It’s been a while and lots of ships have passed under the bridge, including an unnecessary election in the UK, the sacking of 12 White House staff members for various “misdemeanours” but mainly for disagreeing with he who must be obeyed, an interest rate rise in the US and the “successful” launch of yet another North Korean missile. There are sure to have been far more important items on the agenda, but the one constant has been the rise and rise of the US stock market.

One thing that has changed and is unarguably the most important event so far this year is the central bank narrative. Before Bernanke became an ex master of the universe he opined that QE – quantitative easing – didn’t work in the way the Fed had and anticipated i.e. cheap and plentiful money would promote economic growth as businesses borrowed to expand their operations.

They borrowed all right! To the tune of having a lot more debt than in 2008, now representing 45% of GDP. Not too shabby when compared with US government debt at “only” 100% but then they don’t have the distinct advantage of being able to print money. Whilst the cheap money regime continues corporate management will continue to borrow to fund share buy backs that cosmetically enhance earnings per share. Fewer shares, same, or in the case of many US corporates lower earnings, and the value of those shares rise as we are currently seeing.

Interest rates need to rise to make the corporates turn to real investment in their businesses to grow earnings, without the need for financial chicanery. The Fed have been slowly turning the tanker around firstly by cutting off new QE, then by reducing the reinvestment of redemptions and they are now talking about “normalising their balance sheet” by selling back some of their holdings in US Treasuries and other assorted US debt. In other words, “QT” – quantitative tightening.

The ECB have also joined in. Such is central bank speak, they have not said, “yes we will reduce our balance sheet any time soon”, but they are nearly on the same page as the Fed. Meanwhile Kurodasan is still trying to cap JGB yields. When he eventually fails, when not if, the BoJ will join the club too, but a lot of damage will have been done by then. Hubris always seems like a good idea at the time…

The Fed will probably raise at its September meeting into a storm of increasingly poor economic data. The “recessionistas” are repeatedly told that a GDP slowdown won’t happen until the yield curve inverts i.e. short dated yields are higher than long dated, but what should short rates be in an environment where the market sets rates not the central bank? 3%? 4%? There’s your inverted curve right now!

This brings us nicely along to the current state of the markets. How would they react to higher rates and/or a recession? Not well, I guess you would say. Here are some observations from Howard Marks at Oaktree.

“We have some of the highest equity valuations in history.”

• The S&P 500 is selling at 25 times trailing-twelve-month earnings, compared to a long-term median of 15.
• The Shiller Cyclically Adjusted PE Ratio stands at almost 30 versus a historic median of 16. This multiple was exceeded only in 1929 and 2000 – both clearly bubbles.
• While the “p” in p/e ratios is high today, the “e” has probably been inflated by cost cutting, stock buybacks, and merger and acquisition activity. Thus, today’s reported valuations, while high, may actually be understated relative to underlying profits.

“The so-called complacency index – VIX (the S&P500 volatility index) – is at an all-time low.”

• What’s the significance of the VIX, anyway? Most importantly, it doesn’t say what volatility will be, only what investors think volatility will be.
• It’s primarily an indicator of investor sentiment “Forecasts usually tell us more of the forecaster than of the future.” – Warren Buffett.
• In a similar way, the VIX tells us more about people’s mood today than it does about volatility tomorrow.

“There has been an elevation of the can’t-lose group of stocks; the FANGs, reminiscent of the Nifty 50. When taken to the extreme – as it invariably is – this phenomenon satisfies some of the elements of a bubble including:

• trust in a virtuous circle incapable of being interrupted;
• conviction that, given the companies’ fundamental merit, there’s no price too high for their stocks; and
• the willing suspension of disbelief that allows investors to extrapolate these positive views to infinity.

“We have seen a movement of more than a trillion dollars into value agnostic investing aka passives.”

• Passive funds do no research on the companies they buy and are ambivalent about valuation.
• They hold more and more of the increasingly expensive and less and less of the cheaper value stocks.
• Buy at the top sell at the bottom. What could go wrong?

