The BoE’s pre-emptive strike is not without risk

The Financial Times has kindly printed my letter below, arguing that it seems the default answer to almost any economic question has now become “more stimulus” from the central bank.

After 15 years of subprime lending and then quantitative easing, last week’s warning from the Bank of England suggests there are fewer and fewer economic questions to which the default answer is not “more stimulus”.

But it is still disappointing to find the Financial Times supporting this reflex reaction when considering the risks associated with Brexit next month (“Bank of England must grapple with the risks of a no-deal Brexit”, February 6). Nobody would dispute that the bank has a critical role in terms of ensuring financial stability through the Brexit transition. As the FT says, the “potential outcomes are discrete and the impacts vary widely”.

But the bank has already fulfilled this role by publishing its November assessment of the no-deal risks for government and parliament to consider. There is therefore no justification for the bank to pre-emptively impose its views by deciding to keeping interest rates artificially low.

The political risks associated with such an intervention would be large, particularly if the bank’s assessment or its proposed solution proves wrong. And there is also the risk of unintended consequences.

The history of stimulus does, after all, suggest that the only certain outcome of lower interest rates would be a further rise in today’s already sky-high level of asset prices.

Paul Hodges
The pH Report

Fed’s magic money tree hopes to overcome smartphone sales downturn and global recession risk

Last November, I wrote one of my “most-read posts”, titled Global smartphone recession confirms consumer downturn. The only strange thing was that most people read it several weeks later on 3 January, after Apple announced its China sales had fallen due to the economic downturn.

Why did Apple and financial markets only then discover that smartphone sales were in a downturn led by China?  Our November pH Report “Smartphone sales recession highlights economic slowdown‘, had already given detailed insight into the key issues, noting that:

“It also confirms the early warning over weakening end-user demand given by developments in the global chemical industry since the start of the year. Capacity Utilisation was down again in September as end-user demand slowed. And this pattern has continued into early November, as shown by our own Volume Proxy.

The same phenomenon had occurred before the 2008 Crisis, of course, as described in The Crystal Blog.  I wrote regularly here, in the Financial Times and elsewhere about the near-certainty that we were heading for a major financial crisis. Yet very few people took any notice.

And even after the crash, the consensus chose to ignore the demographic explanation for it that John Richardson and I gave in ‘Boom, Gloom and the New Normal: How the Western BabyBoomers are Changing Demand Patterns, Again’.

Nothing seems to change.  So here we are again, with the chart showing full-year 2018 smartphone sales, and it is clear that the consumer downturn is continuing:

  • 2018 sales at 1.43bn were down 5% versus 2017, with Q4 volume down 6% versus Q4 2017
  • Strikingly, low-cost Huawei’s volume was equal to high-priced Apple’s at 206m
  • Since 2015, its volume has almost doubled whilst Apple’s has fallen 11%

And this time the financial outlook is potentially worse than in 2008.  The tide of global debt built up since 2008 means that the “World faces wave of epic debt defaults” according to the only central banker to forecast the Crisis.

“WALL STREET, WE HAVE A PROBLEM”

So why did Apple shares suddenly crash 10% on 3 January, as the chart shows? Everything that Apple reported was already known.  After all, when I wrote in November, I was using published data from Strategy Analytics which was available to anyone on their website.

The answer, unfortunately, is that markets have lost their key role of price discovery. Central banks have deliberately destroyed it with their stimulus programmes, in the belief that a strong stock market will lead to a strong economy. And this has been going on for a long time, as newly released Federal Reserve minutes confirmed last week:

  • Back in January 2013, then Fed Governor Jay Powell warned that policies “risked driving securities above fundamental values
  • He went on to warn that the result would be “there is every reason to expect a sharp and painful correction
  • Yet 6 years later, and now Fed Chairman, Powell again rushed to support the stock market last week
  • He took the prospect of interest rate rises off the table, despite US unemployment dropping for a record 100 straight months

The result is that few investors now bother to analyse what is happening in the real world.

They believe  they don’t need to, as the Fed will always be there, watching their backs. So “Bad News is Good News”, because it means the Fed and other Western central banks will immediately print more money to support stock markets.

And there is even a new concept, ‘Modern Monetary Theory’ (MMT), to justify what they are doing.

THE MAGIC MONEY TREE PROVIDES ALL THE MONEY WE NEED

There are 3 key points that are relevant to the Modern Monetary Theory:

  • The Federal government can print its own money, and does this all the time
  • The Federal government can always roll over the debt that this money-printing creates
  • The Federal government can’t ever go bankrupt, because of the above 2 points

The scholars only differ on one point.  One set believes that pumping up the stock market is therefore a legitimate role for the central bank. As then Fed Chairman Ben Bernanke argued in November 2010:

“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 other set believes instead that government can and should spend as much as they like on social and other programmes:

“MMT logically argues as a consequence that there is no such thing as tax and spend when considering the activity of the government in the economy; there can only be spend and tax.

