vrijdag 24 november 2017

S&P Futures Hit Record High As European Euphoria Takes Over Forgotten China Rout

Yesterday's China stock market rout, in which the Shanghai Composite tumbled the most since June 2016 to three month lows, and which prompted traders to question the dedication of Beijing's plunge protection team, appears to have been forgotten, with the Composite closing unchanged on Friday after some early session weakness, as Chinese yields declined broadly across the board from 3 years highs. As a result, world stocks hovered just below record highs, and set to reverse two straight weeks of losses, and with Asian markets mostly in the green, as MSCI's Asia-Pacific ex Japan index rose 0.2%, the optimism spread to Europe where Germany's IFO Business Climate hit a new record high...


# @jsblokland #EUROBOOOM! #Germany's #Ifo index hits another record-high!
This now points to a Y/Y GDP growth of 4%...


It is worth keeping in mind that while European business optimism has never been higher, 90% of the responses to the survey were submitted before Angela Merkel’s coalition talks collapsed. Still, the IFO print was in line with the latest November Markit PMIs, which also printed strong and beat consensus, with Eurozone’s flash composite PMI rising to a 6.5 year high (57.5 vs. 56 expected) and is at a level that is broadly consistent with 3.5% yoy GDP growth, which Deutsche Bank called "a stunning figure for the continent." In addition to the strong IFO data, there was more good news out of Germany where the SPD is now reportedly ready to negotiate with Merkel to form a government and end the political deadlock. In response to these two developments, the EURUSD rose to the highest level since October 13...


Despite the strong currency European stocks which were in the red in early trading, turned positive, helped to an extent by news Asia would slash import tarfiffs in a boost for consumer goods companies, benefiting European exporters. The Stoxx Europe 600 advanced, also thanks to bank shares as Italian lenders were buoyed by a new proposal to deal with bad loans. “It’s a bit of a Goldilocks situation (for economic growth). It is finely balanced and I think the European Central Bank has very much hinted at that in its actions, but at the moment I can’t really see how this is going to be up-ended,” said Ken Odeluga, market analyst at City Index. Ironically, as Germany's crisis appeared to easing, a new crisis emerged in Ireland, whose bond yields climbed to a 10-day high. The standoff over the Irish deputy leader may lead to an early election at a time when the government has to make key decisions on the Brexit process. Finally, with the US coming back from Thanksgiving holiday for a half-trading Friday, S&P futures are up 6 points, in fresh record territory, with early optimism among merchants expected to benefit from strong Black Friday sales.
# In FX, the US dollar remained under pressure after the minutes from the U.S. Federal Reserve’s latest policy meeting highlighted concerns over persistently low inflation, pushing the DXY 0.2% lower. The Bloomberg Dollar Spot Index headed for its third week of losses, the longest losing streak since July, and is down 1.6% this month. While a drop in Treasuries supported the gauge initially, gains were capped by a rally in cable and demand for the yen after London open, although post-Thanksgiving volumes remained subdued. In Europe, bonds slipped as equities were mixed and crude oil rose. Indeed, as Bloomberg writes, a rebound in Treasury yields wasn’t enough for the dollar to sustain early gains as the London session started off with decent demand for the euro and the pound amid modest post-Thanksgiving flows. Downside Dollar risks prevail on the charts, with momentum driven by the dovish tone from Federal Reserve Chair Janet Yellen earlier in the week amid lack of progress on U.S. tax reform.
Meanwhile, "euro bulls added longs in the spot market, according to traders in Europe and London, albeit in low volumes, with some desks understaffed on Friday" Bloomberg added. As we discussed earlier, the common currency rose to its strongest level in six weeks, with hedge funds and interbank accounts leading the move higher. The latter look more confident on euro gains after the latest European Central Bank account showed that a pickup in inflation isn’t a prerequisite for policy makers to end monetary stimulus. The South African rand heavily underperforms as S&P and Moody’s are due to reassess South Africa sovereign rating and potentially cut further. In commodities, crude futures hit a two-year high on the shutdown of Keystone pipeline, a major crude pipeline from Canada to the United States. WTI crude futures were up 0.9% at $58.53 a barrel from their last settlement. Brent was flattish at $63.46, down 0.1% on the day. In a sign of a tightening market, both crude benchmarks are in backwardation, making it unattractive for traders to store oil for later sale. Iron ore climbed to a two-month high, while industrial metals headed for the best weekly gain in six. Crude oil surged as OPEC and Russia were said to have agreed on a framework to extend supply cuts. Expected economic data include November PMIs. Canada’s Valener is reporting earnings.
# Market Snapshot;
- S&P 500 futures up 0.1% to 2,597.25
- STOXX Europe 600 up 0.2% to 387.68
- Nikkei up 0.1% to 22,550.85
- Topix up 0.2% to 1,780.56
- Hang Seng Index up 0.5% to 29,866.32
- Shanghai Composite up 0.06% to 3,353.82
- Euro up 0.1% to $1.1864
- Brent futures down 0.1% to $63.62/bbl
- Gold spot down 0.1% to $1,290.27
- U.S. Dollar Index down 0.1% to 93.10
# Top Overnight News;
- Former national security adviser Michael Flynn’s lawyers have notified President Trump’s legal team in recent days they can no longer discuss special counsel’s investigation, NYT reports, adding it’s an indication that Flynn is cooperating with prosecutors or negotiating such a deal
- China said it will further cut import taxes for a wide range of consumer goods in a bid to boost consumption
- Germany’s biggest opposition party said it’s open to talks on backing a government led by Chancellor Angela Merkel. The move came after the
- Green party urged Merkel to forge a coalition with the SPD, while ruling out further attempts to gain a place in any alliance.
- German Ifo business confidence rose to a record high of 117.5 in November vs estimate of 116.7 and 116.8 in October
- BOE official Silvana Tenreyro said two more rate increases will probably be needed to get inflation back to target, but Brexit will be the real determinant of where policy goes next
- The U.K. financial services regulator confirmed all 20 banks have agreed to support the London interbank offered rate until 2021 and will work toward developing an alternative benchmark
- ECB executive board member Benoit Coeure said ECB deposit rate will stay at minus 0.4% for a long time
- U.K. consumer confidence tumbled to 106.6 in November, the lowest level since the aftermath of the Brexit vote, according to a poll by YouGov and the Centre for Economics and Business Research
- Ireland's deputy PM is pressured to resign by opposition due to historical conduct; potential for fresh elections as PM support for deputy leads to standoff
- In a Thanksgiving address to troops, Trump credited his policies for allowing progress in Afghanistan and against Islamic State, and warned about sending sophisticated weapons to American allies that one day could become the enemy.
- U.K. Prime Minister Theresa May will meet European Union President Donald Tusk Friday as the country seeks guarantees that the bloc will allow stalled Brexit talks to make progress in exchange for new assurances over money.
- Dalian Exchange cuts trading fees for some iron ore futures contracts
- Noble Group Risks Equity Wipeout as Shares Retreat Yet Again
- Credit Suisse-Backed WeLab Is Said to Plan $500 Million IPO
- Temer Said to Agree on Brazil Pension Vote With House Chief....

German Crisis Averted? SPD Ready To Negotiate With Merkel To End Political Deadlock

