#thefed

The one fatal flaw experts forget when seeking to mimic #Abenomics style endurance

Pain

Over three decades ago, the Japanese introduced a TV programme titled, ‘Za Gaman‘ which stood for ‘endurance‘. It gathered a whole bunch of male university students who were challenged with barbaric events which tested their ability to endure pain because the producer thought these kids were too soft and self-entitled. Games included being chained to a truck and dragged along a gravel road with only one’s bare buttocks. Another was to be suspended upside down in an Egyptian desert where men with magnifying glasses trained the sun’s beam on their nipples while burning hot sand was tossed on them. The winner was the one who could last the longest.

Since the Japanese bubble collapsed in the early 1990s, a plethora of think tanks and central banks have run scenario analyses on how to avoid the pitfalls of a protracted period of deflation and low growth that plagued Japan’s lost decades. They think they could do far better. We disagree.

There is one absolutely fatal flaw with all arguments made by the West. The Japanese are conditioned in shared suffering. Of course, it comes with a large slice of reluctance but when presented with the alternatives the government knew ‘gaman’ would be accepted by the nation. It was right.

We like to think of Japan, not as capitalism with warts but socialism with beauty spots. Having lived there for twenty years we have to commend such commitment to social adhesion. It is a large part of the fabric of Japanese culture which is steeped in mutual respect. If the West had one lesson to learn from Japan it would be this. Unfortunately, greed, individualism and self-entitlement will be our Achilles’ heels.

It is worth noting that even Japan has its limits. At a grassroots level, we are witnessing the accelerated fraying of that social kimono. Here are 10 facts taken from our ‘Crime in Japan‘ series – ‘Geriatric Jailbirds‘, ‘Breakup of the Nuclear Family‘ and the ‘Fraud, Drugs, Murders, Yakuza and the Police‘ which point to that old adage that ‘all is not what it seems!

  1. Those aged over 65yo comprise 40% of all shoplifting in Japan and represent the highest cohort in Japanese prisons.
  2. 40% of the elderly in prison have committed the same crime 6x or more. They are breaking into prison to get adequate shelter, food and healthcare.
  3. Such has been the influx in elderly felons that the Ministry of Justice has expanded prison capacity 50% and directed more healthcare resources to cope with the surge in ageing inmates.
  4. To make way for more elderly inmates more yakuza gangsters have been released early.
  5. 25% of all weddings in Japan are shotgun.
  6. Child abuse cases in Japan have skyrocketed 25x in the last 20 years.
  7. Single-parent households comprise 25% of the total up from 15% in 1990.
  8. Domestic violence claims have quadrupled since 2005. The police have had to introduce a new category of DV that is for divorced couples living under the same roof (due to economic circumstances).
  9. The tenet of lifetime employment is breaking down leading to a trebling of labour disputes being recorded as bullying or harassment.
  10. In 2007, the government changed the law entitling wives to up to half of their husband’s pension leading to a surge in divorces.

These pressures were occurring well before the introduction of Abenomics – the three arrow strategy of PM Shinzo Abe – 1) aggressive monetary policy, 2) fiscal consolidation and 3) structural reform.

Since 2013, Abenomics seemed to be working. Economic growth picked up nicely and even inflation seemed like it might hit a sustainable trajectory. Luckily, Japan had the benefit of a debt-fueled global economy to tow it along. This is something the West and Japan will not have the luxury of when the coronavirus economic shutdown ends.

However, Japan’s ageing society is having an impact on the social contract, especially in the regional areas. We wrote a piece in February 2017, titled ‘Make Japan Great Again‘ where we analysed the mass exodus from the regions to the big cities in order to escape the rapidly deteriorating economic prospects in the countryside.

Almost 25 years ago, the Japanese government embarked on a program known as
‘shichosongappei’ (市町村合併)which loosely translates as mergers of cities and towns. The total number of towns halved in that period so local governments could consolidate services, schools and local hospitals. Not dissimilar to a business downsizing during a recession.

While the population growth of some Western economies might look promising versus Japan, we are kidding ourselves to think we can copy and paste what Nippon accomplished when we have relatively little social cohesion. What worked for them won’t necessarily apply with our more mercenary approach to economic systems, financial risk and social values.

