Will stock markets see a Minsky Moment in 2020?

Few investors now remember the days when price discovery was thought to be the key role of stock markets. Instead, we know that prices are really now set by central banks, on the model of the Politburo in the old Soviet Union.

How else can one explain the above chart? It shows the US S&P 500 Index has risen 50% over the past 5 years, even though US corporate profits have fallen 5% (using US Bureau of Economic Analysis data).

As in the old USSR, central banks have also abolished “bad news”.

All news is now good news, as any ‘bad news’ means the Federal Reserve will rush to provide more price support. It has been so successful that the Index hasn’t even suffered a 20% correction over the past decade, as my Chart of the Decade confirmed.

But does this mean that stock markets will never fall again?  That is the real question as we enter 2020.

On the positive side, we know that companies have also provided major support via buybacks.  Apple alone did $240bn of buybacks between 2014 – 2018. Companies spent $800bn in total in 2018, but cash now seems to be tighter with 2019 purchases down around 15% to $700bn.

We also know that President Trump believes a strong stock market is key to his re-election this year. His Trade Adviser, Peter Navarro, has already suggested 2020 will be another record:

“It’s going to be the roaring 2020s. ”Dow 32,000 is a conservative estimate of where we’ll be at the end of the year.”

Certainly investors seem to be very positive, as the above charts confirm.  Share prices for the FANGAM stocks – Facebook, Apple, Netflix, Google and Amazon stocks have soared to new heights:

  • Apple for example, was up 32% in Q4 and nearly doubled in 2019
  • On its own, it provided 14% of the S&P’s gain in the quarter, and 8.5% of the annual gain

This wonderful performance took place even though Apple’s net income has fallen for the past 4 quarters. It is also hard to argue that Microsoft or the other FANGAM companies are suddenly about to see supercharged growth.

So is there a negative side?  Maybe old-fashioned investors were simply wrong to believe stock markets’ key role as price discovery and the efficient allocation of capital?

If one wants to worry, one has to instead look to the insights of Hyman Minsky, who warned that:

  • A long period of stability eventually leads to major instability
  • This is because investors forget that higher reward equals higher risk
  • Instead, they believe that a new paradigm has developed
  • They therefore take on high levels of debt to finance ever more speculative investments

His argument was that liquidity is not the same as solvency. Central banks can pump out trillions of dollars in stimulus, and make it ridiculously easy for companies to justify new investments. It is hard to argue with a CEO who claims:

“Why not borrow, as it’s not costing us anything with today’s interest rates“.

But what happens if the earnings from the new investments are too low to pay the interest due on the debt?

That is the risk we face today, given there is now a record $3tn of BBB grade debt – the lowest level of ‘investment grade’ debt. If some of these companies start to default, then confidence in the central banks’ ‘new paradigm’ will quickly disappear – and, with it, market liquidity

Investors will then find themselves unable to sell the under-performing asset, and suddenly realise they have over-paid.  In turn, this will prompt a rush for the exits. Prices will drop quite sharply, as ‘distress sales’ start to take place.

China’s former central bank governor has already warned that it may be facing its own Minsky Moment. As investors finish celebrating their 2019 success, they might find it prudent to ponder whether the good times can really continue forever.

Chart of the Decade – the Fed’s support for the S&P 500 will end with a debt crisis

Each year, there has been only one possible candidate for Chart of the Year.  Last year it was the collapse of China’s shadow banking bubble; 2017 was Bitcoin’s stratospheric rise; 2016 the near-doubling in US 10-year interest rates; and 2015 the oil price fall.

This year, the ‘Chart of the Decade’ is in a league of its own. Produced by Goldman Sachs, it shows that the S&P 500 is in its longest-ever run without a 20% downturn.

The reason for this amazing performance is not hard to find.  It has been caused by the US Federal Reserve’s adoption of Ben Bernanke’s concept that:

“Higher stock prices will boost consumer wealth and help increase confidence“.

Set out in 2010, it replaced the previous policy set out by William McChesney Martin that their job was:

“To take away the punchbowl as the party gets going”.

“Don’t fight the Fed” is one of the best short-term investment principles, but the Fed’s success is quite extraordinary when one looks back over the past decade.  Each time the market has threatened to slide, they have rushed in with yet more support:

  • In QE1, the Fed pumped out $1.3tn of support for financial markets, in addition to reducing interest rates to near-zero
  • This free money mostly went straight into asset markets such as stocks, which weakened when the stimulus stopped
  • QE2 came to the rescue with another $600bn of support – but again, stocks then weakened
  • QE3 provided longer-term support, with $40bn/month then increasing to $85bn/month

President Trump’s tax cuts provided even further support when the Fed finally paused, as the Financial Times chart confirms, by encouraging a massive wave of share buybacks.

