Age of Wisdom, Age of Foolishness (49)
“More Like Grim Fairy Stories.”
As the world’s economic policy making boys and girls came out to play, at the IMF and World Bank annual meeting in Washington two weeks ago, the various wondrous stories which they listened to were discounted by the market mechanism that is supposed to tell a rational story all of its own.
Age of Wisdom, Age of Foolishness (47) “Black September – Red October
” observed the insider selling of shares into the continued corporate share buybacks. This buyback bid seems to be very much still in place; suggesting that the capex expansion cycle, which is supposed to kick in when this buyback wave ends, is still some way off. S&P announced that approximately $1 trillion, or 95% of company income, will be spent on buybacks and dividends[i]. The conclusion therefore is that there is still no economic growth in sight in the US and that companies are sweating aged capital assets harder; and massaging earnings per share ratios harder, through reducing the denominator with buybacks. The corporate bid for US equities is therefore still strong, despite the panic selling from speculators.
“Once Upon a Time in Washington.”
This corporate bid should also be added to the global bid for US equities, identified in Age of Wisdom, Age of Foolishness (48) “Alpha and Omega”; created by capital flight back into the US Dollar to avoid the weaker global growth conditions occasioned by the expected Fed tightening and problems in the Middle East.
“The 67% Safe Haven.”
The data shows that S&P 500 companies get approximately 70% of their income from America and the rest globally[ii]. This explains the flight into the US Dollar and US Equities as the global economy weakens.
These flows were assisted by the IMF last week, when it began to opine on the state of economic growth in the key global economies. It would seem that the IMF has started the debate about the global growth issue again. The IMF cut its growth outlook for the German economy[iii], which was then underlined by the weak German industrial production data[iv]. Clearly the IMF would like Germany to revisit its strict resistance to austerity and quantitative easing by the ECB.
France then followed the IMF’s lead and also began to strongly verbally push back against fiscal austerity again[v]. The French were clearly infuriated by Mario Draghi’s adoption of the German position on the Stability Pact, at his press conference the previous week. Rather than conforming, France is aggressively dissenting; its Prime Minister however appears to be out of tune with his people. France has been most careful to equate economic growth with fiscal expansion; hence its calls for growth policies are code for fiscal stimulus. The French have even decided to wreck Draghi’s Asset Backed Security (ABS) purchase plan, in order to get their own way. Germany and Austria have resisted the ABS purchase plan on the principle that it represents deficit monetization[vi]. France has however rejected it because it does not involve national central banks; and is instead centrally controlled by the ECB directly in Frankfurt. This direct central ECB control prevents the national central banks from actively monetizing assets in their own countries; which is clearly something that the Bank of France wishes to do. The ABS purchase plan is therefore dead on arrival; because both France and Germany reject it[vii], for totally conflicting reasons however.
The ECB then put a brave face on its ABS purchase plan and tried to regain the initiative; when Vitor Constancio alleged[viii] that the programme will be one trillion Euros in size. This scope and scale will allegedly have the desired impact on the credit creation process; and hence on economic growth. The markets remain sceptical however; and will only accept QE from the ECB. The situation in Europe therefore has to degenerate further; and the ABS purchase plan has to be given time to fail, before Draghi can start the QE debate. By then the German economy should be weak enough for him to receive a more receptive German audience. The latest German industrial output data is back at August 2009 levels[ix]; and Chancellor Merkel is already looking for “deficit neutral” forms of economic stimulus[x]. Gradually the consensus is developing that Germany is heading into recession. The response by Merkel has been very enlightening.
“She Came, She Saw, She Cut… Deficits!!!”
Age of Wisdom, Age of Foolishness (43) “The Wild Geese Chase”[xi] had observed that Germans were beginning to feel more European as the Russians began to breath down their necks. Germany sought safety in numbers at the EU. It was evident that Germany was also coming round to easing back on austerity, in return for economic reforms in its neighbours and solidarity in the face of Putin. Since then however, Russia has been brought to its knees with crippling sanctions. Feeling less threatened, Germany has begun to feel and behave more German and less European. As it heads into recession, the need for charity to begin at home, rather than in Eurozone neighbours, has made Germany become even less European. Germany’s neighbours, on the other hand, have perversely become less nationalistic and become more German also. Angela Merkel completely destroyed French requests for fiscal stimulus; and Hollande didn’t even complain[xii]. Even the ECB has become more German; and embraced the stability pact with renewed fidelity[xiii]. This reversal of roles spells nothing but trouble for the Eurozone ultimately. Draghi may be hoping that, when the Eurozone faces oblivion, he will be called upon to save the day. This is his and the Eurozone’s only hope at this point in time.
