Bright Current Economic Signals Are Spurious

The market rejoiced on Dec. 5 when the Bureau of Labor Statistics reported that 321,000 new U.S. jobs had been created. The general consensus is that the 3.9% third-quarter Gross Domestic Product (GDP) growth is the harbinger of a brighter trend. The Economist’s team of forecasters has U.S. growth at 3% in 2015, up from 2.3% in 2014, while the International Monetary Fund (IMF) forecasts global growth up from 3.3% to 3.8%. Happy Days Are Here Again—except that they’re not. The benefits of the $40 per barrel fall in global oil prices are emerging ahead of the costs.

The oil price decline will lead to a consumer resurgence, especially in Japan and the EU, where few jobs depend on the energy-extraction sector. In the U.S., gasoline at $2.50 a gallon should free up consumer purchasing power quickly. Fifteen or $20 saved on a tank of gas can be spent on other things, especially around Christmas when spending demands are high and controls lax. That is not immediately offset by loss of purchasing power in the oil sector. Companies have cash reserves, and existing drilling and production programs mostly continue as planned in the hope of an early recovery in oil prices.

In Europe and Japan there is little or no offsetting loss from lower oil prices, so consumption increases and the lethargic economies of the eurozone and Japan flicker once more into a pallid semblance of life. Part of their problems in 2009-11 were caused by the rapid run-up in oil prices to more than $100, so that loss is regained, and those countries’ GDP figures show a couple of quarters of above-trend growth. In China, the wind-down of the immense property bubble continues, but the loss of purchasing power, which a decade of malinvestment is beginning to cause, will at least be postponed for a quarter or two.

Overall, therefore, the first couple of quarters of lower oil prices will look pretty satisfactory worldwide. Because it’s unlikely the Fed or other stimulus-obsessed monetary authorities will begin to raise interest rates (for them, there is always some excuse not to do so), we will hear six months of annoying Keynesian rejoicing as “stimulus” spending addicts and monetary quacks proclaim their remedies to have succeeded, finally producing the faster growth which Keynesians had predicted half a decade ago.

This column has been anticipating the collapse of markets buoyed to infinity by misguided “stimulus” for several years now; the only uncertainty was how long the collapse would be delayed. The latest developments suggest a timeframe for the financial Armageddon. Once the positive effects of the oil price decline have worked their way through the system, the negative effects will arrive, and they will be powerful enough to reverse the upward trend in the markets and the global economy.

As discussed in detail last week’s column, the principal negative effect of the sharp drop in oil prices is the value destruction of billions of dollars of energy-sector investment and the consequent damage to banks and bond markets. This does not happen immediately, which is why the effect of the oil price decline is initially asymmetric. However, the payment cycle in the sector is not longer than a couple of months, many of the highly leveraged companies carry limited amounts of cash and projects in mid-construction suffer especially high cash outflows (though some of the latter’s costs may be reduced by the elimination of the sector’s overheating).

Then there are the oil-exporting countries. Venezuela is already a basket case, desperately trying to figure out a way to raise enough dollars to provide its people with basic necessities, almost all of which have to be imported in that benighted economy. Russia is almost in the same boat, although with $419 billion of foreign exchange reserves (if that figure is not fictitious), it has a certain amount of wriggle room. Even Saudi Arabia, the largest oil exporter, has allowed its welfare budget to explode with the rise in oil prices and will start to struggle pretty quickly with oil prices in the $60-65 range, even though its oil production costs are well below that level.

The timing for the adverse effects of the price drop is fairly clear: it will take about six to nine months, enough for the more leveraged, high-cost oil producers to run out of money and their banks to run out of patience. We will then see a flow of bankruptcies, affecting not only the oil sector itself but also the banking system and the junk-bond market. At the same time, the redundancies that the energy sector has produced will begin to show up in the unemployment figures, and the production destroyed will show up in the GDP figures. These effects can be very substantial and long-lasting.
The similar downturn in gold prices since 2011 has now caused Anglo American to announce it will suffer 60,000 redundancies by 2017. Needless to say, the oil sector is much larger than the gold sector, and prices had previously been on a plateau rather than rising continuously as had gold before 2011. Consequently, the redundancies will appear more quickly and be more severe.

