Archive - May 5, 2013 - Story

The Federal Reserve's extreme monetary policy has done nothing but repress 'safe' assets to the point of making 'risky' assets relatively cheap. This is of course not the case were you to isolate each risky or safe asset and consider its value standalone. Choosing stocks over bonds because "well, what is the alternative?" is akin to the red-pill/blue-pill choice from The Matrix and the reflationary 'normal' that we are supposed to believe in is what 'apparently' justifies a 1.7x rise (12%!) in multiples since QE4EVA was announced. During that same period, consensus earnings expectations have plunged (merely pushed out one more year for the renaissance) and global trade and growth has collapsed. However, while we have shown many divergences from reality in the past, it is the manic/depressive difference between inflation expectations and stock valuations (implicitly supported by reflation) that is the clearest example of the short-term triumph of hope over reality.

Back in December we pointed out the patently obvious: in the absence of an external rebalancing mechanism, i.e., a free-floating currency, the only option for the bulk of the periphery to regain competitiveness was through ongoing wage collapse and persistent localized depression. Five months later, just as predicted, Europe is in a worse shape than ever before, not only in those non-core countries where wage deflation is accelerating, but the weakness has fully spilled over to the core. Of course, none of this is rocket science, and has been quite obvious to anyone who thought for more than 15 seconds about the "future" of the Eurozone. What is surprising, however, is that with every passing day even the most staunchest supporters of the euro, in this case Oskar Lafontaine, German finance minister in 1998-1999, under whose supervision the euro was launched, are becoming the most vocal Euro-skeptics an unsound, political (capital) currency can no longer buy. Here is the Telegraph's Ambrose Evans-Prithard dissecting the conversion of the latest europhile turned euroskeptic.

The clear message from the doctors this week is that they plan to keep administering the pills, in larger quantities if necessary, until the donkey turns into a butterfly. Citi's Matt King reminds us though that they failed to mention the associated risk that the donkey dies of the side effects first (apart, that is, from Dr Osborne, who urged the other doctors to ignore any such possibility entirely). For investors, King notes the immediate implication is that the central banks would like the party in any and all risk assets to carry on. This raises the spectre of a rally back to 2007 valuations, made all the more dizzying this time by the lack of any accompanying justification in the state of the economy. And yet we have played this game before, and it does not end well. Ideally at some point the central banks realize that the donkey is just a donkey, realize that their sole focus on their inflationary (& employment) mandate is blinding them to the risks of asset price inflation. To paraphrase a certain former CEO, when the central bank music is playing, investors are compelled to get up and join the party. Yet we know how that one ends...

Last week at its regular policy-setting meeting, the Federal Reserve affirmed that it is prepared to increase its monthly purchases of Treasuries and mortgage-backed securities if things don’t start looking up. In all, the Fed has pumped more than a half trillion dollars into the economy since announcing its latest round of “quantitative easing” (QE3) in September 2012. With no recovery in sight, where’s all this money going? It is creating bubbles. Bubbles in the housing sector, the stock market, and government debt. In the meantime, real families are suffering. We are certainly not in a recovery. We don’t see the long unemployment and soup kitchen lines like in the Great Depression, but that’s just because the lines are electronic now. We know what the real solution is: allow the marketplace to work. Restore sound money to the economy and the American people. Sound money is the bedrock for prosperity and the best check on big government and crony capitalism.

What is "obvious" to most participants is that the stock rally is fueled by central bank liquidity and quantitative easing, and since there is no limit in sight to these policies, there is also no limit to the stock market running higher. It is also "obvious" that betting against this trend is an excellent way to lose money, so the number of people shorting the market dwindles with each push higher. Every trader wants to short the market after it becomes obvious the trend has reversed. But since there are so few shorts left, the decline (should one ever be allowed to happen) might not be orderly enough for everyone to pile on board. More likely, the train will leave with few on board and the initial drop will leave everyone who was convinced the uptrend was permanent standing shell-shocked on the platform with margin calls in hand. The conclusion? What is "obvious" to those embedded in the conventional, MSM/state-manufactured worldview is not the same as what is obvious to those outside the asylum.