The Euro has jumped to a six week high following the latest record high print in the German IFO Business Climate index, which rose from 116.7 to 117.5 (exp. 116.6), but mostly as a result of what appears to be a breakthrough in the German political deadlock that some likened to "Merkel's Brexit moment", after Germany’s biggest opposition party, the Social Democrats, on Friday morning announced a reversal in their political strategy and said they are open to talks on backing a government led by Chancellor Angela Merkel, offering a way to break the Berlin deadlock and restore political stability to Europe’s biggest economy. As the FT reports, the decision, announced after an eight-hour meeting of SPD leaders in party headquarters in Berlin wrapped up in the early hours of Friday, marks a U-turn for the centre-left party, which had vowed since September’s indecisive general election not to rejoin Ms Merkel’s centre-right bloc in a “grand coalition”. Commenting on the latest political development, UBS economist Paul Donovan said that "the German SPD are discussing the possibility of some kind of support for the CDU, following talks with the German president.
The German political crisis is not really looking very crisis-like. It is all very orderly and, frankly, a little dull." Social Democrat Secretary General Hubertus Heil told reporters that the party is ready to start discussions if that’s the course that President Frank-Walter Steinmeier, who is trying to broker a deal, decides upon. Heil spoke after an eight-hour meeting of the SPD leadership in Berlin. “The SPD is firmly convinced that talks are needed,” Heil was quoted as saying by Deutsche Presse-Agentur newswire. “The SPD won’t reject such talks.” More than two months after an inconclusive election that brought a far-right party into parliament and was the CDU's worst showing since World War II, Merkel is still trying to work out how she can govern after her effort to forge a deal with three smaller parties fell apart on Sunday. Still, while Merkel remains skeptical about ruling without a parliamentary majority and the SPD leader Martin Schulz wants to avoid a formal coalition, the two sides are inching closer as they try to bring stability to the country. Over the past few days, pressure has risen on Schulz to reverse his stance since the smaller free-market Free Democratic Party withdrew from coalition talks last week, plunging Germany into a rare bout of political uncertainty, as a repeat German vote is seen as the worst-case political outcome.
As Bloomberg notes, "Schulz is facing calls by SPD lawmakers and state leaders to drop his refusal to join a Merkel coalition. Schulz favors pledging SPD support for a minority government, an arrangement Merkel wants to avoid. That arrangement might involve an SPD pledge to support Merkel on legislation on a case-by-case basis without joining her administration." Seeking to reciprocate, and sensing the change in the political climate, senior members of Merkel’s party have doubled their efforts to bring the SPD back into the fold. Volker Kauder, head of the CDU-CSU group in parliament, told Germany’s Südwest Presse on Thursday that he would be happy “if the current partners in government found each other once again”. Mr Kauder pointed to the “special responsibility” of the country’s two biggest establishment parties. Seeking to tame hopes that an SPD coalition is now a done deal, Manuela Schwesig, the Social Democrat prime minister of the eastern state of Mecklenburg-Western Pomerania, said on ZDF television that “for us it’s clear that if there are talks, then we will also take part in these talks, but added that "just because we’re saying that we’re open to talks, it’s not automatically a discussion about a grand coalition, and certainly not a vote for a grand coalition.” She also stated that some in the SPD are asking “aren’t there alternatives to the automatic grand coalition or to new elections, are there alternatives in between? Different things are under discussion and we’re saying that we have to talk about these different things now." 
Furthermore, whatever the SPD decides, it will likely require the approval of members, Heiko Maas of the party leadership committee told ZDF television late Thursday. The SPD is holding a party congress in Berlin from Dec. 7 to Dec. 9, when Schulz will be up for re-election as chairman, and his political career is suddenly in doubt. Having led the SPD to its worst result since World War II in September, Schulz is under pressure from within his party to step aside, a move that might help clear the way for a grand coalition. Heil sought to quell the speculation on Thursday, saying “personnel matters” aren’t on the agenda for now. On Thursday, Schulz met with German President Steinmeier as Germany’s head of state, a former SPD foreign minister, tries to secure a stable government. Steinmeier has made clear he wants to avoid new elections, and has urged party leaders on all sides to show flexibility and readiness to compromise. Meanwhile, as they prepare to engage with Merkel, the Social Democrats are split between those on the left who see the two coalitions with Merkel as the main reason for the slump in its support and those who spy a chance to push through policies such as expanded health care and reaching out to French President Emmanuel Macron to strengthen the euro area, according to a Bloomberg wrap. Many in the SPD would prefer to stay out of government to prevent the far-right Alternative for Germany, which entered parliament for the first time with 12.6 percent of the vote in September, from becoming the biggest opposition force...


For now, the market is giving the latest developments the benfit of the doubt, and has sent the EURUSD up as much as 0.2% to 1.1875, its strongest level since Oct. 13; the pair climbs a fourth day, with the euro set for its best yearly performance since 2003...

Pepe Escobar; How Turkey, Iran, Russia, And India Are Playing The New Silk Roads

A pacified Syria is key to the economic integration of Eurasia through energy and transportation connections. Vladimir Putin, Recep Tayyip Erdogan and Hassan Rouhani will hold a summit this Wednesday in Sochi to discuss Syria. Russia, Turkey and Iran are the three power players at the Astana negotiations, where multiple cease-fires, as hard to implement as they are, at least evolve, slowly but surely, towards the ultimate target, a political settlement. A stable Syria is crucial to all parties involved in Eurasia integration. As Asia Times reported, China has made it clear that a pacified Syria will eventually become a hub of the New Silk Roads, known as the Belt and Road Initiative (BRI), building on the previous business bonanza of legions of small traders commuting between Yiwu and the Levant. Away from intractable war and peace issues, it’s even more enlightening to observe how Turkey, Iran and Russia are playing their overlapping versions of Eurasia economic integration and/or BRI-related business. Much has to do with the energy/transportation connectivity between railway networks, and, further on the down the road, high-speed rail, and what I have described, since the early 2000s, as Pipelineistan...

map2

The Baku-Tblisi-Ceyhan (BTC) pipeline, a deal brokered in person in Baku by the late Dr Zbigniew “Grand Chessboard” Brzezinski, was a major energy/geopolitical coup by the Clinton administration, laying out an umbilical steel cord between Azerbaijan, Georgia and Turkey. Now comes the Baku-Tblisi-Kars (BTK) railway, inaugurated with great fanfare by Erdogan alongside Azerbaijani President Ilham Aliyev and Georgian Prime Minister Giorgi Kvirikashvili, but also crucially Kazakh Prime Minister Bakhytzhan Sagintayev and Uzbek Prime Minister Abdulla Aripov. After all, this is about the integration of the Caucasus with Central Asia. Erdogan actually went further: BTK is “an important chain in the New Silk Road, which aims to connect Asia, Africa, and Europe.” The new transportation corridor is configured as an important Eurasian hub linking not only the Caucasus with Central Asia but also, in the Big Picture, the EU with Western China. BTK is just the beginning, considering the long-term strategy of Chinese-built high-speed rail from Xinjiang across Central Asia all the way to Iran, Turkey, and of course, the dream destination: the EU. Erdogan can clearly see how Turkey is strategically positioned to profit from it...

map1

Of course, BTK is not a panacea. Other connectivity points between Iran and Turkey will spring up, and other key BRI interconnectors will pick up speed in the next few years, such as the Eurasian Land Bridge across the revamped Trans-Siberian and an icy version of the Maritime Silk Road: the Northern Sea Route across the Arctic. What’s particularly interesting in the BTK case is the Pipelineistan interconnection with the Trans-Anatolian Gas Pipeline (TANAP), bringing natural gas from the massive Azeri gas field Shah Deniz-2 to Turkey and eventually the EU. Turkish analyst Cemil Ertem stresses, “just like TANAP, the BTK Railway not only connects three countries, but also is one of the main trade and transport routes in Asia and Europe, and particularly Kazakhstan and Turkmenistan ports. It connects Central Asia to Turkey with the Marmaray project in Istanbul and via the Caspian region.
Along with the Southern Gas Corridor, which constitutes TANAP’s backbone, it will also connect ports on the South China Sea to Europe via Turkey.” It’s no wonder BTK has been met with ecstatic reception across Turkey, or, should we say, what used to be known as Asia Minor. It does spell out, graphically, Ankara’s pivoting to the East (as in increasing trade with China) as well as a new step in the extremely complex strategic interdependence between Ankara and Moscow; the Central Asian “stans”, after all, fall into Russia’s historical sphere of influence. Add to it the (pending) Russian sale of the S-400 missile defense system to Ankara, and the Russian and Chinese interest in having Turkey as a full member of the Shanghai Cooperation Organization (SCO).
# From IPI to IP and then II; Now compare the BTK coup with one of Pipelineistan’s trademark cliff-hanging soap operas; the IPI (Iran-Pakistan-India), previously dubbed “the peace pipeline”. IPI originally was supposed to link southeastern Iran with northern India across Balochistan, via the Pakistani port of Gwadar (now a key hub of the China-Pakistan Economic Corridor, CPEC). The Bush and Obama administrations did everything to prevent IPI from ever being built, betting instead on the rival TAPI (Turkmenistan-Afghanistan-Pakistan-India), which would actually traverse a war zone east of Herat, Afghanistan. TAPI might eventually be built – even with the Taliban being denied their cut (that was exactly the contention 20 years ago with the first Clinton administration: transit rights). Lately, Russia stepped up its game, with Gazprom seducing India into becoming a partner in TAPI’s construction. But then came the recent announcement by Russian Energy Minister Aleksandr Novak: Moscow and Tehran will sign a memorandum of understanding to build a 1,200km gas pipeline from Iran to India; call it II. And Gazprom, in parallel, will invest in unexplored Iranian gas fields along the route. Apart from the fact of a major win for Gazprom, expanding its reach towards South Asia, the clincher is the project won’t be the original IPI (actually IP), where Iran already built the stretch up to the border and offered help for Islamabad to build its own stretch; a move that would be plagued by US sanctions. The Gazprom project will be an underwater pipeline from the Persian Gulf to the Indian Ocean.
 From New Delhi’s point of view, this is the ultimate win-win. TAPI remains a nightmarish proposition, and India needs all the gas it can get, fast. Assuming the new Trump administration “Indo-Pacific” rhetoric holds, New Delhi is confident it won’t be slapped with sanctions because it’s doing business with both Iran and Russia. And then there was another key development coming out of Putin’s recent visit to Tehran: the idea, straight out of BRI, of building a rail link between St. Petersburg (on the Baltic) and Chabahar port close to the Persian Gulf. Chabahar happens to be the key hub of India’s answer to BRI: a maritime trade link to Afghanistan and Central Asia bypassing Pakistan, and connected to the North-South Transport Corridor (INSTC), of which Iran, India and Russia are key members alongside Caucasus and Central Asian nations. You don’t need a weatherman to see which way the wind blows across Eurasia; integration, all the way....

