The cashless society

This piece has been written by Simon Black at Sovereign Man a site well worth a visit http://bit.ly/1PFI877 It explains why the powers that be have started a campaign to do away with cash and gives an insight into the ever parlous state of the banking system. Things are never quite as they would have you believe…

This is starting to become very concerning. The momentum to “ban cash”, and in particular high denomination notes like the 500 euro and $100 bills, is seriously picking up steam. On Monday the European Central Bank President emphatically disclosed that he is strongly considering phasing out the 500 euro note. Yesterday, former US Treasury Secretary Larry Summers published an op-ed in the Washington Post about getting rid of the $100 bill.

Prominent economists and banks have joined the refrain and called for an end to cash in recent months. The reasoning is almost always the same: cash is something that only criminals, terrorists, and tax cheats use. In his op-ed, Summers refers to a new Harvard research paper entitled: “Making it Harder for the Bad Guys: The Case for Eliminating High Denomination Notes”. That title pretty much sums up the conventional thinking. And the paper goes on to propose abolishing, among others, 500 euro and $100 bills.

The authors claim that “without being able to use high denomination notes, those engaged in illicit activities – the ‘bad guys’ of our title – would face higher costs and greater risks of detection. Eliminating high denomination notes would disrupt their ‘business models’.”

It’s total nonsense. As long as there has been human civilization there has been crime. Crime pre-dates cash. And it will exist long after they attempt to ban it. Perhaps even more hilarious is that many of these bankrupt governments have become so desperate for economic growth that they now count illegal drug activity and prostitution in their GDP calculations, both of which are typically transacted in cash. So, ironically, by banning cash these governments will end up reducing their own GDP figures.

What’s really behind this? Why is there such a big movement to ban something that is used for felonious purposes by just a fraction of a percent of the population? Cash, it turns out, is the Achilles’ Heel of the financial system. Central banks around the world have kept interest rates at near-zero levels for nearly eight years now. And despite having created massive bubbles and enabled extraordinary amounts of debt, their policies aren’t working.

Especially in Europe, the hope of stoking economic growth (and even the sickening goal of inflation) has failed. So naturally, since what they’ve been trying hasn’t worked, their response is to continue trying the same thing… and more of it. Interest rates across the European continent are now negative. Japanese interest rates are now negative. And even in the United States, the Federal Reserve has acknowledged that negative interest rates are being considered.

They have no other choice; raising rates will bankrupt the governments they support and derail any fledgling economic growth. Look at how low interest rates are in the US and yet 4th quarter GDP practically ground to a halt. They simply cannot afford to raise rates. As global economic weakness continues to play out, central banks will have no other option but to take interest rates even further into negative territory.

That said, negative interest rates will be the destruction of the financial system because sooner or later, if banks have to pay negative wholesale interest rates to each other and to the central bank, then eventually they’ll have to pass those negative rates on to their customers. Many banks have already started doing this, especially on larger depositors. We’ve seen this in Europe where some banks charge their customers negative interest to save money, and in some extraordinary circumstances, pay other customers to borrow money.

There’s a certain point, however, when interest rates become so negative that no rational person would hold money in the banking system. Eventually people will realize that they’re better off withdrawing their money and holding physical cash. Sure, cash doesn’t pay any interest. But it doesn’t cost any either. If you have a $200,000 in your savings account at negative 1%, you’d have to pay the bank $2,000 each year. Clearly it would make more sense to buy a safe and hold most of that money in cash.

Problem is, the banks don’t have the money. For starters, there’s literally not enough cash in the entire financial system to pay out more than a fraction of all bank deposits. More importantly, banks (especially in the US and Europe) are extremely illiquid. They invest the vast majority of your deposit in illiquid loans or securities of dubious long-term value, whatever the latest stupid investment fad happens to be. And many banks have been engaging in a substantial balance sheet shift, rotating bonds from what’s called “Available for Sale” to “Hold to Maturity”.

This is an accounting trick used to hide losses in their bond portfolios. But it also means they have less liquidity available to support bank customer withdrawal requests. The natural side effect of negative interest rates is pushing people to hold money outside of the banking system. Yet it’s clear that a surge of withdrawal requests would bring down that system.

Banks don’t want that to happen. Governments don’t want that to happen. But since central banks have no other choice than to continue imposing negative interest rates, the only logical option is to ban cash and force consumers to hold their money within the banking system.

Make no mistake, this would be, without doubt, a form of capital control. And it’s coming soon to a banking system near you.

Clive Hale –The View from the Bridge – February 17th 2016

To subscribe visit www.viewfromthebridge.co.uk

Download a pdf version here

Negativity, relativity and dark matter

At school, I was taught Newtonian physics. Einstein didn’t get a mention despite having posited his theory on relativity some 60 years earlier and when much later I realised my education had been sorely lacking I wondered what else I hadn’t been told! That’s the trouble with “new” theories, the “old school” takes an eon to get around to changing the common narrative.

