Editor’s Note: Consistent with our ongoing determination to publish in-depth analysis along with the more digestible tidbits that should never be an exclusive source of political and economic analysis and commentary, here is a 2,400 word piece that exposes and dissects the sources of instability and speculative excess in global financial markets. Anyone who has a strong opinion on the sustainability of, for example, 7.75% projected average annual returns for the Los Angeles Fire and Police Pension system, or, for that matter, any other public employee pension system, needs to wade through material like this. Because global financial markets, as author Doug Noland states, are now driving the economy, instead of the other way around. The result are assets that are artificially inflated; to quote Noland, “Contemporary central banking has regressed to little more than a scheme intent upon bolstering securities and asset prices.” Central banking policies, and the ecosystem of financial special interests that exploit them, are creating a global pricing bubble of dangerous proportions, across all classes of assets.
The “economic sphere” versus “financial sphere” analytical framework has in the past been a focal point, but over recent years I have not given this type of analysis the attention it deserves. Conventional analysis holds that the real economy drives the performance of the markets. During bull markets, pundits fixate on every little indicator supposedly corroborating the optimistic view. These days, the bulls trumpet strong underlying profit growth as supporting ever higher stock prices.
Especially in this Age of Unfettered Finance, I’m convinced that the “financial sphere” commands the “economic sphere.” Profits are generally a byproduct of strong underlying growth in finance – hence a lagging indicator. Corporate earnings will appear absolutely stellar at market peaks – as Credit flows freely and financial conditions remain ultra-loose. Profits will be lousy at market bottoms, when risk aversion and attendant tight financial conditions dominate.
Going back now more than twenty years, one of my primary analytical objectives has been to identify, study and monitor the underlying finance fueling booms in markets and economic activity. Fundamental analytical issues include: What is the nucleus of the underlying Credit expansion? Whose balance sheets/liabilities are growing? What is the nature of prevailing financial flows? How stable are the underlying Credit and flow dynamics? What is the role of policymaking and government market intervention? Are there major market misperceptions and resulting mispricings?
Today’s consensus view holds that the economy and markets are sound – robust even. The economy is finally emerging from a difficult post-Bubble period, with the markets appropriately valued based on improving fundamentals. Central bankers and pundits alike assure us that markets have not succumbed to yet another Bubble. Top officials at the Fed and ECB have both recently stated that underlying Credit growth and market leverage are inconsistent with a problematic Bubble backdrop.
I have repeatedly identified troubling parallels between the past twenty year cycle and the protracted boom that ended with the 1929 stock market crash. Having extensively studied the late-twenties period, I was repeatedly struck by how virtually everyone was caught unaware of acute underlying financial and economic fragilities. “How could they have not seen it coming?,” I often asked myself. It all makes clearer sense to me now.
Importantly, this has been a particularly prolonged Credit and speculative cycle (exceeding even the historic 1914-1929 boom). Similar to 1929, everyone has become numb to the scope of Credit excess, speculative leveraging and economic maladjustment. Back in the sixties, Alan Greenspan was said to have pointed responsibility for the financial collapse and resulting Great Depression on a misguided Federal Reserve that had repeatedly placed “coins in the fuse box” to sustain the Twenties boom.
Clearly, a protracted period of repeated central bank market interventions will solidify the notion that adroit policymakers have everything under control. And given enough time – and sufficient inflation in Credit and financial asset markets – price distortions will become deeply systemic – if not commonly appreciated. Importantly, protracted booms create cumulative deleterious effects that, by the nature of things, go completely unappreciated even in the face of precarious “terminal phase” Bubble excess.
I titled a presentation back in early-2000, “How Could Irving Fisher Have been so Wrong?” Only days before the great 1929 crash, the leading American economist at the time famously stated: “Stock prices have reached what looks like a permanently high plateau. I do not feel there will be if ever a 50 or 60 point break from present levels…”
Fisher and about everyone else at the time were oblivious to underlying financial and economic fragilities. With this in mind, I will touch upon what I believe are sources of potential vulnerability. In particular, my focus is on potentially unstable Credit and financial flows – the “financial sphere”.
