Red Lines and Green Lights
Age of Wisdom, Age of Foolishness (35)
Age of Wisdom, Age of Foolishness (31) "The Longest Day”[i] explained how intra-index rotation had accumulated a wall of money, in the larger capitalised stocks within equity indexes, which was dragging up the NASDAQ and Russell. Fear of the “Taper” initially drove this phenomenon, which then latterly became associated with expectations of looser Fed policy as the more ignorant momentum investors looked for a reason to explain the price action.
It was said that:
“The great bubble in equity valuations has now been unleashed, by this asymmetric trade-off of Fed outcomes.”
Last week, the Russell started to move up the field as this bubble inflated, through the combination of long-only and momentum investor driven flows. On the first trading day in July, the great bubble was violently unleashed on the hapless shorts at the market open. This ritual slaughter then carried on through the US June Employment Situation report, which should have offered a respite to the shorts. Risk is now concentrated in the larger capitalised stocks within these indexes. The warning from the Bank of International Settlements[ii], that there is a bubble in equity valuations, was timely but unfortunately totally ignored in the stampede by the bulls.
The Bulls are on Green, the Bears are on Red and the Sheep are Confused
Dow Average Divergence Gives Cause for Concern: Chart of the Day
Click to enlarge
Within the Dow Jones Indexes, the divergence of the Transports from the Industrials[iii] was either bullish or bearish depending upon the observer’s perception (and the P&L). Those of the bearish perception are however starting to perspire rather visibly.
Age of Wisdom, Age of Foolishness (25) “Pride and Extreme Prejudice”[iv] prefaced this evolving situation thus:
“Financial markets are at a new expansion point in the current bubble cycle, despite all the headlines that the “Taper” and higher interest rates are getting.”
The tendency of CEO’s to invest in buybacks, or shares of competitors (through M&A), was also highlighted as a symptom of this excessive liquidity rather than real economic growth. Jeremy Stein had tried to defuse this bubble, but he was banished to Harvard before he completed his task. It was also suggested that the apex of this bubble would be signalled by CEO’s using their own shares as acquisition currency in M&A rather than cash.
The latest data on M&A activity for 2014 shows[v] that this bubble take-off point has been reached. The next six months of the year will mark the consummation of the announced M&A deals, which have heralded this bubble. Sales and Trading revenue has been down on Wall Street, so the Investment Bankers will be the ones delivering the deals for this year’s bumper bonus pool.
“The Helicopter Is Clear to Land at Jackson Hole.”
Chairman Yellen shows no signs of deflating the great inflation; if anything she is even more determined to inflate. Her latest speech[vi] basically opined that she is willing to risk asset bubbles whilst the economic recovery remains below par. She has therefore put herself into a totally predictable asymmetric outcome box. Tighter monetary conditions from the Taper, will ultimately be met with easier monetary policy – “Buy the Dip!” Weaker growth conditions will be met with easier monetary policy – “Buy the Breakout!” (and Buy Gold also, as was observed in Age of Wisdom, Age of Foolishness (33) “Good Fellas”). Yellen is preparing the landing pad for the Helicopter at Jackson Hole, later on this summer. QE, such as it is, represents only a temporary expansion of the money supply. This temporarily increased money supply, thus far has only been multiplied in the capital markets and has yet to be multiplied in the real economy. A withdrawal of QE will thus create a capital markets implosion, which may then knock on to the real economy which is in no fit state to weather this storm. Yellen therefore needs a permanent increase in the money supply, which can only occur when the Treasury is fiscally stimulating with the production of deficit surpluses to permanently monetise. The Obama administration will wish to fiscally expand, wherever the partisan political situation allows, in order to bequeath a legacy of a growing economy; which will also presumably support the case for another Democrat in the White House. So far, only military spending appears to attract a bipartisan consensus; which is why the Islamic Caliphate of ISIS is a blessing, despite the obvious problem it creates for the “Pivot”. In the meantime, Yellen is leading the slaughter of the equity bears. Her words, on the eve of the June Employment Situation Report, effectively put a floor under the following day’s strong jobs number; and precipitated the short covering rally that is developing into a bull market with its own legs. Yellen’s verbal timing is as good as it has always been.
European equities traditionally get dragged into this fun and games in their afternoon session, when New York is open; however in the earlier European time zone it has been a much different story up until when Yellen last spoke. The battle between the German Freshwater School adherents and the Saltwater School at the helm of the ECB is unfolding, with volatile consequences for the Peripheral equity markets. Within the Periphery, Italy stands out as the major transgressor.