Autumn is the traditional time for market crashes and economic upsets, and it seems likely that this timing will recur on this occasion, with the autumn of 2015 being a very difficult period indeed for the market. Doubtless the market, lulled by the euphoria of the initial favorable economic data, will see a further rise in the first half of 2015, maybe with the S&P 500 reaching 2,500. Adverse statistics and the first bankruptcies will begin to appear about July, but the downward slide will not gather momentum until after Labor Day.

If we are very lucky, the Fed may have increased its federal funds target interest rate by a quarter of a percent or so by the time the crisis hits. That will enable the Fed to fight the crisis by reducing the rate again, while the Obama administration will use the crisis as an excuse to attempt to pump yet more worthless “stimulus” spending into the economy. With a Republican Congress, it is to be hoped that the waste can be stopped, as it was not in 2001, 2008 and 2009.

The U.S. budget deficit will be only $600 billion or so in the year to September 2015, after current negotiations have added a chunk of extra spending, while the good economy of the first half of 2015 will cause the fiscal position to outperform expectations. However, once the downturn hits, after the usual lag the budget deficit will widen inexorably from its bloated (by former standards) base. Its projection for the year to September 2017 will be well above $1 trillion by the time the President’s 2017 Budget is announced in February 2016. In reality the deficit for that year will probably reach $2 trillion by the time that fiscal year is finally tallied in October 2017, with the usual election-year slippage, but with no extraordinary spending “stimulus” since the Republican Congress will prevent it.

If this trajectory is correct, the 2016 election looks very good for the Republicans (provided they can avoid their usual election-year pastime of nominating an idiot as Presidential candidate). For the U.S. economy, the trajectory after the downturn hits is less clear. If monetary policy remains under the control of Janet Yellen and her acolytes, we may have to go through yet another cycle of monetary “stimulus” even though the painful recession and the wreckage of the past half-decade’s malinvestment will be massive evidence of the failure of over-stimulative monetary policies.

Since Yellen cannot be replaced until January 2018 it unfortunately seems that at least the beginning of the next cycle will be conducted with the same monetary policy as the present one, suppressing savings for yet more years and de-capitalizing the U.S. economy still further. Only a massive burst of inflation, causing the Fed to panic and raise rates, can save us from this fate. At present no such burst appears to be in the offing, and indeed the decline in oil prices will initially work against the appearance of such a phenomenon. Conventional monetary theory says we should already be in substantial inflation, as M2 money supply has increased substantially more rapidly than nominal GDP for the last five years. Conventional monetary theory is thus pretty obviously wrong, and it’s not clear with what we should replace it.

Globally, it seems likely that a market crash will hit at the same time as the U.S. crash next September/October, and that this will lead to another recession, as it did in 2008-09. Global malinvestment is roughly as prevalent as in the U.S., although it is concentrated in a few areas, such as London and Chinese property. However, the most likely non-U.S. trigger of crash is Japanese government bonds. Even though Japan is a major beneficiary of the oil price decline, the budget deficit in Japan is so large, the debt level so high and the current policies so misguided that a crash seems unavoidable. That crash might naturally occur in 2016 or 2017 rather than 2015, but a global stock market and economic downturn ought to be sufficient to trigger it a year or so early, giving the 2015-16 recession/crash a very nasty second downward leg.

Overall, the economic prognostication is little changed from a few weeks ago, but the timing is perhaps now clearer.

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About the Author:  Martin Hutchinson is the author of “Great Conservatives” (Academica Press, 2005) which examines the British governments of 1783-1830. He was formerly Business and Economics Editor at United Press International. Martin’s weekly column, The Bear’s Lair, is based on the rationale that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. This article originally appeared on the economics website “The Prudent Bear” and is republished here with permission.

No Asset Bubble?

Earlier in the week BlackRock’s Larry Fink commented on CNBC: “A Bubble is predicated on leverage.” Fink was implying that he didn’t see the type of leverage that had fueled the previous Bubble.