And so it is with economics although lets not pretend that it is a science or at least not in the conventional sense that a mathematical model can be created to explain the meaning of everything. Until Einstein, physics was fully understood and the position of the planets known (and unknown) could be modelled precisely; relativity gave us a whole new view of the universe. In economics the current belief system is based largely on Keynesianism although as with many religious texts the meaning is widely open to interpretation and a number of his creeds are conveniently overlooked.

Modern economics makes the heroic assumption that people act rationally in full accordance with the facts. Not true. Modern economics believes that it is possible to explain the myriad variables in the global economy and predict an outcome. Not true. If you don’t believe me look at the Federal Reserve Bank’s record on forecasting inflation. Comparing their forecast with the actual outcome you get a correlation of minus 0.6. For non mathematicians out there that means that they couldn’t have been much more wrong if they tried.

And having tried in many other disciplines and failed, notably quantitative easing, they are now resorting to making it up as they go along. You need go no further for proof than a statement made last year by Haruhiko Kuroda, the governor of the Bank of Japan. He said, “I trust that many of you are familiar with the story of Peter Pan, in which it says, ‘the moment you doubt whether you can fly, you cease forever to be able to do it’. Yes, what we need is a positive attitude and conviction. Indeed, each time central banks have been confronted with a wide range of problems, they have overcome the problems by conceiving new solutions.”

“Pan’s” latest “solution” for Japan, and there have been quite a few since the Japanese bubble first burst back in the early 1990s, is negative interest rates. He’s desperately jumping on a growing bandwagon. Much of Europe has been on this path for sometime. Lead by the Swiss who wanted to dissuade investors from treating the franc as a safe haven and, more latterly, by the ECB in an attempt to persuade the banks to lend and thereby promote growth. Printing money (QE) has failed and now they want to penalise the banks for not making sufficient “sub prime” loans in contradiction to the stated aims of preventing a re-run of 2008. Prime borrowers don’t need bank loans; they either have tons of cash already or have been tapping the corporate bond market.

Banks are in fact tightening lending standards in the face of the fall out in high yield bonds and loans to the energy sector. By turning their income, from their reserves with the central banks, negative, this action is further weakening a banking sector, which already has enough problems to deal with. Over the past few weeks markets have begun to wake up to the fact that all is not well in banking world and we have witnessed the “great and good” being wheeled out to say that everything is fine which is very reminiscent of 2007 when they said much the same thing.

In the short term sentiment has reached a trough and as markets don’t usually go down in a straight line there will be a bounce, and quite possibly what might feel like a substantial one, but, short of the imminent announcement of QE4 by the Fed, that rally will suffer the fate of all the others we have seen over the last month or so. The central banks are losing the plot and the assumption they will support the markets, come what may, is being questioned. Even if they attempt to do “whatever it takes” the market knows that they are pushing on a string and will will probe and probe until the emperor is seen as naked.

We don’t yet have the technology to see dark matter, but it’s out there; this is not the time to be a market hero; except for Bowie fans, but just for one day…

To subscribe to the “view” please visit our website https://www.viewfromthebridge.co.uk

To the Girl in the Pink Dress – I’m Wild About You!

If you cant use your own blog site to wish your beautiful wife a Happy Valentine’s Day then what’s the use of having one?!

For my regular readers there will be another edition of the “View” along later today so in the meantime have a look at some back issues below.

To my gloriously beautiful wife – Happy Valentine’s Day – I love you tons my Bambaji xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx

How I learned to stop worrying…

A headline last week asked if we should be worried about the banks. There have been relatively few times when worrying about the banks has not been in vogue, but now is not one of them. The cap on UK deposit protection was reduced last year to £75,000 per account, to reflect the strength of sterling as the EU wide bank deposit protection scheme is set at €100,000. Given sterling’s current weakness, it may well have to go back up again!

On top of that we are now in a position where any future bank failures, across the EU, will be dealt with by way of a bail in, not a bail out. Under a bail out the banks are given taxpayers money by the government. Under a bail in the banks take money directly from taxpayers’ bank accounts ie if you have more than the deposit guarantee amount you would kiss it goodbye if your bank failed. The residents of Cyprus, including a not insignificant number of ex-pat Brits, found out the hard way how this worked in 2013. They received little sympathy from the main stream media as anyone holding over €100,000 was quite obviously either Russian, an arms dealer or both. There were a few of those, but most of the “serious” money escaped as on the weekend before the banks were closed on the Monday; the London branches of said banks opened for transfers, a facility gratefully taken advantage of by those “in the know”. That didn’t include many ordinary Cypriots whose businesses have still not recovered and whose life savings have mostly vanished forever.

It couldn’t happen here could it? Well it’s one of those “things that makes me go hmm”. Bank CDS across Europe have been rising sharply which doesn’t necessarily spell imminent disaster, but do have a look at the chart of Deutsche Bank and see if that makes you feel any better.

