The Smart Bird

The Smart Bird – Fissures in the Global Investing Environment

This month’s Smart Bird ponders 1) whether traditional economic indicators matter with the financialization of the global economy 2) how the financial sphere’s co-opting of the instruments of power – to reinflate asset bubbles to save the financial system – has lead to the terminal phase of the global credit bubble 3) and how the current global environment affects our investments and future.  First some quotes:

As an important side note, the financial crisis was not resolved by quantitative easing or monetary heroics.  Rather, the crisis ended – and in hindsight, ended precisely – on March 16, 2009, when the Financial Accounting Standards Board abandoned mark-to-market rules, in response to Congressional pressure by the House Committee on Financial Services on March 12, 2009. The decision by the FASB gave banks “significant judgment” in the values that they assigned to assets, which had the immediate effect of making banks solvent on paper despite being insolvent in fact. Rather than requiring the restructuring of bad debt, policy makers decided to hide it behind an accounting veil, and to gradually make the banks whole by lowering their costs and punishing ordinary savers with zero interest rates, creating yet another massive speculative yield-seeking bubble in risky assets at the same time.

John P. Hussman, Ph.D.  – Hard-Won Lessons and the Bird in the Hand (December 1, 2014)


In the worst-case scenario, the faltering of the global Bubble at the Periphery ensures that central bank liquidity stokes “Terminal Phase” excess at the Core. The global monetary experiment is failing spectacularly, though over-liquefied securities markets remain in denial.

Doug Noland – Credit Bubble Bulletin


The BIS has particular authority since its job is to track global lending. It was the only major body to warn of serious trouble before the Great Recession – and did so clearly, without the usual ifs and buts…It now warns that the world is in many ways even more stretched today than it was in 2008, since emerging markets have been drawn into the global debt morass as well, and some have hit the limits of easy catch-up growth…  Debt levels in rich countries have jumped by 30 percentage points since the Lehman crisis to 275pc of GDP, and by the same amount to 175pc in emerging markets. The world has exhausted almost all of its buffer.

Ambrose Evans-Pritchard – Dollar surge endangers global debt edifice (Dec 7, 2014)

In Doug Noland’s ongoing Global Credit Bubble analysis, he sees the signs the current global credit bubble has been pierced and that attempts by central bankers to re-inflate their bubble will lead to the terminal melt up at the core.   And the US markets are at the “core” and the terminal phase means they are the recipients of flows of money fleeing the “periphery” or emerging markets.   Thus the S&P 500 continues to establish new highs, yields continue to decline (US Bonds Rally) and the dollar is rallying even with the termination of QE and the initial popping of the bubble.  Most of these flows exist purely in the financial sphere and are not for economic purposes.

The narrative developing by many independent financial writers is quite different from the mainstream financial media.  While the political-financial complex is indeed complex the narrative emerging is simple — the economic sphere is not growing sustainably because incomes, policy making, corporate management, the markets and monetary policy have been co-opted by the financial sphere and its beneficiaries.  It is also becoming clear the traditional measures of economic output are useless for seeing the next crisis develop as the bubble does not exist in the economic sphere.  And leveraged speculation on purely financial instruments cannot withstand shocks of the current rally in dollars, nor can certain emerging economies and this is leading to destabilization of the financial sphere.

Looking forward, the real battle will be on who shoulders the losses of the next crisis.   The economic sphere can no longer support nor bailout the financial sphere, so the politicians will use the next crisis to further attack federal and military pensions and other social financial contracts with little resistance from a struggling main street.  This will be done to fully meet the obligations of the bond market under the guise that interest rates will go up if “tax payers” default.  The fact is the response to the last crisis drained savers to include individuals, life insurance policies, and private pensions with manipulated low interest rates in order to shore up bank’s balance sheets.  There is little room left for the average American to lose any more retirement income especially for those who ride the next bear market down.

The battle was not and will not be between the 99% and the top one percent;  it is about where and how the wealth of the nation(s) is flowing – the financial elite.    Warren Buffett and Steve Jobs were not part of these elites, they earned their good fortune.  It is those who control other people’s money and reap excessive rent on it that we must consider.  We also must consider how their co-opting of the mechanisms of wealth transfer affects our personal wealth (investments and incomes) and our earned future wealth flows (social security and pensions), not to mention our government and our culture.

Dr. Hussman’s “side note” contains many of the makings of  the Financial-Political Complex.  It includes Congressional influence, accounting standards, the large banks, monetary policy, quantitative easing, the transfer of wealth from ordinary savers to the banks and the present bubble.  There is more of course, but it is a good start to understand that the failure of properly and ethically dealing with the causes of the last bubble and financial crisis have led to the current bubble and makings of the next financial crisis.

