“Black September – Red October”
October 20th, 2014
in aa syndication
Age of Wisdom, Age of Foolishness (47)
“Place Your Bets.”
In Age of Wisdom, Age of Foolishness (45) “Worlds in Motion”, the macroprudential replacements for Jeremy Stein (Tobias Adrian and Nellie Liang) were observed; signalling that the Fed would like the markets to take some risk off, in relation to a smooth transition to its new data dependent stance.
It was said that :
“This report [from Adrian and Lang] is therefore a signal of an upcoming period of risk reduction in American capital markets; rather similar to what happened in Q1 when Jeremy Stein delivered a correction before he was banished by Yellen.”
This was followed by Age of Wisdom, Age of Foolishness (46) “If At First You Don’t Succeed…..” which noted the Scots “No” vote as the turning point at which the equity correction would engage.
Last weekend’s G20 meeting in Australia was the equity bulls last hope of reprieve, before the correction sets in. Sadly they were disappointed. Going into G20, Jens Weidmann provided a hint of the volatility to come. He opined that central banks had reached the limits of what QE could do[i]. This comment could also be taken as an attempt to head off Mario Draghi. Since the TLTRO was a failure and Germany and France refuse to guarantee Asset Backed Securities, Draghi’s only remaining policy option is QE. Weidmann’s comments therefore anticipate this use of QE; and try to prevent it from occurring. Weidmann also offered a warning, to those who think that it is time to return back to deficit spending, with the comment that there was very limited room for this[ii]. He did not however say that there was no room for fiscal stimulus; which therefore suggests that he would accept it if it were accompanied by economic supply side reforms.
Patience in Italy, for Renzi’s economic reforms, has evaporated; leaving the country back in the grip of rising debt and slowing growth[iii]. Renzi gamely promised to press on with reforms however, beginning with the labour market[iv]. As the situation across the Eurozone deteriorated last week, Draghi was therefore obliged to signal that QE is out there if all else fails; when he gave his quarterly testimony. He opined[v] that the ECB is swiftly moving to a more “active and controlled management of our balance sheet.” According to him “unacceptably high unemployment and continued weak credit growth are likely to curb the strength of the recovery. The risks surrounding the expected expansion are clearly on the downside.”
Later in the week, he was forced to admit that the headwind from Russia will be small, because Eurozone – Russian trade is negligible[vi]. This therefore confirms that the hype surrounding these Russian headwinds, which has caused significant weakness in the Euro and European equities, was therefore without much substance. Unfortunately however, this also confirms that European economic stagnation is therefore totally endogenous; and that the negative price action from the Russian hype was really driven by the fact that the Eurozone is on life-support. If Russian headwinds were real, things would now be a lot worse in Europe.
G20 didn’t come out with any major policy initiatives and therefore fell short of the expectations, created by the hosting Australian Treasury Secretary; who had emphasized the commitment to the 2%+ growth objective from the nations involved, prior to the meeting. Coming out of G20, China’s Finance Minister Lou Jiwei actually signalled that there would not be any major economic stimulus policies in the near future[vii]. The best that China can do appears to be the lowering of credit standards in the housing market[viii]. The overall consensus at G20, was one of concern that current asset prices do not reflect the evolution of interest rates and monetary policy[ix]. G20 was clearly in the spirit of Tobias Adrian and Nellie Liang.
G20 did however say that fiscal policy would need to do more of the heavy lifting; which placed the remarks of Weidmann in a very apposite context. Clearly G20 is tentatively coming to the conclusion that a fiscal stimulus of some kind is required. The case for said stimulus would be made stronger, if equity prices nosedive and growth headwinds show up in the economic data, in addition to the news-flows out of the Middle East and Ukraine. G20 was therefore also talking up the correction in risk asset prices, in order to enable the fiscal stimulus. So successful was G20 in its attempt to inculcate bearish paranoia, that the pundits have now started to second guess the last FOMC announcement; by interpreting the words “considerable time” as actually being code for immediate in relation to rate hikes[x].
The response in the form of fiscal policy, is going to be complicated in Europe; because of German opposition to fiscal expansion. A compromise over fiscal expansion plus economic supply side reforms, will therefore be the dynamic in Europe. America is now a step closer to the Helicopter landing; which will result in a permanent expansion of the money supply, enabled by the Fed’s expanded balance sheet until 2020 according to Yellen’s last FOMC statement. A sell-off in equities just makes the case for the Helicopter even more compelling; because equity sell-offs are assumed to portend economic slowdowns. Every cloud therefore has a silver lining for Yellen; and she received more great news from her two greatest critics last week.
“And Then There Was One.”