And it’s not just the commercial banks. The world’s central bankers seem to have lost control of their senses too. The ECB and the BoJ have both instigated NIRP – Negative Interest Rate Policy – which directly translates into negative nominal government bond rates in almost all European countries – as well as Japan – along some part of the yield curve. In Switzerland it’s all the way out to 10 years; Japan has just got there too. The UK 2 year rate is a heady 0.03%; still positive by the skin of its teeth, but negative in real terms…

This just doesn’t make any sense. What the central banks are, in effect, saying to the rest of the banking system is “You haven’t got the message yet. You haven’t made enough loans, so get out there and do it, otherwise we’ll keep cutting until you do because we have run out of fresh ideas and the only thing we can do with this piece of string is push on it.”

The bond market is saying that zero/low real GDP growth plus zero/low inflation equals zero/low nominal GDP growth, which means debt/GDP ratios will keep increasing, which means governments are less able to repay debts, which means bond yields should be going UP, not DOWN! (thanks to Kevin Doran at Brown Shipley for that observation)The world has truly gone mad and we are living in a Dr Strangelove world…and we know how that ended!

The Swiss and Danish central banks are using the same policy, but, in this case, to stem the unwelcome attraction of foreign inflows. As we saw with the Swiss franc early in 2015, when the weight of money overwhelms the central bank the inevitable happens. The People’s Bank of China believe that they too can defy the markets. The Chinese have already thrown a lot of money at their equity market, to little effect, and have spent well over $1 trillion of their reserves supporting the yuan in the face of “imperialist running dog speculators”. A recent People’s Daily op-ed was entitled “Declaring war on China’s currency? Ha ha!” which must have left George Soros quaking in his boots!

They want to manage the yuan downwards at their own pace and not to be seen to have been forced into that position; loss of face is very important in this part of the world. The reality of the situation is that everyone else is busily devaluing and this is making Chinese goods less and less competitive. They need to devalue and by a significant amount. Back in 1994 they devalued by nearly 30%; all in one go. The cheapness of the currency attracted huge foreign investment allowing the Chinese to “come out of the dark ages.” They need to do the same again. If they try to defend the currency they will eventually run out of their foreign reserve buffer and still have an overvalued currency.

They have been facilitating a very profitable carry trade by capping currency and credit risk for a long time so switching horses, as it were, to facilitating currency speculators shouldn’t be a problem for them. The Chinese are inclined to have a long term perspective, which is in direct opposition to the FX market that likes to get where it wants to go with some alacrity. There will be a war of words against the “running dogs” who will ultimately get the “blame” for the inevitable devaluation thus saving face and giving everyone involved what they want.

When the yuan devaluation happens the Hong Kong dollar peg will almost certainly go with it too. At that point it will be time to start getting back into Chinese equity markets, but for now it is a patient waiting game.

To download a pdf version please click here

A picture is worth a thousand words

Well OK charts not pictures, but getting a visual fix on the markets is helpful for some of us. For others technical analysis is akin to astrology or witchcraft, but I prefer to think of it as an aid to behavioural psychology and we all need help on that front. Doug Kass has an interesting way of summing up the debate.

A technical analyst and a fundamental analyst are chatting about the markets in the kitchen.
One of them accidentally knocks a kitchen knife off of the table, and it lands right in the fundamental analyst’s foot.
The fundamental analyst yells at the technician, asking him why he didn’t catch the knife.
“You know technicians don’t catch falling knives!” the technician responded.
He, in turn, asks the fundamental analyst why he didn’t move his foot out of the way.
The fundamental analyst responds: ‘I didn’t think it could go that low!”

So click on this link to see the latest Chart Book from the View.

The Big Short

Last week saw the opening in the UK of the movie of the same name. It is a must see for market historians as well as diviners of the future. It will remind us of the abject greed, arrogance and unremitting belief in a system that was in fact falling apart; in other words denial was the theme, unobserved by the many. The few were laughed out of court until the dénouement. Is history, in its own peculiar way, repeating itself?

The movie ends with the observation that there are now more open CDS contracts than there ever were leading up to the “great” financial crisis. There is also significantly more corporate debt; allegedly much of it investment grade. As in 2007, when the risker end of the asset backed bond market deteriorated, the crisis permeated up the rating scale with some alacrity. High yield bond yields are rising fast, helped admittedly by the carnage in the oil sector, but corporate America has been borrowing to finance share buy backs, at unseemingly rich valuations, which all of a sudden are starting to get cheaper.

Here’s a recent example as told by Zero Hedge www.zerohedge.com. When your organic growth is over, your revenue just missed consensus expectations once again, your stock is trading near 4 years lows and you are stuck in the imploding energy sector, what do you do? Why you announce a $10 billion stock buyback, but since you will have to fund it with more debt (whose cost in recent weeks has soared) you have to get rid of “overhead.” How do you do that? Simple: you announce you are firing 10,000 workers. Terrible news of course, but wait: here is the spin. Schlumberger’s brand new “yield starved” bondholders will give the company $10 billion to create 10,000 new fast food jobs. And that is what, as the US economy careens into recession, passes for growth. Anyone who says otherwise is peddling fiction.