Remarkably, these buybacks came at a time when profits were actually falling as a percentage of GDP, as the third chart shows. Investors should really have been pulling out of shares, rather than buying more. But after so many years of Fed support, most asset managers had either forgotten how to read a Profit & Loss account and Balance Sheet – or had decided these were irrelevant to stock valuation.

Since September, we have been in a new Fed stimulus cycle. As I noted then, a $50bn hole had appeared in New York financial markets.  Regulators and consensus commentators combined to explain this was only due to temporary factors. But since then, the support has reached $376bn, and the Fed has announced it will happily supply another $500bn of support to cover possible year-end problems, probably taking the total close to $1tn since September.

Behind this panic is the IMF’s warning that the $8.1tn of Treasury bonds available as collateral for the repo market, are in fact “owned” by an average of 2.2 different banks at the same time. Understandably, bank CFOs are pulling back, and trying to establish if “their” Treasury bonds in fact belong to someone else.

Regulators should never have allowed this to happen.  They should also have focused long ago – as I suggested this time last year – on the implications of the decline in China’s shadow banking sector.  Just as I expected, China is now exporting deflation around the world, with its PPI falling since June.

China’s slowdown also means an end to the flow of Chinese cash that flooded into New York financial markets, which hedge funds have then leveraged into outsize profits in financial markets.

The Fed turned a blind eye to this, just as it allowed BBB corporate debt to expand at a record rate, as the chart from S&P confirms.   As we noted in June’s pH Report:

“US BBB grade debt, the lowest grade in which most funds are allowed to invest, is now more than $3tn, with 19% of this total ($579bn) in the very lowest BBB– grade. And this BBB– total jumps to $1tn if one includes financial sector debt. S&P also report that global BBB debt is now $7tn, with US companies accounting for 54% of the total.

“The problem is that BBB- debt becomes speculative debt if it is downgraded by just one notch to BB grade. And most investors are then forced by their mandate to sell their holding in a hurry, creating the potential for a vicious circle, as the most liquid bonds will inevitably be sold first. In turn, this creates the potential for a “waterfall effect” in the overall bond market – and to contagion in the stock market itself.”

The Fed’s focus on boosting the stock market is clearly going to end in a debt crisis.  But when warning of this, the consensus responds as in 2006-8, when I was warning of a global financial crash, “That’s impossible”.  And no doubt, once the debt crisis has occurred, it will again claim “nobody could have seen this coming”.

This is why the S&P 500 chart is my ‘chart of the decade’.

Global economy hits stall speed, whilst US S&P 500 sets new records

Whisper it not to your friends in financial markets, but the global economy is moving into recession.

The US stock markets keep making new highs, thanks to the support from the major western central banks. But in the real world, where the rest of us live, the best leading indicator for the global economy is clearly flashing a red light:

  • On the left is Prof Robert Shiller’s CAPE Index, showing the US S&P 500’s valuation is at levels only seen before in 1929 and 2000
  • On the right is the American Chemistry Council’s  global chemical Capacity Utilisation (CU%), which has fallen back to May 2013’s level

They can’t both be right about the outlook.

Chemicals are known to be the best leading indicator for the global economy. Their applications cover virtually all sectors of the economy, from plastics, energy and agriculture to pharmaceuticals, detergents and textiles.  And every country in the world uses relatively large volumes of chemicals.

The chart shows the very high correlation with IMF GDP data. Even more usefully, the data is never more than a few weeks old. So we can see what is happening in almost real time.

And the news is not good.  The CU% has been in decline since January 2018, and it is showing no sign of recovery. In fact, our own ‘flash report’ on the economy, The pH Report’s Volume Proxy Index, is showing a very weak performance as the charts confirm:

  • The Index focuses on the past 6 months, and shows a very weak performance. It has gone negative even though September – November should be seasonally strong months, as businesses ramp up their activity again after the holidays
  • Even more worrying is that the main Regions are currently in a synchronised slowdown. And each time they have tried to rally, they have fallen back again – a sign of weak underlying demand

And, of course, we are now moving into the seasonally slower part of the year, when companies often destock for year-end inventory management reasons. So it is unlikely that we will see a recovery in the rest of 2019, whether or not a US-China trade deal is signed.

