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posted on 18 January 2015

Epoch Of Belief, Epoch Of Incredulity - 'Beginning Of The End'

Written by ,

"Call It."

It's time to start the New Year with a new title. Since the analysis is descriptive, predictive and prescriptive the continuous Dickensian headline theme will be preserved.

"No Light at the End of this Tunnel Vision."

In this spirit of continuity, it is useful to pick up the cognitive dissonance from where it ended in Age of Wisdom, Age of Foolishness (59) "Patience Is a Virtue".

"Our greatest glory is not in never falling, but in rising every time we fall."(Confucius)

Russia staggered into Christmas on its knees. Whilst appearing to provide support, China took advantage of Russia's vulnerability; by extending a currency swap line that will force Russia to supply oil and gas in exchange for Yuan - i. Russia will then be forced to recycle its accumulated Yuan back into Chinese goods, services and assets. Russia therefore becomes a commodity producing satellite of the Middle Kingdom, along with the other nations being similarly assimilated along the new Silk Road.

"The Curious Case of the Hoff and the Dogs that Barked."

The cognitive dissonance was also audible at the Bank of England. Age of Wisdom, Age of Foolishness (59) "Patience Is a Virtue" suggested that battle would soon commence between "the Hoff" and the Office of National Statistics (ONS); over the inconvenient truth about rising English wages. Martin Weale did not waste any breath cooling his mince pies; and instead clearly articulated that wage inflation is a problem that is going to trouble the Bank in 2015 - ii. Weale evidently finds nothing wrong with this data set provided by the ONS. It will therefore be interesting to see what "the Hoff" produces in relation to the same statistic. If the rising wages are accompanied by a slowing of output, the collapse in productivity is going to be something that the MPC cannot avoid.

"She Moves Interest Rates in Mysterious Ways."

"Yesterday's Fish and Chip Wrapper."

Age of Wisdom, Age of Foolishness (54) "Taper Tantrum Redux" - iii

Nemat Shafik is on record - iv for signalling that falling productivity will require swift interest rate increases; so the stage is set for a dangerous splitting of the MPC vote. Age of Wisdom, Age of Foolishness (59) "Patience Is a Virtue" predicted a stalling in the US economy in early 2015; so the UK will be vulnerable, should this occur, because both Europe and America are cooling rapidly.

"Bad News Comes In Threes."

Revised GDP and Trade Balance data, also produced by the perfidious ONS last week, suggested that the MPC will soon be confronted with this conundrum - v. GDP was revised lower to flat year-to-date; so it is now clear that productivity is not improving. The trade balance data was even more intriguing. Since Mrs Thatcher offshored British manufacturing to Asia, Britain has traditionally had a current account deficit, financed by debt. The Credit Crunch was supposed to correct this debt financed current account deficit, but thus far into the alleged recovery the deficit remains high circa 6% of GDP.

The collapse in the oil price means that Britain can no longer hide behind North Sea oil, to cover this trade deficit either. As British industrial investment was offshored, the capital account surplus on foreign investments has traditionally been able to cover the current account deficit. There are signs however, that all is not well with the capital account also. It appears that foreign investors into Britain have been able to earn a higher return than British investors abroad. Britain therefore now has both growing structural current and emerging capital account deficits, to add to its expanding budget deficit. Britain is the land of the "three deficits". Age of Wisdom, Age of Foolishness (59) "Patience Is a Virtue" suggested that what has been termed the "Prestige", whereby George Osborne arbitrages the higher defined tax revenue inflation index against the lower fiscal spending inflation index, had just started to kick in. The arrival of the "three deficits" however, vitiates against and fundamentally undermines the "Prestige".

"The Amazing Osborne."

