Wednesday, December 18, 2013

FED DECISION - EQUITIES WIND UP? OR UNHOLY UNWIND?

I know that I have written about the coming equities market correction for about 3 months now. I am also acutely aware that there will be a growing band of my readers beginning to doubt the call.
It is also evident even some of the brighter economic thinkers are questioning if there is an equities bubble!  Are they joking? Poking at me for a reaction? SERIOUSLY!

With all this in mind, the Fed decision tomorrow is the biggest decision since October when the infamous taper “head fake” caught the market by surprise. It seems to be some kind of game for the Fed, jawboning, taper talk, on again off again. Is it a test of market reaction? If it is then the Fed members are clueless. Market reaction should be obvious, just look at how it panned out in October!

The fact is, the decision that will be handed down tomorrow is HUGE. Make no mistake, I would love to see a taper for the economy, to end this insanity. I want my readership to understand that the underbelly of debt cannot be sustained and that that the only thing preventing the ultimate deleveraging depression is the Fed intervention in the bond market, the $85bn in QE life support.

So what do I see happening tomorrow? What will the Fed do? How will that play out for the equities market? What impact will it have on both the USA domestic economy and the global economy?


WHAT DO I SEE THE FED DOING TOMORROW?
Tomorrow I am tipping something special. Firstly I am going to go on the record tipping NO TAPER. The Fed has said time and time again that a tapering of QE is DATA DEPENDENT. If you take the Fed at their word, then how could they taper into the weakest employment environment in over 35 years?

It is not just the weak employment environment that is of concern. If you delve deeper into the data recently released on personal income and outlays for October, the case for a Fed NO TAPER is all the more evident. Looking at the report, it states that personal savings as a percentage of income had fallen to 4.8% from 5.2%. It also lowlights the fact that proprietors income decreased by $19.7bn. Below is the link for your perusal.


http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm


 If the Fed were to taper into weakness it will trigger an equities market correction, the “unholy unwind” as investors are forced into deleverage mode amidst rising interest rates and increased margin demands. There is no doubt in my mind thata December taper will only be temporary and its effect on markets will have the Fed doing the UNTAPER dance early next year, followed by the INCREASE QE groove not long after.

With household savings at a mere 4.8% of total household income, the economy would fracture if a Taper induced interest rate rise were to manifest itself. To give readers an idea, an interest rate hike from say 4.5% to 5% on a $350,000 mortgage would cost the borrower around $110 per month extra on their mortgage.

 Assuming that the borrower has an income of $800 per week, saving 5% of that is $40 per week or $160 per month. That 0.5% interest rate hike reduces household savings by $110 per month on the mortgage repayments alone. This in effect, reduces the borrowers’ ability to save by more than half!

With savings already at critically low levels this taper inflicted interest rate blow would take all the steam out of the property market. It is for this reason along with the poor employment outlook that the Fed, in my opinion, will maintain the status quo of QE $85bn per month.
I feel that if the Fed maintains the status quo the equities market will flat line, rather than rise as the law of diminishing returns reduces the boost the standard $85bn gives to the markets.

Setting aside the NO TAPER which I feel is a given, what could the Fed do to try and get some more activity out in the economy? When you analyse the recent Fed minutes the topic of lowering the 0.25% interest the Fed pays banks for excess cash reserves is mentioned as a solution to stimulating bank lending into the economy. Right now the banks have around $2.5Tn dollars in excess reserves parked at the Central bank earning a pitiful 0.25%.

I believe the Fed will maintain the $85bn in QE and at the same time reduce this 0.25% interest rate to perhaps 0.15% in an attempt to drive banks away from hoarding cash at the Fed and lend a part of the $2.5Tn in reserves into the economy.


The reason I believe this reduction in interest rates WILL take place is simple. There is not enough credit being created, or money loaned into the economy to sustain current asset prices. Margin loans used to prop up the stalling equities market have surpassed levels prior to 2007 and available “margin credit” is almost dry.

