Rate of Change

The last two weeks have seen US equity markets on a one-way path to the moon, breaking multi-year records in terms of rate of change and soaring to new all-time highs. However, away from the mainstream media's glare, another 'market' has been soaring - but this time it is not good news. Chinese overnight repo rates - the harbinger of ultimate liquidity crisis - have exploded from 6-month lows (at 2.5%) to 4-month highs (6.7% today). The PBOC even added liquidity for the first time in months yesterday (via Reverse Repo - at much higher than normal rates) but clearly, that was not enough and the banks are running scared once again that the re-ignition of the housing bubble in China will mean more than 'selective' liquidity restrictions.

Today there is a great sense of relief that has swept the nation as news flowed through the media that the government shutdown had come to an end.  After all, during the 16 days of the shutdown, there was great hardship inflicted on the average American as the stock market rose by 2.4%, government workers that were furloughed received a 2+ week paid vacation and interest rates fell from a peak of 2.65% on October 1st to 2.59% on October 17th.  Outside of the financial markets, which were never concerned of a "default," the reality is that the government shutdown did likely clip up to 0.5% off of 4th quarter's GDP.  While that clip to economic growth created by the government standoff is temporary - the ongoing persistant weakness of economic growth is another issue entirely.  This is the focus of this discussion. The most disturbing sentence uttered during the debt ceiling debate/government shut down, that should raise some concerns by both political parties, is: "We must increase our debt limit so that we can pay our bills."

While the specter of the debt ceiling debate continues to haunt the halls of Washington D.C. it is the state of retail sales that investors should be potentially focusing on.  While the latest retail sales figures from the Bureau of Economic Analysis are unavailable due to the government shutdown; we can look at other data sources to derive the trend and direction of consumer spending as we head into the beginning of the biggest shopping periods of the year - Halloween, Thanks Giving (Black Friday) and Christmas. The recent downturns in consumer confidence and spending are likely being exacerbated by the controversy in Washington; but it is clear that the consumer was already feeling the pressure of the surge in interest rates, higher energy and food costs and stagnant wages.  As we have warned in the past - these divergences do not last forever and tend to end very badly.

The process the Fed is wrestling with is no different than that of the drug addict. After a certain point, dependency develops. Then the withdrawal process is so painful it is not willingly accepted. The drug analogy is appropriate up to a point. Here is a major problem with the analogy. The drug addict brings the outcome on himself. Those who will suffer the most for the Fed’s actions are not responsible for the pain they will endure. Regardless, the pusher has made most of us junkies. We have been forced into an economic haze that seems real but is not. Whether we know it or not, we are hooked. A great “drying-out” period lies in front of us. Few have understanding of what “economic cold turkey” means, but we will all learn.

In mathematics, the term ‘linearity’ describes a relationship in which the rate of change for a variable is constant. However, just like the erosion of civil liberties, the destruction of financial privacy, the growth in world population, the expansion of the money supply, and the demand/depletion of natural resources, debt is an exponential challenge. The danger with exponential problems is that they can really sneak up on you. The numbers do not lie. Debt grows exponentially. Tax revenue grows linearly. So the only question is – what time would you leave?

While headlines, we are sure, will crow of industrial production's best gain in six months, the sad fact is that the market was expecting more. At +0.4% - against an expectation of +0.5% - this is the 5th month in a row of missed expectations for this significant indicator of economic health. Capacity utilization rose but also missed expectations. It seems manufacturing and mining got a modest boost (the former bounced more than expected but only thanks to a notable prior revision downward) and Utilities dragged the headline index down - so we await the "it's the weather's fault" remarks.

For the right answer, we look to the past....

One of the main reasons that investors so often get caught up in major market meltdowns is due to the short-sighted, near term, focus of market analysts and economists.  The data has to be analyzed with relation to the longer term trends and a clear understanding that all things, despite ongoing central bank interventions, do eventually end.  The problem with the current environment is that the artificial inflations have detached the market from the underlying economic fundamentals which has historically led to larger than expected reversions and outright crashes.

A recent survey of asset managers globally, managing USD 27.4 trillion between them, found that 78% of defined-benefit plans would need annual returns of at least 5% per year to meet their commitments, while 19% required more than 8%, "a target of 5% per year can be reached but only by using leverage, shorting, and derivavtives." And sure enough, as Deutsche Bank (DB) reports, in short, investors have rarely been more levered than today! According to DB, a MoM change in NYSE margin debt >10% has to be taken as a critical warning signal as there are astonishing similarities in the sequence of events among all crises. As the S&P 500 just hit a new all-time high, investors might want to ask themselves when it is a good time to become more cautious – yesterday, in our view. Simply put, the higher margin debt levels rise, the more fragile the underlying basis on which prices trade; with even a less severe sell-off in equities capable of triggering a collapse.

