Jeff Cox at CNCB wrote a reasonable piece yesterday, but chose a 180º wrong headline for it. And that matters for understanding the topic he addresses: what is happening in the financial markets. Cox claims that “Market Madness Started With End Of Fed’s QE”, but it’s the other way around. We’ve had six years+ of madness precisely because of QE, and during that whole time people had ever less idea what anything was really worth, and price discovery, an essential element of any functioning economy, disappeared entirely.
What we see now is the recovery of price discovery, and therefore the functioning economy, and it shouldn’t be a big surprise that it doesn’t come in a smooth transition. Six years is a long time. Moreover, it was never just QE that distorted the markets, there was – and is – the ultra-low interest rate policy developed nations’ central banks adhere to like it was the gospel, and there’s always been the narrative of economic recovery just around the corner that the politico/media system incessantly drowned the world in.
That the QE madness ended with the decapitation of the price of oil seems only fitting. Our economies need oil the way people – and animals – need water. If its price falls the way it has, that’s a sure sign something is profoundly amiss. At this point, we don’t yet know the half of it. It’ll take time for price discovery to work its way through, and for people to recognize what things are really worth. For now there’s really only one that’s certain: everything is overvalued, including you.
As the zombie money injected by QE is drained from the system, deflation is the magic word. And that doesn’t mean falling prices, they will never be anything other than a lagging indicator. For a system as bloated as the one we have at present, deflation depends on two factor: the size of the money/credit supply and the velocity at which the money is spent.
The end of Fed QE shrank the former – and no, other central banks won’t make up for the difference -, while the huge decrease in personal wealth – and wages- across the west (the average American family lost 40% of their wealth since 2008) slowed down the velocity of money. Sure, US car sales are looking good on the surface, but they’re fake, since as David Stockman writes today: “consumers borrowed every dime they spent on auto purchases (and took home a few billion extra in spare change).”
Economic growth in developed nations is just a narrative, kept – zombie – alive by media and things like those subprime car loans. We can all imagine why European countries would be at risk, in various forms and stages, but the US seems to be doing good (5% ‘official’ GDP growth last quarter), right? Well, not according to Jim Clifton, Chairman and CEO of Gallup, who writes this week that “.. for the first time in 35 years, American business deaths now outnumber business births”, and: “This economy is never truly coming back unless we reverse the birth and death trends of American businesses.”
The rich world is not doing as well as the narrative – mostly successfully so far – tries to convince you it is. Not nearly as well. The price of oil should be a flashing red flag with loud sirens for everyone. And it’s not just oil. Everything gets repriced. A 12-year low in commodities, dating back to late 2002, is not a laughing matter.
Commodities (BCOM) tumbled to a 12-year low, led by copper’s biggest decline in almost six years, as slowing global growth curbs demand. [..] Commodity prices are tumbling as a supply glut collides with waning demand, reducing earnings prospects for producers and increasing the appeal of government bonds as inflation slows. The World Bank cut its global growth outlook, citing weak expansions in Europe and China, the world’s biggest consumer of raw materials. Data today is projected to show a gain in U.S. oil inventories. “Oversupply and falling demand are dragging down commodities beyond oil,” said Ayako Sera at Sumitomo Mitsui. “There are a lot of uncertainties and it’s hard to see a reversal in sentiment for the time being. As an investor it’s hard to proactively take on risk at the moment.” [..] “The news everywhere is doom and gloom,” said David Lennox at Fat Prophets in Sydney. “Prices are going to keep sinking.”
Note that the leading word is demand, not supply. And that in one fell swoop takes us beyond developed nations and into emerging markets. But first, let’s let Jeff Cox have his say:
For nearly six years running, the U.S. stock market has withstood a myriad of body blows [..]Now, though, comes a shock that has Wall Street reeling: The Black Swan-like collapse in oil prices that has provided a stern test of whether equity markets can survive nearly free of Fed hand-holding. So far, with volatility spiking, traditional correlations breaking down and the bad-news-is-good-news theme no longer in play, the early results are not particularly reassuring. “Stuff happens when QE ends,” said Peter Boockvar, chief market analyst at The Lindsey Group.
[..] the increase in volatility and its effect on prices across the capital market spectrum was closely tied to the Fed ending the third round of QE in October. That month marked a momentary collapse in bond yields on Oct. 15, a day that also saw the Dow Jones industrial average plunge some 460 points at one juncture before slicing its losses.
In second place for monthly volatility was December, as investors pondered the meaning of “patient” in a Fed statement on when it planned to raise rates and waited for a Santa Claus rally that failed to materialize. January has proven to be an even bumpier month as investors evaluate an oil plunge that has raised questions about longer-term effects on corporate bottom lines and business investment.
Then came Wednesday’s disappointing retail sales numbers, all of which raised concerns about whether Wall Street is capable of negotiating its way through rough times with only zero-bound short-term interest rates as a backstop. “The assumption that low energy prices were unambiguously good was called into question with December retail sales,” said Art Hogan at Wunderlich Securities. “I think it’s all connected, but I’d be hard-pressed to tie it just to monetary policy.”
Should the Fed try to reinstitute QE in the face of more volatility, “their credibility would be shot.” Michael Pento predicted in an October analysis that the end of the Fed’s QE would see “inflated asset prices deflate back to normalized levels,” and believes now that the process is well under way and is likely to continue.
QE works “much better for equity prices than it does for economic growth,” Pento said. “You had a huge separation where markets went based on the Fed’s $1.7 trillion QE(3) program and where GDP growth was on a global basis. Now you’re seeing those two reconcile.” “Copper’s down over 20%. You’re looking at global yields in the toilet and oil prices down over 50%,” he added. “If you add all those things together, it adds up to global slow growth and the bursting of the commodity bubble that we saw courtesy of central banks.”