We toyed with titling this post "Lies, Damned Lies, And Chinese Statistics" but perhaps that is a little harsh, though one glance at the chart below and one instantly comprehends the efforts that are being undertaken to 'show' the world that China's transition is on target (and crumbling into collapse). As we recently noted, it is actually unlikely that China can complete this transition to organic (as opposed to investment-led) growth (with moderate growth the exception not the rule), and China's recent trade data does not pass the smell test. As GREED & Fear's Chris Wood notes, with the Hong Kong trade data being released last week, it is worth noting a growing discrepancy between the data on China’s exports to Hong Kong reported by mainland’s customs department and the corresponding data on Hong Kong’s imports from China reported by Hong Kong’s Census and Statistics Department in March. Such inconsistency in China’s export numbers relative to the imports data from its trading partners has generated growing speculation about the credibility of China’s trade figures. Various explanations have been put forward (below) but the divergence would seem far too large to be simply explained by "different statistical methods" as the Chinese government's official line notes.

With equity valuations no longer levitating but in a different, 4th dimension altogether, and credit spreads compressing dramatically (and unreasonably)... It is in situations like these, when the crash comes, that the proverbial run for liquidity forces central banks to coordinate liquidity injections. However, something tells me that this time, the trick won’t work. Over almost a century, we have witnessed the slow and progressive destruction of the best global mechanism available to cooperate in the creation and allocation of resources. This process began with the loss of the ability to address flow imbalances (i.e. savings, trade). After the World Wars, it became clear that we had also lost the ability to address stock imbalances, and by 1971 we ensured that any price flexibility left to reset the system in the face of an adjustment would be wiped out too. From this moment, adjustments can only make way through a growing series of global systemic risk events with increasingly relevant consequences. Swaps, as a tool, will no longer be able to face the upcoming challenges. When this fact finally sets in, governments will be forced to resort directly to basic asset confiscation.

In the aftermath of last night's second attack in two weeks by Israel on Syria, the immediate response has so far been muted, with Syria condemning the aggression as an act of war. According to UPI, Syria "vowed to retaliate after an apparent Israeli airstrike on the capital Damascus early Sunday. A government official said on CNN the attack on a military research facility was "an act of war" that the government would not take lightly. "Syria is a country that does not accept insults and it doesn't accept humiliation," said Omran Zoabi, Syria's information minister. Zoabi added the attack had opened "a wide door for all possible options." It remains to be seen what, if any, option Syria will take or if it will merely jawbone toothlessly, inviting further unrequited air-based incursions into its territory. Most likely any response will need the preapproval, and the assistance, of Putin. Incidentally, the only response so far has come from Israel. As Stratfor reports, citing Israel News, the airspace in northern Israel has been closed until May 9 due to an Israel Defense Forces directive issued May 5. Which means the only planes flying in north Israel, which borders Syria through the Golan Heights, would be military.

While GBP jumped and the world celebrated the UK's recent avoidance (for now) of a triple-dip recession (defined on GDP as opposed to reality), the situation in the island nation appears to be going from bad to worse. As Carney takes over the reigns of this once mighty nation he faces a country deeply divided. As the BBC reports, while London real estate prices smash old records, a stunning one-in-five households borrowed money or used savings to cover the costs of food in April. This is the equivalent of five million households unable to fund their food via income alone. Over 80% of these people are concerned about rising food prices (just as print-meister Carney is about to go 'Abe' on them) and almost 60% find it difficult to cope on their current incomes. The director of the consumer group 'Which?', noted that "many households are stretched to their financial breaking point," as "families face a cost of living crisis." While equity and real estate prices hit all-time highs, the opposition sums up the country's feeling, "this incompetent government needs to wake up to the human cost of their failed economic policies."

Financial markets operate on a number of implied assumptions about growth, policy direction and other factors. Experience tells us that these assumptions often turn out to be erroneous. A modern economy is an incredibly complex entity that involves millions of transactions every day. The notion that this vast and largely self-governing system can be controlled through tools such as government spending and/or an increase in the quantity of money is - to say the least - bizarre. A flood is rarely a cure-all solution to a drought; it just creates new problems for an already suffering population. From 2002 to 2007, we witnessed a massive attempt by central banks to manipulate interest rates and currency exchange rates. The consequences of this action came due in 2008-2009. Criminal psychologists have long known that villains frequently return to the scene of their crime—in the case of western policymakers, they seem to be looking to finish off a caper that went badly wrong at the first attempt. The end result for the broader community is unlikely to be pretty.

If you thought that Baupost's Seth Klarman would be the next to join twitter, #timestamp his minute-holding trades, ignore the money-losing ones, trumpet his winners, always make money, scream at all those who don't agree with his "strategy", and otherwise become what is known these days as a (momentum) investor, we have some bad news: it's not happening. Here's why.