The result is that almost nobody talks about debt any more, and the need to repay it.  Whenever I talk about this, I am told – as in 2006-8 – that “I don’t understand”.  This may be true. But it may instead be true that, as I noted last month:

“Whilst Apple won’t go bankrupt any time soon, weaker companies in its supply chain certainly face this risk – as do other companies dependent on sales in China. And as their sales volumes and profits start to fall, investors similarly risk finding that large numbers of companies with “Triple B” ratings have suddenly been re-rated as “Junk”:

  • Bianco Research suggest that 14% of companies in the S&P 1500 are zombies, with their earnings unable to cover interest expenses
  • The Bank of International Settlements has already warned that Western central banks stimulus lending means that >10% of US/EU firms currently “rely on rolling over loans as their interest bill exceeds their EBIT. They are most likely to fail as liquidity starts to dry up”.

I fear the coming global recession will expose the wishful thinking behind the magic of the central banks’ money trees.

Stock markets risk Wile E. Coyote fall despite Powell’s rush to support the S&P 500

How can companies and investors avoid losing money as the global economy goes into a China-led recession?  That’s the key question as we enter 2019.  We have reached a fork in the road:

The central banks’ aim was set out in November 2010 by US Federal Reserve Chairman, Ben Bernanke:

“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.”

And the current Chairman, Jay Powell, rushed to calm investors on Friday by confirming this policy:

“We will be prepared to adjust policy quickly and flexibly and use all of our tools to support the economy should that be appropriate.”

His words confirm he equates “the economy” with the stock market, as the chart shows:

  • The Fed no longer sees its core mandate on jobs and prices as defining its role
  • Instead it has become focused on making sure the S&P 500 moves steadily upwards
  • Every time the S&P 500t flirts with breaking the lower “tramline”, the Fed rushes to its rescue

Like Wile E Coyote in the Road Runner cartoons, the Fed has used more and more absurdly complex strategies to try and keep the market going upwards.  But now it is very close to finding itself over the cliff edge.

CORPORATE DEBT IS THE KEY RISK FOR 2019

The Fed should have realised long ago that markets cannot keep climbing forever.  Instead, by printing $4tn of free cash, it has temporarily destroyed their key role of price discovery.  As a result:

  • Investors now have no idea if are paying too much for their purchases
  • Companies don’t know if their new investments will actually make money

We are heading almost inevitably to another  ‘Minsky Moment’ as I described in September 2008,:

“Earnings from the new investments prove too low to pay the interest due on the debt. Confidence in the ‘new paradigm’ disappears and, with it, market liquidity. Investors find themselves unable to sell the under-performing asset, and suddenly realise they have over-paid. In turn, this prompts a rush for the exits. Prices then begin to drop quite sharply, as ‘distress sales’ take place.

This time, however, the risk is in corporate debt, not US subprime lending.  As the charts above show:

  • The ratio of US corporate debt to GDP has reached an eye-watering 46%, higher than ever before
  • Lending standards have collapsed with most investment debt in the lowest “Triple B” grade

Investors’ obviously loved Powell’s confirmation on Friday that he is determined to cover their backs. But they may start to remember over the weekend that the cause of Thursday’s collapse was Apple’s problems in China – about which, the Fed can actually do very little.

And whilst Apple won’t go bankrupt any time soon, weaker companies in its supply chain certainly face this risk – as do other companies dependent on sales in China.  And as their sales volumes and profits start to fall, investors similarly risk finding that large numbers of companies with “Triple B” ratings have suddenly been re-rated as “Junk”:

  • Bianco Research suggest that 14% of companies in the S&P 1500 are zombies, with their earnings unable to cover interest expenses
  • The Bank of International Settlements has already warned that Western central banks stimulus lending means that  >10% of US/EU firms currently “rely on rolling over loans as their interest bill exceeds their EBIT. They are most likely to fail as liquidity starts to dry up”.

CHINA’S CORPORATE DEBT IS THE EPICENTRE OF THE RISK

As the chart shows, China’s corporate debt is now the highest in the world.  Yet it hardly existed before 2008, when China’s leadership panicked and began the largest stimulus programme in history.

The “good news” is that China’s new leadership recognise the problem, as I discussed in November 2017,  China’s central bank governor warns of ‘Minsky Moment’ risk.  The “bad news” – for the Fed’s desire to support the stock market, and for companies dependent on Chinese demand – is that they are determined to tackle the risk, having warned:

“China’s financial sector is and will be in a period with high risks that are easily triggered. Under pressure from multiple factors at home and abroad, the risks are multiple, broad, hidden, complex, sudden, contagious, and hazardous. The structural unbalance is salient; law-breaking and disorders are rampant; latent risks are accumulating; [and the financial system’s] vulnerability is obviously increasing.”

Companies and investors need to take great care in 2019.  China’s downturn means that markets are starting to rediscover their role of price discovery, despite the Fed’s efforts to keep waving its magic wand:

  • Companies with too much debt will go bankrupt, leading to the Minsky Moment
  • The domino effect of price wars and lower volumes will quickly hit other supply chains
  • Time spent today in understanding this risk will prove time very well spent later this year

Once the tramline is broken, the Fed and the S&P 500 will find themselves in Wile E Coyote’s position in the famous Road Runner cartoons – with nowhere to go, but down.