Equally concerning were the remarks made by Schlumberger CEO Paal Kibsgaard. For many of our customers, available cash and annual budgets were exhausted well before the halfway point for the fourth quarter… as pricing levels for frackers has dropped into unsustainable territory.

Our last post commenting on the opening week of 2016 in global markets posed the question, “Is there cause for concern?” The answer is a resounding yes. The preponderance of top-heavy chart patterns has resulted in clear breaks to the downside for many markets; a pattern we have seen repeated in the past.

Screenshot 2016-01-24 17.22.35After some traumatic falls, not just in equity markets, there is bound to be some reaction to the upside. Markets do not travel in a straight line. They also like to complete their journey with as few passengers on board as possible. So rallies in bear markets tend to shake out those with a predisposition towards the “Big Short” and this move started at the back end of last week. How the rally pans out will give us a clue to the next move and we will watch with more than usual interest.

Albert Edwards at Societe Generale has observed that markets correcting from valuation anomalies make the journey in multiple stages. Those of a nervous disposition should look away now…

Since valuations peaked at the most obscene level ever in 2000, we have only seen two recessions and at the nadir of the last one, in March 2009, the Shiller PE bottomed at 13.3x, way above the typical sub-7x bottom. In valuation terms the bear market was not completed in 2009 and indeed after only two recessions there was no reason to expect it to have been completed (past such recessions have on average had 4 downward corrections post the event). If I am right and we have just seen a cyclical bull market within a secular bear market, then the next recession will spell real trouble for investors ill-prepared for equity valuations to fall to new lows. To bottom on a Shiller PE of 7x would see the S&P falling to around 550. I will repeat that: If I am right, the S&P would fall to 550, a 75% decline from the recent 2100 peak. That obviously will be a catastrophe for the economy via the wealth effect and all the Feds QE hard work will turn dust. That is why I believe the Fed will fight the next bear market with every weapon available including deeply negative Fed Funds rates in addition to more QE. Indeed, negative policy rates will become ubiquitous.

Most believe a 75% equity bear market to be impossible. But those same people said something similar prior to the 2008 Global Financial Crisis. They, including the Fed, failed to predict the vulnerability of the US economy that would fall into deep recession, well before Lehman went bust in September 2008.

This chart shows what a move to 550 would look like. Ouch! All the way back to July 1995 and not far from the level when Greenspan got concerned about irrational exuberance! 650-800 is also a likely target and fits in with Albert’s thesis that corrections get progressively more dramatic (we have only had two so far out of an average of 4)
Screenshot 2016-01-24 17.22.56

His valuation thesis uses the CAPE / Schiller Cyclically Adjusted PE. Many of the bulls attempt to undermine the validity of the Shiller PE and Albert has this to say on that particular subject.

Critics opine that using the 10y moving average of reported earnings as the divisor includes the huge collapse in reported earnings in 2009 due to write-offs, and that it does not reflect the recent strong underlying trend of earnings. Now I think this is an invalid criticism as the whole point of using a 10y moving average is to smooth the cycle and get a cyclically-adjusted measure of earnings in which case you should include the write-offs suffered during a recession! But if I do use a shorter 5y moving average there is good news; to complete the valuation bear market, the S&P would only have to fall by two-thirds to around 650 (a fraction below the March 2009 low of 666), instead of falling by three-quarters to 550.

As he admits himself, a lot of people think he is talking utter garbage and that he may be utterly wrong, but this is not the time to be a hero and go “all in” for the recovery as if this were 2009. “This is a market where you don’t make a lot of money. You try to protect your capital and then play another day.”  Hat tip to Jeff Gundlach for this common sense opinion.

Screenshot 2016-01-24 17.23.25

The top pattern is similar to many equity markets, with a large rounding shape, now entering its third year, showing the tug of war between the bulls and the bears. The trend line from the 2011 bottom to the low in August 2015, as well as significant support at 16,000, has been tested, but thus far has held. The current rally that is underway could easily take us to 17,000. With comments from the Fed a la Draghi last week – “We would be foolish not to revisit our plans for monetary policy and may even need to introduce unconventional remedies” – Yikes! – a new high for this index is not out of the question. However if it fails under the falling long term moving average and breaks 16,000 decisively, then watch out below; that dot in the distance will be a very small image of Albert Edwards coming up to meet you. Let’s hear it for the Dow!

Clive Hale – January 24th 2016

To subscribe to the “View from the Bridge” please visit www.viewfromthebridge.co.uk

To download the pdf version click here

Charts courtesy of www.fullertreacymoney.com

Technical update after an “interesting” week

The year has started with the worst week ever for the S&P 500. This update considers what might be in store for the rest of the year.

We recommend clicking here to access the full version with charts that are referred to in the text.

A 6% fall in 5 days for the S&P 500 is the worst start to a year in the US…ever. In the great scheme of things this is a completely meaningless statistic, but, taken along with recent market action, could there be some genuine cause for concern?