As part of my Bubble analysis framework, I have posited that the more conspicuous a Bubble the less likely it is to be systemic. The “tech” Bubble was conspicuous, though gross excesses impacted only a relatively narrow segment of asset prices and a subsection of the real economy.

I received a lot of pushback to my mortgage finance Bubble thesis during that Bubble period. The conventional view held that excesses were not a major issue, especially when compared to the Internet stocks and all the nonsense illuminated with the technology Bubble collapse. The Fed’s unwillingness to move beyond baby-step rate increases (to aggressively tighten Credit) played prominently in Bubble Dynamics. Today, conventional thinking sees a system that has been working successfully through a multi-year deleveraging process. Leverage and speculative excess are believed to be nothing on the order of those that gave rise to the (“100-year flood”) “Lehman crisis.”

As an analyst of Bubbles, I’ve definitely got my work cut out for me. I have seen overwhelming evidence in support of my “Granddaddy of all Bubbles” – global government finance Bubble – thesis. Yet the Bubble is so comprehensive – so systemic – that the greatest financial Bubble in human history somehow goes largely unappreciated – hence unchecked.

Understanding this era’s Credit Bubble (as opposed to the causes of the Great Depression) will prove the ultimate “Holy Grail of Economics.” The past 25 years have been unique in financial history. Indeed, the world is trapped in a perilous experiment with unfettered finance – with no limits on either the quantity or quality of Credit created. Closely associated with this trial in unchecked electronic finance (“money” and Credit) has been runaway experimentations in “activist” monetary management. Just as crucial is the experiment in unconventional economic structure – including the deindustrialization of the U.S. economy, with the corresponding unprecedented expansion of industrial capacity throughout China and Asia. This has engendered a period of unmatched global economic and financial imbalances – best illustrated by the massive and unrelenting U.S. Current Account Deficits and the accumulation of U.S. IOU’s around the globe.

The amazing thing to me is that the world has been subjected to more than 25 years of brutal serial boom and bust cycles (going back to 1987 – although there’s a strong case to start at 1971) – yet there has been no effort to reform either a patently flawed global financial “system” or a reckless policymaking doctrine. Instead, global central bankers have turned only more “activist,” drifting further into the bizarre (that passes for “enlightened”). The world’s leading central banks have resorted to rank inflationism, massive “money” printing operations specifically to inflate global securities markets. And the resulting raging “bull” markets ensure bullishness and a positive spin on just about everything. The sophisticated market operators play the speculative Bubble for all its worth, while the unsuspecting plow their savings into stock and bond Bubbles.

Credit is inherently unstable. Marketable debt instruments exacerbate instability. A financial system where Credit expansion is dominated by marketable debt (in contrast to “staid” bank loans) is highly unstable – I would argue unwieldy, whimsical and prone to manipulation. And a monetary policy regime that specifically nurtures and backstops a system dominated by marketable securities and associated speculation is playing with fire. Importantly, the more deeply central bankers intervene and manipulate such a system and the longer it is allowed to inflate – the more impossible for these central planners to extricate themselves from the financial scheme.

I’m fond of a relatively straightforward analysis that does a decent job of illuminating the state of ongoing U.S. (marketable securities) Bubbles. From the Fed’s Z.1 “flow of funds” data, I tally Total Marketable Debt Securities (TMDS) that includes outstanding Treasury securities (not the larger Federal liabilities number), outstanding Agency Securities (MBS & debt), corporate bonds and municipal debt securities.

My calculation of TMDS began the 1990’s at $6.28 TN, or an already elevated 114% of GDP. Led by explosive growth in GSE and corporate borrowings, TMDS ended the nineties at $13.59 TN, for almost 120% growth. Over this period, GSE securities increased $2.65 TN, or 209%, to 3.916 TN. Corporate bonds jumped 185% to $4.564 TN. It is worth noting that total Business borrowings expanded 9.2% in 1997, 11.5% in 1998 and 10.4% in 1999, excess that set the stage for the inevitable bursting of the “tech” Bubble.