Age of Wisdom, Age of Foolishness (59) "Patience Is a Virtue"

Osborne must now ask Carney to print the Pounds which will be paid out to foreign (and domestic) investors into Britain, in addition to printing the Pounds to pay the national tax receipts. The only solution to the "three deficits" is a Sterling devaluation. The question is now whether this will be engineered by the policy makers or enforced by the speculators. We suggest that it will begin with the former and end painfully with the latter. The rise in interest rates, to reflect both the fall in productivity and currency weakness, will be larger than is currently anticipated.

"Meet Andy Hashtag."

As New Year approached, the Bank's chief economist Andy Haldane signalled that the institution is becoming a reluctant convert to the dark arts of Emotional Finance, propagated on social media networks - vi. Haldane will spearhead the Bank's new attempt to monitor, but more importantly to create and control consensus on, the dangerously pervasive social media networks. After scraping the metaphorical barrel on the search engine and ending up with "KeySignals", Haldane will be able to understand exactly where and when it will all end in #tears. To fill in the gaps in the current groupthink at the Bank, a brief history of the "# UK Recovery" follows below.

The recovery has been one in which low paid unskilled jobs have begun to flourish; because there has been a lack of investment in the real value added sectors of the UK economy since 2013. The wage rises, which animate the Hawks on the MPC, have predominated in the "Jif Jobs", "Burger Flippers", Call Centres, and "Retail Slavery" etc sub-sectors of the UK economy. Wage growth has been so poor, in these sub-sectors, that it still runs way below where it was back in 2008, despite the Hawks suggesting that it is a current cause for concern.

The fact that wage growth now runs above inflation, is because inflation has been redefined lower through George Osborne's "Prestige" strategy, to balance the national accounts by arbitraging higher indexed government receipts against lower index linked payments.

What Nemat Shafik and her colleagues call low productivity, is actually a symptom of the vanishing of investment in the high margin industries that would create real productivity growth. Investment ballooned and peaked in Q2/2014. The jobs that came with the increase in investment, beginning in 2013, where however low and medium skilled. GB Inc. therefore invested in businesses and business models, which use low and medium skilled workers, from Q3/2013 to Q3/2014. Consequently, Britain now has a structurally low/medium skilled economy; therefore it is fair to say that it has structurally low productivity. This structural mediocrity was baked in between 2013 and 2014.

The consumer remains robust and the falling Pound has breathed some life into exports. Exports however, are hostage to a weakening global economy. The heavy lifting in the UK is now all on the shoulders of the consumer. This said consumer is now predominantly structurally low and medium skilled; and therefore has limited purchasing power. If the Bank now feels compelled by its own dogma, to tighten in the face of alleged falling productivity, it will put further much needed investment at risk. If George Osborne has his way with austerity, there can be no investment from the public sector either. The UK economy is therefore just about to implode and then follow the structural trajectory, which it has been bequeathed by the investment in low productivity businesses from 2013 to 2014, to low productivity economic stagnation.

"#Big it up."

Last week the Bank was busy at work framing public opinion, with the positive spin that the "Misery Index" is at its all-time lows - vii. Clearly the Bank needs to spin falling inflation and unemployment as justification for keeping interest rates low. Oxford Economics/Haver Analytics took the bait and are now spreading the "good news" throughout the social media networks that the Bank of England is tapping into.


Pundits are still agonising over whether the fall in the oil price is good or bad for global growth. The fact of the matter is that the oil industry is significantly overrepresented, in all asset classes and derivative instruments in the US capital markets, versus its representation in the real economy. When the oil price fell, the net impact on capital markets has therefore been contractionary. The contractionary impact thus represents a contraction of global liquidity. This contraction in global liquidity is far more dangerous than the positive impact on consumer purchasing power from a fall in the oil price. In fact, rising consumer purchasing power will only lead to inflation in any case, which is a headwind. As it happens, thanks to Shale, the energy sector is also a reasonable chunk of US GDP; but this is insignificant when compared to its share of capital market asset values. The risk presented by the oil price collapse is therefore indirectly through asset prices, rather than directly through employment and output. This negative indirect impact is however significant in magnitude; and more immediately evident in its timing. The same pundits, who are now agonising over the economic effect of the oil price collapse, can however easily read the charts. When they see equity prices following the oil price lower and credit spreads widening, they will shout "recession". They already have a flattening US yield curve, which has apparently predicted this "recession", to frame their opinion. After shouting "recession" they will then shout "QE". The economic slowdown, suggested in Age of Wisdom, Age of Foolishness (59) "Patience Is a Virtue", is therefore a prophecy fulfilled by the behaviour of those lacking in patience and overcompensated with predictable cognitive bias. A weakening US Dollar is the corollary of this self-fulfilling prophecy. The weakening US Dollar will first be read as a signal that US growth has slowed; and then secondly as a signal that interest rate expectations must be revised lower, in favour of further liquidity injections rather than any tightening.