Looking firstly at the UK (page 3), there is something of a line in the sand at 6,000. We are currently at 5,912 and need a three to four-day print, under 6,000 and ending below the August 24th intra-day low of 5768, to make the case for the bears and the “watch out below” scenario. The top patterns, in 2000 and 2008, are very similar to today’s; a rounding shape over a two to three-year period evidencing the distributive phase between buyers and seller, culminating in a significant fall.

In the short term the “Armageddon” narrative has been overdone and a rally back towards the falling 200 day moving average is quite likely. There are any number of players keen to put a base under markets – the Fed, the ECB, the BoJ and let’s not forget the People’s Bank of China, who probably have the largest stake to play with as well as the most to lose.

The UK Small Cap index (page 4) is looking more resilient, but again the bullish impetus from the August lows has failed and another day like the 24th when there weren’t too many bids in the market would see a new low here. The REIT market (Page 4) has been another of the “darlings”, but property shares don’t have anything like the resilience of bricks and mortar as the period into and during the financial crisis demonstrates only too well.

Over on Wall Street (page 5) we have the same rounded top pattern as in the UK, which preceded market shake outs in 2000 and 2008. In 2000 the heroic over valuation of TMT (technology, media and telecoms) stocks was the pin prick and in 2008 it was sub-prime debt. What might it be in 2016?

We have no crystal ball and very often these things come “out of left field” (and of course with hindsight will be completely obvious after the event…) but currently any one of US slowdown, China currency devaluation, euro contagion supplied by Greece, Spain, Italy, France(?!), conflagration in the Middle East – perm two from any of Israel, Syria, Egypt, Saudi Arabia, Iran, Turkey, Yemen or Iraq, no doubt with a little bit of help from the US, China (again), Russia and two Spitfires from the UK (I am sorry if you think we are still a global power…we are not; the US just takes us along for a ride and then drops us off in the boondocks).

China has grabbed most of the headlines so far this year for two reasons. Currency devaluation and stock market manipulation (Page 6). The first should really come as no surprise by looking at the two charts on page 6. For nearly 10 years the yuan was pegged to the dollar. After much gnashing and wailing from the US the Chinese allowed the yuan to revalue. This allowed the Chinese stock market, which had been languishing ever since the tech wreck in 2000, to gain some considerable impetus. When the financial crisis came along it seemed prudent for the yuan to be pegged back to the dollar again. More gnashing and wailing from Wall Street ensued and the PBoC re-embarked on the revaluation process.

However, with monetary policy in the US on a completely different tack, the effect on the Chinese economy was deleterious. Quite why it took China so long to work this out is uncertain, but there is no doubt that devaluation, to make their exports more competitive, is firmly back on the agenda. The knock on effect of this currency war is further deflationary pressure around the globe, as if significantly lower commodity prices hadn’t already ushered in that spectre. Stock market manipulation was easy on the way up, but almost impossible on the way down. The market was closed limit down (-7%) on Friday after just 25 minutes trading. Trying to persuade sellers who haven’t yet reached the door marked “exit” (now a very small cat flap) that such an attempt is unpatriotic, isn’t going to work is it? As ever greed and now fear are the only driving forces that work consistently.

The price of oil (page 7) probably won’t fall much further, having got close to $30, which should provide support. The casualty ward is full of patients making predictions about oil (and pretty much anything else…) so maybe it’s a case of $20 here we come. I can’t remember who it was who heroically stated when oil was at $140 the we would never see $20 oil again, but I am pretty sure he won’t stand up and remind me!

That other unfathomable commodity is gold. It has been far from lustrous since 2011, but in the turmoil of last week it was about the only thing going up apart from blood pressure. It is by no means certain that we have made a bottom, but as Kyle Bass is wont to say “Buying gold is just buying a put against the idiocy of the political cycle. It’s that simple” and if the political rhetoric, as guided by the central banks, is losing its grip on the investment community, then that put is going to become quite valuable. If you are brave enough, gold mining shares offer a geared play on the shiny stuff. Page 7

The dollar index chart (Page 8) exhibits a flag pattern bounded by the 95 and 100 levels, between which it has gyrated for the past year. A resolution to the upside could see another move similar to that starting in the middle of 2014, ie another 20% upside from here. “Impossible!”, I hear you cry. Maybe, but stranger things have happened, but only if the Fed carries on with its “interesting” interest rate policy in the face of increasing signs of an economic slowdown, as evidenced by the Atlanta Fed’s GDPNow forecast of 0.9% for Q4 2015 (see chart on page 9).

The Yen is having a run (Page 8), mainly as folk unwind carry trade positions that are beginning to hurt. It doesn’t make sense from a Japanese economic perspective and the BoJ will be very concerned if this strength last for much longer. Sterling (Page 8), once a reserve currency in its own right, is beginning to “benefit” from renewed weakness – well our exporters will appreciate it. In this race to the bottom who will “win” we wonder?