The problem is very simple:

They see no need to focus on understanding major challenges such as the potential impact of ageing populations on economic growth, the retreat from globalisation and the rise of protectionism, or the increasing importance of sustainability.

Perhaps they are right. But the evidence from the CU% on developments in the real world suggests a wake-up call is just around the corner.

$50bn hole appears in New York financial markets – Fed is “looking into it”

Most people would quickly notice if $50 went missing from their purse or wallet. They would certainly notice if $50k suddenly disappeared from their bank account. But a fortnight ago, it took the New York Federal Reserve more than a day to notice that $50bn was missing from the money markets it was supposed to regulate.

Worse was to come. By the end of last week, the NY Fed was being forced to offer up to $100bn/day of overnight money.  And it was also clear that the authorities still have no idea of what is going wrong.

This is perhaps not surprising when one remembers, as I charted here between 2007-8, that the Fed failed to notice the subprime crisis until Lehman went bankrupt in September 2008.

For the past 2 weeks, extraordinary things have been happening in a critical part of the world’s financial markets. And unfortunately, the NY Fed didn’t notice until after it had begun, as the Financial Times later reported:

  • First, on Monday 16th, the repo market suddenly began to trade higher – reaching a high of 7%
  • Then as the market opened at 7am on Tuesday, “Rates rocketed upward again, to 6% within a few minutes and then to a high of 10%. That was four times the rate the repo market was trading the week before. Typically, repo prices move around by a few basis points each day — a few hundredths of a percentage point.

Finally, someone at the Fed woke up – or perhaps, somebody woke them up – and they announced $75bn of support to try and stop rates moving even higher. Even that had its problems, as “technical difficulties” meant the lending was delayed.

As Reuters then reported next day, this cash wasn’t enough. The shortage “forced the Fed to make an emergency injection of more than $125bn …. its first major market intervention since the financial crisis more than a decade ago.”

Of course, as with the early signs of the subprime crisis, the Fed then went into “don’t frighten the children mode“.  We were told it was all due to corporations needing cash to pay their quarterly tax bills, and banks needing to pay for the Treasury bonds they had bought recently.

Really! Don’t companies pay their tax bills every quarter? And don’t banks normally pay for their bonds?  Was this why some large banks found themselves forced to pay 10% for overnight money, when they would normally have paid around 2%?  And in any case, isn’t repo a $2.2tn market – and so should be easily able to cope with both events?

Equally, if it was just a one-off problem, why did the NY Fed President next have to announce daily support of “at least $75bn through 10 October” as well as other measures? And why did the Fed have to scale this up to $100bn/day last Wednesday, after banks needed $92bn of overnight money?

Was it that corporations were suddenly paying much more tax than expected, or banks buying up the entire Treasury market? The explanation is laughable, and shows the degree of panic in regulatory circles, that their explanation isn’t even remotely plausible.

We can expect many such stories to be put around over the next few days and weeks. As readers will remember, we were told in March 2008 that Bear Stearns’ collapse was only a minor issue. As I noted here at the time, S&P even told us that it meant “the end of the subprime write downs was now in sight“.

I didn’t believe these supposedly calming voices then, and I don’t believe them now. Common sense tells us that something is seriously wrong with the financial system, if large borrowers have to pay 10% for overnight money in a $2.2tn market.

And what is even more worrying is that, just as with subprime, the regulators clearly don’t have a clue about the nature of the problem(s).

My own view, as I warned in the Financial Times last month, is that “China’s (August 5) devaluation could prove to be the trigger for an international debt crisis”.  Current developments in the repo market may be a sign that this is more likely than many people realise.  I hope I am wrong.

 

Perennials set to defeat Fed’s attempt to maintain the stock market rally as deflation looms

Never let reality get in the way of a good theory. That’s been the policy of western central banks since the end of the BabyBoomer-led SuperCycle in 2000, when the oldest Boomer moved out of the Wealth Creator 25-54 age group and into the Perennial 55+ cohort.

Inevitably this led to a slowdown in growth, as the Perennials already own most of what they need, and their incomes decline as they enter retirement.  40% of Americans aged 65+ would have incomes below the poverty line, if Social Security didn’t exist.

The well-meaning folk at the US Federal Reserve chose to ignore this development, and instead launched their subprime experiment   But demographics are destiny, and their first attempt to effectively “print babies” ended in 2008’s near-disaster for the global economy.