Qu’est-ce que c’est……”
(Talking Heads, Psycho Killer)
Age of Wisdom, Age of Foolishness (43) “The Wild Geese Chase”[xiv]
Despite French attempts to promote the growth agenda, the country has surrendered once again to Germany. President Hollande was once viewed as a dangerous radical who would turn the Stability Pact on its head. He played to the gallery in this way, in order to get elected. Once elected, he embarked on the same programme of economic reforms which had got Sarkozy kicked out. Most recently, after the savaging by Draghi and Germany, he fell further into line by embarking on the deconstruction of the generous and unaffordable French welfare model[xv].
Hollande’s surrender has been chronicled by his former partner; and will now be further detailed by one of his former ministers, in another ugly a kiss-and-tell book entitled “the Intractable”[xvi] (Insoumise).
“The Naked Truth About Europe.”
Another European narrative is developing, which will combine with the debate being sparked by the IMF; in order to force Germany to reduce the fiscal constraints and also allow the ECB some room for QE. This narrative opines that Europe is now piling up a large current account surplus, because it has stopped consuming and started saving to meet its fiscal austerity guidelines[xvii]. The narrative is embellished with the illustrations of the massive youth unemployment lines across the continent[xviii].
Drilling down through the thin cover story, it becomes clear that the current account surplus is actually only in Germany; since it is the only country with any semblance of an industrial base left after the ravages of the Credit Crunch. This current account surplus must therefore be balanced by a capital account deficit, or so the economists’ narrative goes. Europeans will therefore recycle the Euro current account surplus by investing in foreign capital market assets. This part of the story also lends itself to the recent capital flight from the Eurozone into the US Dollar, which has been accelerated by the crisis in Ukraine.
Once again drilling through the cover story, it is in fact only the German current account surplus which is being recycled in this way. If Germany recycled its current account surplus, by either buying goods and services from its neighbours and/or investing in their capital market assets, the situation would be balanced again by economic growth within the Eurozone.
“Leaving the Eurozone Party So Soon Angela?”
Germany shows no inclination to do the former, because it wishes to protect its own industry and jobs. It shows no interest in doing the latter, because it labels this as deficit monetization. German industry is therefore happy to weaken the Euro against the US Dollar through capital flight, in the hope that this will make German exports competitive.
Other Eurozone neighbours also hope to export their way out recession this way. At this stage however, American industry is starting to make noises which suggest that it is not happy about the US Dollar strength; especially given that Japan and the Emerging Markets are racing to the bottom of currency pool with Europe. Some nasty discussions over the level of the US Dollar against America’s trade partners are imminent. The American economy is nowhere near strong enough to face the double jeopardy of rising interest rates and a rising exchange rate. When all this blows up in spectacular fashion in the currency markets, through a knee jerk weakening of the US Dollar and a corresponding collapse in global equity markets, the nations involved will be obliged to get around the table and compromise.
So far Germany has been the one nation that has not compromised on anything; so it is reasonable to expect global pressure to be exerted upon it. This pressure will come with the demand for Germany to recycle its current account surplus, through consumption from trade partners and also investment in capital assets, that creates economic growth. At this point, the likes of France and Italy will jump in and say that what Germany calls deficit monetization qualifies as the kind of capital investment which leads to growth. Getting to this point will involve much volatility and a recession in Germany however. The Eurozone may also have to reach breaking point again. Just to help it on its way, Greece is providing the catalyst as usual. Prime Minister Samaras invited the bears into his country, when he gamely announced that Greece would seek to leave the bailout administrative process early; and return to borrow on the global capital markets[xix]. The IMF in the meantime is swiftly forcing convergence on this point, with its latest bearish call on global economic growth[xx].
“Tighter Than Initially Thought.”
Age of Wisdom, Age of Foolishness (48) “Alpha and Omega” explained how the Financial Stability Board (FSB) had tightened global monetary policy, independently from the global central banks. Last week it was revealed that this credit tightening event was even more severe than initially thought. Last week it was signalled that, under the new Loss-Absorbency Rule, the largest banks will have to hold capital equal to 25% of their risk weighted assets[xxi]. The cost of capital has risen significantly; and hence the volume of credit available will be more expensive and smaller in size.
