Gluskin Sheff's David Rosenberg exclaims we are currently are witnessing the Potemkin rally (the phrase Potemkin villages was originally used to describe a fake village, built only to impress). The term, however, is now used, typically in politics and economics, to describe any construction (literal or figurative) built solely to deceive others into thinking that some situation is better than it really is. Ben Bernanke, recently proclaimed “The Hero” by Atlantic Magazine, is the “Wizard of Potemkin.” Since 2009 Bernanke has engage in massive monetary experiments. These experiments lead to future dislocations. There is no doubt that the Fed wants inflation. The problem is they may get more than they ask for. We are currently witnessing the slowest economic recovery of any post-WWII period. However, It is important to challenge your thought process. Read material that challenges your views. Here are David's rules...
It is hard to make sense of the markets these days. For instance, gold showed no support while the geopolitical situation in Asia deteriorated, Japan embarked in the mother of all monetization programs, and a member nation of what is supposed to be a monetary union was imposed controls on the movement of capital. Or take the case of the Euro, which jumped from $1.2750 to $1.2950 on the day of one of the most confusing and embarrassing press conferences the president of its central bank ever gave. However, in a faraway land, where there is no shadow banking, leverage or even capital markets, economic fundamentals still hold, which can help us, inhabitants of the developed world, visualize a dynamics lost in the shelves of our collective memory. The land we are referring to is Argentina, but not Argentina of 2001. Today, we want to write about Argentina of 2013, and no, we will not discuss their legal battles with Mr. Singer.
Over the past four years one of the dominant "deflationists" has been Gluskin Sheff's David Rosenberg. And, for the most part, his corresponding thesis - long bonds - has been a correct and lucrative one, if not so much for any inherent deflation in the system but because of the Fed's actual control of the entire bond curve and Bernanke's monetization of the primary deflationary signal the 10 and certainly the 30 Year bond. The endless purchases of these two security classes, coupled with periodic flights to safety into the bond complex have validated his call. Until now.
It would appear that even though the relative dovishness of the FOMC has increased, a realization that the party has to stop sometime is dawning on the PhDs - though for now, the printing will continue until morale improves...
- SEVERAL FOMC PARTICIPANTS SAID EASING MAY PROMPT EXCESSIVE RISK
- MANY FOMC PARTICIPANTS VOICED CONCERN ABOUT RISKS OF MORE QE
- SEVERAL ON FOMC SAID FED SHOULD BE PREPARED TO VARY PACE OF QE
- FOMC PARTICIPANTS SAID ECONOMY WAS ON 'MODERATE GROWTH PATH'
- SEVERAL FOMC PARTICIPANTS SAW IMPROVED U.S. CREDIT CONDITIONS
- A NUMBER OF FED OFFICIALS SAID TAPERING QE MAY BECOME NECESSARY
Pre-FOMC: ES 1521.00, 10Y 2.01%, EUR 1.3337, Gold $1580, WTI $94.18
After trending gently higher for the first half of the week, the euro has been sold to new three week lows in response to the disappointing Q4 GDP figures. The GDP figures are of course backward looking and more recent data, such as the PMI figures and German factory orders suggest the regional economy is stabilizing here in early Q1.
There is a middle step to go from the GDP figures to the euro and that is the interest rate channel. There has been some speculation that the passive tightening of the euro area financial conditions (including the shrinking of the ECB's balance sheet) and the strength of the euro would prompt the ECB to cut the refi rate later in Q1. The poor GDP readings bolster such expectations and this can be seen in short-term interest rates. The March Euribor futures contract is now implying 0.24% rate, having matched the lowest rate since Jan 23, or before the early repayment of LTRO I was announced.
Following yesterday's G-7 announcement which sent the USDJPY soaring, and its embarrassing "misinterpretation" clarification which undid the entire spike, by an anonymous source in the US who said the statement was in fact meant to state that the Yen was dropping too fast and was to discourage "currency wars", it was only a matter of time before another G-7 country stepped into the fray to provide a mis-misinterpretation of the original G-7 announcement. That someone was the BoE's outgoing head Mervyn King who at 5:30 am eastern delivered his inflation reporting which he said that "it’s very important to allow exchange rates to move," adding that "when countries take measures to use monetary stimulus to support growth in their economy, then there will be exchange rate consequences, and they should be allowed to flow through." Finally, King added that the BOE will look through CPI and relentless UK inflation to support the recovery, implicitly even if it means incurring more inflation.
The main events of this week, monetary policy meetings at the BoE and the ECB on Thursday, are not expected to bring any meaningful changes. In both cases, banks are expected to keep rates on hold and to hold off on further unconventional policy measures. While significant economic slack still exists in the Euro area, and although the inflation picture has remained relatively benign, targeted non-standard policy measures are more likely than an interest rate cut. As financial conditions are already quite easy in the core countries, where the monetary transmission mechanism remains effective, the ECB’s first objective is to reverse the segmentation of the Euro area’s financial markets to ensure the pass-through of lower rates to the countries with the most need for further stimulus.
How does one of the best strategists view the world as we close the page on 2012, and look toward 2013? Find out with the help of these 35 charts.
