From Michael Lewitt [30], author of The Credit Strategist [31]
The Committee To Destroy The World
[32]
Last month, the world mourned the death of beloved actor Leonard Nimoy. Mr. Nimoy, of course, was renowned for his portrayal of the iconic character Mr. Spock on the 1960s television series Star Trek. One of the most memorable Star Trek inventions was the transporter that allowed human beings to be beamed through space and time like light and energy. Investors expecting central bankers to solve the world’s economic problems might as well believe that Janet Yellen is capable of beaming them straight into the Marriner S. Eccles Building in Washington, D.C. Their failure to acknowledge that the Fed is failing to generate sustainable economic growth while contributing to income inequality and crushing debt burdens is inexplicable. Central banks that purport to be promoting financial stability are actually undermining it – with the able assistance of regulators who have drained liquidity from the world’s most important markets.
Negative interest rates on $3 trillion of European debt are an obvious sign of policy failure, yet the policy elite stands mute. Actually that’s not correct – the cognoscenti is cheering on Mario Draghi as he destroys the European bond markets just as they celebrated Janet Yellen’s demolition of the Treasury market. Negative interest rates are not some curiosity; they represent a symptom of policy failure and a violation of the very tenets of capitalist economics. The same is true of persistent near-zero interest rates in the United States and Japan. Zero gravity renders it impossible for fiduciaries to generate positive returns for their clients, insurance companies to issue policies, and savers to entrust their money to banks. They are a byproduct of failed economic policies, not some clever device to defeat deflation and stimulate economic growth. They are mathematically doomed to fail regardless of what economists, who are merely failed monetary philosophers practicing a soft social science, purport to tell us. The fact that European and American central banks are following the path of Japan with virtually no objection represents one of the most profound intellectual failures in the history of economic policy history. While the global economy is facing a solvency problem linked to excessive debt accumulation, the world’s central banks are pursuing policies designed for a liquidity problem. That is like treating cancer with a Tylenol. The only solutions in this known universe for a solvency problem are inflation, currency devaluation or default. Maybe Spock has a different solution but he’s been beamed up to a better place and is no longer on call to save us. Since none of these real-world solutions are politically palatable - no leader on today’s world stage has the courage to propose them and would be voted out of office by selfish and short-sighted constituents if he/she did - central banks are left offering huge doses of debt since equity can’t be conjured out of thin air. But all of this debt is just exacerbating the solvency problem and failing to solve the liquidity problem, pushing global markets closer to the brink.
The global financial system no longer possesses the productive capacity to generate enough income to sustain current asset values. The markets refuse to acknowledge this reality, but they will. In a presentation to the Global Interdependence Center on March 23, 2015 in Paris, France, Christopher Whalen, Senior Managing Director and Head of Research at Kroll Bond Rating Agency, gave an unusually frank assessment of the current state of the global economy. Mr. Whalen, one of the best bank analysts on Wall Street, argued that global banks face trillions of bad off-balance sheet debts that must eventually be resolved (i.e. written off) and are dragging on economic growth. These debts include everything from loans by German banks to Greece to home equity loans in the U.S. for homes that are underwater on their first mortgage. Banks and governments refuse to restructure (i.e. write off) these bad debts because doing so would trigger capital losses for banks and governments. As Mr. Whalen explains, “the Fed and ECB have decided to address the issue of debt by slowly confiscating value from investors via negative rates, this because the fiscal authorities in the respective industrial nations cannot or will not address the problem directly.” But in addition to avoiding the bad debt problem, these policies are causing further economic damage by depressing growth and starving savers. Per Mr. Whalen: “ZIRP and QE as practiced by the Fed and ECB are not boosting, but instead depressing, private sector economic activity. By using bank reserves to acquire government and agency securities, the FOMC has actually been retarding private economic growth, even while pushing up the prices of financial assets around the world.” ZIRP has reduced the cost of funds for the $15 trillion U.S. banking system from roughly $500 billion to only $50 billion annually, depriving savers of $450 billion of annual interest income. Zero interest rates are deflationary and sluggish national income growth renders it impossible to validate and sustain the current level of inflated asset prices. This means that any movement away from these policies, as the Fed now appears to be preparing, portends lower asset prices.
Investors are continuing to cling for dear life to stocks and bonds trading at unsustainable valuations and denominated in deteriorating fiat currencies. While it may appear rational to do so in a world in which professional investors are judged based on their relative performance and would rather fail conventionally than succeed unconventionally, true fiduciaries should protect their clients now from the steamroller that is about to run them over. Central banks have destroyed bonds as instruments of prudent investment and forced fiduciaries to buy assets that are going to generate negative real returns. While Mr. Whalen speaks of the trillions of bad debts that are suffocating growth, even the trillions of nominally money-good debts have been placed at risk by the current policy regime. The only reason the system is not yet in crisis is that interest rates are artificially depressed. Low rates have reduced the cost of debt service to manageable levels but done nothing to improve the productive capacity of companies or economies. But time is running out; the U.S. and Europe may be emulating Japan, but they are not Japan. While low interest rates were intended to buy time for fiscal policy makers to implement pro-growth policies and raise incomes needed to service and retire rising debt burdens, nothing of the sort has occurred. As a result, the global economy’s capacity to service its existing debt as well as its future promises is reaching its limits.
