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posted on 23 March 2015

Epoch of Belief, Epoch of Incredulity (10): Flogging the Dead Horse

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In Epoch of Belief, Epoch of Incredulity (9) "Comfort Zones" Chinese policy makers and the PBOC were observed preparing for the next round of monetary stimulus. This was dutifully delivered at the beginning of last week - [i]; on the eve of Communist Party's annual meeting. It now appears that China has restarted the asset backed security market that it was once forced to shut down, because it was leading to the kind of dodgy lending practices that created the American housing bubble - [ii].

Premier Li began the national Peoples' Congress with the pledge to avoid Graft - [iii]. This pledge was ironic because, as he was pledging, the real "Grafters" were selling stocks into the PBOC easing. Following the insider selling, the Congress was told that the national growth target would now be revised down from circa 7.5% to 7% - [iv]. The Congress was then informed that the fiscal deficit would be increased, as a countercyclical stimulus to support the monetary easing - [v]. The "New Normal" didn't last long before it was revised lower; so one must assume that the current slowdown is creating the kind of public discomfort that leads to unrest. Chinese leaders must deliver growth at all costs. Observing this inability to break with the past former Goldman partner Roy Smith, the man who called the Japanese bubble correctly, sees history rhyming in China - [vi].

Epoch of Belief, Epoch of Incredulity (6) "Game For A Laugh" introduced the idea that the Fed would be forced adopt a tightening bias; in response to Rand Paul's bill to audit the Fed. Epoch of Belief, Epoch of Incredulity (8) "Hedgehogging One's Bets" developed this theme further to suggest that "The Fed therefore needs to be seen to be punishing Wall Street". Last week, Janet Yellen confirmed that the Fed is indeed leaning in this direction - [vii]. She opined that "The risk of regulatory capture is something the Federal Reserve takes very seriously and works very hard to prevent,"; and also that "it is important that anyone serving the Fed feel safe speaking up when they have concerns about bias toward industry, and that those concerns be addressed."

Epoch of Belief, Epoch of Incredulity (9) "Comfort Zones" then theorised that the Chairman of the Senate Banking Committee Richard Shelby, was offering Yellen a neat solution by his embracing of Richard Fisher's proposals to reform the Fed and weaken the power of the New York Fed.

Last week, Fisher himself signalled that his proposals have been met with alacrity by Congress - [viii]; and have taken on a life of their own. Senator Shelby gave further clues about what he specifically has in mind last week. In principle, he believes that the Fed should be held "accountable" to Congress; presumably through the expanded power and oversight of his committee - [ix].

Accountability still gives the Fed independence from political control; however it gives the Congress more influence over the Fed's decision-making by nature of the accountability clause. Shelby also signalled that there is considerable bipartisan consensus - [x]; which will allow his committee to get what it wants. The Democrats hate the Wall Street influence and the Republicans now hate the notion of QE forever; both of these positions are interrelated and highly complementary in creating bipartisan consensus. It is now becoming clear that the New York Fed will lose its powers over monetary policy in order to comply with the bipartisan views.

Stanley Fischer has been forced to accept the new tightening regime, imposed by a bipartisan interventionist Congress, so he is now signalling rate hikes in either June or September - [xi]. Fischer is politically astute on a global basis; therefore he knows when it is time to accommodate the legislators in order to keep a seat at the policy making table. If the proposals to reform the Fed suggested by the outgoing Richard Fisher and supported by Richard Shelby are carried, Bill Dudley and the New Fork Fed stand to be the main losers of power. Dudley is not giving up without a fight; which he intends to wage from the position of the Doves. According to Dudley, the inflation picture and projections remain benign enough to hold back on any tightening this year and well into the next - [xii].

Janet Yellen seems to have caught a much needed break, in the form of the next President of the Philadelphia Fed. Charles Plosser will be replaced by Dean Harker, who is allegedly a closet Yellen sympathizer - [xiii].

It has taken the spectre of Vladimir Putin and the murder of Boris Nemtsov to provide the existential crisis that brings Germany and France together - [xiv].Emmanuel Macron had signalled that he intends to drive policy decisions through the parliament, rather than through his fractured Socialist party - [xiv]. An existential threat which brings the Eurozone together, rather than tries to fracture it as threatened by Yanis Varoufakis, is therefore the order of the day. Austerity measures, pushed through parliament by Macron, will now be framed in the light of the Russian threat; which should have the desired impact of creating a bipartisan consensus to adopt them.

In what must be one of the greatest cases of unintended economic consequences, Mario Draghi is creating the economic reforms which the policy makers are supposed to be doing. According to analysis from S&P, QE has already driven bond yields to levels at which defined benefit pensions plans have become unsustainable at the current levels of employment. Reform of the famously generous European defined benefit schemes is now a necessity - [xvi]; since Draghi intends to unleash more QE. It will be interesting to see if ECB employees and EU politicians embrace this reform, when it comes to their own pensions.