Charles Plosser[xi] and Richard Fisher[xii] have both decided to give up banging their heads against the wall, after being smartly outmanoeuvred by Yellen over the timing of interest rate rises. Rather than stick around to be proven wrong, as the US economy slows down under the global economic and political headwinds, they have decided to retire before the Helicopter lands. Did they jump or were they pushed however?
The “Three Stooges”, as we fondly once knew them, have now been replaced by the “Three Amigos” Evans, Kocherlakota and Dudley[xiii]; who all came out in support of patience on the timing of rate hikes last week. The writing had been on the wall for the “Stooges” for some time. No doubt the initiative by Yellen, at the July FOMC, to make a sub-committee on communication policy in order to get all of the FOMC on the same page, was their last chance to be effective Hawks. The decision to make Stanley Fischer the chairman of this sub-committee, in addition to making him the chair of the Financial Stability Panel at the August FOMC, must have signalled to them that they were onto a losing streak.
Age of Wisdom, Age of Foolishness (46) “If At First You Don’t Succeed” suggested that “the Financial Stability Panel is the true centre of gravity of monetary policy at the Fed.” The exit strategy of Plosser and Richard Fisher confirms this; there is little for them to stick around for if they have been excluded from the real centre of monetary policy making. Kocherlakota then clumsily signalled where all this is going last week[xiv], when he demanded that there should be specific guidance on how the Fed intends to hit its 2% inflation target. Presumably, Stanley Fischer prompted this question; and will shortly direct his communication sub-committee to inform on the answer.
In the meantime, the Fed continues to add to the paranoia in anticipation of tighter monetary policy. The latest asset class to be targeted for a correction is the leveraged loan market; where the Fed recently opined that higher capital surcharges will be applied to banks[xv]. Bullard took another swing at the paranoid last week, when he suggested that the Fed will drop its interest rate pledge at the next FOMC meeting[xvi].
Age of Wisdom, Age of Foolishness (46) “If At First You Don’t Succeed…..” noted a hardening in attitude against the weaker Yen policy, from Japanese industry and members of the finance industry. This hardening attitude was underlined last week by former BOJ Deputy Governor Iwata[xvii].
Age of Wisdom, Age of Foolishness (43) “The Wild Geese (Chase)” suggested that America intends to fight Islamic State by “proxy”[xviii]. These “proxies” became more discernible (and more regional) at the recent Paris conference; which was covered in Age of Wisdom, Age of Foolishness (46) “If At First You Don’t Succeed…..”.
Tony Blair, who has been the shadow indicator on the crisis, ever since he made his comeback in Age of Wisdom, Age of Foolishness (25) “Pride and Extreme Prejudice”[xix] , unofficially started the debate in the public domain over the official involvement of these regional “proxies” last week[xx]. Bliar ruled out Western “boots on the ground”, which therefore opens the way for “regional boots” instead. Once the public consensus accepts this as logical and necessary, it will be time to mobilize said “regional boots”.
Such a regional mobilization has some frightening implications for oil prices, even though the markets are currently well supplied. Said frightening implications will also be a source of economic headwinds, once the spike in oil prices is understood to be a choke on global economic growth, which will then occasion the afore-mentioned fiscal stimulus from G20.
“Wings Over Syria.”
As the consensus on the ground was being created, the consensus in the air was already made; as “regional wings over ground” supported American wings in a bombing mission which was said to have disrupted a major attempt, by a renegade Al Qaeda faction, to send terrorists out of Syria to attack targets in the West[xxi]. The name “Khorasan” was also heard for the first time, in relation to this new group; which now replaces IS as the greatest threat to America and Europe[xxii].
“They Thinks It’s All Over….”
Age of Wisdom, Age of Foolishness (45) “Worlds in Motion” observed that Ayatollah Khamenei has an alternative “New World Order” vision[xxiii], in which Iran plays a leading role. David Cameron provided further kudos to Khamenei; and hence confirmation for his vision, when he agreed to meet with Hassan Rouhani last week[xxiv]. In consequence, Rouhani was able to confirm Iran’s emerging power; by suggesting that a nuclear deal could be reached well before the deadline[xxv]. Such a move of magnanimity is equally as powerful as that of his Sunni neighbours joining the bombing campaign; because it demonstrates a desire for peace and not conflict.
“Cameron Scratch Fever.”
Before Cameron was similarly carried away with a vision of the future and his own role in it, he was swiftly reminded that he is politically expendable. A boastful moment of Cameronian self – congratulation in relation to “feline” words of praise, at her Majesty’s expense, over the Scots referendum was caught on microphone. Cameron has now been forced to apologise and eat some humble pie served cold[xxvi]. A slip of the tongue about another old lady, caught on microphone, was the undoing of the last Prime Minister; so Cameron is following the script.
“Everybody wants to be a Cat.”