Sure, we can embark on a path that racks up huge debts. We can buy up distressed debt and repackage it as investment grade but there is a terminal velocity with this approach.

The Bank of Japan is a canary in the coalmine. It has bought 58% of all ETFs outstanding which makes up 25% of the market. This is unsustainable. The BoJ is now a top 10 shareholder of over half of all listed stocks on the index. At what point will investors be able to adequately price risk when the BoJ sits like a lead balloon on the shareholder registry of Mitsui Bussan or Panasonic?

Will Boeing investors start to question their investment when the US Fed (we think it eventually gets approval to buy stocks) becomes the largest shareholder via the back door? Is the cradle of capitalism prepared to accept quasi state-owned enterprises? Are we to blindly sit back and just accept this fate despite this reduction in liquidity?

This is what 7 years of Abenomics has brought us. The BoJ already has in excess of 100% of GDP in assets on its balance sheet, up from c.20% when the first arrow was fired. We shouldn’t forget that there have been discussions to buy all ¥1,000 trillion of outstanding Japanese Government Bonds (JGBs) and convert them into zero-coupon perpetual bonds with a mild administration fee to legitimise the asset. Will global markets take nicely to erasing 2 years worth of GDP with a printing press?

Who will determine the value of those assets when the BoJ or any other central bank for that matter is both the buyer and seller. If the private sector was caught in this scale of market manipulation they’d be fined billions and the perpetrators would end up serving long jail sentences.

Can we honestly accept continual debt financing of our own budget deficit? Japan has a ¥100 trillion national budget. ¥60 trillion is funded by taxes. The remainder of ¥40 trillion (US$400 billion) is debt-financed every single year. Can we accept the RBA printing off whatever we need every year to close the deficit for decade upon decade?

In a nutshell, we can be assured that central banks and treasuries around the world will be dusting off the old reports of how to escape the malaise we are in. Our view is that they will fail.

What will start off as a promising execution of Modern Monetary Theory (MMT), rational economics will dictate that the gap between the haves and the have nots will grow even wider. Someone will miss out. Governments will act like novice plate spinners with all of the expected consequences.

In our opinion, the world will change in ways most are not prepared for. We think the power of populism has only started. National interests will be all that matters. Political correctness will cease. Identity politics will die. All the average punter will care about is whether they can feed their family. Nothing else will matter. Climate change will be a footnote in history as evidenced by the apparition that was Greta Thunberg who had to tell the world she caught COVID19 even though she was never tested.

Moving forward, our political class will no longer be able to duck and weave. Only those that are prepared to tell it like it is will survive going forward. The constituents won’t settle for anything else. Treat them as mugs and face the consequences, just like we saw with Boris Johnson’s landslide to push through Brexit.

The upcoming 2020 presidential election will shake America to its foundations. Do voters want to go back to the safety of a known quantity that didn’t deliver for decades under previous administrations and elect Biden or still chance Project Molotov Cocktail with Trump?

What we know for sure is that Trump would never have seen the light of day had decades of previous administrations competently managed the economy. COVID19 may ultimately work in Trump’s favour because his record, as we fact-checked at the time of SOTU, was making a considerable difference.

Whatever the result, prepare to gaman!

 

An Abysmal 7

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As of March 28th 2019, the St Louis Federal Reserve updated the status of pre-tax US corporate profitability (ex inventory adjustments). It clearly shows that since 2012 they have tracked sideways. Despite the lowest sustained interest rate environment since WWII, US profitability has drizzled over the last 7 years. Is it any wonder Trump was calling for more QE?

Debunking Modern Monetary Theory (MMT)

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While the Dow & S&P500 indices grind back higher thanks to the US Fed chickening out on a rate rise in because the economy can’t handle it, many people still overlook the fact that core US profitability has tracked sideways since 2012. 6 years of next to nada. Sure one can boost profits by adding back unrealistic  “inventory adjustments” but the reality is plain and simple. If you search for inventory adjusted earnings they’re still marginally growing but there in lies the point. Real profits aren’t.

Record buybacks fueled by cheap debt is the cause for ‘flattered’ earnings. No growth in E  just falls in S.  EPS growth can look spectacular if you ignore 50% of US corporates have BBB credit ratings or worse.