When this margin credit dries up, there is no more play money to continue inflating the asset prices and the game is OVER.  Below is an article in Zero Hedge that supports my argument that margin debt has peaked and that the equity markets are now stalling due to “the ongoing collapse in investor net worth”


http://www.zerohedge.com/news/2013-11-26/margin-debt-soars-new-record-investor-net-worth-hits-record-low


The above article suggests that the collapse in investor net wealth means available “credit” with which to continue increasing leverage into the market is approaching critically low levels. The article was written at the end of November and it appears that the Dow Jones Industrial Average peaked on November 27th at 16,100 points. Since then there has been some deleveraging in an attempt to try and free up some credit and as I type this blog the Dow closed at 15,875 points.


A link to the DJIA monthly chart is copied below :


http://au.finance.yahoo.com/q/bc?s=%5EDJI&t=1m&l=on&z=l&q=l&c=

The margin loan credit availability case has strength and merit. It supports my view that the equities market is on the edge, a debt bubble edge! The market is screaming for gas, sputtering like an old beat up car running on fumes hoping the Federal Reserve gas station is just around the corner.


The Fed knows that QE is now not enough to keep the equities and property market bubbles from bursting. It needs to get the banks creating the endogenous money gasoline and lend to the economy, something they have been unwilling to do as is evident by the mushrooming $2.5Tn in excess cash reserves.


The Fed will, in my opinion surprise everybody tomorrow with NO TAPER and at the same time a cut in the interest rate they pay for excess cash reserves. This must happen if the Fed want to keep the economic improvement illusion going.


If they do that tomorrow, Gold goes much higher, equities go higher also, and the bearded man BERNANKE gives Yellen the hand pass from hell, the ultimate poisoned chalice… couldn’t have happened to a nicer man… oops I mean Woman!

 

Tuesday, December 3, 2013

FINANCIAL SECTOR – THE PARASITE SUCKING THE BLOOD OUT OF THE REAL ECONOMY – MINSKY MOMENT PART II


So when is it going to happen Phil? That is the question I am constantly asked. I am sure many think that I am simply an economic doomsayer. I am guessing the next stage will be trolls calling me a stop clock, when it happens they will say, yeah yeah you were saying that 3 years ago… GIMME A BREAK!!  So I soldier on trying to convey and build my case.

It is becoming more apparent to me that the ultimate implosion is upon us. A Federal Reserve Minsky Moment that is imminent and when it strikes it will be the pin that pricks and bursts the biggest economic bubble the global economy has ever built, the global debt bubble.

I have written about this topic in an earlier blog titled “Global Debt Bubble Set To Burst – The Next Minsky Moment”. This blog will extend on my Minsky Moment analysis. I will set out to describe the bubble I feel will pop first along with the pin that pricks and ultimately bursts it.

There is no doubt in my mind that the global economy is on the cusp of one of the greatest economic calamities the world has ever seen. The economy, has, for far too long operated and relied upon a consumption based debt driven system. This is completely unsustainable as inequalities in foreign debt will eventually spill over when the time comes to finally settle.

The day of reckoning has already been seen in Cyprus, Greece, Italy, Spain, Ireland and Portugal just to name a few. We are also witnessing currency collapses and inflation breakouts in Venezuela and Argentina both of which are destined to enter the hyperinflation HALL OF SHAME.


I am sure many that are reading are thinking but aren’t these small economies, not worth a mention in the big picture? The short answer to this question is YES. The long answer is much more complicated because those that have that view are ignoring the risks the parabolic growth of the finance sector of developed economies have created.

The finance sector of an economy contributes very little in real production and savings, two key drivers to a prosperous and sustainable growth economy. The explosive growth in the financial sector has, metaphorically, developed into the leech that is sucking the blood out of the real production and savings economy, the engine room for sustainable economic growth.

