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.
Italy was one of the 6 founding members of the European Union (EU) in 1957, along with France, the Netherlands, W Germany, Belgium and Luxembourg. Its referendum next month will therefore be a critical test of whether the Eurozone and EU can survive the pressure from the Populists.
If the Populists win, then the future of the Eurozone and the EU itself will be in doubt.
As often happens at critical moments, the subject of the referendum is of relatively minor importance. It was called by Premier Matteo Renzi to amend the constitution by approving a reform of Italy’s Parliament. The problem is that he then made himself the key issue in the referendum, by promising to resign if he lost, as he confirmed to Italian media last week:
“If the citizens vote no and want a decrepit system that does not work, I will not be the one to deal with other parties for a caretaker government”
Italy is now in a 2 week blackout period for polling before the vote on 4 December. But the final polls showed the “No vote” with a comfortable lead. There is therefore a major risk that Renzi will soon be following UK premier Cameron out of office. 3 quite different Scenarios could then develop:
Another premier takes over. Italian premiers have historically not lasted long. Before Renzi took over in 2014, there had been over 50 different premierships since Italy’s first post-War premier, Alcide de Gasperi, resigned in 1954. So maybe, the revolving door revolves again, and a new premier is appointed by the President
New elections are held, and another premier takes over. Renzi was the 3rd Italian premier in a row to take office without have a personal mandate from an election (neither Mario Monti or Enrico Lette had this). An election may therefore take place, after which perhaps the revolving door revolves again
New elections are held and an anti-euro coalition takes office. This would seem to be the base case Scenario, with a probability of at least 50%. It would likely means that Beppe Grillo’s anti-euro 5 Star Movement would take office with Berlusconi’s Forza Italia and the Northern League, and would then hold a referendum on leaving the euro – with the aim of capping Italian debts and nationalising its banks, as Grillo has promised
Given that around €360bn ($400bn) of all Italian loans are classed as “troubled”, and amount to around one-fifth of total loans, capping the debts would cause major disruption to the Eurozone and global financial systems. Leaving the euro would also mean, that foreign holders of Italian debt would be paid in Italian lira, not euros. And presumably this would be after a devaluation of the lira. So as the Financial Times warned on Monday:
“Since banks do not have to hold capital against their holdings of government bonds, the losses would force many continental banks into immediate bankruptcy. Germany would then realise a massive current account surplus also has its downsides. There is a lot of German wealth waiting to be defaulted on.”
DEMOGRAPHIC REALITY IS NOW CONFRONTING STIMULUS FANTASY
Italy’s real problem is not its Parliament, but that its economic policies haven’t adjusted to the New Normal world. Like most developed countries, politicians of all parties have failed since the end of the BabyBoomer-led SuperCycle, to understand the trade-off that has taken place between increased life expectancy and economic growth. Italy has a median age of 45 years, and as the chart above shows:
It now has only 24m in the Wealth Creating 25 – 54 cohort, versus 22m New Olders in the 55+ cohort
By 2030, it will have just 20m Wealth Creators and 26m New Olders
This is completely different from the 1950 position, when there were 18m Wealth Creators and only 8m New Olders
In addition, of course, Italy has become the main route for migrants and refugees following the EU’s deal with Turkey. 168k people have already arrived this year, compared to 154k in the whole of 2015 and 170k in 2014. Resources have been further strained by the sequence of earthquakes, which are made worse by the lack of anti-seismic regulations for its buildings.
It is small wonder, therefore, that the 5 Star Movement is building support, having won Rome in this year’s elections, whilst the Lega Nord (Northern League) won the Veneto and Lombardy regions.
Nor is it surprising that investors are starting to panic. As I discussed on Monday, Italy’s 10 year interest rate has doubled to 2% since the summer. It could go very much higher if Renzi loses, as the prospect of a vote to leave the eurozone and cap Italy’s debts comes closer.
This is the Great Reckoning in action, and there is probably little that the European Central Bank (ECB) can do to mitigate the position. In a few weeks’ time, investors may well wonder how they allowed Italian interest rates to trade below US rates for much of the past few years. And in a few months’ time, it may well seem equally incredible that anyone ever believed ECB’s President Mario Draghi’s 2012 boast that:
“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”.
It could be a very difficult H1 in 2017. Next month’s Italian referendum is followed in March by Dutch elections and in May by France’s Presidential election. Both may well be won by parties committed to leaving the EU itself.
It is therefore hard to ignore the possibility that by June, the EU could have effectively ceased to exist in its current form. Developing a contingency plan, in case this develops, could well be the wisest move you make in 2016.
