Ode to Warren Harding: Q4 2013 Earnings & the End of Normalcy
Team by team, reporters baffled, trumped, tethered, cropped
Look at that low plane, fine, then
Uh-oh, overflow, population, common group
But it'll do, save yourself, serve yourself
World serves its own needs, listen to your heart bleed
Tell me with the Rapture and the reverent in the right, right
You vitriolic, patriotic, slam fight, bright light
Feeling pretty psyched
It's the end of the world as we know it
It's the end of the world as we know it
It's the end of the world as we know it, and I feel fine
"It's The End Of The World As We Know It (And I Feel Fine)"
Peter Buck, Bill Berry, Michael Stipe, Michael Mills
The US equity markets had a pretty bad time last week, causing a number of people to ask why. The Sell Side analysts community wants you to think that the reason for the selloff is merely crappy Q4 earnings, which is at least partly true. Selling hope, after all, is the stock and trade of the Sell Side. But we all need to take a step back and ask ourselves just where we stand on the proverbial economic timeline – in this case stretching over the past century and more. As we ponder the answer, let's keep in mind the words of President Warren Harding from May 14, 1920:
There isn't anything the matter with world civilization, except that humanity is viewing it through a vision impaired in a cataclysmal war. Poise has been disturbed, and nerves have been racked, and fever has rendered men irrational; sometimes there have been draughts upon the dangerous cup of barbarity, and men have wandered far from safe paths, but the human procession still marches in the right direction. America's present need is not heroics, but healing; not nostrums, but normalcy; not revolution, but restoration; not agitation, but adjustment; not surgery, but serenity; not the dramatic, but the dispassionate; not experiment, but equipoise; not submergence in internationality, but sustainment in triumphant nationality.
When President Harding said those words, the US was again foundering in the economic doldrums after a short-lived lift from the first Great War. By 1918, following the end of the temporary economic boom associated with WWI, the deflation and difficult economic circumstances that had prevailed in the first two decades of the 1900s returned and with a vengeance. The impact of the Spanish Flu pandemic of 1918-20, which claimed over 20 million lives, wiped out just about all the growth in the US stimulated by European demand for goods during WWI. The creation of the Federal Reserve System in 1913, an example of the enlargement of the corporate state during the First World War, had little effect on the slack employment market and terrible commodity price deflation seen in the US agricultural sector.
With real economic possibilities limited, Americans embarked upon a period of financial speculation referred to as the Roaring Twenties, not because the US economy and corporate earnings were particularly good, but due instead to growth in “off balance sheet” finance. Sound familiar? Just as the creation of National Banks added a new layer of financial leverage to the US economy in the period of the Civil War, the rise of the culture of popular investment on Wall Street, fueled by the use of “non-consolidated” pyramids of subsidiaries and trusts, added yet another dimension to the US economy just as real economic growth was failing. And yes, the folks at Goldman Sachs & Co were in the middle of the action.
After the Great Crash nine years later, the US was plunged into decades of deflation and private capital flight that extended through the end of WWII. Only with the enormous expansion of government finance following 1945 did the private sector, slowly, painfully return to health. Corporate monopolies, many of which were a function of government credit and guarantees during WWII, thrived. Up through the 1980s, American industry and the culture of the consumer blossomed, driving employment both domestically and around the world. Americans like to tell ourselves that the prosperity of the post-WWII era was a result of the free enterprise system, but in fact much of that growth came about because of the implicit or explicit support of the US government and its agencies following the Great Depression and WWII.
Since the 1980s, however, the growth of the US economy has slowed and with it job opportunities and consumer income, especially measured in real, inflation adjusted terms. I wrote a comment in Breitbart over the weekend about the latest hand wringing about “income inequality” and why public debt and related inflation is the real problem when it comes to income disparity:
Since 1980, the real, inflation adjusted value of the dollar has fallen by nearly 75%. Over this same period, the wages of working people have been relatively flat, meaning that American families have lost enormous ground in terms of what their dollar will buy for housing, food, and other necessities. Over those three decades, Congress under both parties has happily voted for ever increasing federal budget deficits, based largely on the belief that deficit spending is good for Americans. These same luminaries now fret that “income inequality” is a public policy concern.
Since the 1980s, Washington has become obsessed with using ever lower interest rates and deficit spending to prop up the US economy. We don’t talk about this reality, in part because almost nobody in our political life or the US media knows enough about American history to talk confidently about such things. But the reality is that the from the 2000s on through to today, the biggest driver of what we call “growth” in the US economy has been credit expansion by the Fed and the use of off balance sheet fraud on Wall Street. We talked about the role of Paul Volcker and others in encouraging this reckless use of leverage by the largest banks this past December.
Credit expansion by the Federal Reserve System, which is effectively the bank of issue for much of the world economy, provided the leverage to support private extensions of credit by banks and corporations. All of the credit expansion between 2001 and the 2008 subprime collapse were a function of Wall Street’s love affair with off-balance sheet fraud. The pyramid schemes of the 1920s find their precise analog in the mortgage frauds perpetrated by the big banks between 2000 and 2008. But now that the off balance sheet game is over, thanks to Dodd-Frank, the end of the FDIC’s safe harbor for true sales, and other regulatory changes, the US economy is going cold turkey a la the 1930s. This is why jobs and consumer spending has been barely growing since 2008, even with the massive infusions of credit by the Fed.