The latest lexicon is “modern monetary theory” (MMT). The idea that the central banks just manipulate markets in perpetuity. Austerity is no longer needed. Central banks print money and extinguish debts the same way. Seriously why bother with taxation? The question is if it is meant to be a sure winner, why aren’t we all living in 5 bedroom mansions with a Mercedes Benz and a Porsche in the driveway? Why not a helicopter?

Logically if central banks can buy our way out of this debt ridden hellhole, why is growth so anemic? Why is European GDP being cut back? Why is German industrial production at its worst level since 2009? Why does Salvini want to jail the Italian central bankers? Why does the Yellow Vest movement in France carry on for its 15th consecutive week? If MMT works why would the EU care if the UK leaves with No Deal? MMT can solve everything for unelected bureaucrats in theory. Even £39bn can be printed

Last year the US Fed announced it had stopped reporting its balance sheet activity. In 2006 it stopped reporting M3 money supply. Curious timing when inside 2 years the world was flung into the worst recession since 1929. Transparency is now a danger for authorities.

The question boils down to one of basic sanity. All assets are priced relative to others. It’s why an identical house with a view in a nice neighborhood trades at a relatively higher price than one in a outer suburban back lot. The market attributes extra value even if the actual dwelling is a carbon copy. It is why currencies in banana republics trade by appointment and inflation remains astronomical. Investors don’t trust their ability to repay debts unless given extremely favorable terms. Market forces at work.

To put the shoe on the other foot, if all countries adopted MMT why bother buying bonds for retirement? The interest is merely backed by a printing press. Best consume 100% and save zero. The government has moved beyond moral hazard and hopes no one will notice

Take a look at Japan. It has $10 trillion in outstanding debt which is 2x its economy. The Bank of Japan owns 60% of that paper bought through a printing press. The market for JGBs is so manipulated that several Japanese mega banks have handed back their trading licenses because it has become worthless to be on that exchange. The BoJ thinks it can make whatever prices it chooses. The ultimate aim is to convert all of the outstanding debt into a zero coupon perpetual bond with a minor ‘administration’ fee in order to assign some value to it. To the layman, a zero coupon perpetual means you get no interest on the money you lend and the borrower is technically never required to pay the borrowed amount back. Such loans are made by parents to their children, not central banks to politicians (although one could be forgiven to think their behaviour is child like).

Yet the backdrop remains the same. Consumers are tapped out in many countries. Lulled by a low interest rates forever mentality, even minute rises to stem inflation (real is different to reported) hurt. My credit card company constantly sends emails to offer to transfer balances at 9% as opposed to the 20% they can charge if I don’t pay in full.

APRA recently relented on interest only mortgages after demanding it be tightened to prevent a housing bubble getting bigger. Now mortgage holders hope the RBA cuts rates to ease their pain.

Like most new fads, MMT can’t remove the ultimate dilemma that Milton Friedman told us half a century ago. Inflation is always and everywhere a monetary phenomenon. One can’t hope that putting money in the hands of everyone can be sustainable.

The one lesson that we should have learnt from GFC was that living at the expense of the future has rapidly diminishing returns. All we did was double down on that stupidity.

Do we think it normal that Sydney house prices  trade at levels the Japanese property bubble did in the late 1980s? Do we realize that we hold as much mortgage debt than Japanese banks did for a population 5x our size? Do we think that our banks are adequately stress tested? When an economy like ours has avoided recession for a quarter century, it builds complacency.

MMT is nothing more than a figment of the imagination. It preys on the idea that we won’t notice if we can’t see it. Unfortunately behind the scenes, the real economy can’t sustain the distortions. The French make the best modern day example of  a growing number of Main Streeters struggling  to make ends meet.

Central banks monkeying around with MMT smacks of all the same hubris of the past. It is experimental at best and reckless at worst. Markets can be manipulated for as long as confidence can be sustained. Lose the market’s trust and all of a sudden no amount of modern day jargon  can overcome what economists have known for millennia.

If you flood a global economy with cash at 5x the rate the economy can feasibly grow then it will ultimately require bigger and bigger hits to get the same bang before the jig is up. It’s a Ponzi scheme. Bernie Madoff got 120 years jail. Why not the central bankers?