TIME magazine covers often capture the mood of a moment. And that was certainly true in February 1999, with their now famous cover picturing then US Federal Reserve Chairman, Alan Greenspan, under the heading “The Committee to SAVE the World“.
In a further sign of the times, Greenspan was flanked by the US Treasury Secretary and his Deputy, Robert Rubin and Lawrence Summers. The message was clear – the central bank led, and the government followed. And their remit was indeed global, as Time commented:
“As volatility has upset foreign markets and economic models, the three men have forged a unique partnership to prevent the turmoil from engulfing the globe”.
The cover set the pattern for the next 15 years:
“Dotcom crisis in 2000″ – call for Greenspan; “Subprime crisis in 2008″ – call for his successor, Bernanke
Regional crises were the same. “Eurozone debt crisis in 2012” – call for ECB President, Draghi; Japanese deflation in 2013 – call for Bank of Japan Governor, Kuroda; “Brexit crisis in 2016″ – call for Bank of England governor, Carney
But now, it seems that its not just the UK markets that are losing faith in their former super-heroes:
US 10 year rates have risen by a third from their July low to 1.8%
German rates have gone from a negative 0.2% to a positive 0.06%
Even Japanese rates have risen from a negative 0.3% to a negative 0.05%
These are major moves in such a short space of time, especially when one remembers these bonds are supposed to be “risk-free”. Clearly markets are starting to worry that they may not be “risk-free” after all.
In the past, the central banks had made the task of managing the global economy seem very easy. These incredibly powerful men (and today, one woman), seemed able to resolve any financial crisis with a nod and a wink to their friends in the markets, backed up by an interest rate cut and a round of money-printing.
And, of course, markets wanted to believe what they were being told. After all, hadn’t Greenspan invented the “Greenspan put”? This was a phrase derived from the Options market, which meant traders knew he would ride to the rescue if ever markets looked like falling out of bed.
It is true that sometimes (as with subprime) central banks appeared rather slow to realise that a crisis was brewing. But as soon as they did notice, they went straight into action to make sure prices went straight back up again, as Greenspan’s successors followed “The Master of the Universe’s” teaching.
His departure was followed by the “Bernanke put”, and then the “Yellen put”, when Janet Yellen took over at the Fed. Traders therefore learnt to borrow as much as possible after 2000, as Doug Short’s chart shows of margin debt on the New York Stock Exchange. Being bold was best, when you knew the central bank would always cover your back.
But today, many traders worry that their super-heroes can’t actually create the promised growth? They wonder how governments can pay back the vast sums of money they have borrowed for the monetary experiment? How would markets react if, one day, a major economy proved unable or unwilling to pay its debts?
And they are not alone in worrying. Even the IMF has woken up to the fact that borrowing has now doubled to $152tn since 2000, and is still rising. 15 years is, after all, a long time for an experiment to run, without producing the expected results. At some point, the funding tap must be turned off.
This is the Great Reckoning in action. Clearly some traders and investors now don’t believe that monetary policy can deliver the promised results. And as I noted on Friday, even one of the US Federal Reserve Banks has now come close to accepting our argument that demographics – not central banks – really drive the global economy.
Last week as the BBC reported, Bank of England Governor, Mark Carney, explained to an audience in Birmingham that the Bank had saved the UK economy after the Brexit vote in June:
“Between 400,000 and 500,000 jobs could have been at risk if the Bank had not taken action after the referendum, he said. ”We are willing to tolerate a bit of an overshoot [on inflation] to avoid unnecessary unemployment. We moved interest rates down to support the economy.””
Imagine that! How wonderful, that one man and his Monetary Policy Committee could save “between 400,000 and 500,000 jobs“, just with a speech, an interest rate cut, and more money-printing.
There was only one problem, as the chart above shows. Markets didn’t applaud by buying more UK government bonds and so reducing interest rates. They sold off again (red line)*, panicked by the idea that debt was rising whilst growth was slowing and the currency falling (blue line):
Interest rates had fallen after the June 23 vote, as traders bet that Carney would add more stimulus
They fell to 1.09% on June 24, and then to 0.65% after his August confirmation that this was underway
But then, in a departure from the Bank’s script, they bottomed at 0.53% a week later, and began to rise
Premier Theresa May caused further alarm at the Conservative Conference, suggesting Brexit might be for real
They closed on Friday after Carney’s speech at 1.1% – nearly twice the August level, and above the June 24 close
Over the weekend, traders were then able to read the previously unpublished comments of Foreign Secretary, Boris Johnson, on the implications of a Brexit vote:
“There are some big questions that the “out” side need to answer. Almost everyone expects there to be some sort of economic shock as a result of a Brexit. How big would it be? I am sure that the doomsters are exaggerating the fallout — but are they completely wrong? And how can we know?
