Companies and investors have some big decisions ahead of them as we start the second half of the year. They can be summed up in one super-critical question:
“Do they believe that global reflation is finally now underway?”
The arguments in favour of this analysis were given last week by European Central Bank President, Mario Draghi:
“For many years after the financial crisis, economic performance was lacklustre across advanced economies. Now, the global recovery is firming and broadening…monetary policy is working to build up reflationary pressures…we can be confident that our policy is working and its full effects on inflation will gradually materialise.”
The analysis has been supported by other central bankers. The US Federal Reserve has raised interest rates 3 times since December, whilst the Bank of England has sent the pound soaring with a hint that it might soon start to raise interest rates. Most importantly, Fed Chair Janet Yellen told a London conference last week that she:
“Did not expect to see another financial crisis in our lifetime”.
The chart above from Nobel Prizewinner Prof Robert Shiller confirms that investors certainly believe the reflation story. His 10-year CAPE Index (Cyclically Adjusted Price/Earnings Index) has now reached 30—a level which has only been seen twice before in history – in 1929 and 2000. Neither were good years for investors.
Even more striking is the fact that veteran value-investor, Jeremy Grantham, now believes that investors will have “A longer wait than any value manager would like, including me” before the US market reverts to more normal valuation metrics. Instead, he argues that “this time seems very, very different” – echoing respected economist Irving Fisher in 1929 who suggested “stock prices have reached what looks like a permanently high plateau“.
But are they right?
One concern is that central bankers might be making a circular argument. We saw this first with Fed Chair Alan Greenspan, who flooded stock markets with free cash before the dot-com crash in 2000, and then flooded housing markets with free cash to cause the subprime crash in 2008. His successor, Ben Bernanke continued the free cash policy, arguing in November 2010 that boosting the stock market was critical to the recovery:
“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
The second chart highlights how the Fed’s zero interest rate policy has driven the rally since the US S&P 500 Index bottomed in March 2009:
Margin debt in the New York market (money borrowed to invest in stocks) is at an all-time record of $539bn ($2017)
It has increased 197% since March 2009, almost exactly matching the S&P’s rise of 216%
Stock market capitalisation (the total value of stocks) versus GDP is close to a new all-time high at 133%
Meanwhile, the Bank of Japan now owns 2/3rds of the entire Japanese ETF market (Exchange Traded Funds). And the Swiss National Bank owns $100bn of US/European stocks including 26 million Microsoft shares.
Unsurprisingly, given central bank policies, the world is now awash with debt. New data from the Institute of International Finance shows total world debt has now reached $217tn – more than 3x global GDP. As a result, respected financial commentator Andreas Evans-Pritchard argued last week:
“The Fed caused the dotcom bubble in the 1990s. It caused the pre-Lehman subprime bubble. Whatever Ms Yellen professes, it has already baked another crisis into the pie. The next downturn may be so intractable that it calls into question the political survival of capitalism. The Faustian pact is closing in.”
Evans-Pritchard’s concern is echoed by Claudio Borio, head of the central bankers’s bank – the Bank for International Settlements (BIS). Under his predecessor, William White, the BIS was the only central bank to warn of the subprime crisis. And Borio has warned:
“Financial booms can’t go on indefinitely. They can fall under their own weight.”
WHO IS RIGHT – THE CENTRAL BANKS OR THEIR CRITICS?
This is why companies and investors have some big decisions ahead of them. Of course, it is easy to assume that everything will be just wonderful, when everyone else seems to believe the same thing. Who wants to spoil the party?
But then there is the insight from one of the world’s most famous analysts, Bob Farrell, captured in the headline to this post. The chart of The pH Report’s Boom/Gloom Index highlights how the concept of the Trump reflation trade has sent the S&P into an exponential rally – even whilst sentiment, as captured in the Index, has been relatively subdued.
You could argue that this means the market can continue to go higher for years to come, as Grantham and the central banks believe. Or you could worry that “the best view is always from the top of the mountain” and that there are now very few people left to buy. And you might also be concerned that:
Political uncertainty is rising across the Western world, as well as in the Middle East and Latin America
Oil prices are already in a bear market
China’s growth and lending is clearly slowing
And Western central banks also seem set on trying to unwind their expansionary policies
We can all hope that today’s exponentially rising markets continued to rise.
But what would happen to your business and your investments if instead they began to correct – and not by going sideways? It might be worth developing a contingency plan, just in case.
Will 2014 turn out to be a repeat of 2008 for the US economy?
6 years ago, after all, not a single mainstream forecaster – including the IMF and World Bank – was forecasting a recession. Even in September 2008, the consensus was still confident about the economic outlook. Yet the National Bureau for Economic Research later confirmed the official start of the recession as being December 2007.