Finally, bonds (Page9). No one quite understands why they are so expensive yet they just keep on keeping on, with the exception of high yield (Page9) which is wheezing away like a canary in the US coal mine. Much punditry is of the opinion that yields can’t go much higher; history says otherwise – see chart page 9.

So much to ponder after a traumatic start to 2016. With so much gloom around, and that’s just the weather, we can expect some sort of rally and how that unfolds will determine any change in the direction of travel for the longer term. We will keep you posted.

Not another forecast

At this time of year tradition dictates that we peer into the future and pretend that we have the foggiest idea about what is coming down the track. Those with the courage to look in the rear view mirror find they may have got a few of last year’s guesses right and those that don’t…well they just keep on guessing. Here is an interesting observation from Macro Man – http://macro-man.blogspot.comI had to laugh when Yellen said that she “wasn’t aware of a better model” for forecasting inflation….because I wasn’t aware of a worse one! The Fed’s inflation forecasting track record is, to put it bluntly, appalling. If you track the rolling 1 year forward projection for the core PCE deflator with the actual result, you find that they have a correlation of -0.68. Quite literally, they’d have a tough time being more wrong if they tried! 

Far better use of our time might be spent on reflecting on the human follies perpetrated during the year and how to recognise them through the morass of misinformation. David Collum of Cornell University has done just that. He is a Professor of Chemistry and Chemical Biology, but don’t let that fool you! Here is his opening gambit.

I wade through the year’s most extreme lunacies as well as a few special topics while trying to find the overarching themes. I love conspiracy theories and detest detractors who belittle those trying to sort out fact from fiction in a propaganda-rich world. My sources are eclectic and if half of what they say is right, the world is a very weird place.

For those of you who recall Harry Truman’s observation that “A lie will get round the world before the Truth has its pants on” will enjoy what David has to say. The sub title of his review is “Scenic views from Mount Stupid” and he has this to say in the introduction.

Presenting such a review poses a multitude of challenges. There are important topics from past years that remain important but will not be repeated. How many times can one rail on underfunded pension plans, unfunded liabilities, or a quadrillion-dollar derivatives market? These matters are important, but the plot line doesn’t change much year to year. I’m skipping right over Japan; it’s a basket case, but not enough has changed to spill some ink. Despite reams of accrued notes and links, I am light on the Middle East because nobody understands it (or eats parsley.) It’s that Mount Stupid descent again. I leave topics like global warming, mass shootings, and Israel versus Palestine to those who like to shout a lot. Other ideas manage to stay at center stage year after year. Compartmentalizing the topics can seem artificial. How does one separate broken markets from the Federal Reserve? Sovereign debt levels from bond markets? Government from civil liberties?

A link to the full piece, which is a long read, but extremely readable, is at the end. Here are a few more observations along with some memorable quotes that he has gathered. This first is about “broken markets”.

“These markets are all rigged, and I don’t say that critically. I just say that factually.” Ed Yardeni, president of Yardeni Research, Inc.

“Whether it’s QE in the West or China’s recent regulatory intervention in the aftermath of the bursting of its equity bubble, market manipulation has become global in scope.” Stephen Roach, Yale University and former executive director of Morgan Stanley

The markets began breaking way back when Alan Greenspan went narcissistic and accepted the dual mandate to (1) preclude equity price discovery, and (2) subvert the business cycle. Let’s look at the bomb we’ve strapped on by first considering valuation. Goldman put price–earnings (P/E) ratios in the 98th percentile. Not a problem. The Fed model asserts that equity prices should correlate inversely with interest rates, which are at ridiculous multi-century lows. As the Fed jams rates to zero in the limit, the composite P/E ratios should go to infinity, right? (Hey: I didn’t invent the model.) Now let’s drop some acid and ponder Fed chair Janet Yellen’s recent warning:

Potentially anything—including negative interest rates—would be on the table. But we would have to study carefully how they would work here in the U.S.

What does the Fed model predict now? Cliff Asness nicely explains why we should fight the Fed model. Common sense says fight the Fed model. David Einhorn says negative interest rates are like taking the square root of minus one. (For those of you not mathematically inclined or professors at Cornell the square root of minus one is an imaginary term as there is no real number having a negative square…apparently!)

On gold – “Buying gold is just buying a put against the idiocy of the political cycle. It’s that simple.” Kyle Bass, Hayman Capital Management.

On energy – “We keep thinking that lower energy prices are somehow good for the economy. That can’t be, because energy prices or commodity prices in general don’t drive economic growth. Economic growth drives commodity prices.” Stephen Schork

If oil prices stay below $90 per barrel for any length of time, we will witness massive fiscal squeezes and regime changes in one or more of the following countries: Iran, Bahrain, Ecuador, Venezuela, Algeria, Nigeria, Iraq, or Libya. It will be a movie we have seen before.” Steve Hanke, Johns Hopkins University and the Cato Institute, 2014

On bonds – “Bonds have never been more expensive in human history, and yet their supply has never been higher.” Tim Price, PFP Group

If you have the option to hold [bonds] to maturity, your risks are bounded and very small.” Brad DeLong, economist at University of California, Berkeley, ignoring inflation risks.