China Deleveraging Hits Corporate Bonds As Cascade Effect Begins

Following the market lockdown during October’s Party Congress, many commentators were disturbed by the continued rise in Chinese government bond yields as we returned to “business as usual”, with the 10-year rising to 4%. At the beginning of this month, we discussed the sell-off (“China: Shadow Bank Inflows Are Critical To Sustain The Ponzi, But They’re Falling”) and noted a useful insight from the Wall Street Journal. An important anomaly to note about the bond rout: as government bonds sold off, yields on less-liquid, unsecured Chinese corporate bonds barely moved. That is atypical in an environment of rising rates, usually, bond investors shed their less-liquid holdings and hold on to assets that are more easily tradable, like government debt. The question was, why had corporate bond yields barely moved? The answer, according to the WSJ, was that China’s deleveraging policy led to redemptions in the shadow banking sector, in the notorious $4 trillion Wealth Management Products (WMP) sector. Faced with redemptions, shadow banks had to sell something, quickly and highly liquid government bonds were the “easiest option”. Furthermore, and this is potentially significant, the WSJ noted. 
Meanwhile, the nonbanks have held on to their higher-yielding corporate bonds, which at least have the benefit of helping them to maintain high returns. Not any more. We agreed with the WSJ’s explanation at the time, but noted that the government bond sell-off was actually a sign of the unravelling of the WMP Ponzi scheme. The Chinese authorities are wise to the Ponzi which is why they announced the overhaul of shadow banking and WMPs last Friday (“A ‘New Era’ In Chinese Regulation Means Turmoil For $15 Trillion In China's ‘Shadows"). However, the new regulations don’t kick in until mid-2019, a sign to us that when they looked “under the bonnet”, they didn’t like what they saw. We doubt that China can achieve an orderly restructuring of its shadow banking sector, never mind its much larger credit bubble. A sign that we have taken another step towards China’s “Minsky moment” is that the bond sell-off has spread to the corporate bond market. The chart shows how spreads versus sovereign bonds have blown out during the last few weeks... 


Bloomberg noted how the 10-year yield on China Development Bank notes, a quasi-sovereign issue, closed above 5% for the first time since 2014 today while, in another report, it put the corporate bond sell-off in a wider context. China’s deleveraging campaign is finally starting to bite in the nation’s corporate-bond market, a shift that will make 2018 a clearer test of policy makers’ appetites to let struggling companies fail. Yields on five-year top-rated local corporate notes have jumped about 33 basis points since the month began, to a three-year high of 5.3 percent, according to data compiled by clearing house ChinaBond. Government bonds, which have far greater liquidity, had already moved last month as the central bank warned further deleveraging was needed. With more than $1 trillion of local bonds maturing in 2018-19, it will become increasingly expensive for Chinese companies to roll over financing, and all the tougher for those in industries like coal that the nation’s leadership wants to shrink. Two companies based in Inner Mongolia, a northern province that’s suffered from a debt-and-construction binge, missed bond payments on Tuesday, in a demonstration of the kind of pain that may come...


# Bloomberg tries to put a positive spin on the corporate bond sell-off, defaults are healthy in terms of differentiating good and credits. In the long haul, that all may be good for China. Allowing more defaults could see its bond market become more like its overseas counterparts, with a greater differentiation in price. And that could mean it channels funds more productively. “The deleveraging campaign and the new rules on the asset management industry will further differentiate good and bad quality credits, and make the onshore credit market more efficient,” said Raymond Gui, senior portfolio manager at Income Partners Asset Management (HK) Ltd. “Weaker companies will find it harder to roll over their debts because funding costs will stay high.” Gui predicts yields will keep climbing.
The average for top-rated corporate bonds is already 2.2 percentage points above what investors demanded to hold them in October last year. The rise comes as authorities show greater determination to shift the economy onto a more sustainable footing, with less debt. The latest move was a plan to discipline the asset-management industry, including banning guaranteed rates of return. People’s Bank of China Governor Zhou Xiaochuan graphically depicted the risk of excess leverage, by evoking a "Minsky moment," or sudden collapse of asset values. Key to that endeavor will be scaling back some of the implicit credit guarantees that have backed a broad swathe of Chinese borrowers. The country only started allowing corporate defaults in 2014. Last year there was a record, coming in at at least 29. It’s unclear yet whether that total will be met in 2017.
# Bloomberg spoke to an analyst who also believes the recent sell-off in Chinese bonds is more to do with separating the “wheat from the chaff”, rather than anything more profound. "We expect the divergence of performance between different bond categories (Chinese government bonds, policy bank bonds and credits) to become more prominent into 2018," Albert Leung and Prashant Pande, rates strategists at Nomura Holdings Inc., wrote in a note Wednesday. We disagree. From our perspective, it looks like early signs of cascading sell-offs within Chinese financial markets, which have long been abused by excessive leverage and Ponzi characteristics. Talking of which, the Shanghai Composite Index suffered its biggest one-day drop since June 2016...


What caused the sell-off? According to some commentators it was fear that the local bond rout was getting out of control...hence "cascade". We noted last week that traders had been stunned by the official warning from Beijing that some stocks, in this case Kweichow Moutai, had risen "too far, too fast". Zhengyang Shen, a Shanghai-based analyst at Northeast Securites commented. "The decline in Moutai has triggered selloffs in some of this year's best performing stocks." Which sounds an awful lot like another example of cascading selling....

DiMartino Booth Exposes The Fed's Biggest Fear

Former Federal Reserve insider Danielle DiMartino Booth says the record high stock and bond prices make the Fed nervous because it’s fearful of popping this record high credit bubble. DiMartino Booth says, “The Fed’s biggest fear is they know darn well this much credit has built up in the background, and the ramifications of the un-wind for what has happened since the great financial crisis is even greater than what happened in 2008 and 2009. It’s global and pretty viral. So, the Fed has good reason to be fearful of what’s going to happen when the baby boomer generation and the pension funds in this country take a third body blow since 2000, and that’s why they are so very, very intimidated by the financial markets and so fearful of a correction.”
# As a reminder, The Fed is normalizing the balance sheet, and as Yellen said last night, "so far so good". The Fed (since the end of September) has shrunk the balance sheet by 0.17%, or $7.3 Billion of a $4.5 trillion balance sheet...


# Why will the Fed not allow even a small correction in the markets? DiMartino Booth says, “Look back to last year when Deutsche Bank took the markets to DEFCON 1. Maybe you were paying attention and maybe you weren’t, but it certainly got the German government’s attention. They said the checkbook is open, and we will do whatever we need to do because we can’t quantify what will happen when a major bank gets into a distressed situation. I think what central banks worldwide fear is that there has been such a magnificent re-blowing of the credit bubble since 2007 and 2008 that they can’t tell you where the contagion is going to be. So, they have this great fear of a 2% or 3% or 10 % (correction) and do not know what the daisy chain is going to look like and where the contagion is going to land. It could be the Chinese bond market. It could be Italian insolvent banks or it might be Deutsche Bank, or whether it might be small or midsize U.S. commercial lenders. They can’t tell you where the systemic risk lies, and that’s where their fear is. This credit bubble is of their making.”
# In short, the Fed does not know what is going to happen, and according to DiMartino Booth, nobody does. DiMartino Booth contends, “I don’t think any of us know what the implications are for a $50 trillion debt build since the great financial crisis (of 2008). It is impossible to say. We have never dealt with anything of this magnitude.”
# On Bitcoin’s rapid rise in value, DiMartino Booth warns, “To me, Bitcoin is a reflection of panic. It’s a reflection of people trying to get money into a safe place knowing the major governments of the developed world have got their printing presses running 24/7. It is a reflection of anxiety in fiat currencies and the fact it’s not practical to go back to a gold standard. What scares me about Bitcoin is the central bankers are studying it to figure out how the blockchain works... They are going to be controlling our spending with blockchain technology that is being perfected in the crypto currency universe.”
# On gold and silver, DiMartino Booth says, “2017 is the record for quantitative easing (money printing) globally. We have never, not even in the darkest days of the financial crisis, central banks have never injected as much money as they have into the markets... I am not a gold bug, but we do know that in times of corrections that there is no place to hide in traditional asset classes that you can get at your Merrill Lynch brokerage. Gold and silver in the precious metals complex are the only places to hide and get true diversification and safety.”
# Full interview here (23 min)....

