We are being lied to….The Federal Reserve has been telling us how great the economy is and how we are on track for higher rates as it continues to improve. However the markets are most definitely telling us something different.
The stress that the markets are experiencing has not been an overreaction; it is a perfectly reasonable and considered response to a series of real worries which perhaps one at a time would be manageable but grouped together look formidable.
If there was nothing to worry about the ECB would not be talking about more QE, the Bank of Japan would not be introducing negative interest rates, the Federal Reserve would be more upbeat, the Bank of England would be warning of an interest rate increase, discussion of capital controls to curtail emerging market capital outflows would not be a live issue, the China hard landing debate would be old hat, the Schengen agreement would not be under threat of collapse, and fears of a corporate earnings recession would have no substance. These are very unsettling times made worse by the knowledge that there are few if any weapons left in the locker.
In a healthy economic environment stock markets would not react so positively, as they did last Friday , to a very mediocre 4th Quarter US GDP growth number and the shock introduction by the Bank of Japan of a -0.1% interest rate on deposits. Basically the assumption is that the poor US growth number will further delay interest rate hikes with the implication of a rate rise at the next meeting moving down to a mere 12% probability .
Weak growth and stagnant interest rates are obvious signals that the economies of the two countries are not in tip top condition. If there was nothing to worry about, a poor US growth number would send equities lower and the desperate emergency measure by the Bank of Japan , of charging for leaving money in the bank, create alarm. It would be very easy to interpret the BOJ action not only as a response to the slide in the renminbi but also as a major development in the unofficial currency devaluation war.
Time after time conventional thinking and the assurances that come with it have proven to be incorrect, for example that QE = inflation and falling unemployment = wage growth. In a similar vein low oil prices are not, it now seems, the panacea that we have always been told they are. Remember the story that high oil prices are a “tax” on consumers? Remove the “tax” and consumers will spend frivolously. When the money was in the hands of oil producers they spent it on capital investment with multiplier effects that cascaded through manufacturing industry. But put it in the hands of consumers and it turns out that they save part of it, pay off debt and spend the rest in the service sector, so the boost to the economy has turned out to be highly negligible.
Investors with excellent long-term track records are stumbling. Recent large investments by Warren Buffett and Carl Icahn are deeply under water. Equities, corporate debt and government bonds are pricing in a 50% chance of a recession in 2016, according to JPMorgan. Yet, this month’s survey of economists by Bloomberg shows the median probability for U.S. recession in the next 12 months at only 19%. It would seem that some are still a little behind the curve.
The Baltic Dry Bulk Index, often used as a proxy for global trade, has fallen from a peak of 11,000 in 2008 to a current price of 337, down 29.5% this year. “We’ve never seen anything like this,” said Emanuele Lauro, chief executive of New York-listed shipping major Scorpio Bulkers Inc. in The Wall Street Journal of January 21, 2016. “We never thought we would find ourselves in this situation” .
The cost of raising and servicing capital is outweighing the returns companies and emerging markets get from it, and it is a problem. Citigroup said that this has affected one third of all companies—the majority of which posted shortfalls in each of the past three years. The Wall Street Journal of January 13, 2016 reports that Vale, the world’s biggest producer of iron ore, is borrowing $3 billion in emergency financing to “increase liquidity and bridge potential cash flow needs.” Vale is tapping the line of credit partially because “it hasn’t been able to garner as much as expected through the sale of assets.”
Emerging markets are now the problem
According to William White the chairman of the OECD’s review committee and former chief economist, the global situation is “worse than it was in 2007”. QE and zero interest rates were meant to stimulate recovery in Europe, the US and Japan. Inevitably there was leakage into emerging markets which has created credit bubbles and a huge build-up of dollar debt. Combined public and private debt has risen to an all-time high of 185% of GDP in emerging markets and to 265% in OECD countries, both some 35% higher than the credit cycle in 2007.
You have to pinch yourself on hearing such numbers when you ponder that it was excessive and irresponsible debt that triggered the financial crisis in the first place. It is as though nothing has been learnt, all that happened was the parcel of debt had been passed around in the hope that the economies would recover enough to be able to pay it down. However, many of these debts will never be paid off or serviced and there will have to be enormous debt write offs, which in turn will create a new set of problems and political storms.
Emerging markets led by the BRICs (Brazil, Russia, India and China) were part of the solution after the Lehman collapse, now they are part of the problem.