We have a bond market bubble and when that decides to work its way off we are in trouble.” Alan Greenspan, Chair of the STFU Committee

I previously called the bond market the “bond caldera”—a bubble so large that you can see it only from space (or from Greenspan’s front porch). I believe that someday, we will all be hosed when the liquidity leaves the system. This is not a unique view, but many bond speculators believe that (1) central banks would never let rates rise uncontrollably; (2) they are smart enough to get out first; and (3) their counterparties will actually pay them when the time comes. Apparently, there’s a lot of omnipotence to spread around. Until the burst, I simply marvel at the metastability with awe.

On inflation – I was asked recently about why I hold gold while facing deflationary risk. That’s easy: people of prominence and authority are still saying incredibly stupid things and making asinine decisions. Let’s look at a few:

I do not hesitate to say that although the prices of many products of the farm have gone up . . . I am not satisfied. It is definitely a part of our policy to increase the rise and to extend it to those products that have as yet felt no benefit. If we cannot do this one way, we will do it another. But do it we will.” Mario Draghi, European Minister of Inflation and Debasement

Inflation is hopefully giving little signs of moving up in the right direction.” Christine Lagarde, director, IMF

When older cohorts have more influence on the redistributive policy, the economy has a relatively low steady-state level of capital and a relatively low steady-state rate of inflation.” Que? James Bullard, president of the St. Louis Fed

And last but not least …”Even if we had some kind of shock that sent prices up for some reason, the Fed has the tools to stop inflation. That’s not very hard. . . . There is a whole generation of people who don’t remember inflation. They don’t know what it is, and so I think inflation is a non-existent threat.” Alice Rivlin, former Fed governor, making my brain hurt

The award for the most moronic statement goes to . . . envelope please . . . Alice Rivlin! If we don’t know what inflation is, it can’t hurt us. Fabulous!

There is more, much, much more and if your appetite has been whetted here’s the link http://www.peakprosperity.com/blog/95808/2015-year-review It has been posted on Chris Martenson’s Peak Prosperity website where you may find many other items of interest. For those of you not so whetted here’s one final quote.

The ‘risk’ case is only being made circumspectly by people who are being ridiculed as clueless Cassandras. . . . Our belief is that the global economy and financial system are in a kind of artificial stupor in which nobody (including ourselves) has a good picture of what the next environment will look like. The difference between ‘them’ and ‘us’ is that they mostly think that policymakers will muddle through, but we assume that a very surprising and scary environment lies in wait.” Paul Singer, Elliott Management Corporation

Click here to download pdf

Watching and waiting

There’s a title of a song in there somewhere, but we watch and wait upon the ECB and the Fed, which is of course a song and a dance routine. It is widely accepted that everyone knows that everyone else knows that the central banks are not going to let anything untoward happen to the markets. This “belief” started with the Greenspan “put”, morphed seamlessly into the Bernanke “put” and until recently to the Yellen “put”. The present Chairwoman has had her work cut out to maintain the Fed’s credibility as Masters of the Universe, but it does seem that at long last she is about to lay an egg and accede to the clamour to raise rates.

The recent data on employment – there are nearly 2000 indices on the FRED (Federal Reserve Economic Data) website covering employment so there should be something there for all tastes – has been “strong”, but, despite Rosy Scenario’s appearance, the most recent GDPNow number from the Atlanta Fed shows a decline in the growth rate for Q4. The Q1 GDP has been consistently low in recent years, as seasonal factors drag the number down, so we face the prospect of the Fed having to reduce rates again in the New Year. How embarrassing would that be? At least they’ll have something to cut… Maybe that’s the only reason to raise now, but the belief in central bank omnipotence will be wearing pretty thin by then if that’s the case.

Over in Europe, Dr. Aghi is leaning in the opposite direction. His jaw boning is legendary; in July 2012 he uttered the “whatever it takes” phrase, which galvanised the bond markets into believing that he had their backs, and the belief is still in evidence. The Italian 10 year yield, which before that statement was standing at 6.5%, is now 1.4%. To put that into perspective US Treasuries yield 2.2% and Gilts 1.8%. He has further suggested that at the next meeting on December 3rd there is the prospect of more monetary easing. One might wonder why this is necessary having already put aside in excess of €1 trillion to buy up European debt. Quite simply…QE doesn’t work! Certainly not in the way intended, which was to get the money supply moving again by getting the banks to lend to businesses to kick start the economic growth engine. There has been some tepid growth in issuance but demand has been luke warm too mainly as a result of euro austerity as preached by Germany and enforced on the unwilling by the ECB and the EU commission.

It would seem unwise to continue with more QE, so we expect that the introduction of negative interest rates – the short term bond markets have been there for some time – that will give further impetus to the banks to lend and to consumers to spend. What is really needed is an end to austerity. Lower tax rates could very conceivably bring about higher growth rates and in turn a higher overall tax take.