The finance sector has grown exponentially and in many ways is strangling the real economy, ironic, given that it depends on the real economy for its very survival! The inherent risks this growth imbalance promotes stem from the systemic instability it creates.  As Minsky put it :


“The Financial Instability carries important real economic consequences. Financial markets are not quarantined casinos. Both their manias and their crises have powerful consequences for the real economy, where people work to produce real goods and services of real value”

Minsky understood that for an economy to grow sustainably a balance between the financial sector and the private sector real economy that produces REAL goods and services of VALUE needs to be struck. This equilibrium is assisted when the cost of borrowing (interest rates) are allowed to be set by a greater free market influence.

In a free market, interest rates are more likely to reflect the risks involved in a potential investment. This leads to the channelling of financial and other resources into avenues which develop and produce an increase in REAL production of goods and services of REAL value at the most economical PRICE. When the global financial crisis struck in 2008 the economy aimed to reset, equities markets collapsed in an attempt to balance the financial sector back on a path of sustainability. The fact is that 2008 was a market sent message that the financial sector had grown much to aggressively and was unsustainable.

As the financial sector of the major economies grew exponentially, there was a need to find new ways to feed the growth. Bank loan to deposit ratios were increased, equities trading added derivatives trading including options trading, forwards, credit derivatives, CFD’s and so on. Commodity markets followed and so did the forex markets and the financial sector growth spiralled out of control. The debt bomb was officially on steroids.

 The markets were turning into one giant casino, awash with speculators, speculating on what others may be speculating on might move the market not just today but into the future. Three, four, five levels of speculation, cycles, spinning so fast they make you so dizzy you felt like throwing up.
Derivative markets, a bet on a bet, margin lending, seriously people, STEP RIGHT UP, EVERYONE’S A WINNER!

Everybody thought it would just keep going, the stock market, the property market. Debt did not matter, the assets were going up. The growth in the financial sector has turned the global economy into, at best , a giant casino and at worst a miniature Ponzi scheme where success and profit is dependent on the next sucker stepping up to buy the old sucker out.


The financial sector is leeching the money from the real economy to create a money washing machine that achieves nothing more than aiding and abetting high grade speculation.
Global Central bank and policy makers have been complicit in attempting to keep this grand illusion going. Their joint interventions have attempted to pick up the pieces after each correction by reinflating the global economy in an attempt to paper over the structural economic problems that exist beneath the surface. It seems both are intent on applying a Keynesian monetary based solution to a global economy that clearly has a structural problem.


The world just needs a bigger bubble to get over the last bubble bursting right? For those that answered yes, you need to look up the definition of insanity! As the immortal Albert Einstein stated “insanity is doing the same thing over and over and expecting a different result”

With the Central Banks applying the “insanity” monetary QE approach to the structurally fractured economy, the real problems of 2008 are being exacerbated. The QE induced economy is growing the financial sector at an even greater speed and exposing the global economy to an almost guaranteed period of chaos and correction. Make no mistake, the result will be devastating.


If you do not believe this is happening you are ignoring the facts. Take a look at JP Morgan’s recent spate of fines for one misdemeanour after another. The LIBOR rigging scandal, the chatter about the precious metals market riggings. Another day, another scandal in the financial sector that is on steroids in fact the sector has grown so big that it is holding the whole economy hostage.


The growth in the financial sector has been precipitated by the multiples of EBIT applied to a new IPO vs the multiple an owner could get through a private offering. This has forced the shift in thinking from the private sector ownership to public listed companies.


The story of multiples of returns for an IPO compared to a private sale is compelling. When a company is sold from one private owner to another the company valuation almost always attracts a lower EBIT multiple than a publically listed company would. The reason for this is simple, the multiple will factor in perceived risk, growth evaluation and potential and the work of the new owner to achieve the outcomes they desire for the investment.


The private sector is more likely to evaluate key drivers to the success of a business. That is because the new owners are more often than not, stakeholders in the business and not just shareholders. Stakeholders are more likely to play a part in setting the direction of the business, formulating a business plan and playing an active role more generally. Surely this is a more prudent approach to investment than a publicly listed company where the shareholder is lured into a dividend yielding comparison apathy? Where trust is put in a CEO and not the combined thoughts and passions of stakeholders?