“We have the lowest yields in history on low rated bonds and loans.”

Netflix issued €1.3 billion of Eurobonds, the lowest-cost debt it ever issued. The interest rate was 3.625%, the covenants were few, and the rating was single-B. Netflix’s GAAP earnings run about $200 million per quarter, but according to Grant’s Interest Rate Observer, in the year that ended March 31, Netflix burned through $1.8 billion of free cash flow. It’s an exciting company, but as Grant’s reminded its readers, bondholders can’t participate in gains, just losses.

“Yields on emerging market debt are lower still.”

“We are witnessing the highest level of fundraising for private equity in history”

“The biggest fund of all time – Softbank Vision – has just raised $100 billion for levered tech investing.”

“Billions are pouring into digital currencies which are backed by nothing – not even a central bank promise…”

“I absolutely am not saying stocks are too high, the FANGs will falter, credit investing is risky, digital currencies are sure to end up worthless, or private equity commitments won’t pay off. All I’m saying is that for all the things listed above to simultaneously be gaining in popularity and attracting so much capital, credulousness must be high and risk aversion must be low. It’s not that these things are doomed, just that their returns may not fully justify their risk. And, more importantly, that they show the temperature of today’s market to be elevated. Not a nonsensical bubble – just high and therefore risky.”

“Try to think of the things that could knock today’s market off kilter, like a surprising spike in inflation, a significant slowdown in growth, central banks losing control, or the big tech stocks running into trouble. The good news is that they all seem unlikely. The bad news is that their unlikelihood causes all these concerns to be dismissed, leaving the markets susceptible should any of them occur. That means this is a market in which riskiness is being tolerated and perhaps ignored, and one in which most investors are happy to bear risk. Thus, it’s not one in which we should do so.”

On the QT I couldn’t agree more.

Clive Hale –The View from the Bridge – July 30^th 2017

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If you were going to set up an organisation to help control and regulate the economy and the banking system how would you start? Would you employ over 1,000 Ivy League trained economists, many with PhDs, but little or no practical knowledge of running businesses? Would your board of governors come from the same background and would the owners of the organisation be the very bankers that you were duty bound to regulate? I somehow doubt it. But even if you were so minded would you then allow untested economic theories to be implemented without a thorough study of the potential consequences of zero or even negative interest rates on the real economy or the massive inflation of your balance sheet by the purchase of trillions of dollars’ worth of government debt? No, you wouldn’t, but welcome to the world that is the Federal Reserve System of the United States.

Nine years into the recovery from the Great Financial Crisis and the Fed is still wondering why its policies are not working as intended. Their theory goes that if you lower interest rates, companies will be happy to borrow and invest in their businesses as consumers, who begin to feel the wealth effect of rising property and stock prices, pick up their spending levels. Several problems there. Most consumers don’t benefit from “trickle down wealth” and corporations, faced with less than robust demand, saw a perfect opportunity to massage earnings per share by increasing debt to buy back their own shares, which does very little for the economy, but does boost the bonuses paid to corporate executives.

On the regulatory front the legislation brought in after the GFC, known colloquially as “Dodd Frank”, to control the excesses that led to the crisis in the first place, is under threat. It was probably not the best thought through piece of legislation and was of such size that it is unlikely that many senators or members of congress, who passed the bill, have read the thing. It did of course constrain the investment banking community from running proprietary operations amongst other things, which in the run up to debacle were among their most profitable pastimes.

Not surprisingly, given that the Fed is owned by the banks, their protestations and not inconsiderable financial lobbying have found the ears of the Chairwoman, who recently opined that the regulations need relaxing again. Added to the view that interest rates are now a one-way bet, it is no surprise that financial stocks, and the fortunes of the investment banking sector in particular, have been on the rise. The question that doesn’t seem to have been asked is what happens to all those interest rate derivatives when rates get a serious move on.

