Monetary Disorder 2019

'At least at this point, I’m not anticipating a crisis of confidence in an individual institution (i.e. Lehman in October 2008) to dominate Crisis Dynamics. Rather, I see a more general unfolding crisis of confidence in market function and policymaking. A decade of reckless monetary expansion and near-zero rate policies unleashed Intractable Monetary Disorder..'

'I titled last year’s “Issues 2018” piece “Market Structure.” A decade of central bank policy-induced market Bubbles fostered momentous market distortions and structural maladjustment. At the top of the list is the historic shift into passive ETF “investing.” With the ETF complex approaching $5.0 Trillion – and another $3.0 TN plus in the hedge fund universe – financial history has never seen such a gargantuan pool of trend-following and performance-chasing finance. Add to this the global proliferation of listed and over-the-counter derivatives strategies (especially options) and trading, and we’re talking about a world of unprecedented financial speculation. It’s an aberrant Market Structure, and we’re witnessing repercussions.

After powerful speculative flows and early-2018 blow-off excess, we saw the emerging markets (EM) then succumb to abrupt market reversals, destabilizing outflows, illiquidity and Crisis Dynamics. We witnessed how fragility at the “Periphery” propelled inflows to the “Core,” pushing U.S. securities markets into a destabilizing speculative melt-up (in the face of a rapidly deteriorating fundamental backdrop). This speculative Bubble burst in Q4.

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At least at this point, I’m not anticipating a crisis of confidence in an individual institution (i.e. Lehman in October 2008) to dominate Crisis Dynamics. Rather, I see a more general unfolding crisis of confidence in market function and policymaking. A decade of reckless monetary expansion and near-zero rate policies unleashed Intractable Monetary Disorder. Among the myriad consequences are deep structural impairment to financial systems - certainly including global securities and derivatives markets. The world is in the midst of acute financial instability with little possibility of resolution (outside of crisis).

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The global Bubble has begun to deflate. Chinese data continue to confirm a serious unfolding downturn. Not dissimilar to Washington policymakers, Beijing appears increasingly anxious. In theory, there would be advantages to letting air out of Bubbles gradually. But the bigger the Bubble – and the greater associated risks – the greater the impetus for policymakers to indefinitely postpone the day of reckoning. The upshot is only worsening Monetary Disorder. With still rising quantities of Credit of rapidly deteriorating quality, systemic risk continues to rise exponentially in China (and the world).

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There’s a strong consensus view that Beijing has things under control. Reality: China in 2019 faces a ticking Credit time bomb. Bank loans were up 13.5% over the past year and were 28% higher over two years, a precarious late-cycle inflation of Bank Credit. Ominously paralleling late-cycle U.S. mortgage finance Bubble excess, China’s Consumer Loans expanded 18.2% over the past year, 44% in two years, 77% in three years and 141% in five years. China’s industrial sector has slowed, while inflated consumer spending is indicating initial signs of an overdue pullback. Calamitous woes commence with the bursting of China’s historic housing/apartment Bubble.

Typically – and as experienced in the U.S. with problems erupting in subprime - nervous lenders and a tightening of mortgage Credit mark an inflection point followed by self-reinforcing downturns in housing prices, transactions and mortgage Credit. Yet there is nothing remotely typical when it comes to China’s Bubble. Instead of caution, lenders have looked to residential lending as a preferred (versus business) means of achieving government-dictated lending targets. Failing to learn from the dreadful U.S. experience, Beijing has used an inflating housing Bubble to compensate for structural economic shortcomings (i.e. manufacturing over-capacity). This is precariously prolonging “Terminal Phase” excess.

The Institute for International Finance is out with updated global debt data. In the public interest, they should make this data and their report available to the general public.

