By now everyone has seen some version of this chart: it shows that from a record expansion of over $2 trillion in central bank balance sheets in 2017, the incremental liquidity created by the world’s central banks will hit 0 some time in early 2019, at which point it will turn negative for the first time since the financial crisis, as central banks begin the highly deflationary process of monetary destruction.
This process, also known as the transition from Quantitative Easing to Quantiative Tightening, prompted a remarkable admission from Bank of America, which confirmed all we had said since 2009, namely that without central banks, the global stock market would be trading at a fraction of its current value. This is what Bank of America’s Hans Mikkelsen said last week, when discussing “the road from QE to QT.”
While QE was wonderful and led to favorable technicals in the form of too much money chasing too few bonds, QT (quantitative tightening) is the opposite – i.e. leads to unfavorable technicals and periods of too many bonds chasing too few investors.
While QE suppressed volatility and led to a buy-the-dip mentality, QT is the opposite – i.e. higher volatility and sell-the-dip.
While under QE fundamental erosion did not matter and strategists were king, under QT companies better not disappoint and analysts are king.
This “QT” flow reversal is shown in the chart below:
Which brings us to the question asked in the latest Odey Investor Letter.
But first a brief performance update from Crispin Odey, whose International Fund just had its best month since December 2014.
Unfortunately, for the uber permabear, February’s outperformance is too little too fast, and nothing short of a complete market crash could possibly redeem the fund which has lost an unprecedented, 11%, 41% and 21% in 2015, 2016 and 2017. Ironically, it is a crash which not even Odey appears confident will happen because as he writes, “If the pain [in the market] is too great, we go back to the monetisation.”
That is hardly controversial. The question is what happens next, and it is here that Odey may be able to generate some alpha based on his outlook for the post-crash economy and markets. Here’s what he thinks will happen after central banks return with even more QE after the next market crash:
… this time, with full employment and continual Keynesian expansionary measures, there is only one result: higher inflation and ultimately higher interest rates. Then the debt does matter, the authorities will be slow to put up interest rates and the world will witness its first taste of stagflation in fifty years. As Brian Marber said, ‘Experience doesn’t count because you never quite have enough of it.’ No one can remember Brian.
In other words, whereas in the past the central banks could step in with more QE, the fact that the US is already pumping trillions in fiscal stimulus putting the economy on the verge of overheating, would make a return to ZIRP, or QE and/or NIRP, virtually impossible without unleashing runaway inflation at a time when growth is virtually non-existent, if not negative.
To Odey, it is unclear how the world will pull itself out by its bootstraps from that particular economic crisis, which as he notes is unlike anything he has witnessed since the 1970s:
Closing off the Mexican border, giving a massive fiscal boost on top of monetising for 18 months and following it with a few trade tariffs amounts to a massive inflationary shock. Again, I have to go back to the 1970’s to witness something similar. There the monetary expansion came through in asset prices first (the nifty fifty) and then in retail prices. My bet is that we will witness a similar few years. What I can only hope is that after 10 years in which financial alchemy handed all the keys to the mathematicians, these next few years will favour the historians, if there are any left.
He is hardly alone.
His full note below.
Manager’s commentary
‘In each of us there is a bit of a Catholic and a bit of a Protestant. For truth is catholic but the search for it is
protestant’– W.H. Auden
‘If one tells the truth one is sure, sooner or later, to be found out.’
– Oscar Wilde
Hubris is often wrongly perceived to be unheeded pride which rightly comes before a fall, but the Greek origin of ‘hubris’ was a decision or act taken by a human, which could only be taken by a God. Importantly the decision may have been the right one, the good one, but that did not matter. In the world in which central banks have taken on the role of maintaining an equilibrium, markets are subservient to the gestalt. Remember the last bear market started in the inter-bank market, where the central banking CCTV’s were not working.
This time around, the problems are unlikely to come from the banking sector despite the fact that debt has nearly doubled since 2010. The CCTV is now happily functioning. Since 2010, central banks have given to their clients, governments, the gift of issuing effectively cash to pay for deficits and so far it has worked. Japan with a permanent budget deficit of over 7% p.a. for 10 years has less net debt outstanding than ten years ago. No conjuring act could surpass this, and certainly not one involving the amounts of money involved. The other conjuring trick involved US dollar trade and current account deficits. Faced with increased dollar balances, EM countries tied to the US dollar, had to create local currency reserves. This was another bit of QE. However, like all such performances, the longer this goes on for, the more capital intensive it becomes.
Recently I read Daniel Ellsberg’s book on the Pentagon papers. It is a very exciting read. He was very much an insider in the Johnson administration in 1964 and involved in the US’s efforts in Vietnam. The story that he tells is that it was not just Johnson, but JFK and later Nixon all lie to the American people. At no point was the war going well. The escalation in spending which ultimately cost the world the Bretton Woods trading system, was never expected by them to win but just to prevent the US losing immediately.
You might think it had no relevance to today, but of course, it does. Keeping the world’s trading system going is the key job that central bankers feel the need to do. Ever since the central bank in New Zealand in 1989 introduced the idea of inflation targeting, central banks have felt the need to maintain full employment. From 1995 when 5 billion people were introduced into a trading system of 1.5 billion people, central banks have not had to worry about inflation. Globalisation brought deflation.
But today the cash that has been poured into the world economy demands that either globalisation continues to deflate prices and wages, or that miraculously technology intervenes, with the threat of robots, offsetting what is now a shortage of jobs which should come through in wage and price rises.
For the central banks, it does not help that Trump is more concerned about winning the midterm elections than keeping this relatively fragile equilibrium going.
Closing off the Mexican border, giving a massive fiscal boost on top of monetising for 18 months and following it with a few trade tariffs amounts to a massive inflationary shock. Again, I have to go back to the 1970’s to witness something similar. There the monetary expansion came through in asset prices first (the nifty fifty) and then in retail prices. My bet is that we will witness a similar few years. What I can only hope is that after 10 years in which financial alchemy handed all the keys to the mathematicians, these next few years will favour the historians, if there are any left.
In the Vietnam wars, despite the lies coming from government, by 1967, markets had worked out who was going to lose. The soaring budget and current account deficit put pressure on the dollar. The lies wore out LBJ who decided unexpectedly not to stand again for president. Perversely it was France, who had begun the war against Ho Chi Minh in 1946 and whose treachery in 1948 ensured that forever after it became a war of independence, in 1970 forced the USA off Bretton Woods by demanding payment in gold. Many commentators remain convinced that the Fed will end QE this year and normalise monetary policy, because it is their present intention.
When one looks at the risks involved in moving from a system which promotes growth without the need for savings to one which demands the world promptly save an additional 1.9 trillion in 2 years, those risks just remain too great. Printing money made everything work. Funding higher saving demands an increased savings rate and less income to spend. My money remains on a volte-face.
Surely there are too many memories of just what happened when something similar was attempted in 2014. By 2016 the emerging markets were dying. If the pain is too great, we go back to the monetisation. But this time, with full employment and continual Keynesian expansionary measures, there is only one result. Higher inflation and ultimately higher interest rates. Then the debt does matter, the authorities will be slow to put up interest rates and the world will witness its first taste of stagflation in fifty years. As Brian Marber said, ‘Experience doesn’t count because you never quite have enough of it.’ No one can remember Brian.
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