”History doesn’t repeat itself, but it often rhymes“, Mark Twain
Bob Farrell of Merrill Lynch was rightly considered one of the leading Wall Street analysts in his day. His 10 Rules are still an excellent guide for any investor. Equally helpful is the simple checklist he developed, echoing Mark Twain’s insight, to help investors avoid following the crowd:
He worried that emotion often caused investors to buy at peaks or sell at lows, due to following the herd
He identified how most equity market downturns ended with a 10% annual fall, and major downturns with a 20% fall
He also found that most rallies ended with a 20% gain, and major speculative blowoffs ended after a 40% gain
The above chart applies Farrell’s insight to the US 10-Year Treasury bond market, using Federal Reserve data for the monthly interest rate (NB rates move inversely to the price, so a higher yield means a lower price, and vice versa). We only have to adjust the downside levels, as most downturns end with a 20% fall, and major downturns with a 40% fall.
It is hard to overstate the importance of the 10-Year Bond. It is the benchmark interest rate for the global economy, and so should not suffer speculative blowoffs. In fact, it has only seen 2 blowoffs since 1973 – and both were due to the US Federal Reserve’s recent attempts to manipulate the market:
The first was during the 2008 Financial Crisis, when investors rushed for a “safe haven” after the subprime collapse
The second was after 2011, when the major central banks pushed rates lower during the Eurozone debt crisis
Both were followed by 20%+ falls, confirming Farrell’s Rule 1 – that “markets tend to return to the mean over time”
This suggests that Farrell’s simple checklist is a very powerful tool for an investor who wants to avoid being driven by market fear or greed. It also shows that today’s market is close to blowoff levels, with July seeing a peak after a 35% gain. Another warning of potential stress is that this rally ended with the interest rate at 1.5% – the lowest ever recorded by the Fed (the series goes back to 1953). Is this level really sustainable for a 10-year bond?
If not, the recent rally in the Treasury bond market could have been the last in the series. We may learn more from market reaction to the Fed and Bank of Japan’s meetings this week. Any change in sentiment could have important consequences for Emerging Markets and those in the developed world, as the Financial Times warned recently:
“Institutional investors across the developed world have been pouring money into emerging market assets at a rate of more than $20bn a month since the middle of this year — quite a turnround after the outflows that dominated much of the previous 12 months….the big imperative driving the flows comes from the more than $13tn of bonds in developed markets that now charge investors for the privilege of owning them”.
Investors are so desperate for yield, due to central bank interest rate policy, that they have abandoned their normal caution. Many have invested in countries which they would be hard-pressed to find on a map. Others have bought developed country bonds at higher and higher prices – assuming that interest rates will never, ever, rise again.
Of course, markets can always go higher temporarily. But the logic of Farrell’s Rule 1 suggests that developments in the US 10-Year bond market are warning us that the start of the Great Reckoning is not far away. As the Bank for International Settlements (the central bankers’ bank) warned yesterday:
“Developments in the period under review have highlighted once more just how dependent on central banks markets have become”
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 55%
Naphtha Europe, down 56%. “A build up in products supply has punctured refiners’ margin”
Benzene Europe, down 53%. “Pricing and consumption was expected to see an upturn this month following the lull in activity over the summer holiday period, but this has yet to materialise.”
PTA China, down 41%. “Lack of demand for spot cargoes”
HDPE US export, down 27%. “Exports in July accounted for roughly 23% of PE sales.”
S&P 500 stock market index, up 9%
US$ Index, up 18%
The Western BabyBoomers (born between 1946-70), have been one of the luckiest generations in history. By and large, they have escaped the major wars that have plagued society down the ages. They have also lived in a world where living standards and material wealth have made astonishing gains. Equally priceless has been the rise in life expectancy, which means the average 65 year-old can now expect to live another 20 years.
But politicians didn’t want to acknowledge the impact of this shift in life expectancy on the economy. Nor did central bankers want to reveal that it was demographics that created the long economic SuperCycle between 1983 – 2007 (when the US suffered just 16 months of recession in 25 years). That would have spoiled the myth of their genius, and the forecasting ability of their supposedly all-powerful Dynamic Stochastic General Equilibrium economic models.