Their problem, as John Maynard Keynes noted in his conclusion to his 1936 General Theory, was that:

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.

And in the case of today’s central bankers, they are enslaved to the theories of 2 defunct economists:

  • One is Franco Modigliani, who won the 1955 Nobel Prize with his “life-cycle hypothesis”, which suggested individuals plan out their  lifetime income and spending in advance, so as to even out their consumption over their entire lifetime
  • The other is Milton Friedman, who won the 1975 Prize for his argument that “inflation is always and everywhere a monetary phenomenon”, ignoring the importance of supply and demand balances

Modigliani and Friedman were working before anyone realised a BabyBoom had taken place.  When John Richardson and I were researching our book ‘Boom, Gloom and the New Normal: How the Western BabyBoomers are Changing Demand Patterns, Again’ in 2010, the authoritative Oxford English Dictionary gave the earliest use of the word as being in 1979.

So they might have some excuse for not being aware of the demand pressures caused by the fact that the number of US babies rose by 52% in 1946-64, compared to the previous 18 years.   But today’s central bankers have no such excuse.  Common sense, or a quick glance at the charts above would immediately confirm:

  • Increasing life expectancy and falling fertility rates mean that an entirely new generation, the Perennials 55+, is alive today for the first time in history
  • And the data shows very clearly that their spending falls off away once they turn 55, and is down 43% by the time they reach the age of 75

Similarly, common sense suggests that inflation is not a monetary phenomenon, but a function of supply and demand balances. The post-War BabyBoom  was inevitably going to create a lot of demand and hence inflation, particularly as factories had first to be converted back from military production.

Similarly, when all these babies moved into the workforce, it was almost inevitable that:

  • We would see more or less constant demand, as the Boomers reached their Wealth Creator years
  • This demand would be turbo-charged as women went back into the workforce after starting a family, creating the two-income family for the first time in history

Fertility rates fell below replacement levels of 2.1 babies/woman as long ago as 1970. Inevitably, therefore, the number of Wealth Creators has plateaued – just as increasing life expectancy means that the number of Perennials is growing rapidly.

Since 2008, the Fed has completely failed to recognise this critical development for supply/demand balances.

Instead it has “doubled down” on the subprime policy, via record levels of stimulus.  If you ask them why, they will tell you their core economic model – the Dynamic Stochastic General Equilibrium model – doesn’t need to include demographic detail, as it is based on  Modigliani and Friedman’s theories.

We are therefore now almost certainly approaching a new crisis. As the chart on the left from Charlie Bilello confirms :

  • The total of government bonds with negative interest rates has now reached $13tn
  • The stock market is ignoring this evidence of slowing demand, and is still powering ahead

One or the other is soon going to be proved wrong.

THE END-GAME FOR THE STIMULUS POLICIES WILL LIKELY BE MAJOR DEFLATION
The central banks have spent the past 10 years following Friedman’s theory, believing they could create inflation via stimulus policies.  Instead, their low interest rates encouraged companies to boost supply, at a time when the rise of the Perennials meant demand growth was already slowing.

Unsurprisingly, therefore, interest rates are going negative, as the Fed’s policies have effectively proved deflationary.  Very worryingly, around 14% of US companies are already unable to service their debt, because their earnings are not enough to pay their interest bills.

Had the Fed focused on demographics, it would have been obvious that the best way to create demand was to increase the spending power of the Perennials, who typically rely on savings for extra income.  But instead of allowing markets to set higher interest rates, the Fed chose to lower them, making deflation almost inevitable.

History suggests their next round of stimulus policy, if/when the S&P 500 weakens again, will be to introduce Friedman’s idea of “helicopter money” – and electronically transfer perhaps $500 to every American’s bank account.  This will be the ultimate test for Friedman’s theory, as if it doesn’t magically create inflation, the Fed will have nothing more to do.

Maybe, this final burst of stimulus will work.  But probably most Perennials, and many Wealth Creators, will instead save the money – alarmed by the Fed’s sense of desperation.  In turn, this will turbocharge the deflationary cycle – forcing interest rates even lower and risking major economic turmoil.

Uber’s $91bn IPO marks the top for today’s debt-fuelled stock markets

Uber’s IPO next month is set to effectively “ring the bell” at the top of the post-2008 equity bull market on Wall Street.  True, it is now expecting to be valued at a “bargain” $91bn, rather than the $120bn originally forecast. But as the Financial Times has noted:

“Founded in 2009, it has never made a profit in the past decade. Last year it recorded $3.3bn of losses on revenues of $11bn.”

