak cycle between 2000 and 2007, industrial production was reported to have generated a modest 1.5% per year growth rate. But that was almost entirely accounted for by construction materials and defense equipment. Production of non-durable manufactured goods during that period, by contrast, expanded at just a 0.2% annual rate.
But, alas, defense production inherently destroyers economic wealth, whether it provides for the national security or not. And the housing and commercial real estate construction boom did not add to permanent output growth and wealth at all; it amounted to a bubble round trip that has gone nowhere on a net basis during the last 11 years. And the graph below which documents this truth is in nominal terms, meaning that real private construction spending for residential housing, offices, retail and other commercial facilities actually declined by 10-15% after inflation during that period.
Stated differently, bubble finance does not create growth; it funds phony booms that end up as destructive round trips.
Yet, here we are again. The graph below reflects production of oil and gas, coal and other mining products including iron ore and copper. It has soared by 35% since the 2007 peak, and accounts for virtually all of the gain in industrial production ex-utilities over the last seven years.
Yet the plain fact is, the above explosion of mainly oil and gas production did not reflect the natural economics of the free market, and certainly no technological innovation called “fracking”. The later wasn’t a miracle; it was just a standard oilfield production technique that was long known to the industry, if not to CNBC. It became artificially economic during recent years only due to the massive and continuous distortions of both commodity prices and capital costs caused by the world’s central bankers.
Indeed, there are two charts which capture the central bank complicity in the latest bubble distortion of the “in-coming” data. These are the charts of plunging junk bond yields and soaring oil prices which materialized after the world’s central banks went all-in powering-up their printing presses after September 2008.
At the time of the 2008 financial crisis, what remained of honest price discovery in the capital markets caused a hissy fit among traders and money managers—–who had been stuck when the music stopped with hundreds of billions in dodgy junk bonds issued during the prior bubble. Accordingly, yields soared to upwards of 20% when massively overleveraged LBOs and other financial engineering gambits went bust.
Needless to say, that urgently needed cleansing was stopped cold in its tracks when Bernanke tripled the Fed’s balance sheets in less than a year after the Lehman crisis, and then officially adopted ZIRP and the greatest spree of debt monetization in recorded history. The resulting desperate scramble for yield among professional money managers and home gamers alike caused nominal interest rates on junk to be driven to levels once reserved for risk free treasuries.
But it wasn’t cheap debt alone that fueled the energy bubble. The 10- year graph of the crude oil marker price (WTI) shown below is an even greater artifact of central bank financial repression. The unprecedented global credit expansion since 2005, and especially after the financial crisis in China and the EM, caused several decades worth of normal GDP expansion to be telescoped into an artificially brief period of time.
As a result, demand for industrial commodities temporarily ran far ahead of new capacity—–even as the latter was being fueled by low-cost capital. That’s why iron ore prices, for example, soared from $20 per ton prior to the China boom to $200 per ton at the peak in 2012, and have now plummeted all the way back to $60 ton. This implosion is still not over. Owing to this extended period of artificial sky-high prices for the iron ore commodity, the massive investment boom they triggered in mining capacity and transportation infrastructure is still coming on-stream, adding even more increments to supply even as prices plunge.
Call it “operation twist” compliments of central bank bubble finance. It embodies a temporally twisted imbalance of supply and demand that inherently results from false prices in the capital and commodity markets.
Yet this condition is neither sustainable nor stable. Indeed, now we see the back side of this central bank bubble cycle as capacity races past sustainable consumption requirements, causing prices, profits margins and new investment to plunge in a violent correction. Iron ore is just the canary in the mine shaft. The same thing is true of nickel, copper, aluminum and most especially hydrocarbon liquids.
So the oil price chart below does not represent a momentary dip. This time the central banks are out of dry powder because they are at the zero bound or close in the greater part of world GDP, while the lagged impact of the bloated industrial investment boom continues to pour into the supply-side.