SocGen Predicts Market Crash, Bear Market For The S&P

While the charade of sellside analysts releasing optimistic, and in the case of Barclays and Goldman "rationally exuberant"previews of the year ahead...


Is a familiar, long-running tradition on Wall Street, rarely has the intellectual dishonesty and cognitive dissonance been quite so glaring: take Goldman, which while admitting that valuations have never been higher, and the upside case never more reliant on just one piece of legislation which has a significant chance of not passing (GOP tax reform for those unaware), Goldman still has to temerity to predict not only no bear market in the next three years, but goes so far as to suggest an "irrationally exuberant" target of 5,300 in three years. And as of this morning, the penguins are on full parade, with virtually not a single big bank predicting the market will drop in the coming year. Here are the latest S&P price targets, EPS forecasts and implied PE multiples, for the year ahead:
- Bank of Montreal, Brian Belski, 2,950, EPS $145.00, P/E 20.3x
- UBS, Keith Parker, 2,900, EPS $141.00, P/E 20.6x
- Canaccord, Tony Dwyer, 2,800, EPS $140.00, P/E 20.0x
- Credit Suisse, Jonathan Golub, 2,875, EPS $139.00, P/E 20.7x
- Deutsche Bank, Binky Chadha, 2,850, EPS $140.00, P/E 20.4x
- Goldman Sachs, David Kostin, 2,850, EPS $150.00, P/E 19x
- Citigroup, Tobias Levkovich, 2,675, EPS $141.00, P/E 19.0x
- HSBC, Ben Laidler, 2,650, EPS $142.00, P/E 18.7x
Good luck with all those 20x P/Es in a world in which rates are rising and central bank balance sheets will start contracting in one year. Luckily, there is the occasional honest bank, like Macquarie (whose Viktor Shvets has become one of our favorite commentators for his objective, no nonsence analysis) and, as of this morning, SocGen, whose strategist Roland Kaloyan has written a note which warns that with bond yields rising (see the crash in China overnight, where the Shanghai Composite tumbled the most in 17 months on the realization that rising rates is bad for stocks), there is effectively no upside left in stocks, which coupled with the prospect of a US economy recession in 2020 will "crimp returns in 2019" Furthermore, in light of the record vol shorts, SocGen jumps on the VIX-squeeze crash bandwaon, warning vol positioning could "strongly deteriorate the risk reward profile of equity markets." In not so many words: with little stock upside left, with the threat of rising interest rates slamming P/E multiples, with the economy in deep in late cycle, with equities trading at record valuations, with everyone short vol and just begging for a vol short squeeze, SocGen's advice is simple: get out now.
# Here is SocGen: We are less enthusiastic about equities heading into 2018. We do not see much upside on our major equity targets for the next 12 months. We expect stretched valuations and rising bond yields to limit equity index performances in 2018 and the prospect of a US economic slowdown in 2020 to further cramp returns in 2019. We also raise some concerns about the quantity of shorts on volatility, which could potentially strongly deteriorate the risk reward profile of equity markets. Specifically, with regards to the S&P, SocGen reports that US equities are now at, or rather about 100 points above, their fair value:
* The S&P 500 has reached our target for the end of this cycle (2,500pts) and is now entering expensive territory. Indeed, on all the metrics, US equities are trading at levels only seen during the late-90s bubble. Since Trump’s election, the US equity market has risen 24%, but only half of this came from earnings growth. The other half has been driven by P/E expansion. According to our calculations, the US equity market is already pricing in potential tax reform. The rise in bond yields and Fed repricing should be headwinds against further US equity rerating.
If that wasn't enough, SocGen also notes that its valuation model suggests "that upside on the S&P 500 is limited: the US equity market is already pricing in a rebound in growth and inflation. The rise in bond yields and Fed repricing should be a headwind against further US equity rerating." In practical terms, this means that SocGen is predicting that the S&P, which is already 100 points above the bank's year end target of 2,500, will tumble to 2,000, or more than 20%, before rebounding modestly to 2,200 just as the US economy succumbs to a recession, at which point all bets are off. And not just the S&P, but virtually all major European bourses are due for a bear market in the coming 12 months...


Here are some of the key arguments behind SocGen's bearish outlook, first a familiar discussion of the risk posted by the biggest vol short ever observed. Equity volatility, both realised and implied, has been edging ever lower for quite some time now. Being invested in a simple systematic short VIX future volatility has been strongly rewarding: +290% over the last two years. However, when the tide turns (VIX spikes), the drawdown can be significant. The quantity of short positioning on VIX open in the market (see right chart) would potentially amplify any spike of the VIX...


The risk of a VIX surge ties into the question of how the market's risk/return profile will be shaped in the coming year based on what the prevalent VIX level is: The risk /reward ratio as measured by the Sharpe ratio has been very attractive for US equities: good expected return supported by reasonable valuation and EPS growth, a very low Fed fund rate and an ultra-low volatility regime. At the current 12-month forward P/E, we factor in our Fed Fund scenario (2.25% by end-2018) and a different volatility regime. A change of VIX regime from 10% to 15% would push the US equity Sharpe ratio back to its historical average...


Then there is the already record stretched valuations, something even Goldman admitted earlier this week, with "US equities trading above their long-term average and at a level only seen during the dotcom bubble." US equities have not been in attractive territory valuation-wise for a while. Indeed, on all the main valuation metrics, US equities are trading above their long-term average and at a level only seen during the dotcom bubble. However, expected earnings growth for the next 12 months (12%) is below the 20y annual earnings growth average (14%)...


The last risk is that bond yields are going higher, forcing a contraction to PE multiples, as investors shift away from equities into bonds, as the dividend yield on US stocks at 2.0%, is now lower than the 10Y yield of 2.3%... Under our scenario, US Treasures will reach 2.70% at the end of 2018. This should be a headwind for equity markets. Indeed, our US equity risk premium is at 2.9%, one standard deviation below the long-term average . Any increase in bond yields would push the equity market further into expensive territory relative to bonds The dividend yield offered by US equities (2.0%) is already lower than the current US longterm bond yield (2.3%)...


Finally, SocGen points out something that few other analysts have admitted: half the S&P rally since the Trump election has been on the back of multiple expansion, with just 48% the result of earnings growth. Furthermore, as SocGen calculates, assuming tax reform passes, a decrease in the US tax from 35% to 20% as planned by Trump’s tax reform would theoretically boost earnings by 8.5%. The 12-month forward P/E has risen 12% over the last 12 months. In other words, contrary to conventional wisdom, more than 100% of Trump's tax reform is already priced in. Since Trump’s election, the S&P 500 has risen 24%. Only half of this performance has been driven by earnings growth; the other half is from P/E expansion. Assuming that analysts have not factored tax reform into their earnings forecasts, tax reform expectations have been the driver of P/E expansion. The S&P 500 index tax rate is currently 26.6%. Assuming that US companies generate 43% of their profits abroad (here) and pay 35% of their US profits on taxes (i.e. with no loopholes for US profits), the average tax rate outside the US would be 15.5%. A decrease in the US tax from 35% to 20% as planned by Trump’s tax reform would thus theoretically boost earnings by 8.5%. The 12-month forward P/E has risen 12% over the last 12 months...


Separately, turning to Europe, Socgen acknowledges the euro zone's economic recovery is in full swing but - in yet another bearish thesis - argues that the current valuations don't leave "much meat on the bone" and that the expected rise in the Euro could also weigh on exporters in particular, and European stocks in general. Additionally, with the European Central Bank set to progressively unwind its stimulus package, investors are increasingly wary of the amount of debt some companies have accumulated thanks to historically low interest rates. Cable group Altice, whose shares have collapsed more than 50% in the last 30 days due to concerns on its €50 billion euros pile of debt, and whose debt plunge has been seen by some as the catalyst for the recent junk bond swoon, is an example of what is likely to come, Societe Generale said. And while the French bank saw pockets of growth in Germany, France and in sectors such as financials, but warned that political risks are still present, notably in Spain with the Catalonia crisis and Italy which faces general elections in 2018...