What makes the current situation particularly uncomfortable is that the developed economies have not been able to put themselves on a secure enough footing in the meantime to take over the strain of any emerging market economic lag. One engine is stalling while the other is still stuttering. Of particular disappointment has been the performance of the Eurozone.
Suicide Squad
In the forthcoming movie,Suicide Squad, Viola Davis’ character wants to assemble a task force on a suicide mission that will offer them built- in deniability if anything goes wrong….. it is a perfect way to describe what the Bank of Japan did last Thursday with their announcement of negative interest rates. The BOJ (and the ECB, and possibly even the Fed soon enough) is the character Amanda Waller and the banks are Will Smiths’ character Deadshot. The suicide mission is to make loans into a corporate and emerging market sector levered to global trade as the forces of global deflation rage uncontrollably.
Although it is the Fed’s job to support full employment and maintain price stability it is also the Fed’s mandate to maintain the stability of the banking system. And yet their policies are sending some on a mission that they will never return , the suicide mission is making loans into a corporate sector levered to global trade (For instance, Wells Fargo is sitting on more than $17 billion in loans to the oil and gas sector. The bank is setting aside $1.2 billion in reserves to cover losses because of the “continued deterioration within the energy sector). Also the policy-addicted markets will respond exuberantly to anything that can be described as central bank support for financial asset price inflation.
What is concerning is the intentional destabilization of the global financial system for domestic political purposes.
When the ECB instituted negative rates, it was only a single data point, a possible anomaly in the world major economies. With the BOJ’s move last Thursday, we now have a second data point, and the creation of a pattern.
It seems en vogue for every elected politician or politician wannabe to rail against “the bankers” and the terrible mess they’ve made of the world with their “predatory lending” and “easy credit”, even though this is exactly what every politician in the world desires. But now it seems that the central banks are going to throw their own domestic banks into a battle they can’t win which also makes the rest of us the cannon fodder…the guys in the red shirts that used to accompany Captain Kirk on his away missions, or, given the earlier analogy, throwaway members of the Suicide Squad.
But then how can this all be going on un-noticed?
Why do normally clever people fail to see risks and opportunities that are subsequently blindingly obvious?
The modern financial system was surprisingly fragmented, in terms of how people organized themselves, interacted with each other and imagined the world. In theory, pundits often like to say that globalization and the Internet are creating a seamless, interlinked world, where markets, economies, and people are connected more closely than ever before.
A Personal Observation
Back during the 2008 crisis, I saw a world where different teams of financial traders at the big banks did not know what each other was doing, even inside the same (supposedly integrated) institution. Almost everywhere I looked in the financial crisis it seemed that tunnel vision and tribalism had contributed to the disaster. People were trapped inside their little specialist departments, social groups, teams, or pockets of knowledge. Or, it might be said, inside their silos.
That was striking. But as the 2008 crisis slowly ebbed from view, I realized that this silo effect was not just a problem at banks. On the contrary, it crops up in almost every corner of modern life…from wrangling’s between finance and sales/development project managers. One protecting a firm’s interest while the other interested in their own corporate territory, where the sales department believes that without them the firm wouldn’t exist because there would be nobody to sell their product, wherein the truth is that all the departments are crucial to the successful existence of the firm.
The paradox of the modern age is that we live in a world that is closely integrated in some ways, but fragmented in others. Shocks are increasingly contagious. But we continue to behave and think in tiny silos…that as long as we are fine in our own little world that everything will be OK.
We can temporarily jump into a different world by changing the information and news we consume, moving our location, talking to different people and trying to imagine how life might look through their eyes…We can also travel to collide with new people and ideas.
The Internet provides priceless access to a world of ideas and information. Staying in a silo or safe space, or just accepting the boundaries we inherit, often appears a lot easier. After all, we live in a world where people are expected to streamline their careers and become specialists. Our schools and universities put students into boxes at a young age, and academic departments are fragmented., That makes it hard to justify time-consuming activities that do not deliver instant results, such as talking to people from other departments, rotating people across departments, or sending people out on expensive “innovation safaris”.
Back to my point, this kind of myopia causes the very best of us to not be able to see the forest for the trees. We are going through a financial crisis but yet nobody seems to notice. The public have been brought up by the media to expect a zombie apocalypse to accompany any type of end game, but it doesn’t happen that way, just like the rather horrible analogy of placing a frog in slowly boiling pot of water, he won’t notice until it is too late….I had previously written an article that bemoaned the apathetic nature of our current society, however I’m now beginning to wonder if it’s more a case of society acting like a bunch of Lemmings…..
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