The Fed’s aggressive post-tech Bubble reflation ensured already dangerous excess was inflated to incredible new extremes. On the back of a doubling of mortgage borrowings, TMDS expanded 102% in the period 2000 through 2007 to $27.50 TN. Over the mortgage finance Bubble period, Agency Securities jumped 89% to $7.40 TN. Corporate bonds surged 154% to $11.577 TN. Municipal bonds rose 135% to $3.425 TN.

This unprecedented Credit expansion fueled various inflationary manifestations, including surging asset prices, spending, corporate profits, investment, GDP and trade/Current Account Deficits. After beginning the nineties at $6.227 TN, the value of the U.S. equities market surged 409% to end the decade at $19.401 TN. As a percentage of GDP, the nineties saw TMDS jump from 114% to 147%. Spurred by crazy technology stock speculation, Total Securities – TMDS plus Equities – jumped from 183% of GDP to end 1999 at 356%. Although Total Securities to GDP retreated to 284% by 2002, mortgage finance Bubble excesses quickly reflated the Bubble. Total Securities ended 2007 at a then record 378% of GDP.

A “funny” thing happened during the post-mortgage Bubble’s so-called “deleveraging” period. Since the end of 2008, total TMDS has jumped $8.348 TN, or 29%, to a record $37.542 TN. As a percentage of GDP, TMDS ended Q1 2014 at a record 220%. Even more importantly from a Bubble analysis perspective, in 21 quarters Total Securities (debt & equities) inflated $27.2 TN, or 61%, to end March 2014 at a record $72.039 TN. To put this in context, Total Securities began 1990 at $10.0 TN, ended 1999 at $33.0 TN and closed 2007 at a then record $53.01 TN. Amazingly, Total Securities as a percent of GDP ended Q1 at 421%. For comparison, Total Securities to GDP began the nineties at 183%, ended Bubbly 1999 at 356% before peaking at 378% in a more Bubbly 2007. No Bubble today? “Valuations in historical range”?

Let’s return to “A Bubble is predicated on leverage.” Yes, Total Household Liabilities declined $715bn from the 2008 high-water mark (much of this from defaults). Yet over this period federal liabilities increased almost $10.0 TN. Corporate borrowings were up more than $2.3 TN. On a system-wide basis, our system is inarguably more leveraged today than ever.

Many contend there is significantly less speculative leverage these days compared to the heyday (“still dancing”) 2007 period. I’m not convinced. Perhaps there’s less leverage concentrated in high-yielding asset- and mortgage-backed securities. However, from today’s vantage point, there appears to be unprecedented “carry trade” leverage on a globalized basis. I’ve conjectured that the “yen carry trade” – using the proceeds from selling (or borrowing in) a devaluing yen to speculate in higher-yielding securities elsewhere – could be one of history’s biggest leveraged bets. Various comments also suggest that there is enormous leverage employed in myriad Treasury/Agency yield curve trades. I suspect as well that the amount of embedded leverage in various securities and derivative trades in higher-yielding corporate debt is likely unprecedented.

When it comes to leverage, the Federal Reserve’s balance sheet is conspicuous. Fed Assets will end the year near $4.5TN, with Federal Reserve Credit having expanded about $3.6 TN, or 400%, in six years. Few, however, appreciate the ramifications from this historic monetary inflation from the guardian of the world’s reserve currency. I find it astonishing that conventional thinking dismisses the market impact from this unprecedented inflation of central bank Credit.

Over the years, I have argued that “money” is integral to major Bubbles. A Bubble financed by junk debt won’t inflate too far before the holders of this debt begin to question the rationale for holding rapidly expanding debt of suspect quality. In contrast, a Bubble fueled by “money” – a perceived safe and liquid store of nominal value – can inflate for years. The insatiable demand enjoyed by issuers of “money” allows protracted excesses and maladjustment to impart deep structural impairment (financial and economic).

I’m convinced history will look back and view 2012 as a seminal year in global finance. Draghi’s “do whatever it takes,” the Fed’s open-ended QE, and the Bank of Japan’s Hail Mary quantitative easing will be seen as a fiasco in concerted global monetary management. The Fed’s QE3 will be viewed as an absolute debacle. After all, QE3 incited an unwieldy “Terminal Phase” of speculative Bubble excesses throughout U.S. equities and corporate debt securities, along with global securities markets more generally. It unleashed major distortions throughout all markets, including sovereign debt.