So what is the best asset out there? Gold. It can’t be printed. It requires effort to discover it and dig it out of the ground. Of course the barbouros relic deserves to be consigned to the dustbin of history. If that were so Fort Knox might as well leave the gate open. The more it is hated only makes this contrarian investor want it more.

Why discontinue?

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This is a chart of the change in the US Fed balance sheet, a series that has just been discontinued. Is this because the Fed is about to step up its activity and offering wider disclosure on tapering activity might spook markets? Given that 72% of the growth in S&P earnings has been driven by buybacks since 2012, it stands to reason the market is not exactly providing the type of confidence inducing organic lift the index reflects. Bank of America revealed that “net buying of Tech sector in the 1H was entirely buyback-driven.” 

Kind of reminds CM of the day Bernanke’s Fed announced it would no longer report M3 money supply a year before the financial markets headed into the GFC. CM estimated on p.4 of a report several years ago that M3 money supply by 2018 on constant long-term growth rates would turn into around $35 trillion from the $10 trillion at the time it was discontinued.

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Nothing to see here? Throw a deteriorating fixed income market with fewer buyers and corporates that have binged on cheap credit to fuel buybacks, it doesn’t look like the stuff dreams are made of. The chart below shows that quarterly pre-tax US profitability is struggling since 2011. Earnings (E) are not doing so well. It is by the grace of falling number of traded shares (S) that makes the EPS look flattering.

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We took the liberty of comparing corporate profitability since 1980 and correlating it to what Moody’s Baa rated corporate bond effective 10yr yields. An R-squared of almost 90% was returned.

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Why not use the Aaa spread instead? Well we could do that but looking over the last decade the average corporate debt rating profile looks like this. We have seen a massive deterioration in credit ratings. If we look at the corporate profitability with Baa interest rates over the past decade, correlation climbs even higher.

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We shouldn’t forget that the US Government is also drunk on debt, much of it arriving at a store near you. $1.5 trillion in US Treasuries needs refinancing this year and $8.4tn over the next 3.5 years. Couple that with a Japan & China pulling back on UST purchases and the Fed itself promising to taper (but now hide the results of) its balance sheet. So as an investor, would you prefer the relative safety of government debt or take a punt on paper next to junk heading into a tightening cycle?

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Discontinuation of series always carries a sense of deep cynicism for its true intention. It is not an onerous data set to cull. Sure we can fossick around and try to find it hidden in the archives of the Fed website but the idea is that they probably don’t want to publicise how much more they intend to flog.

Jan 2008 again?

3mthTB

Back to Jan 2008 10yr Treasury – 3mth Treasury Bill spread levels of 0.84% overnight. Shaded areas are previous recessions. I’m sure it is nothing. The friend who sent me the link also sent a Barron’s article last week which interviewed Kiss legend Gene Simmons who believes the Dow is poised for 30,000. He may well be proved right, although I wonder just whether algo trading is linked to Twitter followers. Maybe if Katy Perry starts jawboning about Dow 40,000 we should shut up and buy the trend. More useful than some Goldman Sachs nerd with a PhD in nuclear fission to read the runes…

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Some interesting reading

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John Mauldin has put together a few interesting pieces over the weekend. Some of the select quotes from Thoughts from the frontline:

Money Velocity (which CM wrote about in 2016):

velocity of money, which is continuing to fall, as it has for almost 20 years…So it is somewhat disturbing to see velocity now at its lowest point since 1949, and at levels associated with the Great Depression.”

Income Disparity:

Note that it is the 95th percentile of workers that has received the bulk of the increase in wages. The bottom 50% is either down or basically flat since 1979. Even the 70th percentile didn’t do all that well.

Budget Deficits:

Over the last half-century, higher deficits have been associated with recessions. After recessions end, the deficit shrinks, and occasionally we get a surplus. That’s not happening this time. Deficits are growing even without a recession…but in the next recession tax revenues will fall, and spending will increase enough to not only swell the annual deficit but also to add north of $2 trillion to the national debt each year. We’re using up our breathing room, and that will be a problem – sooner or later.