“Italy Flashing Red”
Data shows that Italy has been borrowing with gay abandon, whilst Mario Draghi provides the low interest rates[vii]. Unfortunately however, the Italian economy has not been growing fast enough to maintain this level of borrowing. Italy now has bigger debts than Germany, whilst its economy grows at a small fraction of the pace. At least when Spain did this, it created jobs and faux growth in a bubble in the real estate sector. Italians haven’t even bothered wasting money on a Potemkin façade of any kind; instead choosing to “appropriate” the cash directly in return for issuing IOU’s which they can’t honour. Italians are past masters of debt malfeasance, so the loot from cheap financing is swiftly transferred to the issuers of financial assets. The risk is transferred to holders of said Italian financial assets. This explains why Prime Minister Renzi is leading the charge to have a pro-growth 2015 EU Budget and looser fiscal criteria. Germany is however having none of this, since it fears that the combination of Draghi at the ECB, weaker fiscal rules and a pro-growth EU Budget will cause overheating in the German economy. Renzi is all for overheating. As Italy takes over the rotating EU Chair, he has stated that he intends to drive the next move towards Federalism[viii]. Clearly, he hopes to be rewarded by Germany, in the mutualisation of his country’s debts with those of the abstemious German people. Looking more closely at the profile of Germany’s fiscal position going forward however, Italy seems to be out sync.
There is also the real potential for unintended consequences within Italy itself. If Italians won’t create jobs and growth, with interest rates at 0%, it is unlikely that they will do so with looser fiscal constraints or even if interest rates go negative. In fact negative interest rates in Italy, would cause a run on the banks; and the exporting of capital abroad so that it will create even less growth within Italy. Negative Italian interest rates would mean that the new scam would be for Italians to get paid twice; first to borrow and then second to earn a spread by arbitrage through lending to borrowers who will pay them interest. Italy will become a booming financial centre, with companies rather than banks being the major players. If said companies are listed on the Italian equity exchange, the bubble will manifest itself there. If said companies are not listed, it will manifest itself as a shadow banking bubble similar to those found in places like Cyprus, China and the SPV’s with weird names that America spawned during the Subprime Crisis.
If interest rates are negative in other Eurozone countries, there is no reason why the whole Eurozone does not go down this route. The chart above of M&A volume will look like a tiny blip, if the M&A bubble unleashed by the ECB kicks in. If the ECB is happy to play along with this scam, by buying up tranches of asset backed securities which pay interest to those who get paid to borrow money through negative interest rates, then the problem becomes systemic. One has to wonder if Mario Draghi has really thought this one though, whilst he is reciting “do whatever it takes” in the shaving mirror. One suspects that Jens Weidmann[ix], Andreas Dombret[x] and Wolfgang Schaeuble[xi] know ultimately where all this is going. The BIS clearly knows how it will end, but not when it will end. It is the when that counts however, because this determines the magnitude of the crash that ensues. This magnitude will also determine the P&L of those who ride this next wave with skill and perspicacity on the ways up and down.
“Singing From the Same Page”
How the “Three Teutonic Tenors” sing like the Fat Lady, in order to try and end the act without upsetting the wider Federalist European Project, is going to be an amusing performance to watch. They have motive and opportunity. The motive is plainly to prevent a combination of loose monetary and fiscal policy, which will create overheating in the German economy. Opportunity is presented by the fact that the Chair of the G7 rotates to Germany this time around. The German Finance Ministry has signalled their intentions and capabilities. Germany intends to have a balanced budget in 2015[xii], which will then be the status quo going forward until 2018. Clearly this sets the tone for upcoming Eurozone 2015 budget negotiations and beyond. At G7, Germany will also try and temper the enthusiasm for fiscal stimulus at the global level. It is looking like global military fiscal stimulus and central bank monetary stimulus are going to square off and eventually overcome this German resistance.
Italians now also wish to reward themselves with EU taxpayer funds, in addition to cheap borrowing, which they also have no intention of repaying. All PIIGS are no longer equal however. The Portuguese, Irish, Greeks and the Spaniards have all towed the line, on fiscal austerity, so it is unlikely that they will have much empathy towards the Italians. Prime Minister Renzi now has the unenviable task, of tax hikes and fiscal spending reductions. He was elected to reform and curtail government largesse however, so let’s see how long he lasts before Mr Berlusconi reappears and does for him. Suddenly he has morphed from a domestic budget reformer into a European budget reformer; the original reform now moving in the opposite direction at the EU to promote more borrowing and spending. Presumably, some bright spark (most likely a German) will opine that this problem is a direct result of the ECB’s low interest rate regime. The conflict will then be played out in Italian assets, until it spreads to French assets and beyond. The European markets breathed a huge sigh of relief when Juncker’s nomination was upheld over Cameron’s objections. The relief rally was violent, however it does nothing to cover the cracks that are opening up around Italy and the 2015 EU budget. It took Yellen and then Draghi’s re-framing of emotional financial perceptions onto lower interest rates for longer, to distract from the unfolding dilemma for Renzi.