What causes hyperinflations? The answer is: Quasi-fiscal deficits (A quasi-fiscal deficit is the deficit of a central bank)! Why have we not seen hyperinflation yet? Because we have not had quasi-fiscal deficits! Essentially, hyperinflation is the ultimate and most expensive bailout of a broken banking system, which every holder of the currency is forced to pay for in a losing proposition, for it inevitably ends in its final destruction. Hyperinflation is the vomit of economic systems: Just like any other vomit, it’s a very good thing, because we can all finally feel better. We have puked the rotten stuff out of the system.
While many believe that with the output gap so wide that inflation is not an immediate threat, longer-term, as UBS notes, excessive money printing could indeed generate inflation and that inflation expectations are unusually volatile and could quickly be dislodged. This inflation hedges are a very valid concern. An oft-cited reason for owning stocks is that they have an implicit inflation hedge, however, just as with many market myths, UBS finds that, in fact, equities do not look like a compelling hedge against rising inflation. Indeed, they provide an appropriate hedge to rising inflation only in a limited number of cases. In short, equities provide only a partial hedge – one which works only for small positive inflation shocks.
N as in "Nominal". Nominal GDP targeting, the latest burlesque of monetary fiction. But first things first. There is a land, where people calculate a "potential GDP". How do they do that? By simply extrapolating trends. Potential GDP is "the level of economic activity achievable with a high rate of use of its capital and labor resources". In the past, the differences from observed GDP were not very large, though now we are growing "below trend". But what if that trend has changed? With a flawed measurement of economic activity, leading to an imaginary output gap, what else might our economic elite come up with? Stagnating real GDP and high unemployment are no fun. After exhausting every traditional and non-traditional tool of monetary and fiscal policy, what else could be done to make that GDP grow? Nominal GDP equals real GDP plus inflation. So if real GDP doesn't want to grow... Eureka! you just have to cause more inflation, and nominal GDP will obediently join its potential GDP. Except for one little error of judgment: if elevated inflation led to wealth creation and jobs, Zimbabwe would be the richest country on earth. As real incomes of US employees have stagnated for more than a decade, rising prices would either lead to falling volumes, or force households further into debt. Also, how would this be different from a communist command-style economy?
The good news this morning is that the 2nd estimate of the third quarter (3Q) GDP was revised up from 2.0% initially to 2.7%. This is up sharply from the 2Q print of 1.3%. However, the combination of rising levels of unsold goods (inventory), slowing sales growth and declining incomes all point to weaker GDP growth in Q4 and into the early quarters of 2013. Look for GDP growth in the 4Q to decelerate to 1.5% to 1.7%. While there is currently not an official recession in the U.S. economy, as of yet, the details of the current economic growth are not ones of robust strength. If we are correct in my assumptions the economic underpinnings will continue to negatively impact fundamental valuations as profit margins continue to be compressed. While most of the media, and mainstream analysts, continue to focus on the state of the economy from one quarter to the next - the trend of the data clearly shows the need for concern. Of course, this also why Bernanke is already considering QE4. As we stated previously, while economic growth did pick up this quarter it is the makeup, and more importantly the sustainability, of that growth is what we need to continue to focus on.
We remain in the throes of a secular era of disinflation. We also are in a long-term period of sub-par economic growth and below-average returns. This has become so well entrenched that U.S. pension plans now have more exposure to bonds than to stocks, as we highlighted two weeks ago. Look, this is not about being bearish, bullish or agnostic. It's about being realistic and understanding that in our role as market economists, it is necessary to provide our clients with information and analysis that will help them to navigate the portfolio through these stressful times. Our crystal ball says to stick with what works in an uncertain financial and economic climate — in other words, maintain a defensive and income-oriented investment strategy.
It is not going to be a new government that necessarily ushers in a whole new era of growth, prosperity and confidence. Even under the revered Ronald Reagan, the period of secular growth and bull market activity took two years to unfold — it didn't happen right away. It took the inflationary excesses to be wrung out of the system and concrete signs that the executive and legislative branches could work together to usher in true fiscal reform — and to get blue Democrats on board with reduced top marginal tax rates. Hope isn't generally a very useful strategy, but there is reason to be hopeful nonetheless. The critical issue is going to be how we get Washington to move back to the middle where it belongs. This requires bipartisanship which in turn requires leadership. Reagan's whole eight-year tenure in the 1980s occurred with the House being in Democrat hands the whole way through. Bill Clinton's second term coincided with both the House and Senate controlled by the Republicans.
It can be done!
With this in mind, the best that can happen is a Reaganesque and Clintonesque return to compromise on the road to fiscal reform. It will be painful. We all know it will be painful.
With Greece and Spain (and arguably Portugal and a few others) stuck in dramatic debt-deflation spirals, the political need for maintaining these nations in the euro far outweigh the economic 'benefits'. As UBS notes, looking at the euro area today, one cannot help but notice the parallels to Japan of the early 1990s. Europe today, as with Japan a generation ago, is an aging society with structural rigidities, pockets of corporate excellence, but wide swathes of inefficiency; but the two most striking similarities (and not in a good way) lie in the banking system (bloated from over-leveraging, under-capitalization, and bad loans); and fiscal policy (which is inherently pro-cyclical - as the politics of monetary union preclude national level stimulus - leaving ineffective monetary transmission channels unable to help fiscal failure). As UBS concludes, the current euro's similarities to Japan are key impediments to growth - and as such we should expect sclerotic economic activity for a five-year period.