Oh, and the UK too: "We also recommend staying away from the UK as Brexit negotiations are accelerating and several scenarios are possible: only a soft Brexit would be supportive for the FTSE 100. And yet, after all that, not even Socgen is willing to bite the bullet, and warn that ahead of what clearly is "a bear market is coming" call, investors should dump risk: so ingrained is the desire to run with the penguin herd, that even the most contrarian calls are doused in such a big layer of caveats, Arnold could easily driver his hummer on top of. To wit: "But then again, should we be outright bears? After all, we do see some value pockets in the market and some specific themes (M&A, consumer in the eurozone)"....

The Source Of The Next Crisis

In 1992, the CBOE hired Robert Whaley to develop a tradeable volatility product on equity index option prices. A year later, in 1993, the VIX was born when the CBOE started publishing real-time quotes on the implied volatility of the calculated S&P 500 index options. In those early days, I very much doubt Robert ever imagined his volatility index would someday be the cornerstone of some of the world’s most actively traded ETFs. In fact, for the next decade, no VIX instruments traded at all, and it wasn’t until 2004 that the VIX future was listed. And then, it took another five years before the first ETF based on those futures hit the exchanges. But what a ride it’s been. Nowadays, everyone knows the VIX index. It’s no longer some arcane index reserved for derivative traders, but instead a highly liquid, easily traded way to bet on future implied volatility. And I doubt most participants realize that last part. They are not betting on current volatility. They are not betting on future volatility. They are betting on future implied volatility. Remember that point. It’s important. We’ll come back to it later. During the 2008 Great Financial Crisis, implied volatility went through the roof...


It had spiked during other crises, like Long Term Capital Management and the Asian crisis, but nothing like 2008. The Great Financial Crisis saw VIX explode to over 90. It was truly mind boggling. The amount of future volatility the market was pricing in was unprecedented. No one trusted anyone, the financial system was imploding, and everyone was desperate to buy insurance. And then, just like that, like all crises, it passed. But in the ensuing years, the panic might have been over, but it wasn’t forgotten. And since buying VIX had been the home run trade of the last crash, investors kept going back to VIX long positions like Lindsay Lohan goes back to the bar. So even though the actual volatility of the stock market had declined to normal levels, investors kept paying too much for the insurance, betting that future volatility would once again rocket higher. This chronic overpricing led to one of the greatest trades of the past few decades. Sure, buying VIX before the 2008 spike was profitable. But you needed to be nimble and get the timing right. After all, it wasn’t up there for long. Yet, shorting VIX - that was the trade that kept giving. For the past 7 years, it has consistently been one of the most outstanding trades the financial world has ever seen. Don’t believe me? Look at this chart of the VXX ETF. The VXX has split countless times, so this chart reflects those splits. From 2009, when it was trading at a split adjust level of almost $120,000 per share (yup - you read that right - 120k), it is now trading at $32...


Just for kicks, I figured out the Sharpe Ratio of the VXX over the past year. It is -5.3! This means shorting VXX has been a consistent, and hugely profitable strategy, with surprisingly low draw-downs. Hedge fund managers do terrible unspeakable things for Sharpe Ratios of 2.5 or 3, so finding an asset with 5+ is probably awfully demoralizing. It’s no wonder everyone is shorting VXX. Which brings me to present day. For the longest time, I felt the concerns from the VIX were overblown. For years, market pundits have been bandying about charts meant to scare investors about the potential dislocation in the VIX market. I even wrote a piece called, The VIX Article no one will like. Yet the frenetic pace of VIX shorting has intensified to a level that frightens me. There is now $1.2 billion of market cap of the inverse VIX ETF XIV, with another $1.3 billion of SVXY (another inverse ETF). This is insanity. Robert Whaley never expected his little VIX product to be the epi-centre of a multi-billion dollar casino. To me, this just reeks of the old Warren Buffett quote, “what the wise do in the beginning, the fool does in the end.” I wonder how many of these short VIX investors understand the products they are buying? With VIX currently at 10, a simple move back to 20, the longer term average, would mean a doubling of the index, and if it was quick enough, could wipe out these two inverse ETFs.
For example, the XIV has a provision to wind down if the NAV declines by 80%. Think about that. One missile from Little Rocket Man aimed at Guam or Hawaii, what do you think VIX trades at? My guess is that opens at 25 and gets uglier from there. Or how about a simple flash crash? It’s not as if these markets are deep and liquid. If Central Banks step back (or heaven forbid pull out some pink tickets), it could easily cascade. Regardless, at these VIX levels, 80% moves are by no means unrealistic. What about the VIX futures? ETF managers use them to hedge their products, but there are also outright speculators. What’s the margin required on these instruments? The exchange minimum is $6,200 for the front month - representing 53% of the underlying, $4,000 for the next month - which works out to 31% and the far months are $2,500 - at just 17% of the total value of the contract. Again, this is not nearly enough. And shrewd brokers that understand risk, like Interactive Brokers, are adjusting for this reality. IB has decided to require margin for a 10% overnight move in the S&P 500. Harsh, but not out of the realm of possibilities. They have calculated that this would translate into a VIX level of 37. That means, IB clients need to put up more than 300% of the underlying value of the contract if they want to short VIX futures. Probably overkill, but given that few other brokers understand this risk, maybe justified. If we get a sharp move higher in VIX, there will be snowball effect.
If it is big enough, monster positions, like $2.5 billion of short VIX ETFs will have to be bought back in a hurry. And let me break it to you, there is no one large enough to take the other side of that trade. At least no one willing to do it without extracting many pounds of flesh first. Don’t forget, VIX futures are the forward levels of implied volatility, not actual volatility. VIX can trade at 50 while the S&P 500 index has an actual volatility of 15. There is nothing but arbitrageurs keeping this in line. Yet in a crisis, stupid shit happens all the time. How many new sellers will be there ready to takeover an upward spiraling VIX position? Let me break it to you, it’s going to be a lot higher than the current quote. Now there really isn’t anything new in my concerns. Yet another wanna-be-wise guy warning about the over popularity of the short VIX trade. Take a number and join the queue. But recently I was talking with MacroVoices’ Erik Townsend about my worries. After letting me stumble around citing my reasoning, Erik said, “you know Kevin, it’s actually much worse than that,” and here is where Erik’s deduction outshone my own, “in that unwind scenario you are describing, there is a high likelihood that some market participants will find they do not have adequate margin, and will find themselves in a negative equity position.”
I instantly understood the brilliance of Erik’s comment. Let’s say VIX rises 80%, and the XIV gives notice that they are closing the fund. They have another 20% of equity to buy back their short, but what if it skids through that? What if it costs them an extra billion dollars to get their short back in? Who is on the hook? Chances are, it’s the clearing houses. A VIX spike is dangerous not only for everyone that is playing in the VIX square, but for all market participants. Given the size of the VIX complex, it has the potential to destabilize the entire financial system on its own. If the move is abrupt and large enough, it will not only bankrupt many different parties, but will cause a ripple effect in other markets. Not only that, but chances are that a VIX spike will be the result of some other factor that markets will need to deal with, so the threat to the clearinghouse system from a VIX debacle will only exacerbate the problem. Erik instantly grasped the real worry. It’s not that a bunch of target managers will lose their fortunes that they have accumulated over the past half decade shorting VIX. No, the real worry is that they lose a whole lot more. Erik gets it. Interactive Brokers gets it. Guys like Jesse Felder who have been warning on this for a while get it.
I finally get it. Shorting VIX, at these low levels, in the size they are doing, is not only dumb, but crazily dangerous, not only to the parties trading it, but also to the stability of the entire financial system. I always emphasize that the next crisis won’t look anything like the past one. And when hedge fund managers make fancy presentations of the coming collapse in high yield credit or real estate, I usually just ignore them. After all, that’s what happened last time. It won’t be the same. But how ironic would it be, if the instrument that was the hands-down winner during the last crisis (VIX), ended up causing the next crisis because too many people were short it?

donderdag 23 november 2017

David Stockman; The Mother Of All Irrational Exuberance

You could almost understand the irrational exuberance of 1999-2000. That's because everything was seemingly coming up roses, meaning that cap rates arguably had rational room to rise. But eventually the mania lost all touch with reality; it succumbed to an upwelling of madness that at length made even Alan Greenspan look like a complete fool, as we document below. So doing, the great tech bubble and crash of 2000 marked a crucial turning point in modern financial history: It reflected the fact that the normal mechanisms of honest price discovery in the stock market had been disabled by heavy-handed central bankers and that the natural balancing and disciplining mechanisms of two-way markets had been destroyed. Accordingly, the stock market had become a ward of the central bank and a casino-like gambling house, which could no longer self-correct. Now it would relentlessly rise on pure speculative momentum, until it reached an asymptotic top, and would then collapse in a fiery crash on its own weight. That's what subsequently happened in April 2000 when the hottest precincts of the stock market, the NASDAQ 100 stocks, began a perilous 80% dive; and it's also what happened in the broader markets, including the S&P 500, in 2008-2009, when a thundering 60% plunge unfolded in a hardly a year's time. So with the market raging in self-fueling momentum at the 2600 mark on the S&P 500, we reflect back to the great dotcom crash for vivid reminders of what happens next.
That earlier meltdown is especially pertinent because in many ways today's stock market mania is far less justified than the one back then. Moreover, the dotcom version was also the first great central bank fueled bubble of modern times, a creature that market participants understandably did not fully grasp. Yet to its everlasting blame, the Fed's subsequent experiments in reflationary bailouts of the casino gamblers has only caused Wall Street's muscle memory to atrophy further. Indeed, after 30 years of Greenspan-style Bubble Finance and two devastating crashes, Wall Street is even more credulous today than it was on the eve of the tech crash. Back then, in fact, there was a considerable phalanx of Wall Street old-timers who warned about the dotcom insanity. Now almost no one sees this one coming...