David Stockman, former Director of the Office of Management and Budget under President Reagan, makes the case that the Federal Reserve was co-opted by Wall Street to target the stock and bond markets as a transmission of monetary policy to the real economy.  Interestingly, there is scant evidence a rising stock market leads to increased economic output as the Federal Reserve would have us believe, but the evidence is strong that it provides a transmission of wealth to the financial sphere by way of boom and bust cycles in financial assets.  Before we get to his rant, let’s take a look at two bottom lines from research papers found at the St. Louis Federal Reserve’s publication website.  The first is titled “Has QE Been Effective”.

…The analysis presented here suggests that QE had little or no effect in reducing long-term yields relative to what they would have otherwise been.  If QE did not significantly reduce long-term yields relative to what they would have otherwise been, it cannot have increased output or employment either.

The second is titled “Projecting GDP Growth Trends in Labor Force Participation”.  Mr. Martin discusses the labor force participation trends and the expected reduction in economic growth:

…The calculations described above imply that real GDP would grow at a 2.3 percent annual average between now and 2022, declining slightly toward a 2.0 percent annual average by the next decade. These rates are significantly lower than the 3.3 percent average annual growth rate of real GDP between 1955 and 2007.

When expressed as a fraction of the labor force, the output gap is essentially closed and there is no further role for stabilization policies. Assuming current demographic trends persist, we should not expect output and output per capita to return to their pre-recession trends. Furthermore, the use of these variables to measure the output gap may lead to persistent misdiagnoses of the state of the U.S. economy.

Now on to David Stockman’s rant.

However, notwithstanding the fact that the Fed has pumped $4 trillion of new reserves into the financial system since the year 2000, there has not been a single hour of gain in private non-farm labor inputs supplied to the US economy during the past 14 years…

Yet here is where the Wall Street connection enters the picture. While the modern Fed’s incessant manipulation of money market rates, the yield curve and the price of risk assets generally can have no lasting effect on household and business spending, it does cause massive financial bubbles. The latter, in turn, can be harvested by adroit speculators during the 5-7 year intervals between the inevitable busts which result from central bank financial repression and artificial inflation of risk asset values.”

That essentially is the reason for the present universe of some $3 trillion of hedge funds, and the trillions more of mutual funds and institutional investors which surf on their momentum driving waves. Their assigned function in the scheme is to be the first-in and first-out as these central bank financial bubbles inflate and bust.

David Stockman –B-Dud Explains The Fed’s Economic Coup – Or Why Every Asset Price Is Manipulated

So how is main street doing?  John Mauldin of Mauldin Economics presents us with James Montier and his recent GMO white paper, “The World’s Dumbest Idea” that brings in the other element of the financial sphere—CEOs of publicly  traded companies and their financial officers.  While Stockman rails on Wall Street, Mr. Montier “tirade” is on the rise of shareholder value maximization (SVM) over prudent corporate managerialism that existed prior to 1990.

He presents evidence that the large CEO compensation packages that include stock-related pay has actually lead to worse performance of the companies (economic sphere) partly through less corporate business investment all the while enriching the CEOs (financial sphere).  How enriching?  Prior to 1989 the CEO to worker compensation ratio was less than 30, presently it is over 300!  Also consider, the average life of an S&P 500 company has recently been reported around 15 years compared to 27 years in 1970s and 75 years in 1920s.  Mr. Montier highlights a parallel trend of maximum rent seeking of CEOs in the minimum time possible since the average CEOs tenure was 6 years in 2010 down from 12 years in 1970.

So how are the majority of Americans doing?   Mr. Montier again paints the picture in his white paper.  Since 1997, the bottom 90% average savings rate has been ZERO percent or below.  Think about that awhile.   Any drop in income after taxes leads either to a drop in spending (drop in GDP), a savings drawdown, or increased credit to maintain spending.  The reported savings rates we normally see published at the Federal Reserve’s websites comes solely from the top 10% then averaged out with the rest of Americans.   Also consider that during the last two economic expansions since 2000, the bottom 90% incomes have declined.  Before deficits and QE became the permanent policy, investment in economic productive growth came directly from savings out of income.

That corporations can increase reported earnings per share by decreasing business investment, not fully funding pension plans, and other financial engineering – all unstainable – leads to larger financial boom and bust cycles.  Yes the business cycle has been replaced by a much larger and a more dangerous financial cycle and it is global in nature.   With business cycles, one nation could go into a recession while others were still in a growth phase.  This allowed that nation to make financial adjustments to come out of recession.  The last financial crisis created simultaneous recessions globally with all nations trying to make economic adjustments and working against each other.  The last crisis did not emerge from the economic sphere.   The Federal Reserve’s secretly lending of over 2 trillion dollars to the financial sphere restarted the frozen credit markets prior to a global economic depression setting in.