First of all, Credit financing asset speculation is inherently unstable. Broker call loans and various leveraged structures proved catastrophic in the 1929 crash and subsequent financial meltdown. During booms, speculative leveraging engenders their own self-reinforcing liquidity abundance. But as we saw firsthand during the 2008/09 fiasco, the cycle’s vicious downside, with the forced unwind of speculative leverage, pressures market liquidity and asset prices in a self-reinforcing market crash. Contemporary central banking has regressed to little more than a scheme intent upon bolstering securities and asset prices.
It is my view that the current amount of global speculative leverage across securities and asset markets is surely unprecedented – stocks, bonds, EM, real estate, collectables, etc. The global leveraged speculating community has grown significantly since the ’08 crisis, while there has been a proliferation of instruments, vehicles and funds that boost returns through the use of embedded leverage. Anecdotes suggest global “carry trade” speculative leverage has inflated to unprecedented extremes, certainly bolstered by central bank currency/liquidity manipulation (the U.S., Japan and China at the top of the list). And I worry that booming markets for ETFs and derivatives (of all stripes) ensure the utilization of massive amounts of leverage (along with trend-reinforcing “dynamic trading” hedging strategies).
At the same time, record margin debt and booming “repo” markets suggest speculative leverage from traditional sources remains as prominent as ever. What are the ramifications for system stability from record quantities of stocks and bonds at record high prices underpinned by record amounts of speculative leverage?
Sheila Bair penned an interesting op-ed in Friday’s Wall Street Journal: “The Federal Reserve’s Risky Reverse Repurchase Scheme.” I appreciate the analysis and particularly the notion of a “scheme.” I actually believe that there is a critically important evolution that occurs during protracted Credit and speculative cycles. In simple terms, over time runaway financial and economic booms transforms from a Bubble dynamic to one more akin to a sophisticated financial scheme.
Importantly, mounting financial and economic fragility fosters progressive government intrusion throughout the markets and real economy. Resulting market instability and poor economic performance then provoke only more meddlesome government “activism.” As we’ve witnessed over the past six years, massive fiscal spending has bolstered the economy and inflated corporate profits. Meanwhile, central bank interest-rate manipulation, market intervention and massive “money” printing incited risk-taking and incentivized speculative leveraging. If the great American economist Hyman Minky were alive today, he would undoubtedly label this one of history’s most outrageous episodes of “Ponzi Finance.”
It’s certainly no coincidence that we’ve been witnessing a proliferation of financial jerry-rigging. The loosest financial conditions imaginable have spurred record stock buybacks that have bolstered equities prices, while goosing earnings-per-share (EPS). Other popular methods of financial engineering include “tax inversions,” master limited partnership and various other tax avoidance schemes that work to inflate equity market valuation. Government and central bank largesse has also incited a historic M&A boom that will leave a legacy of problem debt.
It’s surprising that there has not been more concern regarding conspicuous excess throughout the corporate debt market. Corporate borrowings are notoriously cyclical and potentially disruptive. One can look back to the late-eighties corporate debt boom and resulting early-nineties bust. Then there were late-nineties excesses that left a legacy of problematic telecom debt, along with a severe tightening of Credit conditions. Yet those excesses were left in a trail of dust by the 2006/07 corporate lending fiasco that played prominently in the subsequent financial crisis.
So let’s take a brief look under the hood of today’s corporate debt boom (beyond record issuance of bonds – risky and otherwise). From the Fed’s Z.1 “flow of funds” report we see that non-financial corporate borrowings increased at a seasonally-adjusted and annualized rate (SAAR) $873bn during Q1, up sharply from 2013 Q4 and at a pace surpassing even 2007’s record $862 growth in corporate debt. It is worth noting that the two-year 2012-2013 corporate debt expansion of $1.45 TN surpassed the $1.42 Trillion gain from 2006-2007. And while we’re at it, the 1998-1999 lending boom saw corporate debt increase $801bn and the 1987-1988 Bubble posted growth of $395bn. Some would argue that the 9% (or so) pace of corporate debt growth over the past nine quarters remains below 2007’s 13.6%, 1998’s 10.8% and 1987’s 10.4%. I would counter that today’s record low corporate borrowing costs work to somewhat temper overall growth in corporate Credit. Excesses – including issuance and mispricing – are greater than ever.