Indeed, today's nutty forecast by Goldman Sachs that the S&P 500 will hit 3,100 by the end of 2020 makes Greenspan's earlier bubble blindness look clairvoyant by comparison. In hindsight, Alan Greenspan did see it coming early on, when he broached the "irrational exuberance" topic in passing during a speech in December 1996. Unfortunately, he has mostly been dinged for being allegedly way too early in making the call. In fact, we don't think he was making much of a call at all, he's was just musing out loud with no intention of reining-in the then rampaging bull. What he actually did was to conduct several gumming fests at subsequent Fed meetings and then diffidently raised interest rates a single time by a pinprick 25 basis point in April 1997. After that the Maestro (so-called) apparently forgot all about "irrational exuberance" even as that very thing soon began infecting the entire warp and woof of the financial system. In fact, Greenspan's fatuous amnesia became so pronounced that by the very eve of the dotcom crash in April 2000, he proved himself blind as a bat when it comes to central bank created bubbles. Said the Maestro to a Senate committee on April 8 when asked whether an interest rate increase might prick the stock market bubble: That presupposes I know there is a bubble.
I don't think we can know there is a bubble until after the fact. To assume we know it currently presupposes we have the capacity to forecast an imminent decline in (stock) prices". At least he got the latter part right. After the NASDAQ had risen from 835 in December 1996 to 4585 on March 28, 2000, or to an out-of-this-world 5.5X gain in 40 months, Greenspan wasn't even sure he was seeing a bubble! Accordingly, he apparently didn't have that capacity to predict an imminent decline, although the 51% crash to 2250 by the end of the year would seem to have been exactly that. Indeed, after unloading the above tommyrot at the tippy-top of the NASDAQ-100 bubble, Greenspan proved himself a clueless, pitiable fool when this giant bubble deflated by 81% over the next two years. In fact, the index ended up in September 2002 almost exactly where it had been when Greenspan spoke the words "irrational exuberance" and then moved along with the Fed's printing press at full speed, laiming there was nothing to see...

Bijschrift toevoegen

Still, back then you could almost have made a (lame) excuse for the Fed chairman's bubble blindness. The Maestro was operating in the early days of monetary central planning and wealth effects management, and its potent capacity to unleash rampant speculation in the financial system was not yet fully understood, even if the underlying monetary theory defied all the canons of sound finance. Moreover, in addition to rampant bubbles in the financial market, the Fed's money pumping during the 1990s did also seem to be producing some seemingly robust real world effects on main street and in the booming new tech part of the economy. And, in turn, these positive macroeconomic developments were unfolding in a global political/strategic environment that had suddenly become more benign that at any time since June 1914. Indeed, the outside world fairly buzzed with positive developments. These included the fact that the internet/tech revolution still exuded adolescent vigor, the government's fiscal accounts were nearing balance for the first time in two decades, the vast market of China was convincingly rising from its Maoist slumber and the Committee To Save the World (Greenspan, Summers and Rubin) had just rescued Wall Street with alacrity from the Long-Term Capital Management (LTCM) meltdown. Likewise, Europe was launching the single currency and expanding the single market.
In place of the Soviet Union, which had disappeared from the pages of history in 1991, Russia, its breakaway republics and the former Warsaw Pact (captive) nations were all bursting out of their statist chains and experimenting with home grown capitalism and reaching out to the west via rising trade and capital flows. In the US, the combination of the end of the cold war and the internet revolution contributed a doubly whammy to growth and prosperity. When defense spending fell from 7% of GDP on the eve of the Soviet collapse to under 4% by the year 2000, substantial domestic resources were released for private investment and a resulting substantial productivity uplift. In fact, real private nonresidential investment grew at 7.3% per year from the 1990 pre-recession peak through 2000. That was more than double the still respectable 3.4% rate recorded between 1967 and 1990; and causes the anemic 1.4% real growth of fixed investment between the pre-crisis peak (2007) and 2016 to pale into insignificance...


Notwithstanding all of these positives, however, the great bull stock market of the late 1990s ended-up getting way ahead of itself. That was especially the case during the next 18 months after the Fed's heavy-handed and somewhat panicked bailout of LTCM in September 1998 had confirmed to the newly energized casino gamblers that the Greenspan Put was most definitely operative. In the Great Deformation we tracked 12 of the highest-flying big cap stocks ("Delirious Dozen") during the period between Greenspan's December 1996 speech and the April 2000 dotcom bust. During this 40-month period, the combined market cap of these 12 leading momo stocks, including Microsoft, Cisco, Dell, Intel, Juniper Networks, Lucent, AIG, GE and four others, soared from $600 billion to $3.8 trillion. That eruption did indeed give the notion of trees which grow to the sky an altogether new definition. To wit, the total market cap of the Delirious Dozen grew by 75% per annum for nearly 4 years running; and the future outlook was claimed to be even more fantastic. For instance, as of mid-2000 Intel was valued at $500 billion and traded at 53X its $9.4 billion of LTM earnings. Yet it was argued that this nosebleed multiple was more than warranted because the company had grown its net income from $1 billion to $9.4 billion during the previous decade, and that there was nothing but blue sky ahead.
Here's the thing, however. Intel was and is a great company that, in fact, has never stopped growing. But during the 17 years since mid-2000, its net income growth rate has sharply slowed to just 1.79% per annum; and its $12.7 billion of LTM net income for September 2017 is valued at only 15.7X or $210 billion. In short, at the peak of the tech bubble Intel's market cap had vastly outrun its long run-earnings capacity. Even today it has only earned back 40% of its bubble peak valuation. Likewise, Cisco was valued at $500 billion in July 200 and sported a 185X PE multiple on its $2.7 billion of LTM net income. And it, too, has continued to grow, posting LTM net income of $9.7 billion for September 2017. Yet today's earnings are accorded only a 19X multiple after 17 years of 2.4% per annum growth; Cisco's current $181 billion market cap, in fact, sits at just 36% of its bubble peak. Even the mighty Mr. Softie has experienced pretty much the same fate. Back in mid-2000, it posted $8.3 billion of LTM net income and was valued at $600 billion or 72X. Today its net income has tripled to $23.1 billion, but its PE multiple has receded to just 29X. Stated differently, Microsoft's net income has grown at 6.1% per annum since the company vastly outran it true value back in early 2000.
Accordingly, its market cap gained just 0.4% per annum during the last 17 years. That is, it has taken one of the greatest tech companies of all time upwards of two decades to earn back its peak dotcom era bubble valuation. And when it comes to the industrial and financial conglomerate empire that Jack (Welch) built, the story is even more dramatic. GE's mid-2000 market cap of $500 billion stands at just $155 billion today; and its PE multiple of 60X has shrunk to just 22X. In short, that was irrational exuberance back then, and it did not take long for the vast quantities of bottled air in the market cap of the Delirious Dozen to come rushing out. By the bottom in September 2002, four of these companies had vanished into bankruptcy and the market cap of the survivors had imploded to just $1.1 trillion. That's a fact and you can look it up in the papers. In less than 30 months, $2.7 trillion of market cap had literally ionized. And these were the leading companies of the era. None of them, it might be noted, were valued at 280X shrinking net income, as is Amazon today; or at infinite PE multiples like much of the biotech sector and momo hobby horses like Tesla.
More importantly, the promising macro-economic situation at the turn of the century has given way to a world precariously balanced on $225 trillion of debt and the tottering $40 trillion Red Ponzi of China. Likewise, the benign geo-strategic environment of that era has long since disappeared into the madness of RussiaGate, endless wars in the middle east and Africa and the incendiary confrontation between the Fat Boy and the Donald on the Korean peninsula. Finally, after 30 years of rampant monetary expansion the central banks of the world have been forced to reverse direction and begin to normalize interest rates and balance sheets. And that now incepting and unprecedented experiment in massive demonetization of public debts is coming at a time when, after 8 years of business cycle expansion, the US, Japan and most of Europe are running monumental "full-employment" budget deficits. Even then, these reckless fiscal policies are happening in the teeth of a demographically driven tsunami of pension, medical and welfare spending. For the period just ended, the S&P 500 companies earned $107 per share on an LTM basis, or just 2% more than the $105 per share posted back in September 2014; and also only modestly more than the $85 per share recorded way back at the June 2007 pre-crisis peak.
Stated differently, on a trend basis S&P 500 companies have grown their earnings at 2.33% per annum over the last decade. How that merits a 24.3X PE multiple on today's 2600 index price is hard to fathom, let alone Goldman's 3100 target for 2020. Indeed, just to retain today's absurd PE multiple would require $130 per share of GAAP earnings by 2020 at the Goldman target price. That's right. By the end of 2020 we would be implicitly in the longest business expansion in recorded history at 140 months (compared to 118 months in the 1990s), Furthermore, the term structure of interest rates will be 200-300 basis points higher according to the Fed's current policies, while the US treasury will be running $1 trillion plus annual deficits and experiencing recurring debt ceiling and financial crises. Even then you would need 7% annual earnings growth to hold onto today's 24.2X PE multiple at the Goldman S&P 500 target. As we said, relative to today's casino madness and the Goldman fairy tale hockey stick, Alan Greenspan circa April 2000 looks like a model of sobriety by comparison. So if that was Irrational Exuberance back in April 2000, what we have now is surely the mother thereof....