January 16 – Financial Times (Jonathan Wheatley): “Emerging-market companies have gorged on debt. Slower global growth and higher funding costs will make servicing that debt harder, just as the amount coming due this year reaches a record high. The result? Less investment for growth and yet more borrowing. These are some of the concerns raised by the Institute of International Finance… as it published its quarterly Global Debt Monitor… The world is ‘pushing at the boundaries of comfortably sustainable debt,’ says Sonja Gibbs, managing director at the IIF. ‘Higher debt levels [in emerging markets] really divert resources from more productive areas. This increasingly worries us.’ The IIF’s data show total global debt — owed by households, governments, non-financial corporates and the financial sector — at $244tn, or 318% of gross domestic product at the end of September, down from a peak of 320% two years earlier. In some areas, though, borrowing is rising. Of particular concern is the non-financial corporate sector in emerging markets (EMs), where debts are equal to 93.6% of GDP. That is more than among the same group in developed markets, at 91.1% of GDP.”

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Considering the unprecedented global debt backdrop, it’s difficult for me to believe last year’s corrections went far in resolving deep structural issues throughout the emerging markets - and for the global economy more generally. “A record $3.9 trillion of emerging market bonds and syndicated loans comes due through the end of 2020…” “…Borrowers face $2 trillion of maturing debt in 2019, with about a quarter of those loans made in dollars.”

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Pondering the massive pool of unstable global speculative finance, I wonder how both EM and global corporate Credit will trade in the event of a more sustained recovery in global equities and sovereign yields. Bear market rallies feed optimism and perceptions of abundant liquidity. But I believe the global liquidity backdrop has fundamentally deteriorated. This predicament, however, is completely concealed during rallies – only to reemerge when the buyers’ panic runs its course and selling resumes. It would not be surprising to see liquidity issues resurface in EM currencies and debt markets. In general, the more intense the counter-trend rallies the greater the vulnerability to sharp market reversals and a return of illiquidity.

Fed officials have fallen in line with the Chairman’s cautious language. But I would not totally dismiss “data dependent.” With labor markets unusually tight, a scenario of a trade deal, speculative markets and economic resilience could possibly see the Fed contemplating a shift back to “normalization.” Market pundits were quick to highlight “hawkish” Kansas City Fed President Esther George’s newfound dovishness. Comments from “dovish” Chicago Fed President Charles Evans were as notable: “I wouldn’t be surprised if at the end of the year we have a funds rate that’s a little bit higher than where we are now. That would be associated with a better economy and inflation moving up.” It’s going to be a fascinating year.'

- Doug Noland, Monetary Disorder 2019, January 19, 2019



'The next question, then, is whether the U.S. is nearing an economic recession. On that subject, we’re probably a bit less committal than one might imagine, because we’re still monitoring a few components of our Recession Warning Composite. Specifically, we’d be inclined to wait until we observe a decline in the ISM Purchasing Managers Index below 50, coupled with an uptick to an unemployment rate of anything above 4%, and a slowdown in year-over-year job growth to 1.4% from the current 1.8%.'

'As market conditions currently stand, valuations remain extreme and market internals remain negative. So aside from the likelihood of a knee-jerk market spike on any variant of the word “deal,” we continue to be in a trap-door situation with respect to market risk. Though we did take the edge off of our negative outlook to allow for a scorching relief rally, my present view is that the overall function of that relief rally has been served.

As a side-note, I’ve renamed the measure above to the Margin-Adjusted P/E (MAPE) rather than the Margin-Adjusted CAPE. The reason is that it seems to be confused for Robert Shiller’s cyclically-adjusted P/E (CAPE). So MAPE it is.

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On the subject of errors, it’s one thing to err because something happens that violates all evidence from history, but it’s another to repeatedly make the same mistake as a result of ignoring history altogether. It seems to me that ignoring extreme valuations – and pricing stocks based on earnings projections that have no link to the way earnings have behaved across history – is an error of the second type.