Interestingly, a number of the same people who were wary of the outlook in 2008 are equally wary today. Thus Nobel Prize-winner Robert Shiller warned last week:
“I am definitely concerned. When was [the cyclically adjusted P/E ratio or CAPE] higher than it is now? I can tell you: 1929, 2000 and 2007. … We don’t know what it’s going to do. There could be a massive crash, like we saw in 2000 and 2007, the last two times it looked like this. But I don’t know. … One thing though, I don’t know how many people look at plots of the market. If you just look at a plot of one of the major averages in the U.S., you’ll see what look like three peaks – 2000, 2007 and now – it just looks to me like a peak. I’m not saying it is. I would think that there are people thinking that way – it’s gone way up since 2009. It’s likely to turn down again, just like it did the last two times.”
And, of course, there is the fact that Q1 GDP was a negative 2.9%. Of course, all the professional optimists immediately told us that this was just due to bad weather, and we would see an immediate and sustained recovery. They may turn out to be right, of course. But it seems many forecasts are now quietly being revised down..
The Bank for International Settlements (BIS, the central bankers’ bank) has also warned explicitly of the dangers for the global economy:
“Obviously, market participants are pricing in hardly any risks….Financial markets are euphoric, but progress in strengthening banks’ balance sheets has been uneven and private debt keeps growing. Macroeconomic policy has little room for manoeuvre to deal with any untoward surprises that might be sprung, including a normal recession.”
The BIS issued similar warnings in July 2007 and July 2008 which were, as now, mostly ignored.
The key issue is complacency. Markets believe that central banks would never again make the mistake of allowing a Lehman Brothers to go bankrupt. Therefore they believe that it is perfectly safe to chase stock prices higher and higher. As the above chart of the IeC Boom/Gloom Index shows:
- The US S&P 500 Index is making new highs month by month, despite bad news on the real economy (red line)
- The key is the liquidity programmes from the US, Europe and Japan, which provide free cash to investors
- But the Index itself seems likely to have peaked in March (blue column)
It is also not hard to identify a catalyst for a future panic as investors insist on continuing to wear their rose-tinted spectacles. They seem totally unaware of the massive potential downside that could be inflicted on an over-leveraged global economy by the unwinding now underway of China’s ‘collateral trade’.
The reason is they have completely failed to understand that China has abruptly changed economic course under its new leadership. President Xi and Premier Li know only too well that disaster could follow if they continue with the old policies of stimulus-led growth. Thus on a tour of central China last week, premier Li brushed aside concerns from senior province governors that:
“The aluminum, coal and steel sectors are still suffering heavy losses. … Lending rates, especially for smaller businesses, have grown by at least 20% on average,” and that ”footwear and textile exporters are struggling with weak foreign demand”.
This is a major development in the world’s second largest economy. But nobody talks about it, or its possible consequences.
Maybe Shiller is wrong to be worried. Maybe the BIS is also wrong. But they were right before when everyone else was wrong. And if they are right again, then as the BIS has also warned, central banks now “have little room for manoeuvre to deal with any untoward surprise”.
WEEKLY MARKET ROUND-UP
The blog’s weekly round-up of Benchmark price movements since January 2014 is below, with ICIS pricing comments:
PTA China, flat 0%. “Buying interest for higher-priced cargoes were curbed by prevailing weak downstream demand”
US$: yen, down 3%
Brent crude oil, up 2%
Benzene, Europe, up 6%. “Several players in Europe are uncertain whether prices are sustainable at current levels”
Naphtha Europe, up 6%. “Europe is structurally long on naphtha and has to export to petrochemical markets in Asia and the gasoline sector in the US”
S&P 500 stock market index, up 8%
HDPE US export, up 7%. “International buyers are not interested in building inventory at high prices”
William White was the only central banker to publicly warn of the risks to the world economy long before the Crisis, when he was chief economist of the Bank for International Settlements (the central bankers’ bank). He also warned of the problems that would be caused by their stimulus programmes as early as September 2009.
A blog reader has now kindly forwarded a lengthy interview with him in Swiss journal Finanz und Wirtschaft where White confirms all the blog’s fears about the current outlook.
The brief extracts below will give you a sense of the dangers that White now sees ahead. You can read the full article by clicking here. Please circulate it as widely as you can.
“William White is worried. The former chief economist of the Bank for International Settlements is highly sceptical of the ultra loose monetary policy that most central banks are still pursuing. «It all feels like 2007, with equity markets overvalued and spreads in the bond markets extremely thin», he warns.
“The honest truth is no one has ever seen anything like this. Not even during the Great Depression in the Thirties has monetary policy been this loose. And if you look at the details of what these central banks are doing, it’s all very experimental. They are making it up as they go along. I am very worried about any kind of policies that have that nature.