The 10 year US Treasury note reached a high in terms of yield in 1981 of 15.84%; younger readers may need to go and have a lie down. This was from a low 35 years earlier in 1946 of 2.08%. 35 years on from the peak, in 2016, Treasuries hit a low of 1.36%. The perceived wisdom is that rates won’t get above 3% as this will put a cap on economic growth and rates will start to fall again. At the same time, US equity prices are reaching for the sky. However, seven year projected real returns for US large cap stocks, from US based investment managers GMO, are around minus 1%-2%, which implies something of a re-rating from here. GMO’s CIO is Jeremy Grantham, a Yorkshire man at heart, who knows a good deal when he sees one, and whose favourite observation is that value managers are never wrong, just early. If you are wondering how sustainable the Wall Street fan club at Dow 20,000 can be, just remember which organisation has been mainly responsible for getting us to these giddy heights via a series of uncontrolled and untested policy experiments; aka cheap and “free” money.

Clive Hale –The View from the Bridge – February 18^th 2017

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PS – the title for this piece and some of its content has been inspired by Danielle DiMartino Booth’s new book Fed Up: An Insider’s Take on Why the Federal Reserve is Bad for America. She was adviser to Richard Fisher the former president of the Dallas Federal Reserve bank, which gave her great insight into the workings of the machine. I have quoted below the publisher’s introduction to the book.

In the early 2000s, as a Wall Street escapee writing a financial column for the Dallas Morning News. Booth attracted attention for her bold criticism of the Fed’s low interest rate policies and her cautionary warnings about the bubbly housing market. Nobody was more surprised than she when the folks at the Dallas Federal Reserve invited her aboard. Figuring she could have more of an impact on Fed policies from the inside, she accepted the call to duty and rose to be one of Dallas Fed president Richard Fisher’s closest advisers.

To her dismay, the culture at the Fed–and its leadership–were not just ignorant of the brewing financial crisis, but indifferent to its very possibility. They interpreted their job of keeping the economy going to mean keeping Wall Street afloat at the expense of the American taxpayer. But bad Fed policy created unaffordable housing, skewed incentives, rampant corporate financial engineering, stagnant wages, an exodus from the labour force, and skyrocketing student debt. Booth observed first-hand how the Fed abdicated its responsibility to the American people both before and after the financial crisis and how nobody within the Fed seems to have learned or changed from the experience.

Today, the Federal Reserve is still controlled by 1,000 PhD economists and run by an unelected West Coast radical with no direct business experience. The Fed continues to enable Congress to grow our nation’s ballooning debt and avoid making hard choices, despite the high psychological and monetary costs. And our addiction to the “heroin” of low interest rates is pushing our economy towards yet another collapse.

This book is Booth’s clarion call for a change in the way America’s most powerful financial institution is run–before it’s too late.

Those of us with children will be used to this refrain as we turn out of the driveway on the way to destinations unknown. Equally we will smile when recalling that “les enfants terribles” were more than likely asleep when we did eventually get there. A perfect analogy for market participants in this most unloved bull market perhaps. In the last edition of the View we asked “When?” and suggested that all was fine as long as the central bank narrative held together. This past week has put that idea very much to the test.

The US jobs numbers were below expectations and the markets rallied thinking that the Fed wouldn’t raise rates in September after all – the 21^st is the day to put in your diaries. Then the Fed vice chairman, Stanley Fischer, opined that negative interest rates seem to be working in other countries; “seem” being the operative word… He was quick to deny that the Fed would introduce them in the US and even implied that they could raise rates whilst others were cutting!

We then had Kurodasan, the Bank of Japan governor, saying that he would cut rates as far into negative territory as needs be if the current policies fail to stimulate the economy; a dilemma the BoJ has been facing for the last 25 years and counting; will they ever get the message? Well the bond market might just deliver it to them. In the past few weeks the yield on the 10 year JGB has gone from minus 0.3% back to pretty much 0%. It doesn’t sound much, but the losses inflicted on short term traders, especially those whose positions have any element of gearing, have been more than painful; it has been described as a “VaR event”.