The European economy desperately needs a kick with unemployment across the euro area averaging 10.8%. It’s less than half that in Germany 4.5% and nearly twice that in Spain 21.2%. In Germany wage growth has continued unabated for the last 10 years whereas in Spain it has been flat at best. Any improvement in the Spanish economy has come as a result of “labour” taking a hit. European markets aren’t expensive, but Europe isn’t “fixed” either so we watch and wait to see what magic the good Doctor comes up with on the 3rd. Here’s hoping!

To download the pdf version with charts please click here

My name is Bond

Bond has been on my mind a lot of late but, unlike many people, it is not the Daniel Craig film but the horror movie – or perhaps the comedy of errors – that is the fixed income sector I have been watching through my fingers. This world is not full of fast cars and vodka martinis – well, perhaps for a few of the fund managers it might be – but the rather more mundane considerations of duration, liquidity and the direction and timing of interest moves.

The numbers of actors who have played 007 on-screen may be growing but it has nothing on the fixed income cast-list. In the three most popular Investment Association bond sectors – Sterling Corporate Bond, Sterling Strategic Bond and Global Bonds – the listed funds align themselves to a total of 70 different indices and benchmarks, with more than a few declining to follow any benchmark at all.

The huge range of strategies on offer even within those three fund groupings makes it very difficult to say who has done a decent job. Such is the variety of ways to make – and lose – money in bonds, many investors have settled on using ‘strategic’ funds on the heroic assumption their managers will know what is going on at the ECB, BoE, BoJ, SNB and others and position their portfolios accordingly.

And yes, I deliberately omitted the Fed from that list on the basis barely anyone – including most of the FOMC members – has a clue what is going on there. US policymakers seem to be saying rates should be going up and yet, at the ECB, Mario Draghi has threatened they might actually be about to go down …

But why in fact do we need to invest in bonds at all? A lot of them have negative real yields and the attraction of the high-yield sector is on the wane as defaults inevitably start to rise. Yields are also on the up there, of course, but that should be taken as a warning not a magnet.

Over the past 35 years or so, the bond bull market has been the only game in town and, looking at the chart to the right, it may still be. The asset class posted its most recent all-time high in September – so no sign of a bear market … or at least not yet. Over the same time period, portfolio construction has been in thrall to modern portfolio theory and mean variance optimisation. Bonds, based on their historical long-term track record, are deemed to be less volatile and hence less risky than equities so exponents of mean variance optimisation will tell you an allocation of 60% to bonds and 40% to equities will be a nice and cosy low-risk strategy.

Yet that assumes bond and equity returns will behave in the same way they have done for the last 35 years, which seems ever so slightly unlikely, does it not? The current seven-year forecasts for real returns from US large cap equity and US bonds suggested by GMO, for example, are minus 0.6% and minus 1.1%. Stick that in your mean variance optimiser and see what comes out of the sausage machine …

Now, GMO suffers from the same problem as the rest of us – we are all fallible when it comes to forecasting, but the point with modern portfolio theory is that a small change in your assumptions can make a disproportionate difference to the asset allocation you end up with. GMO’s three highest forecasts are for emerging market equity, emerging market debt and timber – an interesting sort of a portfolio that would cause a certain amount of indigestion for the ‘Modernistas’. The long-term historical US equity return may be 6.5% but, in our monetary policy-constrained, experimental world that seems a far-off realisation too.

Liquidity received a mention in the opening paragraph and there is no doubt it could be an almighty problem one fine day. If that comes to pass, it will not be just the bond giants and their investors who will suffer, it will be all the bond funds – large and small. How long would any dislocation last? If it is a ‘flash crash’, high-frequency trading-type event, maybe not very long. If it is based on the perception rates are going up for some time and to levels that only five years ago were deemed ‘normal’, then probably a lot longer than most investors can stay solvent.

Those who were early to eschew bond world used cash as their proxy but, in a negative real rate environment – and one that looks like getting worse before it gets better – we need to look elsewhere. In short, we need ‘alternatives’. Along with ‘hedge fund’ and ‘derivatives, that word does not always receive a good press – ‘Too difficult for the end-investor to understand’, as the refrain often runs. But they will understand all right on the day their 60% allocation to bonds is found wanting …

While we wait for the Fed to make up its mind on whether or not to raise interest rates in December, we also need to contemplate negative nominal rates in Europe, which is one way Draghi could force the banks to use their reserves more effectively. He would hope for them to make more loans to businesses but it is just as likely the money will move into the asset markets.

With global GDP still anaemic at best – the CEO of Danish shipping giant Maersk has said the IMF’s forecasts of growth are far too optimistic – how far can equity multiples be pushed until it is finally spotted the emperor is lacking in the clothing department? A mistake on interest rates either way could usher in the ‘Spectre’ of significant market volatility in both bonds and equities – the scenario that, in their infinite wisdom, the central banks are trying so desperately to avoid.

Click here to download in pdf format