The cyclical boom and bust dynamic saw Credit expansion slow rapidly during the early nineties, with corporate debt actually contracting 2.3% in 1991 (and growing only 0.8% in ’02). Booming corporate debt growth was cut in half by 2001, and then expanded only 1.3% in 2002 and 2.0% in 2003. Corporate borrowings were also cut in half in 2008, before contracting 3.1% in 2009 (expanding only 1.7% in 2010). Importantly, corporate debt is prone to cyclicality and instability.
Returning to “financial sphere” analysis, I discern latent fragility. Sure, Q1 total non-financial sector Credit expanded SAAR $2.113 TN (up from 2013’s $1.812 TN), surpassing my $2.0 TN bogey for Credit sufficient to drive a maladjusted economic structure. But the federal (SAAR $874bn) and corporate (SAAR $873bn) sectors accounted for the vast majority of system Credit expansion. And I believe both Credit booms have been heavily impacted by central bank QE liquidity injections. After all, Fed holdings expanded SAAR $911bn during Q1, after surging $1.086 TN in 2013. Importantly, we’re now only a few months away from the end of QE.
July 25 – Financial Times (Vivianne Rodrigues and Michael Mackenzie): “Junk bonds are on track for their worst monthly return in nearly a year, with investors fretting the era of easy US central bank money is at an end and calling time on a bull run for one of the market’s riskier asset classes. Years of quantitative easing by the Federal Reserve have driven investors into bonds, real estate and equities, sparking concerns of looming asset price bubbles. Junk-rated debt, in particular, has attracted record inflows and generated robust returns for investors prepared to bet on bonds sold by companies with the lowest credit ratings.”
July 25 – Wall Street Journal (Katy Burne and Chris Dieterich): “Investors are selling junk bonds at the fastest pace in more than a year, as fresh interest-rate fears and geopolitical turmoil amplify valuation concerns following a long rally. Prices on bonds issued by lower-rated U.S. companies tumbled to a three-month low this week… Investors yanked $2.38 billion from mutual funds and exchange-traded funds dedicated to junk bonds in the week ended Wednesday, the largest weekly withdrawal since June last year, said… Lipper. That came on the heels of $1.68 billion that poured out the week before. Companies have taken note, with some borrowers delaying scheduled debt sales and others canceling planned deals. New issuance is on track for its slowest month since February, according to… Dealogic.”
I suspect that the end of QE could very well send shudders throughout the corporate debt marketplace, and I would furthermore expect the initial tightening of financial conditions to manifest with the marginal “junk” borrowers. Especially after hundreds of billions have flooded into high-yielding vehicles (certainly including the ETF complex), an abrupt reversal of flows would spell Credit tightening trouble. Further, any meaningful deterioration in corporate Credit Availability would have negative ramifications for an overextended stock market Bubble. As I have written previously, with QE winding down the securities markets are increasingly vulnerable to a destabilizing bout of “risk off.” It wouldn’t require a major de-risking/de-leveraging episode to dramatically alter the marketplace liquidity backdrop.
There is another element of “financial sphere” analysis that I believe could play a major role in unappreciated latent fragilities: Integral to the “global government finance Bubble” thesis is that excesses today encompass the world and virtually all asset classes. While not readily apparent, I believe there are various international financial flows that today stoke asset inflation and Bubbles – flows that could prove especially destabilizing in the event of globalized financial tumult. Myriad flows originating from the likes Japan, China, overheated EM Credit systems and elsewhere unobtrusively inject liquidity and drive price gains throughout our stocks, bonds, real estate and the real U.S. economy more generally.