“God (of Inflation) is Dead.”
Mario Draghi’s latest “presser”[xiii] followed up on the damage inflicted upon the equity shorts by Yellen the previous day; and kept alive Italian dreams in the process. In rebuttal of the BIS warning over “euphoria”, Draghi deflected the questioning by underlining that ECB policy is directed at macroprudential stability. In his eyes deflation and low credit growth, skew the bias of stability to the downside rather than to overheating risk. Draghi therefore reiterated Yellen’s groupthink mantra of “Buy the Dip!” Weaker growth conditions will be met with easier monetary policy – “Buy the Breakout!” (and Buy Gold also, as was observed in Age of Wisdom, Age of Foolishness (33) “Good Fellas”).
“The Manhattan Project”
Age of Wisdom, Age of Foolishness (34) “Blowback” drew attention to China’s imploding fraudulent commodity leveraged finance bubble. In the real economy further evidence emerged of the physical consequences of this bubble, with the edifice of the derelict replica of Manhattan in Tianjin[xiv]. Such edifices tend to be manifest as a key signal at the apex of property bubbles.
The subtle positioning of the GOP in preparation to militarily intervene in Iraq, in response to the persecution of Christians as noted in Age of Wisdom, Age of Foolishness (34) “Blowback”, was reflected on the ground with alacrity in the latest reports of Christian minorities in exodus from the Mosul region[xv]. The Syrian government also began bombing ISIS positions within Iraq, with the full approval of Prime Minister Maliki. Regional contagion has now occurred; and the 360 degree battlefield picture is one in which America’s enemies in one country now act as its allies in a neighbouring country. This process was explained in Age of Wisdom, Age of Foolishness (33) “Good Fellas”, where it was summarised thus:
“The picture presented deliberately obscures the friend of my friend, enemy of my enemy and friend of my enemy etc; so that there are multiple permutations. Each character can therefore pursue their own agenda with impunity and also with the support of the other players.”
The satellite perspective ultimately conforms to the prescription Prime Minister Netanyahu gave to President Obama on the June 22nd CNBC’s “Meet the Press”; when he opined that
“when your enemies are fighting each other, don’t strengthen either one of them. Weaken both”[xvi].
To apply the “Good Fellas” sobriquet, “an enemy of my enemy, is my friend”; even when he is still my enemy. Israel’s enemies are fundamentally weakened relative to itself; so that when it has to deal with them in combat, it will face weakened military opposition on the ground and weakened political opposition from Washington.
“Not Necessarily Friends of Ours”
It was amusing (and also enlightening) to watch Prime Minister Netanyahu adopting the mobster vernacular[xvii], which we have used to characterise the situation, with his own qualification:
“In the Middle East, my enemy's enemy is still my enemy”.
As was stated in “Age of Wisdom, Age of Foolishness (24) “The Short Good Friday”[xviii]:
“Israel on its present economic and political course is headed for a major conflict”.
“Oh look, it’s time to go,go,go!”
Don't Think, F-e-e-e-el
The weakening of its numerous regional enemies accelerates the timing of this conflict, by creating tactical windows of opportunity. These windows however, can only be opened by direct attacks upon Israeli interests. The recent campaigning of ISIS, in the numerous regional territorial threats to Israel, opens some of these windows simultaneously. The other windows are being opened by the combination of Hamas and Iran. In relation to the murder of the abducted Israeli teenagers, Prime Minister Netanyahu has vowed
"Hamas is responsible, and Hamas will pay”[xix].
Just as Israel raised the stakes, ISIS also declared a new state spanning the Trans-Jordan region[xx]. The ISIS incursion into Jordan was flagged as a tactical “red line” by Netanyahu. He also took another step towards the brink, when he announced that preparations were underway to expand operations in Gaza[xxi]. Readers should remember that Gaza is the place where Israel intercepted Iranian missiles destined for Hamas earlier in March this year[xxii]. He also announced that he fully recognizes Kurdish independence from Iraq[xxiii]; thus confirming the analysis in Age of Wisdom, Age of Foolishness (34) “Blowback” that Israel is the first country to officially recognise Kurdistan. His new strategy is to build a wall of defensive capabilities from Eilat to the Golan Heights. Israeli positioning in Gaza reciprocates the positioning of the Hamas faction, in the new Palestinian Unity Government, which asked for Iranian intervention[xxiv] just two days before Netanyahu signalled that the general mobilization was underway. Israeli positioning also reciprocates the positioning of ISIS in Trans-Jordan. The major Israeli conflict suggested in “Age of Wisdom, Age of Foolishness (24) “The Short Good Friday”[xxv] is now in process. The risk is that regional allies of America (and America itself) become compromised by this Israeli involvement. America has thus been dragged in, whether it likes it or not. Once again, confirming suspicions that President Putin is a key player and not the nemesis which he is portrayed as being in the American media, Russia provided aircraft and military advisers for the Maliki government to attack ISIS[xxvi]. As was stated in Age of Wisdom, Age of Foolishness (33) “Good Fellas”:
“This strategy bears the hallmark of a game that is also being played in Ukraine; so one must assume that it is all one and the same.”