Deutsche Asks A Stunning Question: "Is This The Beginning Of The End Of Fiat Money?"

One month ago, Deutsche Bank's unorthodox credit analyst, Jim Reid published a phenomenal report, one which just a few years ago would have been anathema in the hushed corridors of high finance as it dealt with two formerly taboo topics: is a financial crisis coming (yes), and what are the catalysts that have led the world to its current pre-catastrophic state, to which Reid had three answers: central banks, financial bubbles and record amounts of debt...



Just as striking was Reid's nuanced observation that it was the fiat monetary system itself that has encouraged and perpetuated the current boom-bust cycle, and was itself in jeopardy of becoming extinct when the next megacrash hits: We think the final break with precious metal currency systems from the early 1970s (after centuries of adhering to such regimes) and to a fiat currency world has encouraged budget deficits, rising debts, huge credit creation, ultra loose monetary policy, global build-up of imbalances, financial deregulation and more unstable markets. The various breaks with gold based currencies over the last century or so has correlated well with our financial shocks/crises indicator. It shows that you are more likely to see crises/shocks when we break from hard currency systems. Some of the devaluation to Gold has been mindboggling over the last 100 years...


The implications of this allegation were tremendous, especially coming from a reputable professional who works in a company which only exists thanks to the current fiat regime: after all, much has been said about Deutsche Bank's tens of trillions in gross liabilities, mostly in the form of various rate derivatives, backed by hundreds of billions in deposits and, implicitly, the backstop of the German government as Deutsche Bank discovered the hard way one year ago. However, what shocked most readers was that at its core, Reid's report was dead accurate, and as Reid writes in a follow up report published this morning, it is the topic of the fiat system itself as potentially the weakest link in any future crisis that generated the most debate. In the report titled, "The Start of the End of Fiat Money?" Reid writes that "as we road-showed the document a theme that had minor billing in the report started to gain more and more prominence in the discussions and as such we wanted to expand upon it in this short follow-up thematic note. The basic premise is that a fiat currency system - the likes of which we’ve had since 1971, is inherently unstable and prone to high inflation all other things being equal. However, for the current system to have survived this long perhaps we’ve needed a huge offsetting disinflationary shock.
We think that since around 1980 we’ve had such a force and there is evidence that this influence is now slowly reversing." And here comes the shocking punchline: not only does Reid concede that the fiat system "may be seriously tested over the coming decade and ultimately we may need to find an alternative" but that one such alternative is none other than cryptocurrencues,  bitcoin, ethereum and so on. Which, while it may be a surprise to institutional investors appears to have been all too obvious to buyers of cryptocurrencies. If we’re correct, the fiat currency system may be seriously tested over the coming decade and ultimately we may need to find an alternative. This is not necessarily a story for the next few months or quarters but we think the trend reversal is already slowly in place. Maybe we can explore future alternatives to the current monetary system in a second part sometime in the future. Cryptocurriencies are all the rage at the moment and are as much about blockchain as anything else but there could be an increasing desire for alternative medians of exchange in the years to come if we are correct. Below we excerpt some of the key observations from Reid's note:
*) The Future of Money Part 1; The Start of the End of Fiat Money? In “The Next Financial Crisis” we suggested how China's fairly sudden integration into the global economy at the end of the 1970s and a very favourable once-in-alifetime shift in demographics from around 1980 onwards could have contributed to the modern boom/bust culture that has made financial crises more regular in recent decades. The argument is based around a view that a positive labour supply shock from China and developed countries' demographics between 1980-2015 has allowed inflation to be controlled externally as the surge in the global labour supply at a time of rapid globalisation has suppressed wages. With inflation controlled externally it has allowed governments and central banks the luxury of responding to every crisis and shock with more leverage, loose policy and latterly more and more money printing. Its not usually this easy as inflation would have normally increased with such stimulus and credit creation. It could be argued that this external disinflation shock has perhaps ‘saved’ fiat currencies after the runaway inflation of the 1970s in the immediate aftermath of the collapse of the Bretton Woods quasi Gold Standard from 1971 onwards. If this theory is correct then any reversals in this demographic super cycle could spell problems for the fiat currency system. Under this scenario inflation would pick up externally due to working age populations no longer rising and labour pricing power returning. Central banks and governments which have ‘dined out’ on the 35 year secular, structural decline in inflation are not able to prevent it rising as raising interest rates to suitable levels would risk serious economic contraction given the huge debt burden economies face. As such they are forced to prioritise low interest rates and nominal growth over inflation control which could herald in the beginning of the end of the global fiat currency system that begun with the abandonment of Bretton Woods back in 1971.
# Fiat currencies and inflation; For virtually all of financial history up to the collapse of the Bretton Woods system in 1971, most currencies were backed by precious metals for the vast majority of times. Over the preceding century or so these systems periodically broke down for many countries due to wars and notably during the Depression years of the 1930s. However, countries generally reverted to some kind of precious metal fix after experiencing high inflation in the years where they suspended membership. Figure 1 shows our global median inflation index back over 800 years and then isolates the period post 1900 where inflation exploded relative to long-term history...


Figure 2 then shows this in year-on-year terms and as can be seen, in the 700 years before the twentieth century inflation and deflation were near equal bedfellows with only a gradual upward creep in inflation as new precious metals were mined or governments periodically punched holes in existing coins and thus slightly debasing the currency...


As someone that has studied economic history it always amuses me to hear that we live in times of extremely low inflation when history would suggest these are relatively high inflation times. Indeed a look at the right hand chart of Figure 2 shows we haven’t had a single year of negative (median) global inflation since 1933. What has happened though is that we saw a 35 year disinflationary period start in 1980 that took inflation down from the extremes at the start of that decade to what we think will be the secular lows around the middle of this decade.
# Inflation since 1971, a loss of control and then a positive disinflationary shock; In the first decade of global fiat currencies post 1971, global inflation saw one of its biggest climbs in history. Although the oil shocks were partly to blame, the fact that the shackles of the Bretton Woods system were removed and countries were freer to borrow and find ways of liberalising finance and credit surely contributed to the inflation surge. Gold saw an annualised nominal return of 32.2% p.a. in the 1970s way above the long term return of 1.97% p.a. from 1800. However a miracle occurred post 1980 which many have attributed to the Volker Fed taming the inflationary dragon. Clearly their tighter policies helped but was the global structural story providing phenomenal disinflation tailwinds from this point and is it now slowly reversing?
# China and Developed Country demographics to the rescue;  We think that the effective global labour force exploded from around 1980 due to natural global demographics and China opening up its economy to the outside world at the end of the 1970s. Figure 3 shows the 15-64 year olds (working age population proxy) in the More Developed Regions + China where the second bars repeat the exercise with China zeroed before 1980 to reflect its virtually closed economy before this point and the effective surge in the global labour supply thereafter. So we first see the impact in 1990 on this graph...