Needless to say, the emerging worldwide liquidation of the energy bubble will hit the highest cost provinces first—-which is to say, the shale patch and oils sands of North America. When drilling rigs start being demobilized by the hundreds rather than just by the score—-and its only a matter of weeks and months—the present the US mining production index shown above will bend back toward the flat-line just as housing and real estate construction did last time around.
Stated differently, there is no “escape velocity” in the forward outlook—– notwithstanding the delusional expectations unloaded again this afternoon by Yellen and her merry band of money printers. Much of what meager production and job growth there has been in recent years will soon be taken back as the energy bubble comes back to earth.
Needless to say, the Keynesian pettifoggers at the Fed and the other central banks around the world see none of this coming. So once again in its post-meeting statement, the Fed majority could not bring itself to let go of ZIRP, choosing to assert that it will remain “patient” as far as the eye can see—– while presiding over a meaningless policy change which might be called N-ZIRP. That is, “nearly” zero cost money, and just as destructructive.
Needless to say, the promise of almost free money for the carry trades is all the Wall Street speculators needed to hear. Within a minute or two, the robo-traders and gamblers managed to put a half-trillion dollars of fairy-tale money back on the screen.
But here’s the thing. The meaning of the oil crash is that the central bank fueled bubble of this century is over and done. We are now entering an age of global cooling, drastic industrial deflation, serial bubble blow-ups and faltering corporate profits.
So if some headline grabbing algos want to hyper-ventilate because the clueless money printers in the Eccles Building have now emitted the word “patient”, so be it. But why would you pay 20X for the S&P 500’s bubble bloated profits which have already peaked, and which will be subject to fierce global headwinds as far as the eye can see?
Indeed, the Fed’s lunatic assurance this afternoon that the Wall Street casino will have had free money for 76 months running, and that it will remain quasi-free long thereafter only means that the current financial bubbles in virtually every class of “risk assets” will become even more artificial, unstable and incendiary.
In any event, it ought to be evident by now that “potential GDP” is a fairy tale and that N-ZIRP has no more chance of generating that magic ether called “aggregate demand” than did ZIRP. We are at “peak debt” in nearly every precinct of the world economy, and that means that central banks cannot close this wholly theoretical and imaginary gap; they can only blow dangerous bubbles trying.
What counts is production of real goods and services based on honest prices and the efficient utilization of labor and capital. And it goes without saying that cannot happen under the current central banking regime of false prices and drastic misallocation of economic resources.
The current illusion of recovery is a result mainly of windfalls to the financial asset owning upper strata, the explosion of transfer payments funded with borrowed public money and another supply-side bubble – this time in the energy sector and its suppliers and infrastructure.
But that’s not real growth or wealth. Indeed, the desultory truth about the latter is better revealed by the fact that the American economy is not even maintaining its 20th century level of breadwinner jobs.
Breadwinner Economy – Click to enlarge
And the real state of affairs is further testified to by the lamentable trend in real median household incomes.
That figure – not distorted by the bubble at the top of the income ladder – is still lower than it was two decades ago.
So much for the Keynesian rap. Yet that’s about all that underpins the latest Wall Street rip.
We are sure it’s nothing – since stock markets in China and The US are soaring – but deep, deep down in the heart of the real economies, there is a problem. The Baltic Dry Index has fallen for 21 straight days, tumbling around 40% since Thanksgiving Day.
This is the biggest collapse in the ‘trade’ indicator (which we should ignore unless it is rising) since records began 28 years ago…
As The Index itself hovers very close to the post-crisis lows…
Do you want to know if the stock market is going to crash next year? Just keep an eye on junk bonds. Prior to the horrific collapse of stocks in 2008, high yield debt collapsed first. And as you will see below, high yield debt is starting to crash again. The primary reason for this is the price of oil. The energy sector accounts for approximately 15 to 20 percent of the entire junk bond market, and those energy bonds are taking a tremendous beating right now. This panic in energy bonds is infecting the broader high yield debt market, and investors have been pulling money out at a frightening pace. And as I have written about previously, almost every single time junk bonds decline substantially, stocks end up following suit. So don’t be fooled by the fact that some comforting words from Janet Yellen caused stock prices to jump over the past couple of days. If you really want to know where the stock market is heading in 2015, keep a close eye on the market for high yield debt.