This leaves currency devaluation, inflation or default as the only possible resolutions to the end of the Debt Supercycle that began 30 years ago. All three are similar in kind because they deprive lenders of repayment of their loans in constant dollars. But that is the nature of debt in human economies; debts are rarely repaid in full in real terms. Human economies pay it forward and time erodes the value of money. Einstein famously said, “The only reason for time is so that everything doesn’t happen at once.” The same is true about debt. Debt was created because everything in economies can’t happen at once; in order to sustain ourselves, some future wealth must be brought forward into the present. In order to do that, we create money that doesn’t yet exist in the form of debt. We then hope to earn that money in the future through our economic activities and eventually repay it. Hyman Minsky taught us that “[c]apitalism is unstable because it is a financial and accumulating system with yesterdays, todays, and tomorrows.” Debt seeks to bridge that instability through the form of contracts that ultimately rely on the good will of those who sign them. In that light, we can see the real tragedy of negative interest rates: they not only have the perverse effect of reversing the flow of time, but they demonstrate that borrowers are not acting with the good faith incentives normally associated with someone who needs money. Rather than paying forward, borrowers are paying backwards because they are effectively trying to return something they don’t want. Such an arrangement renders it impossible for an economy to grow. By destroying the temporal and moral structure of money, negative interest rates destroy the economy. When tomorrow cannot be paid, the current regime must fail. The only question to be determined is the form that failure will assume. This may sound like philosophy but it is cold, hard reality.
Beam Me Up, Janet!
Another enduring image of Mr. Spock was watching him play three-dimensional chess, a game that demonstrated both his superior intellect and his ability to see the complexities of the universe in ways far beyond the limited abilities of mere mortals. Rather than think in only two dimensions, Spock was able to think in three (or even more). This is something that investors must be able to do in a digitalized world, particularly when currencies start to move as dramatically as they have since last summer. As a citizen of the 23rd century, Mr. Spock was able to envision a digital world that we are only beginning to experience.
Today, we inhabit a world in which we are just beginning to deconstruct every conceivable kind of data into different combinations of 1s and 0s that can then be reconfigured and transmitted around the world in the blink of an eye. For example, Israeli cybersecurity company Cyactive, which was just acquired by PayPal, uses evolutionary biology algorithms in its cybersecurity business. Cyactive’s specific area of expertise is predicting malware before it hits a network based on the premise that malware behaves like a virus; it mutates as it spreads. Algorithms are a common digital language that can be applied across biological and non-biological systems. The possibilities are truly as limitless as the space explored by Spock and his fellow travelers.
In the financial world, every stock, bond, loan, currency, commodity or derivative can be broken down into its constituent digital parts. Financial technology reveals the underlying reality that all financial instruments are merely different expressions of the same underlying economic information. For example, currencies and interest rates are different versions of the same underlying phenomenon – the cost of money. And while economists have taught us to think about the difference between “real” and “nominal” returns primarily in terms of inflation effects, inflation is inextricably linked to currency movements that affect the cost of money. With interest rates at or near zero and traditional inflation measures suppressed, currencies have picked up the mantle from interest rates for the transmission of real returns on capital. “Real” returns are intended to measure the return on capital in constant currencies, which today means adjusting them primarily for changes in the value of fiat currencies. Investors are playing on a multi-dimensional chessboard where the pieces are being moved around by increasingly desperate central bankers. When the currencies in which investments are denominated experience historic levels of volatility (i.e. the euro has dropped by 20% against the dollar since last July), a new dimension enters the investment landscape. The unstable currency regime has created a highly unstable investment environment that is placing capital at risk.
The Cannibal Economy
While most investors choose to remain blissfully ignorant about the nominal value of their investments, the real value of what they own is deteriorating. One symptom of the continuing destruction of the economic base is the increasingly cannibalistic nature of economic activity in both the private and public sectors. Instead of investing in the future – or creating a future – public and private sector actors are borrowing from the future while devouring the present. Promises to pay future obligations in constant dollars are literally no longer worth the paper on which they are written because those promises of future payment are being actively debauched. Having mortgaged our future and limited our ability to engage in productive economic activity, public and private economic actors are now consuming themselves.
Since 2009, companies in the S&P 500 have spent more than $2 trillion repurchasing their own stock. These repurchases have accelerated as stock prices have risen, which means that corporations’ appetite to eat their own has increased as their stocks have grown more expensive. In 2014, members of the S&P 500 bought back $550 billion of their own stock, according to data compiled by S&P Dow Jones Indices. In contrast, investors in mutual funds and ETFs bought only $85 billion of equities last year. Companies announced another $104.3 billion in buybacks in February, the highest on record according to TrimTabs Investment Research. In many cases such as IBM and Herbalife, they borrowed a great deal of money at low Fed-subsidized rates to eat their own.