Monetary Policy:

Ominously, you can see from Grant’s labels (In the above chart) with arrows that peak yields tended to correspond with crises. If the current breakout persists, it is probably going to get its own label, and I bet we won’t like it.

Nothing to see here?

 

Just how far behind the curve is the Fed?

As the Fed raised its Fed Funds Rate to 1.5~1.75% overnight, one has to question just how far behind is it? 3M Libor rates have surged from 0.5% in 2016, c.1% at the start of 2017 to 2.27% today, the highest levels since 2008.  Normally Libor minus Overnight Index Swap (OIS) rates don’t diverge so much without causing a credit issue. The gap is effectively the market price over and above the risk free rate. At the time of the GFC, the Libor-OIS spread hit 3.5%, with 1% being the detonator level. While it is currently at 0.54% spread, it has risen consecutively for the last 32 sessions.

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As Libor drives corporate credit recycling, with corporate debt piles approaching record highs and average credit ratings the worst they’ve been in over a decade (chart below depicts Top tier as AAA and bottom tier as BBB-) we could see the Libor-OIS spread keep expanding.

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What could be causing this? If we think logically the US Treasury has to refinance $1.5 trillion over the next 12 months and $8.4 trillion over the next 4 years. Add to that a Fed looking at quantative tapering and a less eager Japan and China as buyers of US$ federal debt then the corporate will undoubtedly get crowded out. The demands for refinancing are not being met with the supply of funds.

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Of note, the St Louis Fed reports the YoY increase in inflation reported by the CPI in the US in Feb 2018 was 2.3%. The 10yr breakeven inflation rate is around 2.08%. CPI ex food items is still at 1.9%. In any event the US remains in a negative real yield environment.

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The Fed can bang on all it wants about healthy growth, full employment but the depth of problems stored up is getting worse. $9 trillion in unfunded public pension liabilities, $67 trillion in combined public, private and corporate debt…

…many are recently talking of the huge pent-up profit boost to banks which have had such compressed spreads for so long. Indeed that all makes absolute sense from a theoretical (and to date practical) reasoning but banks like those in Australia up to their gills in mortgage debt, rising spreads have far nastier implications for blowing up balance sheets than boosting P&L accounts.

In a sense it is almost futile to call central banks as being behind the curve. The failure to take the harsh medicine of almost two decades ago is gathering momentum in so far as there is not much can left to kick down the road.

New Fed Chairman to trigger historic stock market crash in 2018 – ZH

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ZeroHedge writes that the new Fed Chair will trigger an historic stock market crash in 2018. Glad to have loaded up on put options in recent weeks. Perhaps the cheapest priced products in an asset bubble everywhere world. Some shorter dated put options priced as little as 2c in the dollar. Risk is definitely not being priced for fear. Maybe why Blackstone has built up $22bn of short positions in recent months.

Rick Santelli rants at central banks and yells “don’t help anymore”

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I don’t often watch CNBC but Rick Santelli made absolute sense when he tore into US Fed Chairman Janet Yellen over her plan to potentially buy equities to support the market like the Bank of Japan does now. Yellen still will have to get approval from Congress to embark on such a journey but it goes against her statement during the FOMC press conference where she boldly claimed “we’re not a body subject to group think”. Santelli correctly pointed out that price discovery would be ruined by such action.

As we know from Japan’s experience, the BoJ has had zero impact on consumer behaviour by buying equities and ruined market dynamics by becoming the largest shareholder in a growing number of companies. If they keep up the good work Japanese corporate’s will become state owned enterprises.

Going back to the Fed. Last week I wrote that Yellen’s language beggars belief. On the one hand she talks about the faster pace of economic growth all the while the Fed cuts long term and 2016 growth to 1.8%. Not one week later the NY Fed has cut 2016 growth to 1.4%.

Im amazed at how blind markets can be. Equitie markets continue to sustain lofty heights based on slowing aggregate earnings, worsening credit ratings and a complete failure by central banks to restore confidence.

Last report from the ECB showed it took €18 to create €1 of GDP given all their asset purchases. This is the problem. Without money velocity the  central banks only highlight to themselves it is the wrong path yet they still watering the lawns with gasoline while smoking. 