Covered Bond yields have now gone negative, thanks to the ECB - [xvii]. If and when the whole term structure of benchmark interest rates becomes negative, it will play havoc with the actuarial calculations of the size of the pension deficits when the bean-counters try using a negative discount rate to present the value the pension liabilities. Presumably this will all balance out on paper, if an appropriately lower discount rate is used to value the assets in the funds; and nobody adds a risk premium for a Eurozone breakup!

The Greek public sector is a clear intended victim of this reform; as it is forced to adhere to the Troika's terms for debt extensions. Just to press the point home Valdis Dombrovskis, the defined benefit pension scheme enrolled member and Vice President of the European Commission, suggested that Greece may need a third bailout - [xvii]. Yanis Varoufakis will therefore have to slash and burn the public sector and the rest of the economy, to get the pyrrhic victory of avoiding the third bailout. Having avoided the third bailout, he will presumably have become so unpopular that he loses his job. He may however be able to hang onto his defined benefit pension!

Fortunately for the Eurozone, growth is appearing. Epoch of Belief, Epoch of Incredulity (9) "Comfort Zones" observed that the monetary aggregates in the Eurozone were picking up after bottoming in 2014. Last week, retail sales data showed blowouts occurring in late 2014 - [xix], which continued into the New Year, especially in Germany - [xx].

The sting in the tail is that Germany will now demand higher interest rates rather than more QE. Draghi is lucky that inflation is still falling, thanks to the oil price. No doubt Jens Weidmann will soon be opining on the temporary nature of the fall in oil prices and inflation. Speculation, no doubt also instigated by Germany, has increased that the Eurozone has reached escape velocity; and therefore that there is no need for more QE. Mario Draghi stopped this speculation in its tracks at his press conference last week.

Whilst acknowledging the improving credit picture and economic traction, he was swift to point out (and to take great "satisfaction" - [xxi] and credit in the fact) that this improvement was all created by his QE programme. He then reiterated that the next leg of QE will start on March 9th - [xxii]; and belittled the pundits who now are saying that he won't find anything to buy because all the best assets have been locked away at negative interest rates. Draghi clearly intends to have a go. It must therefore be noted that the ECB has beaten BOJ Governor Kuroda to the next punch, in the great fist fight to pummel currency values against the US Dollar.

In Britain, there is a dawning realization that the next parliament will be a hung one. The SNP will virtually deliver this, if Scottish voters give them the 56 out of 59 seats that the polls suggest - [xxiii]. Labour, which took the Scots for granted for too long as it also has done with the North, will therefore lose any chance of a majority. Further inroads into Labour by UKIP in the North, will only exacerbate the trend. George Osborne's skilful manipulation of public opinion, with his "Northern Powerhouse" mirage, will do the rest. Osborne may not get it all his own way however post-election; but by then he won't care. The latest Bank of England interest rate decision, only seemed to confirm suspicions of the deal between Osborne and Carney to keep rates unchanged before the election. The first rate hike is now being built-in, post-election in late summer.

Carney also is under attack, from Britain's version of the American "Audit the Fed" witch-hunt. The SFO has taken the unprecedented step of investigating the Bank of England's potentially fraudulent conduct, in relation to its part in the bailout of the financial sector after the Credit Crunch - [xxiv]. Carney can pin the blame and the jail-term on former Governor Mervyn King; but he will also have to draw a line under QE as it becomes a legally suspect strategy. The Bank of England therefore, also has an enforced tightening bias going forward. Carney's signal of this tightening bias came last week when, despite the latest Bank of England survey showing that consumer inflation expectations had fallen below 2% the lowest since 2001 - [xxv], he awarded his staff 2% pay increases - [xxvi].

Two weeks ago Prime Minister Netanyahu intervened in American foreign policy and flogged the Iranian nuclear dead horse again, to a divided Congress - [xxvii]. It is almost a year ago that this intervention was first flagged in Age of Wisdom, Age of Foolishness (18) "Beyond the Pale" - [xxviii]. Not much has changed since then. The events in Ukraine and Iran are still inextricably linked, as America tries to "Pivot" towards China. As was said back then it's Spring time; therefore it's time for "Alpha Males and Females to come out to seek Alpha". It's time for the big moves in the markets to discount the upcoming big global-macro events.

The US Employment Report was the catalyst for the search for Alpha in the capital markets.