Similarly, nobody rushed to have a conversation with the voters about the need for a major increase in pension age:
□ The UK introduced state pensions just a century ago in 1909, when life expectancy was just 50 years. Only 400k of the UK’s 40 million population were eligible to receive it
□ It was “social insurance” – “a small amount of money for a small number of people for a small amount of time”
□ Today, it has become a universal benefit, received by 17% of the population. And this proportion is set to rise as the Boomers move into retirement
Of course, no politician wanted to tell voters that pension age should be increased in line with life expectancy. Nor did they want to face the consequences of the post-1970 collapse in fertility rates. This means that in more and more countries,there are more people over the age of 65 than children under 15. And as Bloomberg notes:
“A shrinking workforce cannot foot the pension bill”.
CENTRAL BANKERS DON’T WANT TO ADMIT THEY WERE LUCKY, NOT CLEVER
But now, the Boomers’ luck is running out, at least in the UK. The warning sign was seen in 2008 with the financial crisis. This highlighted the fact that today’s ageing population are creating a “replacement economy”. Monetary policy is irrelevant when confronted with the fact that 65-year olds do not have the same spending power as when they were 35. Equally important is that they now own most of the things they were buying when they were younger.
But it would be too embarrassing for central bankers to admits they had been lucky rather than clever.
Now the Brexit vote is bringing the chickens home to roost. Last week, the Bank of England put on its “Superman” tunic again – deciding to take interest rates even lower, and weaken the value of the pound.
They chose to ignore the fact that their action probably created a “disaster scenario” for pension funds.
The interest rate for government borrowing is the major factor in determining the solvency of any pension scheme. And a zero, or negative, rate for government bonds makes it almost impossible for a pension fund to meet its commitments to pensioners. The chart above, based on new data from the official Pension Protection Fund highlights the problem:
□ Massive funding deficits have developed since the Bank began its stimulus programme in 2009
□ More than 4 out of 5 defined benefit corporate pension funds are now in deficit – 84%
□ Their total deficit (including the surplus schemes) increased in July to £408bn ($530bn)
□ They were then only 77.4% funded – and the situation will be worse today due to the further decline in interest rates
As the former Pensions Minister, Ros Altmann, told the Financial Times yesterday:
“The Bank wants to stimulate the economy by bringing down interest rates, but the Bank is not acknowledging the negative impact these measures are having on pension deficits, and neither is the government.”
As Altmann warns, this deficit will have real world consequences. Either employers will have to increase their contributions, or pensioners will not get their promised pensions. Both outcomes will have negative consequences for the UK economy, as they will either reduce company profitability or reduce pensioners’ future spending power.
One also cannot ignore the potential for political fall-out if pension funds fail to meet their commitments to pensioners.
The problem is that the Bank – like its peers in Europe, USA and Japan – loves to be the centre of attention. It therefore chooses to ignore the fact that by creating further artificial demand for gilts in the short-term, it is creating major economic and political risks for the medium and longer term. And as we all know, there is a moment when a medium-term risk becomes short-term reality.
We may not be too far away from that moment now, as millions of pensioners start to realise their pension funds may well go bankrupt.
It may be an idea to keep your smartphone charged and within reach, if you are planning a trip to the beach this month. Certainly market behaviour since June has been more and more skittish. The experts, after all, were telling us that central banks were certain to do more major stimulus efforts to boost stock and commodity prices: they were also sure that the US economy was poised to do well.
Instead, we have had minimal stimulus from the European Central Bank (ECB) and Bank of Japan (BoJ), whilst the US Federal Reserve was clearly taken by surprise with Friday’s weak GDP news for Q2.
Now investors are beginning to worry that the central banks are out of stimulus ammunition, and have very little further room for manoeuvre. Japan has suddenly become the “weak link” in the chain:
Its interest rates have risen sharply since Friday when the BoJ disappointed markets with only minor policy moves
The benchmark 10-year bond is almost yielding a positive amount, after offering only negative yields since March
Some traders now even worry that the BoJ may have to raise interest rates to protect the banking sector
There was a similar state of confusion at the ECB last month, when markets were told to wait until after the holidays for any further stimulus.