So with that short history of 20th Century American finance, why did the US financial markets get slaughtered last week?
The first reason for the selloff is the impending end of the Fed's program of quantitative easing (QE) and zero interest rate policy or "ZIRP." The prospect of a change in FOMC policy of financial repression, and the end of artificial environment that has subsidized debtors, is perhaps the single biggest factor and one nobody wants to acknowledge. It is not just that we have been on life support since 2008 – we have -- but an end to Fed easing marks a reversal of policy that goes back three decades.
As we've note afore in ZH, we are living in The Matrix. Or as Morpheus said to Neo, “You still think that is air you’re breathing?” Without QE driving liquidity out of bonds and subsidizing Uncle Sam's debt addiction, federal deficits and yields soar, and stocks will be flat to down once the Fed stops punishing savers to subsidize debtors. Since the 1920s, the stock market has been one of the most important sectors providing marginal growth to the US economy. In the post subprime world, the end of creative finance also spells a sharp curtailment of nominal growth as measured by such yardsticks as consumer spending and the velocity of money.
The second reason for the selloff is the slack economy, particularly a weak jobs market and slumping housing. A LOT of the lift in both financial and corporate earnings is due to ZIRP and cost cutting. Corporates have refinanced their debt at absurdly low interest rates even as the Fed has stolen $100 billion plus per quarter from savers who are foolish enough to keep their money deposited in banks. There is no revenue visibility for financials or corporates. Again, the Sell Side analysts pretend it isn’t so, but the forward guidance from the S&P 500 says otherwise.
Remember, the peak in the housing recovery was end of Q2 2013, in part because the cost of American homes is rising much faster than consumer income. Real estate remains a good measure of inflation despite official efforts to hide the wasting effect of price increases. The Fed and various government agencies tell us that inflation is low, < 2% annually, but in fact the real rate of inflation is much higher. Again, nobody wants to acknowledge this. As my friend Marc Faber told Bloomberg News:
But one thing I wanted to show you and talk about because you said that lower interest rates help people. Well, if money trending helps everybody, then why does not everybody in the whole world always have zero interest rates? And everybody would be rich. You keep on printing money and you don't need to work here, you don't need to put on makeup. I could stay in bed the whole day and go drinking in the evenings. So, let's just print money and be all happy. It doesn't add up. One thing about the figures you showed: first of all, you live in New York. Do you really think that your cost-of-living increase is a 1.2% per annum? You really believe that? It doesn't feel like more, it feels like five times more, or even ten times more.
And the third factor giving Wall Street a dose of reality is the deceleration in many emerging markets and especially China, which has been trying to keep itself from imploding since 2008 and is now running out of options. The Chinese have been hoping, praying that the US economy would revive and demand for exports would return to pre-crisis levels. Not happening. China has been using massive amounts of debt to prop up economy, but as my pal Lee Miller at China Beige Book wrote, ‘credit transmission is broken.”
Q: Could it be that the Chinese are even more addicted to debt than the Americans? A: yes
The train wreck in China is just part of a more generalized collapse in the emerging markets. The situation in Argentina, for example, is going from bad to worse, leading to a 20% currency devaluation last week. The mounting political chaos in Argentina (and related capital flight from Uruguay and Brazil) is good for Florida real estate, where 60% of home purchases were for cash in December. But it also illustrates that the end of the long term economic cycle in terms of the US serving as the “engine of growth” in the post WWII era implies significant economic and political instability and change around the world.
And then there is my favorite emerging nation, Italy, where like China the heavily subsidized economy has been dependent upon export markets that no longer exist. The capital flight from Italy into US real estate markets is more focused on New York than Florida, but suffice to say that a lot of Italians are looking to get out while they can. They figure that the world’s largest developing economy, namely the US, is the place to hide. These same Italians might have gone to Argentina once upon a time, but now somewhere in the East Coast of the US is the desired destination.
What all of this means is that 2014 is shaping up to be a major inflection point not only for the US economy but for the world as well. If the US cannot use steadily falling interest rates and other expedients to goose nominal growth, then the many parts of the global economy that have grown and prospered as a result of US consumption must suffer as well. The same slack demand that is hurting earnings visibility for the S&P 500 is also undermining stability in China and other global markets.
If the 20th Century was the era of free trade, paid for by the US consumer and taxpayer, then the 21st Century is shaping up to be a very different model, one based more on self-interest and limited trade and global financial flows which, let us recall, were a function of American largesse in the post-WWII era. Let us repeat the words of President Harding:
America's present need is not heroics, but healing; not nostrums, but normalcy; not revolution, but restoration; not agitation, but adjustment; not surgery, but serenity; not the dramatic, but the dispassionate; not experiment, but equipoise; not submergence in internationality, but sustainment in triumphant nationality.
That last phrase, “sustainment in triumphant nationality,” is likely to be the theme of the 21st Century. With the US unable or unwilling to continue expanding credit and debt, the major nations of the world face lower economic growth, less dependence upon global trade and financial flows, and a resurgence of nationalism that is likely to end as it has before, in war.
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