But the crisis is over, the stock market says so?  I have never thought Quantitate Easing was about the economy, it was about bailing out the Federal Reserve’s system and its owners’ (the banks) impaired balance sheets that Dr. Hussman’s side note alludes to.  I wonder if the Fed’s so-called targeting of the stock market is actually just a cover story along with inflation and unemployment targeting for continuing to bail out the balance sheets…if the stock market is up, the sheep will go back to sleep.  But Dr. Hussman also warns us that QE does not guarantee the maintenance of a permanently elevated stock market.  In his 24 November commentary titled “A Most Important Distinction” he provides us this:

The upshot is this. Quantitative easing only “works” to the extent that default-free, low interest liquidity is viewed as an inferior holding. When investor psychology shifts toward increasing risk aversion …default-free, low-interest liquidity is no longer considered inferior. It’s actually desirable, so creating more of the stuff is not supportive to stock prices. We observed exactly that during the 2000-2002 and 2007-2009 plunges, which took the S&P 500 down by half in each episode, even as the Fed was easing persistently and aggressively.

That said, it’s worth noting that the inclinations of central banks toward quantitative easing and interest rate suppression are increasingly taking on a tone of desperation in the face of accelerating economic weakness in Japan, Europe and China. While the stated objective is to increase inflation, low inflation isn’t really the economic problem – low growth, intolerable debt burdens, and misallocated capital are at the core of global challenges here.

Unfortunately, QE only misallocates capital toward more speculation and low-quality debt (primarily junk and leveraged loan issuance), without much impact on real growth.  China’s move was prompted in part by a surge in bad loans to the highest level in nearly a decade. The largest European banks now have gross-leverage ratios as high as 30-to-1 (during the credit crisis, one could order the sequence of defaults accurately using this metric, with Bear Stearns, Lehman, and Fannie Mae right at the top). But liquidity does not create solvency, and with credit spreads widening, the growing desperation of monetary authorities is more a negative signal than a positive one.

Is it desperation or ideological arrogance and greed?  Stockman provides his opinion.

This purported “output gap” is conveniently self-serving. It has been interpreted to mean that the Fed has a plenary mission to fill-up the nation’s economic bathtub…

Except this is all a fiction. There is no such economic ether called “aggregate demand”; it is an utterly artificial construct of Keynesian economic models….

But the arrival seven years ago of William Dudley straight from the top economics job at Goldman Sachs took the matter to a whole new level.

In effect, under Dudley’s supervision the New York Fed has been transformed from a dabbler in the money markets to the plenary master of the entire financial system.

But it is not just the US central bank that has been financing unproductive debt creation.  Doug Noland sites a Financial Times article on China and then provides his warning:

November 28 – Financial Times (Jamil Anderlini): “ ‘Ghost cities’ lined with empty apartment blocks, abandoned highways and mothballed steel mills sprawl across China’s landscape – the outcome of government stimulus measures and hyperactive construction that have generated $6.8 trillion in wasted investment since 2009, according to a report by government researchers. In 2009 and 2013 alone, ‘ineffective investment’ came to nearly half the total invested in the Chinese economy in those years, according to research by Xu Ce of the National Development and Reform Commission, the state planning agency, and Wang Yuan from the Academy of Macroeconomic Research, a former arm of the NDRC.

Doug Noland:  With global “hot money” now on the move in major fashion, it’s time to start paying close attention to happenings in China. It’s also time for U.S. equities bulls to wake up from their dream world. There are Trillions of problematic debts in the world, including some in the U.S. energy patch. There are surely Trillions more engaged in leveraged securities speculation. Our markets are not immune to a full-fledged global “risk off” dynamic. And this week saw fragility at the Global Bubble’s Periphery attain some significant momentum. Global currency and commodities markets are dislocating, portending global instability in prices, financial flows, Credit and economies.

Japan is a basket case, China’s debt situation makes the US sub-prime situation look like a good investment and then there is Europe experiencing a financially created political and economic crisis.  The US Federal Reserve has been able to back up their talk with monetary action but with diminishing returns and the world is discovering the European Central Bank’s talk has no authority and has been nothing more than a Psyop campaign (See Draghi’s authority drains away as half ECB board joins mutiny).

While the US economy motors along and many analyst continue to focus on the traditional lagging and coincident economic indicators, the tremors of the next big financial crisis are being felt and seen in Japan, Europe, China and the rest of the emerging markets.  The normally forward looking stock market will not foresee a coming economic recession, it will create one after responding to the disruptions in the financial sphere very much like the last crisis.

It is now not just a matter of timing of when to sell stocks and bonds, it is also a matter of where to invest those funds safely.   For if the present bubble – the largest of them all encompassing the wealth of nations themselves – burst, how does one protect his future.  In the meantime, the US is the global core and will continue to enjoy rising markets as the next crisis develops…until the day of reckoning.

So Dr. Hussman, maybe the “terminal phase”  of a global financial sphere bubble explains your quandary as to how the US stock market can be so overvalued and become overbought and over bullish and stay there longer than any time in history before.  But you are correct about the final outcome.

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