VaR, or value at risk, is a rather quaint, but almost universally accepted, method of determining the risk that, for example, trading desks in banks subject themselves to in their dealing with Mr. Market. VaR calculates the likelihood of loss in the following days trading based on current positions and historic volatility of those instruments. So VaR may be say an acceptable 1% or 2% with usually a “high” degree of probability. There are of course outliers outside the “high” range, but they are only supposed to come along once in a blue moon, and risk controllers and management content themselves with that fact; until it all blows up, which is beginning to look like the case with JGBs.

The malaise has already spread to other sovereign bond markets with a Bloomberg headline on Friday proclaiming that Bund yields had “soared” to 0%! This came on the back of the ECB press conference on Thursday, given by Mario Draghi, who was far from convincing in terms of both what he said, “the European economy continues to recover”, and his general demeanor, which was something a lot more than “defensive”. As for the latter a rabbit in the headlights would be apt and as far as the economic recovery goes, saying that it is anaemic at best would be very generous.

The equity markets, oil and precious metals all took a hit as well and the opening on Monday morning will be “interesting”! The futures markets are already suggesting that FTSE will open 70 points below Friday’s close so tin hats on and let’s see what these central bankers are made of!

Clive Hale –The View from the Bridge – September 11^th 2016

When?

“The art of financiering consists principally in multiplying and confusing accounts, till, at last, no one has courage to undertake an examination of them.” William Cobbett “The Budget” 1805

“I imagine that Ben Bernanke, Mario Draghi and Haruhiko Kuroda all stay awake at night imagining ways to force negative rates on savers. But the larger question, beyond a sociopathic desire to control others in service of one’s own intellectual dogma, is why anyone would advocate such policies. I can’t emphasize strongly enough that there is no economic evidence that activist monetary intervention has materially improved economic performance in recent years.” John Hussman 2016

The effects of quantitative easing may be diminishing compared with a few years ago, but “what we should say is, ‘Effects are diminishing, so let’s do more.’ This is the spirit of Abenomics.” Etsuro Honda, an advisor to Japanese prime minister Shinzo Abe

William Cobbett would no doubt be amazed at the level of “multiplying and confusing” that is practised by the central banks and the general banking system at large. Large perhaps not being an adequate description of say the Fed’s balance sheet, investment banks’ derivatives’ books or unacknowledged bank bad debt all of which are up there in the trillions.

John Hussman has dared suggest that the emperor has no clothes. It is no mere suggestion, but fact, that quantitative easing, negative interest rates, deployment of helicopters (do they know how expensive it is to fly helicopters?!) and other sundry methods, designed on the back of a fag (cigarette to our US readers) packet, to normalise economies, has failed. Unless of course your goal is to inflate the stock and bond markets to levels of over valuation that will ultimately lead to a crash, which of course our heroic masters of the economic universe will fail to see coming and will have very little ammo left to do anything about.

The question is of course, “When?” With any degree of accuracy, it is an impossible question to answer. Etsurosan is typical of his breed confidently predicting that more of the same will work…eventually – beatings will continue until moral improves etc etc. Japan has been subjected to 25 years of monetary experimentation and has little, and that’s being generous, to show for it. GDP is barely above 1991 levels and the mean growth rate is less than 1%. The Nikkei was over 22,000 and interest rates were 6%; today they are 16,500 and minus 0.1%. The only thing to have gone up is the BoJ’s balance sheet from under Yen 1 trillion to over Yen 4 trillion and, as if that weren’t enough, they want to do more!

Super Mario, the president of the ECB, not to be confused with Shinzo Abe the PM of Japan, who donned the Nintendo “suit” at the Rio closing ceremony, cannot sport any better credentials. Doing whatever it takes has produced some growth in the Club Med economies, but given how low growth had got down to, that would have happened anyway. The economies of Germany and France are struggling to get any meaningful traction 7 years into the “recovery” phase.