If you are not familiar with junk bonds, the concept is actually very simple. Corporations that do not have high credit ratings typically have to pay higher interest rates to borrow money. The following is how USA Today describes these bonds…
High-yield bonds are long-term IOUs issued by companies with shaky credit ratings. Just like credit card users, companies with poor credit must pay higher interest rates on loans than those with gold-plated credit histories.
But in recent years, interest rates on junk bonds have gone down to ridiculously low levels. This is another bubble that was created by Federal Reserve policies, and it is a colossal disaster waiting to happen. And unfortunately, there are already signs that this bubble is now beginning to burst…
Back in June, the average junk bond yield was 3.90 percentage points higher than Treasury securities. The average energy junk bond yielded 3.91 percentage points higher than Treasuries, Lonski says.
That spread has widened to 5.08 percentage points for junk bonds vs. 7.86 percentage points for energy bonds — an indication of how worried investors are about default, particularly for small, highly indebted companies in the fracking business.
The reason why so many analysts are becoming extremely concerned about this shift in junk bonds is because we also saw this happen just before the great stock market crash of 2008. In the chart below, you can see how yields on junk bonds started to absolutely skyrocket in September of that year…
Of course we have not seen a move of that magnitude quite yet this year, but without a doubt yields have been spiking. The next chart that I want to share is of this year. As you can see, the movement over the past month or so has been quite substantial…
And of course I am far from the only one that is watching this. In fact, there are some sharks on Wall Street that plan to make an absolute boatload of cash as high yield bonds crash.
One of them is Josh Birnbaum. He correctly made a giant bet against subprime mortgages in 2007, and now he is making a giant bet against junk bonds…
When Josh Birnbaum was at Goldman Sachs in 2007, he made a huge bet against subprime mortgages.
Now he’s betting against something else: high-yield bonds.
From The Wall Street Journal:
Joshua Birnbaum, the ex-Goldman Sachs Group Inc. trader who made bets against subprime mortgages during the financial crisis, now has more than $2 billion in wagers against high-yield bonds at his Tilden Park Capital Management LP hedge-fund firm, according to investor documents.
Could you imagine betting 2 billion dollars on anything?
If he is right, he is going to make an incredible amount of money.
And I have a feeling that he will be. As a recent New American article detailed, there is already panic in the air…
It’s a mania, said Tim Gramatovich of Peritus Asset Management who oversees a bond portfolio of $800 million: “Anything that becomes a mania — ends badly. And this is a mania.”
Bill Gross, who used to run PIMCO’s gigantic bond portfolio and now advises the Janus Capital Group, explained that “there’s very little liquidity” in junk bonds. This is the language a bond fund manager uses to tell people that no one is buying, everyone is selling. Gross added: “Everyone is trying to squeeze through a very small door.”
Bonds issued by individual energy developers have gotten hammered. For instance, Energy XXI, an oil and gas producer, issued more than $2 billion in bonds just in the last four years and, up until a couple of weeks ago, they were selling at 100 cents on the dollar. On Friday buyers were offering just 64 cents. Midstates Petroleum’s $700 million in bonds — rated “junk” by both Moody’s and Standard and Poor’s — are selling at 54 cents on the dollar, if buyers can be found.
So is there anything that could stop junk bonds from crashing?
Yes, if the price of oil goes back up to 80 dollars or more a barrel that would go a long way to settling things back down.
Unfortunately, many analysts are convinced that the price of oil is going to head even lower instead…
“We’re continuing to search for a bottom, and might even see another significant drop before the year-end,” said Gene McGillian, an analyst at Tradition Energy in Stamford, Connecticut.
As I write this, the price of U.S. oil has fallen $1.69 today to $54.78.
If the price of oil stays this low, junk bonds are going to keep crashing.
If junk bonds keep crashing, the stock market is almost certainly going to follow.
For additional reading on this, please see my previous article entitled “‘Near Perfect’ Indicator That Precedes Almost Every Stock Market Correction Is Flashing A Warning Signal“.