Boris Johnson and Nigel Farage would never be caught out in this way, because they hide their indiscretions in the plain sight of the public domain; which serves as what the electorate assumes to be charisma and therefore makes them so attractive and so electable.
“Wings of British Democracy Over Whitehall.”
“These Shoes Weren’t Made for Walkin’.”
“Black Swan’s On Offer All Week.”
The UK has been the source of the volatility which has become the correction in the global equity markets. One exogenous source of risk, which has not been fully understood and discounted in global markets, is the event surrounding the Tesco restatement of its numbers[xxxi]. Portfolio managers are hoping that this is a company specific Alpha event. There is however a strong probability that it is a market Beta event. During the period of Stagflation created by QE, companies have raised prices and cut costs; in addition to buying back shares and doing M&A. The Tesco incident also shows that the large companies with high expectations for earnings consistency have been massaging their numbers. Instead of margin pricing power in the real economy, there has thus been pricing power on the operating cash flow statement instead. This suggests that companies may have run out of the ability to keep raising prices, but have been afraid to break this bad news to their shareholders. There must therefore be several other “Tesco’s” out there, in all sectors of the global equity markets and not just the UK. The real bottom line however is that companies aren’t making money and are lying about it. When the markets finally understand this and correct accordingly, it will then be time for the Treasury to put some new money into the hands of the consumer and for the Fed enable this process aka the Helicopter.
“Blue Horseshoe No Longer Loves Anacott Steel!”
Another warning signal comes from the behaviour of Insiders.
“The Fed’s Gift that Kept On Giving”
Whilst companies have been buying back shares, to massage the earnings per share multiples in the weak economic recovery, Insiders have actually been dumping their own stock. These Insiders therefore clearly have little faith in the economy, or their company’s sales performance and pricing power; and have therefore been using the corporate share buyback strategy to support the stock price as the bid to bail out on. Allegedly[xxxii] “a total of 7,181 insiders bought their own stock this year through Sept. 12 and 23,323 sold shares, according to data compiled by Bloomberg and Washington Service. The ratio of buys to sells is near the lowest since 2000.”
“The Hope of the “Perma-Bulls”
The “Perma-Bull” case is that low borrowing costs, thanks to the Fed, have so far financed buy-backs; however this cash is now about to get ploughed into capital investment which will boost the top-line and hence the share prices. Clearly the Insiders aren’t buying into this story. They expect companies to keep on using aging plant, which is still running at lower capacity than in previous economic cycle peaks. Once the economy runs out of steam again, they assume that there will be plenty of spare capacity around. Even if this spare plant is aged, it still won’t be sweated hard enough by the weak economic conditions for it to break down. As part of a massive fiscal stimulus, which gives tax credits for capex however, one could clearly see an investment led cycle picking up. Insiders would also need to see evidence of money in the pockets of their consumers though; so this is presumably where the Fed and the Treasury would like the next dip to take us in terms of the application of Helicopter money.
“Something to Hide?”
One could look no further than the knee-jerk reaction restatement of the profit target from TNT[xxxiii], along with its 12% share price slide, for another Tesco moment waiting to happen. To get ahead of the game and avoid a Tesco moment, many companies will swiftly start guiding lower and blaming the macroeconomic environment. The executives guiding lower may avoid jail, but the share prices will behave as if they had been convicted.
“Shiny Performance Numbers, Shady Dealing.”
The Tesco contagion seems to have found its way into the asset management industry also; at the home of the “Bond God”[xxxiv]. Creative accounting and valuation techniques are not only the forte of humble greengrocers and couriers it seems.
“Coming Home to Roost.”
Going into October, with the prospect of rising interest rates just as the global economy is slowing, the Black Monday scenario Black Swan is swimming into view. An oil price rise, as a result of the footfall of the “regional boots”, would just be the needle that broke the camel’s back; metaphorically speaking. Global central bankers will then be judged to be crazy to consider tightening; and prudent to consider further easing. A global fiscal stimulus would also be well received.
The financial investor cohort, which has driven the rise in US house prices and rents, is now fleeing the sector[xxxv]. There has also been a rush to find hedges and other forms of protection in the US Housing ETF sector[xxxvi].
The US equity markets are sending out some ominous technical signals of their own also.
The Hindenburg Omen has cast its shadow over the market; and a long-term Elliot Wave target of 17,280 has been taken out in the Dow. Those who hold great store by such signs are starting to get nervous. The sad fact about such signals however, is that they only have any meaning with hindsight; after the market has crashed in order to fulfil their prophecies.
“The Wolf of Downing Street.”