The private sector is merely mimicking what the public sector has adopted as its formal economic policy. Since 2009, the Federal Reserve has purchased $4 trillion of Treasuries and agency securities that are currently sitting on its $4.7 trillion balance sheet. The European Central Bank has launched a $1 trillion bond purchase program while the Bank of Japan has gone farther and is buying gobs of stock and ETFs (which strikes me as wildly insane). So governments are also devouring themselves. In the latest version of this phenomenon, the oil market, where supply is outrunning demand, is now consuming itself as massive amounts of product are being bought into storage at what are believed to be low prices. It remains to be seen just how low those prices will prove to be after the final costs of storage and carry are calculated.
Any society that eats its own is doomed to perish. I am unaware of any race of cannibals that has thrived in the history of mankind. Eventually they run out of victims.
The Fed and the U.S. Economy
Markets reacted with their usual irrational exuberance to what they interpreted as a dovish tone in the FOMC’s formal statement after its March 17-18 meeting as well as Janet Yellen’s remarks afterwards. Rather than dovish, however, I believe the Fed is extremely worried. As well it should be. The denizens of the Eccles Building have painted themselves – and the rest of the world – into a corner. The Fed finally acknowledged that the economy is weak and that it doesn’t expect it to strengthen quickly. This is something I have been warning about repeatedly. Neither an over-indebted U.S. economy nor an even more over-indebted global economy is in any position to reach so-called escape velocity. The only velocity that is increasing is the velocity of denial among Fed apologists and stock investors who are going to hit a brick wall at high speed in the not-too-distant future if they don’t snap out of it.
After maintaining for months that the economy was improving, the Fed finally acknowledged that it is not. It now expects economic output to expand by between 2.3% and 2.7% in 2015, a downgrade from its December 2014 estimate of 2.6% to 3.0%. Even more important, it lowered its estimate of the non-accelerating inflation rate of unemployment (the unemployment rate below which inflation rises, also known as NAIRU) to 5.0% to 5.2% from 5.2% to 5.5%. This suggests that the Fed sees much more slack in the economy than before. While some might see this downgrade as giving the Fed more time before it needs to raise rates, a Fed that is concerned about low inflation should read it as a signal to accelerate its timetable in order to infuse some inflation into the economy with higher interest rates. But we all know that isn’t going to happen. Instead, the Fed lowered its forecast for the Fed Funds rate by 50 basis points across the board (0.675% by year-end 2015; 1.875% year end 2016; and 3.125% year end 2017). The economy looks increasingly exhausted.
The Fed has been consistent in its failure to forecast the economy with any accuracy, which is as much a commentary on forecasting as on the Fed’s abilities. Based on this track record and its outlook, it is hardly surprising that Mrs. Yellen & Co. are reluctant to raise rates even in the face of rising risks to financial stability posed by interminable zero rates. Having explicitly targeted asset prices and the so-called “wealth effect” as its policy after the financial crisis, the Fed is terrified of what might happen when it reduces the massive subsidy it has provided to the economy (primarily the wealthy). The problem with this regime, however, is that targeting asset prices, particularly stock prices, is far beyond the Fed’s purview and leads to distorted markets, misallocated capital and dangerous long-term economic, social and political consequences. Why the denizens of the Eccles Building can’t figure that out is best explained by those who awarded them their advanced degrees.
With the exception of jobs numbers, the string of disappointing economic data has been unrelenting in 2015. In fact, it would be difficult to point to any positive economic data other than employment data over the last three months. The Bloomberg Economic Surprise Index is at its lowest level since March 2009 and the Citi Surprise Index was recently at its lowest level since 2011. While factors like the West Coast port strike and arctic conditions in the northeast are no doubt having some impact, there is obviously a problem when economic data is flirting with levels last seen at the depths of the recession and the financial crisis. As the March Chicago PMI report stated, “While part of this decline may be attributable to the cold weather snap and strike action at west coast ports, the continued weakness in March points to a wider slowdown in business conditions.” I may have been an outlier when warning about a growth scare last November (just as I remain an outlier regarding the meaning of low oil prices for the U.S. economy), but I would rather be an outlier and correct than part of the consensus and wrong. There is something seriously awry in the U.S. economy. There is no self-sustaining economic recovery occurring. Instead, there is simply an inexorable build-up of debt that can never be repaid and that is sapping growth. The incessant flow of negative economic data is not an aberration – it is the new normal.
On March 11, Bridgewater’s Ray Dalio warned the Fed that raising rates now risked a 1937-style stock market slump. Mr. Dalio is likely correct that higher rates will strengthen the dollar and contribute to deflationary pressures, but the Fed should not be worrying about the stock market. The policy of targeting asset prices that the Fed adopted after the financial crisis has been an abject failure. The so-called “wealth effect” that these policies were supposed to create only helped those who have wealth; it has damaged the 99% of those who don’t. Trillions of dollars of direct bond purchases plus trillions of dollars of further subsidies in the form of zero interest rates may have caused the stock market to triple since its March 2009 low, but they have left the U.S. deeply indebted and struggling to grow at 2%.
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Much more in the full letter: pdf [33].