Every time real personal income goes negative, a recession occurs. Now that personal income is falling, a recession is baked in. The Big Lie of the "recovery" is that it is self-sustaining. Minus government transfers, the reality that the Fed and Federal government are simply enriching the top 1/10th of 1% with access to unlimited credit at zero interest is revealed.

As readers are well aware by now, at 8:30 am today we get to see the rewriting of US GDP history back to 1929 with the revisions from the BEA. It’s a big last day of July with the Fed meeting coming after the GDP release. For GDP, real growth is expected to be as low as 1.0% in Q2. Opinions vary widely on today’s GDP number with one major US investment bank’s estimate as low as 0.2%, a number of bulge bracket banks at 0.5% while there are also plenty of economists above 1.5%. It is not news to anyone that nominal GDP is very low at the moment - especially in a world of nosebleed high debts - and today could see this have a 1-handle YoY (and at best a 2-handle) - a level not even normally seen at the depths of most recessions.

On occasion of an address to economists at a conference in France, Bundesbank  president Jens Weidmann reminded the audience that 'the ECB cannot solve the crisis', because it is due to structural reasons and therefore requires structural reform. Weidmann rightly fears that governments will begin to postpone or even stop  their reform efforts now that the ECB has managed to calm markets down. In a Reuters article on the topic, a number of people are quoted remarking on ECB policy. What is so interesting about this is how far removed from reality general perceptions are when it comes to judging current central bank policies. In short, Weidmann wants to end the three card Monte, whereby commercial banks buy the bonds issued by governments because they don't have to put any capital aside for the purpose, which bonds they then can in turn pawn off to the central bank for refinancing purposes. Weidmann wants to see the connection between banks and sovereigns severed, a connection that has been fostered by governments over many centuries in order to enable them to spend more than they take in through tax revenues.

Before the current turmoil began, Ben Bernanke's hope was that rising asset prices would lead to a "wealth effect" that would encourage the American consumer to start spending again, and thus help the American economy finally leave the "Great Recession" behind. However, the empirical data does not support this notion and equally the economy isn't booming sufficiently to make the reverse case that the economy drives the stock market. So what is causing the markets to boom right now? Steve Keen notes that during the period from 1890 to 1950, there was no sustained divergence between stock prices and CPI, and that almost all of the growth of share prices relative to consumer prices appeared to have occurred since 1980; and then, boom! - what must certainly be the biggest bubble in stock prices in human history took off - and it went hyper-exponential in 1995. So are stocks in a bubble? Yes - and they have been in it since 1982. It has grown so big that - without a long term perspective - it isn't even visible to us. It has almost burst on two occasions - in 2000 and 2008 - but even these declines, as precipitous as they felt at the time, reached apogees that exceeded the previous perigees in1929 and 1968.

The all important ECB press conference is set to begin momentarily. Will Draghi answer questions regarding the readiness of the OMT's use in Portugal whose short end has exploded this morning, or will he be forced to wait for the German court's decision first? Or maybe Draghi will finally have some comments on either the ongoing Monte Paschi scandal or the recently revealed Italian derivative debacle which took place under Draghi's watch. We somehow doubt it...

*DRAGHI SAYS ECB RATES TO STAY LOW FOR EXTENDED PERIOD OF TIME
*DRAGHI: IMPROVEMENT IN FINANCIAL MARKETS SHOULD REACH ECONOMY
*DRAGHI SAYS INFLATION RATES MAY BE VOLATILE THROUGHOUT YEAR
*DRAGHI: RECENT TIGHTENING OF MARKET RATES MAY WEIGH ON GROWTH

The recent one month spike in interest rates, along with the mind numbing chatter about the end of the "bond bull market," has sent investors scurrying from from the bond market right into the waiting arms of a stock market correction. Will the "bond bull" market eventually come to an end?  Yes, it will, eventually.  However, the catalysts needed to create the type of economic growth required to drive interest rates substantially higher, as we saw previous to the 1980's, are simply not available currently.  This will likely be the case for many years to come as the Fed, and the administration, come to the inevitable conclusion that we are now in a "liquidity trap" along with the bulk of developed countries.  While there is certainly not a tremendous amount of downside left for interest rates to fall in the current environment - there is also not a tremendous amount of room for them to rise until they begin to negatively impact consumption, housing and investment.  It is likely that we will remain trapped within the current trading range for quite a while longer as the economy continues to "muddle" along.