So traders have gone on holiday leaving a vacuum behind them. And as we all know, “nature abhors a vacuum”. Oil prices are thus becoming a key indicator for the financial sector:
They are now down $11/bbl since their early June peak, a 21% fall
Their attempts to rally are being beaten back by news of ever-higher supply gluts in oil and products
And even though the US$ has weakened sharply over the past week, the hedge funds are not moving back into the market, as has always happened in recent years, when they believed that “weak dollar = higher oil prices”
So we could now be watching the second stage of the Great Unwinding in action. The first stage began nearly 2 years ago, when the dollar began to rise and oil prices to collapse. Now we may be seeing markets start to ignore the actions of central banks, and instead focus for the first time since 2008 on the fundamentals of supply and demand. If they do this, they may not like what they see:
Oil markets have record levels of inventory all around the world
Traders have become nervous about buying shares with borrowed money in the New York stock market
Developments in the European debt and refugee crises are also not encouraging
Plus there is increasing nervousness around the world over the outlook for the US Presidential election
As always, the IeC Boom/Gloom Index is highlighting the potential turning point. Although the S&P 500 has recently made a new all-time high, the Index did not confirm the higher numbers. Instead, it has retreated to just above the 4.0 level which has signalled pullbacks in the past.
If this proves accurate, and oil prices keep tumbling, then we may have a busy month ahead.
Oil markets are entering a very dangerous phase. Already, many US energy companies have gone bankrupt, having believed that $100/bbl prices would justify their drilling costs. Now the pain is moving downstream.
The problem is the central banks. Hedge funds have piled into the oil futures markets since January, betting that there would be lots more free cash from the Bank of Japan and the European Central Bank. They also gambled correctly that the US Federal Reserve and Bank of England would back off the idea of interest rate rises.
So, once again, markets have lost their role of price discovery, based on the fundamentals of supply and demand. Instead, prices have jumped 50% in 2 months, as financial speculators have rushed to buy oil in the futures markets:
- As Reuters noted at the beginning of March, “Hedge funds have switched from a very bearish view on crude oil prices at the end of last year to a much more bullish one“
- The red line in the chart highlights the dramatic shift that has taken place
- By 1 March, they had created a 445 million barrels net long position – equal to 5 days of total world demand
- They added 61mbbls in just the first week of March, building their longest position since the summer
This move had nothing to do with the fundamentals of supply and demand, which are still getting worse, not better.
As I describe in the video interview with ICIS deputy news editor, Tom Brown, the rally mirrors what happened a year ago in the SuperBowl rally – when traders put about the story that a fall in the number of US drilling rigs would reduce production. Of course that didn’t happen, because the rigs are becoming very much more productive.
But the hedge funds did’t care about that – they simply knew there was money to be made as the central banks handed out vast quantities of free cash.
Now the central banks are doing it again. And so, once again, oil prices have jumped 50% in a matter of weeks, along with prices for other major commodities such as iron ore and copper, as well as Emerging Market equities and bonds. In turn, this will force companies to buy raw materials at today’s unrealistically high prices, as the seasonally strong Q2 period is just around the corner. Some may even build inventory, fearing higher prices by the summer.
If this happens, and prices collapse again as the hedge funds take their profits, many companies will face the risk of bankruptcy as we head into Q3. They will be sitting on high prices in a falling market – just as happened in January. Only Q3 could be worse, being seasonally weak, and so it may take a long time to work off high-priced inventory.
We cannot stop the central banks handing out free cash to their friends in the hedge fund industry. They think high commodity prices are good news, as they might create inflation and reduce the real cost of central bank debt. All companies and genuine investors can do is to instead avoid taking any positions, long or short.
As experienced poker players say, “If you don’t know who the sucker is at the poker table, then it is probably you”.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 62%
Naphtha Europe, down 58%. “Petrochemical cracker margins drop off”
Benzene Europe, down 55%. “The upward momentum on crude oil was keeping the market volatile, and perhaps also limiting any spot trading as players waited for clearer direction.”
PTA China, down 42%. “Dips in upstream crude oil and energy prices in the first part of the trading week exerted downward pressure on PTA prices”
HDPE US export, down 35%. “Expectations of tightening supply because of the onset of the plant turnaround season.”