But just like in the years leading up to the crash of 2008, there are all kinds of naysayers proclaiming that a collapse will never happen.
Even though our financial problems and our underlying economic fundamentals have gotten much worse since the last crisis, they are absolutely convinced that things are somehow going to be different this time.
In the end, a lot of those skeptics are going to lose an enormous amount of money when the dominoes start falling.
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Simply put – ignore this…
Thanks to the massive surge of speculative trading account openings, Chinese stocks are up 28% in the last month and a stunning 52% since China unleashed ‘QE-Lite’.
This has sent the total market capitalization of China’s stocks soaring relative to the rest of the BRICS.
In fact, Chinese stocks are now worth 55% more than Brazil, Russia, India, and South Africa combined… the most ever.
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It appears The PBOC needs to force delever again…
For some reason I feel like this is a good time to review what we can expect when our government and its agencies attempt to create wealth out of thin air. We can see the absurdity and hubris of our policymakers who believe they can circumvent economic laws in the following excerpt from the “The National Homeownership Strategy: Partners in the American Dream”. This is a document that was put together by HUD and some other private and public stakeholders at the request of President Clinton way back in 1995. Isn’t it amazing how poor policies that seem so right at the time, to some, end up kicking us in the ass for decades. And as much as the government has gotten comfortable with the storyline suggesting banks are responsible for the entire mortgage bubble mess of the mid 2000′s, it was, in fact, all started by government agenda. Have a look at this little gem which I am suggesting is the document that led us to the economic devastation from which we are yet to crawl out.
For many potential homebuyers, the lack of cash available to accumulate the required downpayment and closing costs is the major impediment to purchasing a home. Other households do not have sufficient available income to to make the monthly payments on mortgages financed at market interest rates for standard loan terms. Financing strategies, fueled by the creativity and resources of the private and public sectors, should address both of these financial barriers to homeownership.
And while we all love a bit of creativity in life, maybe best to avoid creativity in an effort to ignore risk fundamentals. Yet our government was certain it could defy gravity. A child could tell you that if a person doesn’t have sufficient money to pay back a loan, well they shouldn’t have a loan in the firsplace. And so to force banks to lend depositors’ money to borrowers who have neither the required down payment nor the cash-flow to cover monthly payments is simply absolute unadulterated stupidity. Most of us, if we had been made aware of that thought process, would have put a stop to it straight away.
So what lesson did we learn the hard way? Looking around today, absolutely nothing. Our government officials and policymakers continue to operate under the presumption they are gods, not subject to the laws of this world. Despite creating such immense devastation last time around they have actually convinced themselves that they are not responsible (evidenced by the $350 billion they have pillaged from the banks in the name of justice for having created the housing bubble). And so by not acknowledging their mistake it allows them to still believe they can make pigs fly. Specifically, the central bank is printing incredible stocks of money and pushing it directly into the stock market in an effort to create economic growth from nothing. Their storyline is that such a strategy will create so much wealth at the top that it will spill over onto the rest of society. They also believe there will be no consequence to printing an unprecedented supply of dollars despite the laws of economics very clearly telling us there most certainly will be consequences.
Now while they have managed to delay the inevitable devastation, it is coming. You see everything is a trade off. You can create long drawn out overpriced markets but ultimately fundamentals will trump all and the subsequent recalibration will be that much more painful. The fundamentals always come back into the equation. Like anything, if you want to reduce the iterations you can but each iteration will then be larger. Let me show you what I mean by reviewing historical market trends.
The following charts depict monthly returns (green line) and S&P price level (blue line) with a 24 month moving average (black line). Note each chart depicts a different time period. The first chart is 1950 to 1981, the second is 1981 to 1993 and the last chart is 1993 to present. I’ve separated them in this way because there are 3 very distinct characteristics that are present between the three periods. Look closely at the 24 month moving average and compare them across the three periods.