And Friday’s updated prospectus confirmed that it lost up to $1.1bn in Q1 on revenue of $3.1bn. In more normal times, Uber would have been allowed to go bankrupt long ago,

So why have investors been so keen to continue to throw money at the business?  The answer lies in the chart above, which shows how debt has come to dominate the US economy.  It shows the cumulative growth in US GDP since 1966 (using Bureau of Economic Analysis data), versus the cumulative growth in US public debt (using Federal Reserve of St Louis data):

  • From 1966 – 1979, each dollar of debt was very productive, creating $4.70 of GDP
  • From 1980 – 1999, each dollar was still moderately efficient, creating $1.20 of GDP
  • Since 2000, however, and the start of the Federal Reserve’s subprime and quantitative easing stimulus programmes, each dollar of debt has destroyed value, creating just $0.38c of GDP

After all, if one ignores all the hype, Uber is just a very ordinary business doing very ordinary things.  Most people, after all, could probably run a serially loss-making taxi and food delivery service, as long as someone else agreed to keep funding it.

Yes, like the other “unicorns”, it has a very customer-friendly app to help customers to use its service. But in terms of its business model:

  • When one takes a ride with Uber, the driver often also drives for Lyft and for the local taxi firm, and her car is often also the same car
  • This means that in reality, Uber’s main competitive advantage is its ability to subsidise the ride or the food bought via Uber Eats

DEBT HAS CHANGED FINANCIAL MARKET BEHAVIOUR

This addiction to debt on such a scale, and for such a long period, has changed financial market behaviour.

Nobody now needs to do the hard graft of evaluating industry dynamics, business models and management capability.  Instead, they just need to focus on buying into a “hot sector” with a “story stock”, and then sit back to enjoy the ride. The chart above from Prof Jay Ritter confirms the paradigm shift that has taken place:

  • It highlights how 80% of all IPOs last year were loss-making, compared to around 20% before 2000
  • The only parallel is with the late 1990s, when dot.com companies persuaded credulous investors that website visits were a leading indicator for profit

Like other so-called “unicorns with $1bn+ valuations, today’s debt-fuelled markets have allowed Uber to raise money for years in the private markets. So why has Uber now chosen to IPO, and to accept a valuation at least 25% below its original target?.

CORPORATE DEBT IS INCREASINGLY FUNDING STOCK BUYBACKS TO SUPPORT SHARE PRICES

The above 2 charts from the Wall Street Journal start to suggest the background to its decision:

  • They show the ratio of US corporate debt to GDP has now reached an all-time high at 48%.  The quality of this debt has also reduced, with the majority now just BBB-rated and with record levels of leverage
  • BBB ratings are just above junk, and most major investment managers are not allowed to hold junk-rated bonds in their portfolio. So they would have to sell, quickly, if this debt was downgraded

The problem is that much of the corporate debt raised in recent years has gone to fund share buybacks rather than investment for the future. President Trump’s tax cuts meant buybacks hit a record $806bn last year, versus the previous record of $589bn in 2007.  According to Federal Reserve data, investors sold a net $1.1bn of shares over the past 5 years – yet stock markets powered ahead as buybacks totalled $2.95bn.  As Goldman Sachs notes:

“Repurchases have consistently been the largest source of US equity demand. Since 2010, corporate demand for shares has far exceeded demand from all other investor categories combined.”

THE FED’S RECENT PANIC OVER INTEREST RATES HIGHLIGHTS THE STOCK MARKET RISK

Against this background, it is not hard to see why the US Federal Reserve panicked in January as 10-year interest rates rose beyond 3%.  For years, the Fed has believed, as its then Chairman Ben Bernanke argued in November 2010 that:

“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.”

Rising interest rates are likely to puncture the debt bubble that their stimulus policy has created – by reducing corporate earnings and increasing borrowing costs for buybacks.

Uber’s IPO suggests that the “smart money” behind Uber’s IPO – and that of the other “unicorns” now rushing to market – has decided to cash out whilst it still can, despite the valuation being cut. They must have worried that in more normal markets, they would never be able to float a serially loss-making company at a hoped-for $91bn valuation.

If they really believed Uber was finally about to turn the corner and become profitable at last, why would they accept a valuation some 25% below their original target of less than  a month ago?  The rest of us might want to worry about what they know, that we don’t.