Jean - ; Claude Trichet gave the signal - viii of how global policy makers will coordinate the response to the next drop in global growth. The uncoordinated response thus far has translated into beggar-thy-neighbour currency devaluations; which have been great for equity punters but a zero sum gain for the real economies involved. Trichet hinted that a new currency accord was being formulated between the developed nations. Speculating on how this will be created, one can suppose that the current level of exchange rates will be accepted with some boundaries of fluctuation of say plus or minus three percent. Once these exchange rates and boundaries have been agreed upon and accepted; each developed nation will then be expected to fiscally and monetarily stimulate their own domestic economies. The Americans will do the Helicopter, the ECB will allegedly do QE and the BOJ will be allowed to continue with Abenomics. If they all do this at the same time, the agreed upon exchange rates will not fluctuate violently.

It all sounds as though one ought to sell FX volatility and buy developed market equities and Gold during the next economic contraction. Those with more aggressive risk appetites may wish to get long FX volatility and short developed market equities (ex-cyclical growth stocks) going into the next crisis. Famous accords of the past have been named after the locations in which they were agreed; such as Louvre and Plaza. Since the next economic crisis looks set to be triggered by the Europeans (and because Trichet is a European), the next accord will no doubt be named after an iconic monument in a European city.

"Consider Your Bluff Called."

The Greeks seem happy to play the role of fire-starter again. By now, the average Greek has become so accustomed to economic hardship that they no longer panic when their Prime Minister tells them to vote for his Presidential nomination or face another crisis. Prime Minister Samaras's bluff was thus called, when he failed at three attempts to get his presidential nominee elected - ix. The third failure now triggers parliamentary elections, in the New Year, which will start the European dominoes falling in 2015. In anticipation of a political transition towards anti-austerity, Germany parachuted in its point man Jorg Asmussen, to connect with the Syriza party which is expected to win the upcoming elections - x. Once Greeks realize that the alleged anti-austerity party Syriza has effectively been compromised, by selling out to Germany, the real political chaos will then occur.

"What a Praet?"

Age of Wisdom, Age of Foolishness (58) "Dialectics"

The ECB's eponymous Peter Praet, swiftly verbally intervened, with the hope for QE - xi at the next ECB meeting, in order to try and restore order to the chaos unleashed by the Greeks. His efforts were negated with similar alacrity by Klaas Knot - xii, who made it very clear that QE may be discussed at the next meeting, but is by no means a formality. Knot opined very strongly, that northern Europe has a "deep distrust" of the willingness of southern European countries to make "painful, internal reform measures". Given the tenuous situation, Draghi was then compelled to give his strongest hint yet that QE is coming soon - xiii. Most market participants have however forgotten, that QE has already been discounted as lacking in scope and scale to move the economic needle in any case.

"Under the Radar Screen."

China, it would seem, is already ahead of the developed nations. Not only is it fixing the exchange rates of its developing nation trade partners against the Yuan, but it is also easing by stealth; through the development banks rather than the PBOC - xiv. The Chinese Development Bank Corporation has allegedly eased four times in the last four months. Its traces have been evident in the 4% rallies in equities which accompanied this not so stealthy monetary operation. Unfortunately, stealth easing seems to only beget equity market bubbles which are not translated into real economic growth. China therefore has some work to do on the monetary transmission mechanism, just as its developed nation counterparts also need to do.