Janet Yellen & Co seem to be afraid of their own shadows, having raised rates last December and then blinked. The data in the US is just as patchy as in Europe with the numbers from the Bureau of Labor Statistics about as believable as Team GB coming second in the medal table – no wait – but you get my gist. Will they raise rates again this year? Probably, maybe, who knows?

Carney has cut rates at the BoE in the belief that Brexit has unleashed Armageddon, as the Remaindeers would have you believe. Brexit has been blamed for anything and everything. The only worry in this corner is that it won’t happen at all. ComeWhatMay seems more than reluctant to invoke Article 50 and is undoubtedly getting support from across the pond, where their European “diplomatic initiative” would be in tatters if we do actually leave, with the threat of France and Italy following suit.

The central banks can keep this Ponzi scheme going for a lot longer than you or I can remain solvent by betting against them, but ultimately it is their solvency that is the issue. Whilst they continue to make things as complicated for folk to understand as Cobbett implied, maintain the narrative that “they have got your back” and “muddle through” as John Mauldin is wont to say, then they will hang on to the illusion of control.

However, when, not if, a true black swan event comes out of left field, then the bond, equity and real estate markets will find that they have been priced for perfection and the down draught will be a sight to behold. Whilst we wait for the dénouement, where do we put our hard earned cash.

Winning by not losing is a maxim that springs to mind as being eminently useful for this predicament in which we find ourselves. If you want to invest in negatively yielding debt, feel free; free of any return that is. Equity prices have been bid up by corporate management borrowing at insanely low rates and buying back company stock, as opposed to investing in research and development, which is what the central banks want them to do. They would have done, had interest rates been at meaningful levels, where improving efficiency was the better way to earnings growth, rather than the artificial accounting sleight of hand we have at present. Other than deep value equity plays, this market, too, is for the birds.

Real estate has been one of the bond proxy’s for those seeking yield, which is pretty much all of us, but reality is returning to real estate. The great residential property boom looks to be ending with significant corrections in Vancouver and parts of Oz. London has maintained some degree of order as a weaker pound has made it relatively attractive for foreign buyers, but the sheer amount of new properties going up makes parts of the metropolis look like China New Town. Commercial property is all fine, allegedly, but the market place is changing rapidly as the internet of things changes our shopping and working habits. Retail, office and industrial property ownership is going through a significant sea change; not everyone will come out of this on the right side.

So if not there, where? Hedge funds have been getting a bad press as they have not performed as well as pure equity funds. Guess what? That’s what they do when equity markets go on a tear! The FCA has launched an inquiry into whether they represent value for money, so folk will in all probability be put off just at the time when they come back into their own. Remember the reasons for buying an asset; these funds, and trend followers (CTA funds as they used to be known) in particular, are insurance policies against market instability. If the monetary base continues to be compromised by the central banks then the only real currency is another must; gold of course. There are still pockets of the equity markets where deep value can be found, but if you have to hold equities in general make sure you build in some optionality into your portfolios.

Where might this elusive black swan appear? China? Nobody except Kyle Bass thinks they will devalue the yuan in a rush, but will take their time as is their nature. Kyle is a Texan and branded by all those who “know better” as the archetypal Stetson wearing article. Those who really do know better and know the man himself realise that his admonitions are based on logic and experience that only a few possess and have more than a fair chance of happening; sooner rather than later. The US? If Hilary wins it will be the same old same as, but a Trump in the White House could have more unintended consequences than the fragile infrastructure can bear. Europe? We have a plethora of insolvent banks in the EU. Draghi can probably fix the Italian Job, but any fall out across France and Germany might be impossible to contain. There could be more defections from the EU. Le Pen is gearing up the French right and Renzi, the Italian PM is nearly as unpopular as Hollande. When the natives get restless things tend to change pretty fast. And we haven’t even mentioned Russia, the Ukraine, Syria and many more potential bear traps besides.

We truly live in interesting times do we not?

Clive Hale –The View from the Bridge – August 23^rd 2016

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