“The fuel for the fire over the last several years has been stock repurchases, and that has been fueled for the most part by the zero interest rate environment. As long as that continues, there’s still some room for the stock market to continue higher,” said Brian LaRose, a strategist at United-ICAP. “The path of least resistance is still to the upside.”
There are some good points in that article, but, as I said, the headline is upside down, and also, emerging markets are missing. I talked about their importance to the global economy a month ago in The Biggest Economic Story Going Into 2015 Is Not Oil and again last week in Price Discovery and Emerging Markets, but I think they warrant a lot more attention than they presently get. People simply don’t seem to have enough insight into either the importance of emerging markets – they’re half the global economy -, nor the state they’re in. Bill Pesek at Bloomberg has this:
.. China will have to loosen monetary policy soon in order to ensure that GDP growth stays above last year’s target of 7.5% (it’s currently around 7.3%). That’s worrisome because of a different number entirely: 251. That, in percentage terms, is Standard Chartered’s working estimate for China’s debt-to-GDP ratio. Already worryingly high compared to where Japan was 25 years ago when its own bubble burst, the number will only rise further with additional stimulus. The more China gins up growth in 2015, the more irresponsible lending it will have to service in the decade ahead.
The math simply doesn’t work out. Even if China could somehow return to the heady days of 10%-plus GDP growth, its debt mountain would by then be nearly unmanageable. “We’ve got the biggest debt bubble that the world has ever seen and credit is continuing to grow twice as fast” as output, Charlene Chu, a former Fitch Ratings analyst, said. Those who believe China can somehow grow its way out of this problem are fooling themselves.
“Mathematically, that’s impossible when something is twice as big as something else and growing twice as fast,” as Chu noted. It took Japan more than a decade after its bubble burst in 1990 to create the Resolution and Collection Corporation, modeled after America’s Resolution Trust Corporation, to dispose of bad loans. China can’t afford to wait that long to head off a full-blown crisis.[..] Yet for all the official talk about curbing borrowing and adjusting to a “new normal” of lower growth, Xi’s government still hasn’t shown the stomach necessary to bring China’s debt problems out into the open and deal with them.
Even one of the first defaults on an offshore bond by a Chinese developer last week ended happily. Kaisa missed a $23 million interest payment, but quickly received a waiver from HSBC. Since all property companies won’t get last-minute reprieves, these kind of maneuvers just delay a reckoning. Chu, now with Autonomous Research in Hong Kong, put Chinese bank assets at around $28 trillion the end of 2014, a huge increase from $9 trillion in 2008. As any 12-step program participant can attest, sobriety requires first admitting the magnitude of one’s problem – and publicly.
Whereas nations elsewhere in Asia would seem to have even larger immediate issues. It’s about the rise of the US dollar. Well, on connecting with the fact that they borrowed themselves silly in dollar denominated terms as Fed QE was happening. But that’s the thing: they’re now coming back to normalcy, albeit with a severe hangover. It’s not as of normalcy just ended.
Asia’s rapid accumulation of debt in recent years is holding back central banks from easing monetary policy to fight the risk of deflation, endangering private investment needed to boost faltering growth, according to Morgan Stanley. Debt to GDP ratio in the region excluding Japan rose to 203% in 2013 from 147% in 2007, with most of the increase coming from companies, [..] The ratio is close to or has exceeded 200% in seven of 10 nations including China and South Korea. Deflation risk is spreading from Europe to Asia as oil prices plunge..
“When real rates are high, only the public sector or government-linked companies will take on leverage,” the Morgan Stanley economists wrote. The key concern with an approach of keeping real rates at elevated levels is that the private sector will remain hesitant to take up new investment..
India, South Korea, Indonesia, Thailand and the Philippines all held their benchmark rates last month. The Asian Development Bank in December cut the region’s economic growth forecasts for 2014 and 2015. Oil’s decline to the lowest in more than 5 1/2 years has hurt crude-exporting Asian nations like Malaysia while benefiting others like the Philippines and Indonesia.
China could tighten rules to allow faster recognition of non-performing debt in the corporate sector, Morgan Stanley said. While this could lead to a period of sharper slowdown in credit and GDP growth, it will reduce risks and open up the door for aggressive monetary as well as fiscal easing [..]
Troubled times ahead indeed. But it still simply the world reverting to normal. To functioning economies – though that doesn’t mean they’ll be doing well – and to price discovery. To get there, though, we need for trillions of dollars in zombie money to go up in thin air. It’ll be musical chairs with not nearly as many chairs as contestants.
And then the Fed can add to the damage. Which I keep thinking they will. It’ll be murder on emerging markets, and on most Americans, but Wall Street banks should be faring just fine, thank you. The Fed has been ‘leading’ its own narrative for months now, with various figures coming out of the woodwork with pro or con rate hike messages. It’s all staged, and here’s Yellen (a contradictory story will again come in a few days from some regional Fed head):
Janet Yellen is leaving the Greenspan “put” behind as she charts the first interest-rate increase since 2006 amid growing financial-market volatility. The Federal Reserve chair has signaled she wants to place the economic outlook at the center of policy making, while looking past short-term market fluctuations. To succeed, she must wean investors from the notion, which gained currency under predecessor Alan Greenspan, that the Fed will bail them out if their bets go bad – just as a put option protects against a drop in stock prices. “The succession of Fed puts over the years has led to a wide range of distortions in financial markets,” said Lawrence Goodman at the Center for Financial Stability. “There have been swollen asset values followed by sharp declines. This is a very good time for the Fed to move away.”
So much for the stock market. But should we really be worrying about that when we know it’s all been a six-year headfake anyway? Isn’t it better to have price discovery back than to have so-called ‘investors’ trip on Bernanke blue pills? Oh well, never mind, oil made that decision for us.