Further evidence of this failed transmission mechanism is visible in what have been termed "zombie factories" - xv; which are obsolete yet kept alive by local governments in order to transfer wealth to a potentially violent crowd of obsolete workers. The recently released industrial profits data, however suggests that the pace of factory closures should be accelerating as profits fall to their lowest in two years - xvi. A far more worrying development is the PBOC's broadening of the classification of what current bank liabilities constitute deposits, in order to nudge the banks into increasing lending against this increased "zombie" deposit base - xvii. China has therefore increased the money supply by fiat, whilst simultaneously weakening the health of its banking sector even more. A classic bank run on the deposit base will now end in disaster.

"Weak Yen U-Turn Ahead."

Japan was already ahead of its developed nation trading partners, in undermining the Yen to levels which have caused Trichet et al to call time out on beggar-thy-neighbour devaluations. As Boxing Day was being celebrated, by FX traders trying to push the Yen back to its lows for the year, the Cabinet Office released data which showed that the savings rate has turned negative for the first time since 1955 - xviii.

The shock of rising sales taxes and inflation has forced the Japanese to start to eat into their savings, in order to sustain their living standards. Abe had hoped that his policies would have prompted Japan Inc. to invest, hire and pay higher wages by now. Instead, the cost of his policy has fallen totally upon the consumer. The consumer has now stopped saving, so Japan is reliant upon the tolerance of international investors to finance its debt pile and its increased consumption.

In view of the fact that interest rates are negative and the Yen is falling, said foreign investors should now start to demand a risk premium for their investments; rather than the current form of momentum driven capital gains that their slower witted brethren are creating by arriving late to the party. A rising risk premium and/or early foreign investors taking their capital gains and risk off the table, will force Japan into a situation in which neither foreign nor domestic investors can be relied upon.

At this point only the BOJ can be relied upon as investor of last resort; however it is already overly committed to buying Japanese assets through its QE process. Data released last week, suggests that 2014 was the Year that foreign investors finally lost their faith in Abenomics. Foreign inward investment is down 94% on 2013, which is the slowest pace of investment since 2008 - xix. The Japanese government must now therefore adopt austerity. A continued fall in the Yen is now more dangerous, for Japan's finances in general, than beneficial to its economy. In fact, the behaviour of Japan Inc. suggests that there has been no benefit at all to the real economy from Abenomics.

Just as Abe recently received his mandate to continue at the ballot box, this mandate has been taken away by the precarious nature of Japan's finances. Japan will now have to repatriate the profits on its foreign assets, which have been boosted by the fall in the Yen, in order to finance itself going forward. Additionally and alternatively, Japan will have to raise interest rates to encourage domestic investment and to maintain inward foreign investment. The resultant policy mix is no longer Yen negative but more Yen neutral. As if to underline this new currency vector, the Government last week approved a $29 billion stimulus package, to overcome the sales tax hike - xx, which is effectively deficit neutral. The government is therefore cannibalising existing fiscal spending from other budgetary line items, rather than increasing spending and financing it with debt.

To mitigate this effect, with some genuine deficit spending however, corporate income taxes will be cut - xxi. The reduction in in corporate income tax will allegedly cause Japan Inc. to start hiring and raising wages. In practice however this gift from the taxpayer will be used to reward shareholders. In the recent snap election, the turnout was dreadful; and Abe won because there was no credible opposition, rather than on the strength of his policies and performance to date.

"The View from Abe's Grassy Knoll."