“….. The Fed has moved to a completely different motivation. From the attempt to get the markets going again, they suddenly and explicitly started to inflate asset prices again. The aim is to make people feel richer, make them spend more, and have it all trickle down to get the economy going again. Frankly, I don’t think it works, and I think this is extremely dangerous.
“…..You see, we have a lot of zombie companies and banks out there. That’s a particular worry in Europe, where the banking sector is just a continuous story of denial, denial and denial. With interest rates so low, banks just keep evergreening everything, pretending all the money is still there. But the more you do that, the more you keep the zombies alive, they pull down the healthy parts of the economy. When you have made bad investments, and the money is gone, it’s much better to write it off and get fifty percent than to pretend it’s still there and end up getting nothing. So yes, we need more debt reduction and more recapitalization of the banking system. This is called facing up to reality.
“…. It all looks and feels like 2007. And frankly, I think it’s worse than 2007, because then, it was a problem of the developed economies. But in the past five years, all the emerging economies have imported our ultra-low policy rates and have seen their debt levels rise. The emerging economies have morphed from being a part of the solution to being a part of the problem.
“….Investors try to attribute the rising stock markets to good fundamentals. But I don’t buy that. People are caught up in the momentum of all the liquidity that is provided by the central banks. This is a liquidity driven thing, not based on fundamentals.
“…..This is the last of a whole series of bubbles that have been blown. In the past, monetary policy has always succeeded in pulling up the economy. But each time, the Fed had to act more vigorously to achieve its results. So, logically, at a certain point, it won’t work anymore. Then we’ll be in big trouble. And we will have wasted many years in which we could have been following better policies that would have maintained growth in much more sustainable ways. Now, to make you feel better, I said the same in 1998, and I was way too early.
“…..The one person in the US Federal Reserve that was kicking up a real fuss about asset bubbles was Governor Jeremy Stein. Unfortunately, he has gone back to Harvard.
“….. I’ve met so many people who are in the markets, thinking they are absolutely brilliantly smart, thinking they can get out in the right time. The problem is, they all think that. And when everyone races for the exit at the same time, we will have big problems. I’m not saying all of this will happen, but reasonable people should think about what could go wrong, even against a backdrop of faster growth.
“…At the moment what I am most worried about is Japan…. The reason I worry now is that they are much further down the line even than the Americans. What is Abenomics really? As far as I see it, they print the money and tell people that there will be high inflation. But I don’t think it will work. The Japanese consumer will say prices are going up, but my wages won’t. Because they haven’t for years. So I am confronted with a real wage loss, and I have to hunker down. At the same time, financial markets might suddenly not want to hold Japanese Government Bonds anymore with a perspective of 2 percent inflation. This will end up being a double whammy, and Japan will just drop back into deflation…..I have no difficulty in seeing this thing tipping overnight into hyperinflation. If you go back into history, a lot of hyperinflations started with deflation.
“….Housing tends to be the big thing that goes wrong when you have too easy financial conditions.”
Stock markets soared after the eurozone meeting this week. But the head of the German central bank warned “The envisaged leverage instruments are similar to those which were among the origins of the crisis, because they temporarily masked the risks.”
It is clearly far too early to assume that EU leaders have really decided to take the difficult decisons necessary to restore long-term financial health. The key issue remains Italy, where major doubts remain over the government’s willingness, as well as ability, to make the major cuts necessary to reduce its borrowing to manageable levels.
Unsurprisingly, international lending to Greek banks has dropped quite sharply over the past 12 months, according to latest data from the BIS (Bank for International Settlements). As the chart shows, it was $111bn at the end of June, compared to $174bn in June 2010, and $182bn in December 2009, when the blog first discussed the problem.
Greece of course continues to borrow the same amounts. Instead, it now borrows from the European Central Bank. This means Eurozone taxpayers are standing directly behind the loans, rather than indirectly when the loans were made by the big commercial banks.
This seems to confirm June’s analysis of how the issue will play out:
• Greece will remain in “can’t pay, won’t pay” mode
• Germany will get even more upset about paying Greece’s bills
• Private investors will continue to pass their Greek debt to governments
• The ECB will worry about default, and its own stability if this occurs
The politicians’ habit of ‘kicking the can down the road’ is not solving the key issues. Rather, it is increasing the overall economic cost, and the political risk associated with this.
Meanwhile, European commercial bank loans to the 2 major economies under pressure – Italy and Spain – were $1388bn. This is lower than December 2009’s $1753bn, but an increase since December 2010’s $1326bn. This perhaps explains investors’ underlying nervousness about what happens when the politicians finally have to confront reality.
TUESDAY UPDATE. Greece’s decision to hold a referendum on its austerity plan highlights the fragility of the political consensus behind the current eurozone plans.