The big Alpha event of the US Employment Report, was framed against some alarming statistics about the lack of real economic growth. The productivity data - [xxix], before the Employment Report signalled that the Fed has a bigger problem with labour cost inflation than with falling output. The Fed's enforced tightening bias from Congress is therefore underwritten by the productivity data. US share buybacks, averaging $46 Billion a month, are the biggest driver of equity market inflows - [xxx]. Clearly there is no growth, or at least CEO's don't think so; as share buybacks dwarf portfolio investment flows by six to one. If one factors in the impact of high frequency trading, that significantly leverages off the genuine portfolio investment, the situation looks even more frightening.

Dow Jones waved the red flag on growth, with the decision and timing to replace AT&T with Apple as a Dow Jones 30 Index component - [xxxi]. Apple is the only corporate growth story in America; so Dow Jones is trying to avoid the next bear market (and hence lack of interest in its index) by doing the ultimate momentum trade of stock-picking Apple. As Apple grows in value, the index will remain supported. Picking growth stocks and ejecting non-growth stocks is the fundamental reason why the Dow has been in a secular bull market ever since it was invented. If the Apple bet doesn't work out, Dow Jones will simply have to replace it with the next momentum stock. Passive index trackers, who have to buy the basket and sell the ejected stocks, will always underperform the index itself however. Just buying the index itself, rather than the component stocks, neatly avoids the sleight of hand played by Dow Jones in order to create a smoothed rising index.

Other red flags appeared in the Social Media and Biotech sub-sectors of the Technology Sector. Funding valuations of Social Media start-ups have reached levels; as surplus capital chases the misperception of the next growth opportunity in an economy which lacks growth opportunities - [xxxii]. Large Cap Technology however, trades on 15 to 17X P/E multiples which makes it look like a relative safe haven in the face of the Social Media bubble.

In the Biotech sector, short interest keeps growing - [xxxiii]. Going into the Employment Report, John Williams signalled that the big discussion about tightening will occur in June - [xxxiv].

Despite the fact that the BIS reported that the major global banks still need to find $300 billion in safe assets - [xxv], the Fed's own stress test found that the major banks it regulates will weather the storm of another crisis - [xxvi]. The Fed's stress test therefore gives the green light for tightening later this year.

The February Employment Report - [xxxvii] simply confirmed the justification for the Fed's tightening bias; to be manifested as the dropping of the word "patient" at the very least in March and a rate hike at the very most in June. Combined with the productivity data, the Employment Report suggests that more Americans are being employed to do even less work; and that they are being paid handsomely for this privilege also. The February Employment Report is therefore a lack of productivity signal and not an economic growth signal.

The Fed will now have to appear to nip this unproductive expansion phase in the bud, before the Social Media bubble becomes the next Housing Bubble. Having nipped the bubble in Shale Oil (and the global oil price) in the bud recently, the Fed is moving on to address other asset bubbles (that it has created!); and the problems that these bubbles create for productivity as a consequence. Mario Draghi, on the other hand, has signalled that he is envious and will try his best to create such bubbles in the Eurozone. The underperformance of the Euro and outperformance of European equities are therefore given variables. The Eurozone and the Japanese economy should prove to be the last global hiding places of asset bubbles.

Epoch of Belief, Epoch of Incredulity (9) "Comfort Zones" observed the game-changing "clean" Fracking technology, that Roman Abramovich is rolling out in the American Shale industry - [xxxviii]. The major beneficiary of this game-changer appears to be Exxon. In what can only be seen as a major shift in strategy, CEO Rex Tillerson announced that US Shale is going to form the core of Exxon's business - [xxxix]; as the company transitions from global major to US domestic major. Exxon either has a negative view on global economic growth, or on the rapacious attitudes of governments in oil producing countries, or both. Cryptically, Tillerson opined that Exxon will use the cash it generates from American Shale to fund other global projects. It therefore appears that Exxon's costs of production are now cheaper in America than they are globally.

The company will therefore now become the major consolidator, as indebted US Fracking companies go into liquidation. Said companies think they have found a way to avoid liquidation, by booking drilled but untapped wells as proven reserves - [xl]. They therefore hope to fool the auditors, exchange regulators and Wall Street analysts into accepting that drilled reserves are the same as oil stored above ground in tanks. This sounds like creative accounting, verging on fraud, rather than Contango. The oil business is clearly becoming even dirtier than ever. Exxon's refocus on US Shale hints at global Peak Oil; in so far as cheap global reserves are no longer available to global oil majors. The fraudulent accounting, ongoing at US Shale drillers, should provide the cheap barrels of distressed reserves that Exxon has excelled at acquiring globally during its illustrious past.

It should also be noted that Exxon is still expanding into Russia - [xli], as sanctions bite and Russian crude oil reserves therefore get cheaper on paper.

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