Obviously, this is highly simplified and in a globalised world we should probably include more countries than China as various lower labour cost nations have transformed from relatively closed low income countries to more developed globalised ones. However, China dwarfs all these by its size. It’s also simplistic to include all of the working age population increase from China in one decade as we do in the chart. It should probably be spread out over time but it’s hard to assess the increments that they should be added over the last 35 years. The disinflationary journey would be the same though. At a developed world level there's little doubt that labour's share of GDP has declined over the last few decades. Figure 4 shows this decline for a selection of G20 countries from 1980. In addition Figure 5 shows real wage growth (YoY change) over the last few decades for a selection of the largest countries around the world. As can be seen in the two decades we have data for prior to 1980, real wage growth was much higher than the post 1980-period. It's interesting that China's wage growth over the period was much higher which fits with our thesis that the EM workers that integrated into the global economy benefitted most from this globalisation period...


# So will a falling working age population increase inflation? As can be seen in Figure 3 above, the peak of the ‘working age population’ in the MDW plus China occurred around the middle of this decade. Going forward the supply of labour will in aggregate start to decline after rising for the last three and a half decades. While the pace of decline will be slow, the fact that it’s not increasing at the rapid pace of the last 35 years surely must have an impact on labour costs. If economic growth simply increases at trend over the next few years and decades then all other things being equal a flat to declining labour force should bring upward pressure on wage costs.
# Would fiat currencies survive if labour’s share of GDP reversed? In terms of addressing inequality and the increasing gap between capital and labour, higher wages would undoubtedly be good news. However the problem for the current global monetary system is that over the last 45 years it has relied on governments and central banks being able to turn on the stimulus spigots at the drop of a hat when a crisis has come. This has enabled each crisis to be dealt with via increasing leverage rather than creative destruction type policies. For this to be possible you’ve needed an offset to such stimulus to prevent such policies being inflationary. Fortunately (or unfortunately if you believe it’s an inherently unstable equilibrium) the external global downward pressure on labour costs ensured that this has happened. So what would happen to the global monetary system if labour costs started to reverse their 35 year trend? If central banks had their current mandates of keeping inflation around 2% then they would be duty bound to tighten policy more often regardless of the external environment. However, such an outcome is probably unrealistic given how much debt there is at a global level.
Governments would surely first change their mandates to allow higher inflation or look to reduce their independence rather than allow interest rates to rise to economically uncomfortable levels given high debt levels. Ultimately, if and when labour costs rise at the margin rather than fall at the margin, we will likely have a much more difficult environment for policy makers and in a democracy where politicians have to be elected it is likely that inflation will be the casualty. If we get higher trending inflation then bond yields would be very vulnerable, especially relative to current near record (multi-century) lows. Given the near record level debt burdens around the world, it is likely that central banks would be forced to buy more securities again to ensure that yields stayed comfortably below nominal GDP. This would likely lock in higher inflation as you would have negative real yields, very loose financial conditions and higher wages. Eventually, it’s possible that inflation becomes more and more uncontrollable and the era of fiat currencies looks vulnerable as people lose faith in paper money.
Once the value of debt has been eroded the debate would likely be live as to what replaces fiat currencies as surely the backlash would be severe against the system that allowed us to get to such a situation. Although the current speculative interest in cryptocurrencies is more to do with blockchain technology than a loss of faith in paper money, at some point there will likely be some median of exchange that becomes more universal and a competitor of paper money. It’s far too early to fully speculate on the future of money but if there is demand we will look to add a part 2 to this series where we look at the alternatives and perhaps a more in-depth look at cryptocurriences going forward.
# What if people retire later? If populations extended their retirement well beyond 65 years old then the working age population will get a boost. However, while this is undoubtedly happening, in democracies this is proving incredibly hard to legislate on a big enough scale to seriously impact the overall natural demographic story. Maybe one day retirement ages will go up significantly and change the argument but this probably requires a major global shock and subsequent rewriting of contractual agreements between governments and their populations.
# Conclusion; We would argue that fiat currencies are the rarity in financial history and are always associated with higher inflation. Perhaps the now 46 year experience with fiat currencies can be broken down into two periods; 1) The 1970s where inflation rose around the word at the fastest pace on record; and 2) the last 35 years where inflation has always been positive at a global level but has progressively fallen largely due to demographics, China and the associated globalisation trend. Given we know that demographics are now slowly turning, it’s possible that a new era is slowly emerging towards higher wages, which will perhaps be encouraged by the rise in populism. As such, will fiat currencies survive the policy dilemma that the authorities will experience as they try to balance higher yields with record levels of debt? That’s the multi-trillion dollar question for the years ahead....

Kevin Muir; EU Shadow Rate Madness

The other day I stumbled upon this great tweet from Holger Zschaepitz, the senior editor of the financial desk of the German newspaper, Die Welt...


I have often said the last thing any equity bull should hope for is a strong economy, especially one accompanied with an uptick in inflation. A near perfect nirvana environment would be one with low inflation and, decent, but not exploding growth. And low and behold, this is exactly what Europe is experiencing...


Inflation is stumbling just enough for the ECB to err on slowing the pace of their tapering, but meanwhile, the economy is ticking slightly above expectations. What’s the result of this combination? Quantitative easing for slightly longer. Nothing like the Central Bank goosing financial markets higher with more blue tickets. If the economy and inflation were both running a percentage point higher, what do you think would be the ECB’s response? They would be tapering (and maybe even tightening) at a much quicker pace. So ironically, a slightly below target economy could well be the absolute best environment for stocks. When Holger describes the current EU economic numbers as Goldilocks, I must admit, I concur completely.
# Shadow rates; Over the past decade, as more and more countries have adopted ZIRP (zero interest rate policy), with some even pushing down to NIRP (negative interest rate policy), economists have struggled with a way to measure the degree of accommodation that their unconventional policies were exerting on the economy. First introduced by Fisher Black in 1995, the concept of a shadow rate gained widespread adoption in days following the 2008 Great Financial Crisis. There are various models, with the Wu-Xia model gaining prominence in the United States. However, the Reserve Bank of New Zealand has created models for a wider swath of countries, and these series are rising in popularity. Although the math for these shadow rates is complicated, the important thing to realize is that if rates are positive, shadow rates are essentially the same as the actual rate. But when rates hit zero (or below), the shadow rate measures the theoretical negative rate. Even though US rates never went below zero in the last cycle, the shadow rate was deep into negative territory at the height of Bernanke’s quantitative easing madness. If we combine inflation to these short-term shadow rates, we get a crude sense of the real rate. This is the amount that monetary policy is set above or below inflation. Let’s have a look at these variables for the European economy over the past couple of decades...


From 1997 to 2008, the real rate drifted around between 2% and -0.50%. But then look what happened after 2008. Real rates broke down and fell deeply into negative territory. If you look closely at the white line, the shadow rate, you will notice that it wasn’t until 2011 that it broke zero. But then over the next half dozen years, the shadow rate went from 0% all the way down to minus 8%! Think about that for a second. According to this model, the actual short-term rate is minus 8%! I know I am repeating myself, but it bears repeating. That’s nuts. At the time, inflation was basically zero, so the real rate was also minus 8%. Nutball Mario, right? Well, not so fast. Here is the same graph for the United States...


Look closely at the period around 2011. Although the shadow rate only declined to minus 5%, inflation was running positive. Therefore in the depths of the quantitative easing, the real rate bottomed at minus 8%! Coincidence? What has happened to the US stock market since that crazy monetary extreme? It’s rocketed higher. I know there are differences between the US and Europe, and there is much more than just monetary policy to factor into an investment decision, but sometimes it’s just this easy. Monetary policy acts with a long lag. In the years following Bernanke’s stimulus, investors were skeptical of the American stock market rally, but it kept going, and going, and going. My guess is that the same will happen with Europe today. They are just a few years behind the Americans.
# Just like Japan; The current situation in Europe reminds me a lot of Japan from a couple of months ago. I remember the Nikkei breaking out, and even though it was a clean chart pattern, tons of investors had all sorts of reasons why Japanese stocks wouldn’t rise...


The rally was quiet, and filled with skepticism. Well, I suspect there is a good chance the same thing will happen in Europe...


So don’t bother sending me all the reasons why Europe can’t rally, it will only make me think it looks all the more like Japan. And for those of a more bearish persuasion, I think long European / short US stocks makes tons of sense in here. You have one Central Bank that refuses to ease up on the accelerator, while the other is looking to raise rates more quickly than the market has priced in. If for no other reason than that, it’s worth having a gander at the trade....