“At the Heart of the Fractured Global Economy.”
The conclusion therefore is that the Fed can’t tighten because it will decimate the global economy, just as Germany heads into recession. In fact, the Fed may soon have to start easing again; to expand global liquidity and to weaken the US Dollar for US exporters.
“Time For Some More QE?”
The five-year Treasury breakeven is back at the level which has been a consistent signal of an imminent QE programme[xxii]; so clearly there is great scope for more QE as global headwinds have blown away the consensus for rate hikes in 2015. Since QE clearly isn’t working, which is why the breakeven is back in the trough, something different must be attempted next time. The policy option of choice seems to be the Helicopter; with a cargo of the permanent expansion in the money supply, enabled by a permanent expansion of the Fed’s balance sheet and a transmission to the Middle Class through a reformed tax code. The FOMC Minutes[xxiii] confirmed that there was some concern over the headwinds, from the slowing global economy and crises in Ukraine and the Middle East; causing an export sapping rally in the US Dollar which was already underpinned from rising interest rates and low inflation. Speculators immediately began to unwind the stronger US Dollar trade and take back the expected rate hike priced into the forward curve. The weakening US Dollar then drove the export improved bid for US equities and the markets squeezed higher, on the release of the FOMC Minutes.
“Abeshima’s Three Arrows Prove Fatal.”
The picture in Japan is deteriorating rapidly. It was revealed that, just as in America, corporations are the biggest buyers of their own shares. The “Solactive Japanese Buyback Index”, tracking 15 to 25 companies, has surged 12 percent so far this year against a 0.1 percent gain for the JPX-Nikkei 400[xxiv]. There is no real growth in Japan; and companies massage their earnings-per-share numbers through buybacks. Japanese QE therefore goes to companies who plough income back into equities.
Speculators weakening the Yen, have so far failed to drive sales growth for companies; so the companies have continued to buy back shares instead. Speculators, who think that Japanese equities are strong because the Yen is weak, have been making an incorrect assumption. Algorithm traders, who have encouraged them in this assumption, have compounded the error. In addition last week, there were signals that lawmakers are becoming uncomfortable with the Yen weakness. In a sign of panic, some lawmakers actually openly called for guidance on BOJ stimulus exit[xxv]. The FOMC Minutes then drove the Yen higher versus the US Dollar; prompting the Algorithm traders to assume that this Yen strength will be bad for Japanese equities. Suddenly, both Yen weakness and strength are viewed as bad for Japanese equities.
The inflection point has just been reached. The IMF has also decided that the collapse of Japan, rather than the success of Abenomics, is more congruent with its current worldview. The IMF therefore decided to derail the Japanese equity and currency markets last week, by opining to the BOJ that the risks created by the weak Yen were greater than the economic benefits[xxvi]. The BOJ’s timeframe for meeting the 2% inflation target has therefore been destroyed; and hence with it all certainty in relation to future policy and behaviour of the BOJ.
The “FOMC Minute Squeeze” lifted all boats; however it is hard to see that the event was positive for equity markets in general. The only way for all equity markets to continue rallying out of the confusion, is for consensus to develop that all nations will be racing to the bottom; by increasing their monetary and fiscal stimulus policies to maintain their currency competitiveness. The Gold market suddenly came out of intensive care; and started to return to life again, in anticipation of this outcome. The Gold price however suggests that the Euro and the Yen will not experience the anticipated fiscal and monetary stimulus. The Gold price therefore suggests that QE from the ECB and further QE from the BOJ will only occur once the US Dollar has dropped to a level that threatens European and Japanese exports again. It fails to take into account the fact that there are still counter-flows out of Europe, Japan and Emerging Markets into the US Dollar.
There is therefore no overwhelming global consensus, which means that currency and equity markets will move by 1%+ each day, as each different flow driver dominates the daily trading pattern. In general, this chaos sounds like a driver of a pickup in volatility; which generally is not favourable for those wishing to go long risk for anything longer than a day trade after the preceding day’s 1%+ fall. Going long risk, in anything other than buying the US risk dips, is also fraught with further risk; since the underlying flow is to exchange global risk for US risk. Markets will get churned and manager performance will suffer in consequence.