Playing with Financial Plutonium

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I am still dumbfounded by the level of complacency in financial markets. How  can there be any confidence in our financial system?  Reality is that confidence continues to wane. I mentioned a while back that the headline stock index in Europe has no financial stocks in it. Never in my history in financial markets have I witnessed this. It isn’t because other stocks have got bigger. Financials in Europe have shrunk to such irrelevant levels that they don’t make the cut. Argue all you want about FinTech revolutionizing banking as we know it however don’t dismiss that the core of financial markets resembles a rotting carcass with so little meat that even vultures are considering vegetarianism so slim are the pickings. If the financial sector is sick and it is what greases the economy beware this signal.

One thing that hasn’t changed is the arrogance of the banks. Deutsche proudly protesting that the DoJ’s $14bn fine is just a “starting point” all the while its shares dwindle at all time lows.  Europe’s most powerful bank 1/3rd the size of Australia’s NAB. I’m working on a report looking at the deterioration of financial profitability and market relevance.

All the while though I keep shouting from the rooftops like the tramp from Blazing Saddles and the bell chimes right as I try to warn of impending  global economic disaster.

“The world economy is dying (clang!)”

“what did he say?”

“I think he said the world economy is flying!”

“No, goddamnit!, I said the world economy is dying (clang!)”

You get the picture. What people still haven’t grasped is the velocity of money continues to slow rapidly. For every dollar pumped into the economy, smaller fractions of GDP are created. In Europe it takes €7 to create €1. In China it takes RMB8 to create RMB1. In the US it takes around $4.5. The more morphine that is pumped into the patient the less efficacy. The debt burden mounts to unsustainable levels. Asset bubbles abound. Central banks keep pushing on sweeping the damage under the carpet. Europe is at stall speed. France and Italy didn’t grow last quarter. The US stumbled into 1% territory while the previous quarter was revised to 0.8% – hardly cracking growth.

The most recent worrying red flag is Greenspan weighing into the central bank policy debate. If there was ever a tail-end Charlie behind the curve he is it. I look at the propaganda pushed by the White House in a self congratulatory tone. This idea that everything is fine. American wealth at all time highs and poverty at 50 year lows. The problem with such fiction is that Main Street is actually living the struggle. They are not theory. They are reality. Whether crushing pensioners with a lack of sensible low risk income products, or celebrating recent inflation through rent rises and healthcare costs is not to pat one’s back over. Real wages are falling, consumption is waning and life is getting tougher. Steeper Obamacare prices and higher rents don’t boost economic growth. This is bad inflation and most other items continue to struggle under the weight of chronic overcapacity. Hanjin Shipping woke us up to that sad fact.

It’s brutal out there but the Democrats talk of prosperity at the same time complaining at the lack of progress on welfare despite having their wise sage Obama at the helm for the past 8 years.

More misguided central bank policy continues in group think like fashion.  It is as if they are enriching financial plutonium to such dangerous levels that imminent detonation could occur. The experiment keeps going but the scale of the collateral damage is growing exponentially. Many central bankers know how bad things have got but pray they can leave their ivory towers and seek shelter before it blows up on their watch so they can evade direct responsibility.

For all of the pump priming, toxic asset buying and NIRP strategies of central bankers, there is one constant in all of this. Pain must eventually be taken to restore equilibrium. The longer we store up the gangrenous irradiated mess that has and is being created for almost two decades the bigger the scale of fall out.

So many are totally unprepared for the coming event. People will still argue that the most experienced and brightest minds work within these banks so we should back their collective wisdom but I’d bet money that most if not all have no idea about how the average Joe and Joanne works. Funny thing is the average Joe and Joanne are feeling the pain everyday as they struggle to get by. They’ve had enough.

I’m surprised the Democrats, the party that is supposed to favour the afflicted, continue to miss the obvious. Trump would never have seen the light of day had the establishment listened to their cries for help.

In closing, I feel the same vibes I did when I called the impending crisis that was GFC1. This time will be much worse.  Financial plutonium is too rich and reaching fissile levels. Discount everything coming from the authorities. Pure common sense tells us the numbers don’t match reality.

There will be no “I told you so!” moment for me. Who would want to bask in misery?