I regularly admit my own error in the recent advancing half-cycle, particularly because I hope it can be instructive. Despite anticipating the 2000-2002 and 2007-2009 collapses, and admirably navigating decades of complete market cycles prior to 2009, I made a very specific error in the recent half-cycle that was detrimental. The error was my bearish response to severe “overvalued, overbought, overbullish” syndromes that had regularly been followed by air-pockets, panics, and crashes in market cycles across history, but failed to place any limit on speculation in the face of zero interest rate policies.

In late-2017, I finally threw up my hands and abandoned the idea that we could rely on any historically-defined “limit” to speculative recklessness. Instead, I resolved that whenever our measures of market internals are uniformly favorable (which we use to gauge speculative pressures, because speculators tend to be indiscriminate), we would rule out adopting or amplifying any bearish outlook in the future. No exceptions. Period. Sufficiently extreme conditions can push us to a flat, neutral outlook, but never to a bearish one unless ragged and divergent internals indicate that investor psychology has shifted from speculation to risk-aversion.

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On recession risk

The next question, then, is whether the U.S. is nearing an economic recession. On that subject, we’re probably a bit less committal than one might imagine, because we’re still monitoring a few components of our Recession Warning Composite. Specifically, we’d be inclined to wait until we observe a decline in the ISM Purchasing Managers Index below 50, coupled with an uptick to an unemployment rate of anything above 4%, and a slowdown in year-over-year job growth to 1.4% from the current 1.8%.

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Don’t take hope in Fed intervention to support the market, other than knee-jerk reactions. First, remember that the Fed eased persistently throughout the 2000-2002 and 2007-2009 collapses with no effect. When investors are inclined toward risk-aversion, safe liquidity is a desirable asset, not an inferior one. My view is that it’s essential to monitor market internals directly. We don’t disclose the details of our own measures, but I’ve discussed uniformity, divergence, breadth, leadership, price-volume sponsorship, credit spreads, and other factors often enough that the central concept should be clear: when investors are inclined toward speculation, they tend to be indiscriminate about it.

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My impression is that Jerome Powell is highly aware of how loose the cause-and-effect links are between monetary policy and the real economy. But apart from noting that the Fed’s workhorse economic model estimates only a 0.2% change in the unemployment rate after 3 years in response to each $500 billion in asset purchases, there’s nothing in his past speeches that indicates an intellectual opposition to QE. It’s not at all clear that the Fed recognizes its role in creating repeated cycles of bubble and collapse. So we have to allow for another round of QE in response to the next recession. Again, the appropriate response on our part will be to align ourselves with market internals. A favorable shift would likely encourage a constructive or aggressive investment outlook, particularly if valuations have retreated substantially at that point.

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I know that many observers are quietly repeating Milton Friedman’s phrase that “inflation is always and everywhere a monetary phenomenon.” The problem is, you won’t reliably see that in the data. As a former economics professor, I get it. The quiet job of the economics profession is to indoctrinate teenagers with purely theoretical models by showing them line-drawings. Nobody ever asks them to spend time staring at actual numbers.

So they become adults – and sometimes even Fed governors – who take theoretical diagrams as reality, for example, the notion that the Phillips curve is a relationship between unemployment and general price inflation, when there’s utterly no evidence for it. In fact, as I’ve regularly argued, when you actually look at A.W. Phillips’ data (a century of British unemployment and wage data during a period of stable general prices under the gold standard), the Phillips Curve is actually a relationship between unemployment and real wage inflation.

Of course, money creation and general price inflation are undoubtedly linked when money creation hits the pace of the Weimar Republic or Zimbabwe. But for the U.S., there’s no economic factor that predicts the rate of inflation better than the rate of inflation itself (and related uniformity in the behavior of inflation-sensitive securities including precious metals, exchange rates, bond prices, commodities, TIPS, and related securities). Just like a shift in market internals, it may be difficult to predict, but it’s fairly easy to align yourself with it.'

- John P. Hussman, Ph.D., Questions we hear a lot, January 18, 2019



Context

Loving Your Enemies - By Martin Luther King, Jr

'Global Financial Crisis is the Paramount Issue 2019. Last year saw the bursting of a historic global Bubble..'