The Democratic Party is now finally getting a credible opposition figure, in the form of Goshi Hosono - xxii; who was the minister in charge of Japan's recovery from the Fukushima disaster. His photogenic legend, as a trustworthy problem solver, is now being busily burnished with his alleged fellowship of the cult of JFK. Hosono is long on sound-bites and short on policies; which bizarrely makes him extremely electable to most Japanese, because he is the antithesis of everything they have come to loathe about Abenomics. As the antithesis of Abenomics, he is therefore the emerging political catalyst to reverse the Yen's weakness and equity market gains that have been associated with Abe.

"Time to Shoot the Cash Cow."

In Age of Wisdom, Age of Foolishness (59) "Patience Is a Virtue" the readership was given a first glimpse of the impending "Hispanic Spring". A little more leg was revealed, as this story starts to run, last week as Mexico resorted to what is effectively confiscation of shareholder wealth at Pemex - xxiii. What is most alarming, about this wealth confiscation, is the fact that it comes against a backdrop of falling revenues at the company as the oil prices nosedives. The Mexican cash cow has now been sacrificed in the name of political survival. At some point in the New Year, the White House can be expected to declare the unfolding situation in Mexico a national security threat to the United States.

The next Hispanic domino fell in Chile; where wealth was confiscated from the investors in listed mining companies ,where the profits are similarly being squeezed by the bear market in commodities, in favour of the mining unions - xxiv.

"You've Already Been Strictly Tangoed."

Argentina is leading the political song and dance of its neighbours; and last week announced a further contraction in GDP, following its second default in the last thirteen years - xxv.

"Banana Republic."

Age of Wisdom, Age of Foolishness (59) "Patience Is a Virtue" anticipated the knock-on effect from Cuba into Venezuela. Last week, President Maduro acknowledged "Hispanic Spring", when he opined that he would unleash an "economic counteroffensive" - xxvi. Said counteroffensive was however light on detail; but apparently the economy will get fixed some time in 2015.

"A Painless Brazilian?"

"Hispanic Spring" is now rapidly becoming generic "Latin American Spring", as Brazilian austerity - xxvii is now being compensated with malfeasance at Petrobras - xxviii; some of which ends up in the national treasury and some of which ends up in Switzerland. Brazilian finances are now so stretched, that the central bank has had to halve its currency intervention to halt the fall in the Real and the inflation that this creates - xxix.

Brazil is not giving up because it wants to however, but because it can't afford to defend its currency and fight inflation any longer. Dilma Rousseff's New Year vow, to achieve economic reform whilst "minimising" sacrifices to the population, hinted that wealth confiscation from the wealthy and foreign elites is now government policy; as she seeks to avoid becoming a victim of "Latin American Spring" - xxx. Robbing from the local and foreign elites however guarantees that she will be joining the likes of Putin on the IMF's hit list.

"Global Ignorance Is Bliss."

Typically, the American consumer is blissfully ignorant of the credit headwinds blowing in from the global and domestic economy; and is more focused upon the increased purchasing power from cheaper gasoline. US Consumer Confidence is back in positive territory for the first time since 2007 - xxxi.

The reversals, of the economic fortune of the US economy and the US Dollar, therefore resemble Wile e Coyote running off the cliff and treading air before he collapses.

The IMF is however fully aware of the problem; and is trying to get out ahead of it. Last week, it started to prepare global capital markets for the big U-Turn on the Fed exit; by opining that the negative impacts of rising US interest rates on the global economy could be mitigated by the Fed not selling its bond holdings into the open market - xxxii. If the Fed does not sell its bond-holdings, then QE becomes permanent by default. The IMF has therefore taken the first global step towards endorsing US Helicopter Money.

The US equity market is therefore being prepared for one of those infamous dips that are supposed to be bought.

"Hear no... See no... Speak no."

Age of Wisdom, Age of Foolishness (59) "Patience Is a Virtue"

Age of Wisdom, Age of Foolishness (59) "Patience Is a Virtue" also observed the Bush dynastic pretensions coming back to the fore. This was confirmed last week, when Jeb Bush resigned from his advisory position with Barclays and his non-exec board seat at Rayonier - xxxiii.


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