July 16 Wall Street Journal (Min Zeng) “China Plays a Big Role as U.S. Treasury Yields Fall – Record Chinese Purchases of Treasurys Help Explain U.S. Bond Rally.” “Investors wrestling with the mysterious U.S. bond rally of 2014 got a clue about where to look: China. The Chinese government has increased its buying of U.S. Treasurys this year at the fastest pace since records began more than three decades ago… The purchases help explain Treasurys’ unexpectedly strong rally this year… The world’s most-populous nation boosted its official holdings of Treasury debt maturing in more than a year by $107.21 billion in the first five months of 2014… “
July 9 – Los Angeles Times (Tim Logan): “A record amount of foreign money is flowing into the U.S. housing market… Overseas buyers and new immigrants accounted for $92 billion worth of home purchases in the U.S. in the 12 months ended in March… That’s up 35% from the year before, and the most ever. Nearly one-fourth of those purchases came from Chinese buyers. And the place they’re looking most is Southern California… The report highlights the growing effect of global capital on some local housing markets. The $92 billion amounts to 7% of all money spent on homes in the U.S. during those 12 months, and nearly half of it was concentrated in a handful of cities, including Los Angeles.”
Perhaps it’s coincidence that the ECB is commencing a major new liquidity operation just as the Fed’s QE winds down. Clearly, the “Draghi plan” to bolster fragile European peripheral debt markets should be viewed as a sophisticated financial scheme. Thus far, the Bank of Japan (BOJ) shows no indication that its “money” printing scheme is ending anytime soon. And despite all the talk that the Chinese were serious about financial and economic reform, they apparently took one alarming look at rapidly unfolding systemic fragilities and opted to let their historic Bubble run. The Chinese Bubble is a government-dictated financial scheme of epic proportions.
So it’s become an equally fascinating and alarming global dynamic: a multifaceted global scheme to support massive amounts of debt, inflated securities markets and a grossly maladjusted global economic structure. Worse yet, it’s a global scheme held together by various governments that are increasingly engaged in heated geopolitical strife. In the end, “Ponzi Finance” financial schemes boil down to games of confidence.
So I’ll attempt the briefest responses to the above noted key questions: What is the nucleus of the underlying Credit expansion? Answer: Non-productive government debt, speculative leverage and borrowings to support financial engineering. Whose balance sheets/liabilities are growing? Answer: The Fed’s and Treasury’s, along with corporate America. What is the nature of prevailing financial flows? Answer: Financial speculation – chasing yields and inflating securities prices. How stable are the underlying Credit and flow dynamics? Answer: I believe highly unstable and susceptible to changing market perceptions and faltering confidence. What is the role of policymaking and government market intervention? Answer: Profound impact on all markets and the real economy. Are there major market misperceptions and resulting mispricings? Answer: Confidence in both ongoing liquidity abundance and the power of central banks has fostered profound systemic mispricing throughout securities and asset markets on a global basis. Is the backdrop consistent with a momentous financial scheme? Absolutely.
About the Author: Doug Noland has been the Senior Portfolio Manager of the Federated Prudent Bear Fund and Federated Prudent Global Income Fund since December 2008. Prior to joining Federated, Mr. Noland was employed with David Tice & Assoc., Inc. where he served as an Assistant Portfolio Manager and strategist of Prudent Bear Funds, Inc. Prudent Bear Fund and Prudent Global Income Fund from January 1999. From 1990 through 1998, Mr. Noland worked as a trader, portfolio manager and analyst for short-biased hedge funds including G. W. Ringoen & Associates from January 1990 to September 1996, Fleckenstein Capital from September 1996 to March 1997 and East Shore Partners, Inc. from October 1997 to December 1998. He earned a B.S. in Accounting and Finance from the University of Oregon and a M.B.A. from Indiana University. This post originally appeared on the economics website “The Prudent Bear” and is published here with permission.