As a compromise is now being sought in Ukraine, the players have shifted their focus to the Near and Middle East; to resolve the Eastern Question that remains unresolved since Versailles. In a contemporary recasting of the domino effect of the general mobilizations of the Great Powers, which characterised the Great War, Iran mobilised its airforce in Iraq[xxvii] whilst the Kingdom of Saudi Arabia moved its forces to the Iraqi border[xxviii]. An assassination of today’s equivalent of a Grand Duke is anticipated with foreboding, by those who understood how it all began almost one hundred years ago today. The way it seems to be playing out, this time around, is that Maliki has called upon Iran to intervene; and then the Iraqi Sunnis, who have called upon ISIS to intervene, call upon the Kingdom to intervene once ISIS has been eviscerated. In a recent Reuters panel, Henry Kissinger opined that the Great War was “structurally unavoidable”[xxix]. A similar kind of structural inevitability is now occuring in Iraq.
“Abeshima’s Offence is His Own Best Defence”
Following the Great War pattern, Japan did not miss out on the global opportunities for a return to militarism, presented in the emerging geopolitical climate. The Constitution was reinterpreted[xxx], to say in effect that offence is the best defence. Japan’s armed forces, which have hitherto been referred to in terms of “collective self-defence”, have now been legally mandated to go onto the offence. The conflict between Japan and China, flagged as a real Black Swan event by Nouriel Roubini[xxxi], is steaming into view with Dreadnoughts on the South China Sea. Every cloud has a silver lining however; quite literally if you are a central banker and are mandated to do more QE to counteract the geopolitical headwinds. Every cloud has a silver lining, especially if you are also a Scottish ship yard devolved or otherwise.
“Hail, men-o'-war's men -- safeguards of your nation
Here is an end, at last, of all privation;
You've got your pay -- spare all you can afford
To welcome Little Buttercup on board.”
It would seem that the Queen Elizabeth has been launched in the nick of time to project the much maligned, yet truly missed, British influence back onto the pages of the atlas that used to be “Imperial Pink”[xxxii]. Christening the Nation’s largest ever warship on American Independence Day was both a crowning achievement and a subtle declaration of British intentions and capabilities.
- The Longest Day
- Financial Times
- Dow Average Divergence Gives Cause for Concern: Chart of the Day
- Pride and Extreme Prejudice
- 2014 Is On Track To Become The Second Biggest Year For M&A In History
- Yellen Says Financial Instability Shouldn’t Prompt Rate Change
- Italian Debt Swells to Rival Germany as Bond Yields Slide
- Italy to push for 'United States of Europe' when it holds the EU presidency
- ECB's Weidmann calls for stronger euro debt rules
- Draghi’s Calm Markets Spark Concern of German Risks: Euro Credit
- Finance Minister Warns of Dangerous Signs in German Real Estate
- German Balanced-Budget Push Aided by ECB in Boost for Schaeuble
- Here Comes The ECB Decision...
- China Builds Its Own Manhattan -- Except It's a Ghost Town
- Mosul Archbishop Says Iraq Christians Flee From ISIL Militants
- Israel Warns U.S. That Militant Threat in Iraq May Serve Iran’s Nuclear Aims
- 'In the Middle East, my enemy's enemy is still my enemy': Netanyahu
- The Short Good Friday
- Netanyahu: 'Hamas Will Pay' For The Killing Of 3 Israeli Teens
- Isis rebels declare 'Islamic state' in Iraq and Syria
- Israel Is Ready to Expand Operations in Gaza: Netanyahu
- Israel Displays Arms It Says Were Headed to Gaza
- Netanyahu: I support Kurdish independence
- Hamas Calls on Iran to Join the 'Struggle' Against Israel
- The Short Good Friday
- Russian Jets and Experts Sent to Iraq to Aid Army
- 'Iranian attack jets deployed' to help Iraq fight Isis
- Report: Saudi troops deployed to Iraq border
- Reuters Insider Report
- Japan OKs collective self-defense, reinterprets Constitution
- Roubini doom scenario: It looks like 1914 again
- HMS Queen Elizabeth: supercarrier will be source of inspiration and pride, says Queen