¥:$, down 9%
S&P 500 stock market index, up 5%
3 years of massive stimulus spending in Japan has had no impact on the problem it was supposed to solve. This is highlighted by new government data on household spending for 2015, as the charts above confirm – they compare 2015 data with that for 2012, before Abenomics began:
- Spending was almost exactly the same at every age group in 2015 versus 2012, when premier Abe took office
- Spending in the peak age range of 50 – 59 was just ¥250/year higher, and ¥7900 lower in the 40 -49 age group
- It still declines 31% once people reach the age of 70 – critically important with Japan’s ageing population
- In US$ terms, of course, the numbers are lower due to Abe’s focus on devaluing the yen since he took office
- US$ spending in the two peak age groups of 40 – 49, and 50 – 59, has fallen by $15k/year to $29k/year
This matters, because consumer spending is 60% of Japanese GDP.
The quite scary result is that the Bank of Japan has spent ¥200tn ($1.84tn) since Abe came to power on its quantitative easing programme. Yet the Abenomics policy has completely failed to achieve its major objectives of boosting GDP and inflation:
As a result, Japan now has the world’s highest level of government debt as a percentage of GDP at 226%.
Yet premier Abe and Bank of Japan Governor Kuroda refuse to accept that their policies have failed. Instead, just like the European Central Bank yesterday, they have decided to implement their policies on a greater scale. Thus Japan introduced negative interest rates in January, meaning that the Bank now charges you to deposit money with it.
Clearly these are increasingly desperate measures, which have a vanishingly small chance of being successful. Past performance is no guarantee of future results, but it is usually the best guide that we have. And understandably, Japan’s Diet (its parliament) is becoming very concerned – Governor Kuroda has been summoned for questioning a record 25 times so far this year.
One major concern is that Japan’s value proposition for foreign investors is looking increasingly unattractive:
- Foreigners have to pay the government to lend it money (and so are guaranteed to get back less than they lend)
- They also know devaluation remains a key policy, meaning that the return in their currency will probably be lower
- And GDP growth is almost impossible with Japan’s median age now 47 years and its population will decline 600k/year by 2020
Premier Abe initially promised that he would restore the country to growth within 2 years, and push inflation to at least 2%. Today, 3 years later, his Abenomics policies have entered the end-game. Some investors will no doubt continue to maintain positions in Japan, as it is still the world’s 3rd largest economy.
But they will no doubt be keeping a close eye on their exit opportunities. When the rush starts, nobody will want to be left behind.
The Financial Times has kindly printed my letter below
, arguing that central bank stimulus can’t restore growth to previous Super Cycle levels.
Sir, John Plender’s excellent analysis “Central banks’ waning credibility is the real threat to confidence
” (Insight, February 17) highlights the need for a new narrative to explain the economic slowdown of recent years.
It was always rather surprising that investors ever believed central banks could control the economic destiny of the world’s 7.3bn people, simply by adjusting short-term interest rates and printing electronic money.
Instead it is perhaps time to rehabilitate Masaaki Shirakawa, former governor of the Bank of Japan, who was retired in 2013 by prime minister Shinzo Abe’s new government. His argument that demographics drive demand, not central bank money-printing, has certainly stood the test of time. Common sense, after all, suggests that a paradigm shift has been under way in the global economy since 2001, when the oldest baby boomers joined the low-spending, low-earning ‘new old’ 55-plus generation.
The boomers were the largest and wealthiest generation in history, and it was no surprise they created an economic supercycle during the 1980s as they moved into the wealth creator 25-54 age group, when incomes rise exponentially and people often settle down and have families.Now we are seeing the downside of this process, as the boomers also have the longest life expectancy in history.
UN data suggest that a record one in five of the world’s population will be new olders by 2025, while the collapse in global fertility rates (which have halved to just 2.5 babies/woman since 1950), means that relatively fewer wealth creators are now supporting an increasing number of new olders. Central bank stimulus programmes have succeeded in temporarily boosting the prices of financial assets, at the cost of increasing the debt burden for the future. But in terms of demand growth they are impotent, as they cannot print babies.