With this debt bomb building it is becoming more apparent that the global economy needs to reset and rethink its attitude to debt and the deflationary effects that it creates. It seems China has identified the fact that whilst creating a credit/debt driven growth economy may seem sustainable at first, the liquidity trap eventually captures the economy. This means that there is a diminishing rate of return with respect to dollar returned in GDP for each dollar of credit/debt created. In essence this what fosters a DEBT DEFLATION riddled economy.


It seems China is now recognising the fact that piling up debt and building a credit reliant economy is not the solution. China has noted that its own central bank balance sheet cannot keep expanding the way it has been to provide credit for its domestic economy and facilitate the debt driven economies of the world.

In a recent announcement on new economic reforms China signalled its intentions of exiting US Treasury purchases. In mocking the Federal Reserve monetary policy position, Peter Schiff quipped recently “While the Fed is talking about tapering, China is actually going to do it”. This highlights a significant shift in China’s attitude toward USA Debt and their exposure to it.

The reforms also included a more open approach to the once centrally planned dominated economy which will allow increases in foreign investment dollars to supply the debt it needs to keep economic growth going. The aim is to import some inflation through foreign investment.


There is also the looming question on whether a deal was reached between the USA and its major creditors that was settled with the implementation of “operation twist”. While the Federal Reserve was buying the Long term treasuries and swapping them for short term treasuries, was China on the other side of that trade? This ensures China has less exposure to long term treasury risks allowing them to "manage" their USA debt holdings in the event of a looming bond market collapse!

While the world focuses on The Fed’s ballooning balance sheet, many are ignoring the explosion of the Bank Of China’s balance sheet. Since 2008 China’s assets on the balance sheet expanded $15.4 Trillion. This is approximately four times the speed of the Fed bank balance expansion.


The fact is China cannot support USA debt any longer as domestically more credit creation is needed to keep economic growth going. It seems that the more credit and debt that is created, the less efficient that credit/debt creation becomes at assisting sustainable GDP growth. The evidence is that China will soon join the global economy in experiencing a debt deflationary economic environment.
Below is an article from Zero Hedge which discusses the underlying debt bubble in China.

 http://www.zerohedge.com/news/2013-11-19/big-trouble-massive-china-nation-might-face-credit-losses-much-3-trillion


The key point for me is not just the balance sheet explosion but the hidden erosion in effectiveness of debt/credit expansion in generating GDP growth.

As the article states “China’s lending spree has created a debt burden similar in magnitude to the one that pushed Asian nations into crisis in the late 1990s, according to Fitch Ratings”.
The article highlights the liquidity trap that unsustainable growth in credit/debt levels creates. The law of diminishing returns applies so as the article points out:
“As companies take on more debt, the efficiency of credit use has deteriorated. Since 2009, for every Yuan of credit issued, China’s GDP grew by an average 0.4 Yuan, while the pre-2009 average was 0.8 Yuan, according to Mike Werner, a Hong Kong-based analyst at Sanford C. Bernstein & Co”



With all of this said it is clear that China has its own problems, they are “all in” with their USA debt holdings and have burdened their great productive economy with a credit/debt time bomb that will be almost impossible to control.
Make no mistake the global debt bubble will burst soon. There is now a raft of supporting data that show the global economy has a debt deflation issue. Professor Steve Keen had written a piece debunking neo classical view on economics. The piece focused on the role of the banking sector and is a great read. The article is posted below.

http://www.businessspectator.com.au/article/2013/12/3/economy/neverending-debt-trap

Whilst Professor Keen focuses his attack on the ignorance of neo classical modelling for not incorporating the banking sector, my post has aimed at illustrating the flow on effects the banking sector has through credit/debt expansion and the impact it ultimately has on the “real” economy.
With all of this being said it appears that global Central bank balance sheets are imploding at a greater velocity than the growth in real GDP or economic growth it is aiming to generate. It seems to me that this accelerated central bank balance sheet implosion may likely be the pin that will eventually burst the global debt bubble and trigger the next MINSKY MOMENT.