“Inflation: Not Too Hot and Not Too Cold…. One Hopes…..”
The IMF solution to the crisis, which it is helping to engineer, is directly aimed at the real economy. This solution strongly resonates with the principles behind the Helicopter; which would see the permanent monetary expansion transmitted to the Middle Class via the tax code. The IMF pushed a little further towards this outcome last week, when it opined that interest rates needed to rise to avoid concentrating further risk from QE into already overvalued financial assets[xxvii]. Interest rates should therefore rise to stimulate investment into real economy capital assets, rather than into financial assets. The IMF is playing with fire. Not only does it wish to cause a bursting of the financial asset bubble, but it also wishes to unleash all the liquidity stored up in these financial assets into the real economy. It hopes that the capital formed will prevent the liquidity from creating price inflation in goods and services.
The IMF hopes that, if interest rates are high enough, the liquidity will create a hyper-capital investment boom rather than hyperinflation. The risk being contemplated is massive. What the IMF is proscribing, is the same Weimar Republic economic policy which yielded booming useless capital investment and consumption simultaneously. The party was great until it ended. Germany clearly understands all this; which is why it is pushing back so hard and balancing its budget.
“Not On the Same Page.”
By the end of the week in Washington, it was abundantly clear that the two competing schools of economic thought, labelled the Chicago Freshwater School and the New England Saltwater School, had mixed violently and then separated clearly; to create an unpleasant cocktail for global financial markets.
“Old Boys Defending Their School.”
This division and lack of cooperative spirit was evinced by the war of words between Draghi and Schaeuble about fiscal stimulus[xxviii]. Draghi, a protagonist for the Saltwater School of MIT, supported fiscal stimulus; whilst Schaeuble for the Freshwater School denounced it. Larry Summers, also an MIT alumnus, then joined in the German bashing debate in Washington[xxix].
“The Teutonic Order of Chicago.”
“All Is Revealed.”
The tale of two cities, where “it was the age of wisdom” and “it was the age of foolishness”, from which the title of this series of reports is derived, can therefore finally be revealed; as the tale of Chicago versus Boston. Kudos to those readers who had already worked this out.
The “FOMC Minutes Squeeze”, signalled that there is a Saltwater chapter within the Fed, that is moving the goalposts in order to accept global deflation and its cipher the strong US Dollar as the main risks. The main protagonist and manipulator of this view, was also revealed last week. Stanley Fischer, the doyen of the Saltwater School and mentor of its current class of global policy makers, signalled that he is the individual referred to in the FOMC Minutes in relation to deflation risk and the strong US Dollar[xxxi]. This should be no surprise, because readers will already be familiar with his first comments on this subject back in the article entitled “Beggar Thy Neighbour Tightening” in June 2013[xxxii]. Last week, Fischer also opined that the words “considerable time”, in relation to the Fed’s current policy, have a duration between two months and one year[xxxiii]. This suggests that the unfolding global markets’ crisis and recession will occur over the next two months; after which Fischer has a further 10 months to reverse the decision to tighten, to become a decision to increase the fiscal and monetary stimulus.
“That’s another fine mess you’ve gotten us into Stanley.”
Age of Wisdom, Age of Foolishness (37) “The Third Mandate”[xxxiv]
His former pupil, Mario Draghi, is now being heavily relied upon to engineer the “fine mess” in Europe which Fischer requires. Teutonic resistance will actually play into Fischer and Draghi’s hands, by making the financial crisis worse. There are tangible signs that consensus is swiftly changing to reflect Fischer’s worldview, with each fall in equity markets[xxxv]. The Basel Committee is now pro-actively working with banks to prepare for the worst.
In November, the BIS intends to publish a report; which will name and shame the banks who are not modelling and pricing risk on their balance sheets correctly[xxxvi]. The banks assume that they are “Too Big to Fail”, but central bankers are making it abundantly clear that they must pick up the tab for the next losses by raising capital buffers now. In the next crisis, the Fed’s liquidity is going to be channelled into the real economy directly via the tax code; and not via the banking system. The US commercial banking system has been disintermediated and quarantined, so that in the next crisis the taxpayer will not be called upon to bail it out. The US taxpayer will work directly with the Fed. Mario Draghi is expected to do the same thing in Europe, but first Gotterdammerung must play in Frankfurt as well as at Beyreuth.