“And then there is the worry about Scotland, and the possibility that an English-only “leave” vote could lead to the break-up of the union. There is the Putin factor: we don’t want to do anything to encourage more shirtless swaggering from the Russian leader, not in the Middle East, not anywhere.
“And then there is the whole geostrategic anxiety. Britain is a great nation, a global force for good. It is surely a boon for the world and for Europe that she should be intimately engaged in the EU. This is a market on our doorstep, ready for further exploitation by British firms: the membership fee seems rather small for all that access.
“Why are we so determined to turn our back on it?”
Its just a pity that it was left until now for Johnson’s “alternative view” on Brexit to emerge. It confirms my fear immediately after the Brexit vote, that Brexit will prove to be:
“The canary in the coalmine. It is the equivalent of the “Bear Stearns collapse” in March 2008, ahead of the financial crisis. And as I have argued for some time, the global economy is in far worse shape today than in 2008, due to the debt created by the world’s major central banks.”
The sad conclusion is that the world is now likely to suffer some very difficult years. Markets will have to relearn their true role of price discovery, based on supply and demand fundamentals, rather than central bank money-printing. On Wednesday, I will look at some of the wider implications for global interest rates.
* Bond prices move inversely to interest rates, so a higher rate means a lower price
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 50%
Naphtha Europe, down 48%.“Petrochemical demand high despite margin drop”
Benzene Europe, down 53%. “Prices have ebbed and flowed with the crude oil/energy market as well as market developments in the US”
PTA China, down 40%. “Bottle chip producers in China have been staying away from purchasing import cargoes, with traders describing demand for PET producers as ‘soft”
HDPE US export, down 31%. “The depreciation of Chinese Yuan dampened buying interest for import cargoes”
S&P 500 stock market index, up 9%
The world’s central bankers would have been sacked long ago if they were CEOs running companies. They would also have been voted out, if they were elected officials. Not only have they failed to achieve their promised objectives – constant growth and 2% inflation – they have kept failing to achieve them since the Crisis began in 2008.
But they are neither, So instead, they cling on to office, becoming more discredited with every year that passes. Even the IMF is now warning that:
“Advanced economies are facing the triple threat of low growth, low inflation, and high public debt. This combination of factors could create downward spirals where economic activity and prices decline—leading to increases in the ratio of debt to GDP—and further, self-defeating attempts to reduce debt.”
Much of the IMF’s analysis could easily have come from the blog – with just one exception. It, like central bankers themselves, is still too proud to admit that demographics drive the world’s economies – not central bankers:
- Central banks revelled in the idea they were geniuses during the Boomer-led SuperCycle
- Like UK Finance Minister, Gordon Brown, they claimed to have conquered the cycle of “boom and bust”
- But their economic models were so out of date, they couldn’t even forecast the subprime crash
- Yet its inevitability was obvious even to the blog, long before it happened, as documented in “The Crystal Blog“
Finally, however, 8 years later, the voice of common sense is starting to be heard. As the World Bank’s country director for Indonesia told the Financial Times:
“No country becomes rich after it gets old. The rate at which you grow [with] a whole bunch of old people on your back is much lower than the rate of growth at which you can grow when people are active, are educated, are healthy.”
Nobel Prize-winner, Prof Joseph Stiglitz has also argued the need for change:
“It should have been apparent that most central banks’ pre-crisis models – both the formal models and the mental models that guide policymakers’ thinking – were badly wrong. None predicted the crisis; and in very few of these economies has a semblance of full employment been restored. The ECB famously raised interest rates twice in 2011, just as the euro crisis was worsening and unemployment was increasing to double-digit levels, bringing deflation ever closer.
“They continue to use the old discredited models, perhaps slightly modified. In these models, the interest rate is the key policy tool, to be dialled up and down to ensure good economic performance. If a positive interest rate doesn’t suffice, then a negative interest rate should do the trick….If central banks continue to use the wrong models, they will continue to do the wrong thing.”
But central bankers can’t be sacked by shareholders or voted out by the electorate. And now they are starting to cover up for their own mistakes by blaming each other. Thus as the Wall Street Journal headlined over the weekend:
“U.S. chides five economic powers over policies
“U.S. officials are increasingly concerned other countries aren’t doing enough to boost demand at home, relying too heavily on exports to bolster growth. “Counting on cheap currencies as a shortcut to boosting exports can create risks across the global economy, as nations fight to stay ahead of their competitors”.