A quick one-word refresher on “Terminal Phases:” Precarious. Their inherent danger arises from egregious late-cycle speculative excess and attendant maladjustment coupled with timid policymakers. Over recent years I have repeatedly invoked “Terminal Phase” in my analyses of a progressively riskier Chinese Bubble backdrop impervious to hesitant policy “tinkering.”

Here at home, we’re beginning to hear the apt phrase “The Fed is behind the curve.” Traditionally, falling “behind the curve” indicated that the central bank had been too slow to tighten policy in the face of mounting inflationary pressures. “Behind the curve” dictated that more aggressive tightening measures were required to rein in excesses. These days, “behind the curve” is applicable to an inflationary Bubble that has taken deep root in stock and bond markets. With the Yellen Fed seen essentially promising to avoid even a little baby-step 25 bps rate bump for another year, highly speculative Bubble markets can blithely disregard poor economic performance, a rapidly deteriorating geopolitical backdrop and the approaching end to QE. Worse yet, market participants are emboldened that “behind the curve” and the resulting dangerous market Bubbles preclude the Fed from anything but the most timid policy responses. A dangerous market view holds that, after instigating inflating securities markets as a direct monetary policy tool to stimulate the economy, the Fed would not in any way tolerate a problematic market downturn.

Ref. June 26 – Bloomberg (Steve Matthews and Jeff Kearns): “Federal Reserve Bank of St. Louis President James Bullard predicted the central bank will raise interest rates starting in the first quarter of 2015, sooner than most of his colleagues think, as unemployment falls and inflation quickens. Asked about his forecast for the timing of the first interest-rate increase since 2006, he said: ‘I’ve left mine at the end of the first quarter of next year.’ ‘The Fed is closer to its goal than many people appreciate,’ Bullard said… ‘We’re really pretty close to normal…’ If his forecasts bear out, ‘you’re basically going to be right at target on both dimensions possibly later this year… That’s shocking, and I don’t think markets, and I’m not sure policy makers, have really digested that that’s where we are.’”

The same day Bullard was talking hawk-like, Federal Reserve Bank of Richmond President Jeffrey Lacker was also making comments that should have the markets on edge. Countering uber-dove Yellen, Lacker stated that the recent jump in inflation was not entirely “noise.” Interestingly, he suggested that the Fed follow closely the FOMC’s 2011 exit strategy. “It’s not obvious to me a larger balance sheet should change any of our exit principles. I still think we should, as our exit principles say, be exiting from mortgage backed securities as soon as we can…” And following the lead of Kansas City Fed head Esther George, Lacker believes the Fed should allow its balance sheet to begin shrinking by ending the reinvestment of interest and maturity proceeds. Bullard also said the Fed should consider ending reinvestment.

Market ambivalence notwithstanding, I’m sticking with my analysis that the Fed can’t inflate its balance sheet from $900bn to $4.5 TN – and then end this massive monetary inflation without consequences. Things get even more interesting when talk returns to the Fed’s 2011 “exit strategy” road map. Regrettably, instead of exiting the Fed doubled-down – literally. And Dr. Bernanke may now say (while earning $250k) that the Fed’s balance sheet doesn’t have to shrink even “a dime.” Yellen and Dudley likely agree. But there’s now a more hawkish contingent that has other things in mind, and I don’t believe they will be willing to simply fall in line behind Yellen as officials did behind Greenspan and Bernanke.

Actually, I believe the so-called “hawks” (i.e. responsible central bankers) are gearing up to try to accomplish something that might these days appear radical: normalize monetary policy. Read “Systematic Monetary Policy and Communication” presented this week by Charles Plosser. Read Esther George’s “The Path to Normalization.” Re-read Richard Fisher. While you’re at it, read John Taylor’s op-ed from Friday’s WSJ: “The Fed Needs to Return to Monetary Rules.” I’m with Taylor (and Plosser!) on having and following rules. I’m also with Bullard: “I don’t think markets… have really digested… where we’re at.”

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.