“Rupert’s Bear Markets.”
Age of Wisdom, Age of Foolishness (38) “Rosebud”[xxxvii]
By the end of the week in Washington, it was also becoming clear that the scenario predicted in Terminal Velocity (14) “Goldilocks Economy and the Three Bear Markets”[xxxviii]; and suggested in Age of Wisdom, Age of Foolishness (38) “Rosebud”[xxxix] was being framed as the global consensus. Central bank QE policies have pulled growth from the future into the present. A convergence point has now been reached, at which the current growth phase meets the future black hole where the growth was taken from. Economic growth has not been strong enough to reduce fiscal deficits in general. In general, fiscal deficits have been reduced by spending cuts. Growth however, is now not great enough to carry the debts which remain outstanding. A new credit crunch could occur, if central bankers take back the temporary QE stimulus and raise interest rates. Once realization of this fact occurs, the temporary QE stimulus will be made permanent. At this point, speculators will smell inflation and return to inflation hedges such as Equities and Gold.
Whilst the economic policy makers created the economic headwinds, the politicians created the geopolitical headwinds last week. These geopolitical headwinds are being blown by the issue of “regional boots on the ground” in Syria. Progress towards this scenario, which enables what was termed America’s “Pirouette” in Age of Wisdom, Age of Foolishness (48) “Alpha and Omega”, had been running smoothly until Joe Biden felt the need to intervene.
“Joe You’re Out of Step Again.”
The incursion by IS into the Kurdish town of Kobane[xl], adjacent to Turkey would have been the ideal catalyst for some “regional boots”. Turkey would have been forced to provide the “regional boots” in this instance; especially after the helpless Kurds opined that airstrikes alone were not working without ground support[xli]. John Kerry also admitted that a credible opposition on the ground was necessary to get the full combat value from airstrikes[xlii]; so the stage was set. Joe Biden is not known for his verbal dexterity, therefore it was no surprise at all to hear that he had directly accused America’s trusted ally the United Arab Emirates of financing IS[xliii]. As the “regional boots on the ground” scenario started to crumble with his words, he was forced to apologise unreservedly. There were no apologies made, by the British Army’s “Brass”, to Saudi Arabia and Qatar however; whom they accused of the same transgression[xliv]. The situation was made even more obscure by the Syrian rebels themselves, who now allege that coalition airstrikes against Assad actually strengthen IS more than themselves[xlv]. It appears as though a rolling conflict is emerging, with IS as the first priority, followed by Assad and then presumably finally by Iran. In these circumstances, it’s no surprise that Joe Biden is confused.
“…. Soldier, Spy.”
Britain also followed up by appointing a new chief of intelligence[xlvi], from an operational and military background; replacing an outgoing career diplomat at the helm. Clearly Britain feels that the current situation requires a different skill set.
The most enlightening signal of global consensus creation was however revealed by the Nobel awards last week.
“ A Star is Born.”
The peace prize award to Mulala Yousafzai was a clear reference to the need for consensus on the global threat of Islamic Fundamentalism; and therefore needs no explanation.
“What Goes Around Comes Around.”
What was ignored however, is the signal provided by the literature prize. The judges of this prize clearly have a sense of humour; and a sense of history. Some older readers may remember the time when the clandestine policy makers in Washington were able to manipulate a “forbidden book”, by an obscure Jewish writer in the Soviet Union at the height of the Cold War[xlvii], to receive a Nobel Prize for literature. This time around, the current Cold War between Germany and the Anglo-Saxons is reflected in the award.
“A Play on Words.”
The prize was given to the obscure French author Patrick Modiano. Modiano is the son of a Sephardic Jewish Frenchman who allegedly collaborated with the Nazis during the occupation.
“La Place de L’etoile.”
The son’s literary creative output, for which he has now been recognised, flourished during his exploration of his estranged father’s role in this episode in history.
“Etoiles in their eyes.”
The parallel with today is clearly evident in the collaboration of Hollande, who is himself also Jewish, with Germany’s domination of his country and the Eurozone. The can of economic worms was opened in Washington last week; and the can of political worms was opened in Stockholm. The debate and the revelations, about the past and current situation, will now directly influence how Germany wishes to be remembered in posterity. So far Germany (and France) is reverting to historic type.