This would be sound advice, if it wasn’t for the awkward fact that the US Federal Reserve is currently relying on a devaluation of the US$ to support the US economy. Just as in Japan and Europe, the Fed’s optimism about its policies creating the magical 2% inflation and a return to SuperCycle growth have just been proved wrong again:
But still, they refuse to recognise the economic impact of demographic change. Instead central bankers are now starting to fight amongst themselves. Each wants a lower value for their currency – even though common sense says this is impossible – and is also irrelevant to meeting the challenge of ageing populations.
So we continue to move through the Cycle of Deflation, as the chart shows. We are heading, if nothing changes, towards major currency wars. And it is no surprise that populist politicians such as likely Republican Presidential candidate, Donald Trump, are now starting to argue for trade protectionism to preserve jobs.
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 58%
Naphtha Europe, down 53%. “Naphtha prices rise to fresh 2016 highs on Brent crude”
Benzene Europe, down 53%. “Both benzene and oil initially moved lower due to uncertainty deriving from the decisions expected from the Bank of Japan and the US Federal Reserve”
PTA China, down 39%. “Buyers could book PTA cargoes earlier in the May/June period due to the upcoming preparations for the G20 meetings in China from July onwards, when producers in the entire polyester chain are expected to reduce operating rates.”
HDPE US export, down 27%. “Continuous weak buying interest weighed on the market sentiment in China.”
¥:$, down 4%
S&P 500 stock market index, up 5%
Central bank policy-making is becoming more and more dysfunctional, as German Finance Minister Wolfgang Schäuble‘s comments highlighted on Friday:
“The debt financed growth model has reached its limits. It is even causing new problems, raising debt, causing bubbles and excessive risk taking, zombifying the economy….and may have laid the foundation for the next crisis.”
One clear sign of the problems this is causing can be seen in the latest capacity utilisation (CU%) data from the American Chemistry Council. As the chart chows, last month was the weakest January since 2009:
- The chemical industry is known to be the best leading indicator for the global economy
- It is the world’s 3rd largest industry after energy and agriculture, and contributes $800 to GDP for every man, woman and child on the planet
- Its slowing CU% rates had warned of the downturn all through 2015 – for example, my January 2015 analysis was headlined “Rocky road ahead for global economy as chemical industry remains downbeat“
Chemical bellwether BASF confirmed the downturn on Friday, when it told analysts that “Chemicals 4Q15 is a good proxy for 1Q16…the start of the year has been relatively slow”. As one leading analyst told me afterwards:
“This is shocking. In recent history, only 4Q08 and 1Q09 have been as poor as 4Q15.”
The second chart highlights the scale of the problem. As the New York Times has confirmed, official IMF data shows global GDP fell by 4.9% in current dollars in 2015 (only slightly less than the 5.3% fall in 2009), whilst global trade fell by 13.8%. Yet the US Federal Reserve seems stranded, like the proverbial “rabbit in the headlights” in deciding how to respond to this crisis, as vice-chairman Stanley Fischer admitted last week:
“I expect most of you are less interested in what we did at our previous meetings, and more interested in what we are going to do at the next one. I can’t answer that question because, as I have emphasized in the past, we simply do not know.”
This is equally shocking. It is one thing to say you can’t discuss potentially market-sensitive information. That would be normal. But for the world’s main central bank to say “we simply do not know” is unbelievable:
- It has, after all, run-up $3.7tn of debt in pursuit of its stimulus policies. This is not small change
- Any finance director who continued to tell his Board that “we simply do not know” the likely outlook for next month, would be sacked pretty quickly
Schäuble at least recognises that the policies have created more problems than they solved. But will this stop ECB President Mario Draghi launching more stimulus next month, as he has threatened? ”We simply do not know”…
And, of course, policymakers continue to reject the idea that demographics, not monetary policy, drive the global economy. They persist in arguing that the 3 men and 1 woman running the world’s major central banks can somehow control the economic fortunes of the world’s 7.3bn people.
Even more disturbing is the fact that the arrival of 1bn people in the lower-spending, lower-earning New Old 55+ generation means the debt created by their policies can never be repaid. They have indeed “laid the foundations for the next crisis”. And cleaning up after this crisis is going to be a very difficult job – if, indeed, it is possible.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 67%
Naphtha Europe, down 63%. “Crack spread fluctuates but remains negative”
Benzene Europe, down 60%. “As downstream demand tapers off next month and into Q2, sources said that there was room for some downward movement on benzene spot levels”
PTA China, down 45%. “Major PTA producers in the country said they were also increasing run rates. Rates in China are estimated to increase to about 60-65% in March”
HDPE US export, down 42%. “Domestic prices remained stable following the slight move up in a few prices last week”
¥:$, down 11%
S&P 500 stock market index, unchanged