The position of the UK at the heart of the upcoming financial instability was exemplified by the perverse behaviour of Chancellor Osborne; who thus far has been able to dodge the bullets and position himself well for a run at Number 10 after it is vacated by David Cameron. Osborne may however have unwittingly made the kind of political move which comes back to haunt him. For some bizarre reason he has decided to associate his office with the inauguration of an academic financial institute, which intends to do research and provide analysis on financial stability in global markets and the global economy. This would be a laudable act, were it not for the fact that it is being funded by a fund manager that makes its money from the very instability which it now allegedly wishes to stop; and which relocated operations from London to jurisdictions where regulators seeking to enhance financial stability could not regulate it[xxxviii].
The conflicts of interest would make a lesser man than Osborne sick with worry. In the past, wealthy fund managers devoted themselves to excess and philanthropy. This new trend of putting their money where their feeding mouths are, is an insidious development; that needs careful attention to be paid to where it ultimately leads. It will be interesting to see the fund’s performance overlaid with the research and policy recommendations made by this at arm’s length research foundation. Making money through global-macro trading is clearly not what it used to be; and neither is policy making. It was the nexus of traders with politicians which was at the heart of the last crisis. This well intentioned partnership is deeply compromised; and symbolic of the same problem wrapped in a more politically correct skin. It is also symbolic of a market that is about to crack up.
“Those Who Live in Glass Houses Are Now Throwing Stones.”
Calpers caused a storm, when it recently announced that it was pulling out of hedge fund investing. The company was quick to opine that this was not a performance issue[xxxix]. Closer inspection of its reasoning showed that the company spends an egregious amount of time in due diligence and monitoring of this sector (at great cost); which at only 1% of its portfolio allocation doesn’t actually move its needle in terms of performance. It is thus literally all about performance relative to the perceived risk; and Calpers is therefore being disingenuous.
In their infancy hedge funds used to make a name for themselves, with great performance predicated on the small size of their start-up funds under management. Volatility was therefore their friend as they sought to maximize return on a small capital base, using their trading skills and leverage. The successful ones grew in size through attracting funds under management, so that their business model changed to deriving income through management rather than performance fees. Successful hedge funds therefore now need stability and predictability. Currently they are getting their performance eroded by the growth of Algorithm Traders; who are sending them false signals to buy and sell, based on nothing but statistics rather than real investing data signals.
Fund managers are getting churned by the Algo’s; so that their investors are questioning the utility of the eroding performance versus the high and consistent fees paid out. The latest churn is coming from the fact that the most prevalent Algorithm, at the heart of this sub-sector, is playing the volatility in Dollar – Yen. Since this currency pair is fundamentally tied to Abenomics and the greater phenomenon of global central bank QE, the global-macro guys, who claim to trade on their fundamental understanding of this currency pair, are getting churned on a daily basis by the Algo’s; whose time horizon is seconds rather than months.
The Algo’s and Abe have got the global-macro boys convinced that a weak Yen is the answer to everything, even when the data and commentators from Japan have shown that it is clearly not working. At the Zero Bound of interest rates, paying a 2% management fee, which is the custom, is a very expensive business; especially when it gets churned up within seconds by the Algo’s. When inflation is low, this fee is even more egregious.
Returns have not been anywhere near as good; since the Fed gave everyone’s performance a boost in 2009 with its first round of QE. The “2 + 20” fee structure has been replaced by “1 + 15”; but at the Zero Bound, with low inflation and static manager performance, it looks as though it is just about to get dispatched. Managers are now in a race to the bottom on feews; and investors already have the perception from the mutual fund business, which is outperforming most active managers, that a 0.5% fee structure is where the race to the bottom will end. Of course there will always be those who can command higher fees, if they have the edge. Clearly being in league with the policy makers is the greatest edge of all.
As it happens, policy makers also need the stability and predictability in markets that managers are now starting to crave. The combination of the two mutual desires for the same thing, is therefore a marriage made in heaven. The new move in central banking, to put the whole world under the macroprudential umbrella of the Fed and its allies, is the final great enabler of the marriage. The mutual self-interest, makes for the kind of groupthink which builds up dangerous systemic risk in global markets and the global economy. In this not so brave new world, speculators will reward policy makers for executing policies, which have been debated with and signalled to them in advance.
There is however no discounting mechanism in place to price incorrect policy action. The current situation in Japan, with the weak Yen being rewarded by capital markets even when it is not reflected in the real economic performance, is a classic illustration of what to expect. Through creating alleged stability, groupthink has created the mother of all instability. It has never been a better time to be a contrarian therefore. As the cosy nexus of fund managers and policy makers builds up, there will always be one institution or individual who breaks from the ranks of consensus and goes the other way first. This was evinced by Goldman’s “Big Short” in 2008. It never pays to be last in. Goldman’s latest call[xl] for Japanese equities to fall, as Abenomics fails, therefore looks prescient to say the least.