What we discover from the first chart is that between 1950 and 1980 we see very even cyclicality in the 2 year moving average of quite moderate positive peaks and negative troughs repeating every 2 or 3 years. However, subsequent to 1981 we see something quite different. Our 2 year moving average no longer has negative troughs. In fact, the 2 year moving average stays positive and very calm from the end of ’81 through to mid ’93. The third chart takes us into the extreme bubbles phase. Here we see a strong positive trend with more variation than in the previous phase but with intermittent significant drawdowns. This is different from the first phase where drawdowns were very regular but minimal in size and not catastrophic. Whereas in this latest phase we have much longer periods in between drawdowns but each drawdown is many times more severe than in the first phase.
So this all begs the question why? What caused the normal market cyclical iterations to change so significantly seemingly out of nowhere? Well think about Fed policy between the three phases. In the early phase our monetary policy was constrained by Bretton/Woods. The second phase coincides with Volker taking over as Fed Chair and implementing very tight monetary policy with a focus shift to inflation control and so limiting money supply expansion. The final phase corresponds with a very sharp increase in M2 expansion that continues today.
And so these variations in market trends seem to correlate to the underlying monetary policies. Certainly there are significant changes within the sophistication of the market itself however, human behaviour is the same over time and markets react to market forces the same way over time. And so what is different then are the underlying market forces. And we see three very distinct market trends indicating there are three very different underlying market forces between the three periods. Understanding these differences should make it easy to identify and acknowledge how monetary policy is affecting markets.
There is perhaps no natural best trend but the people should decide which market behaviour suits what we want out of a market and then apply the appropriate policies accordingly. If large bubble build ups followed by infrequent but devastating crashes is the objective well then it appears our policymakers are right on point. But let’s try to understand exactly what is taking place.
You can see the acceleration of M2 expansion in the mid 1990′s that has yet to slow down. But money supply is not the only major underlying economic shift. Thing is if we are allocating that money supply efficiently then economic growth would be extraordinary and that would support the notion of all time high markets. So let’s see how efficiently we are deploying our money.
We can see back in the ’60′s and ’70′s efficiency of money allocation was fairly steady around 1.75. Then into the Volker years money velocity improved slightly in the first half of the decade and then really took off toward the end of the ’80′s and into the first half of the ’90′s. However, monetary efficiency seems to have peaked around the time M2 money stock started into it’s hyper-acceleration phase in the mid 1990′s. Since then monetary efficiency has been a falling knife, yet to hit the ground. And if we look at the next chart it really ties this altogether for us.
Right up until the early to mid 1990′s we were allocating money to economic boosting investments. Things like fixed capital reinvestment. However, toward the mid ’90′s we began to reallocate money toward financial markets and away from economic investments. This trend too continues today. The end result is that our economic policymakers and really the consciousness of society is so narrowly focused on “The Market” that we seem uninterested in all things not securitized. And what this suggests is that once again our policymakers believe they can ignore economic laws. That they can somehow create economic growth from nothing.
Last time it was handing out houses to folks who had not earned those assets in hopes that would somehow become real. This time its printing endless amounts of dollars, sticking them in the stock market money machine and expecting that to somehow create economic prosperity to all. It is mind boggling that men with so much power can be so incredibly thick. The hubris is par for the course with such power, but one would not expect such stupidity. The real ugliness of it all is that while those on top will ultimately create more wealth from the coming devastation, the vast majority of Americans have been forced to play along. Forced to put their savings in the money machine that is now the only game in town.
And so when it does inevitably all come tumbling down only 6 years after the last policies failure, it will mean the end for so many. And because those stories would reflect poorly on the prominent men whose stupidity led to such destruction those stories will not be told with truth. They will be told as though retirees were taking outrageous risks late in life when everybody knows you should not be in the market. Just as it was the banks, the borrowers and the brokers who were solely responsible for the housing bubble that devastated so many, including the folks you never hear about who lost 30% equity in their homes but continued to quietly and responsibly pay their mortgages. Yes once again those responsible will profit from their misguided policies and will bear no accountability for the horrible consequences of their decisions. Ah yes, America…. ain’t she wonderful!