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Category: Economics

Authored by David Stockman via The Daily Reckoning,

Given the anti-Trump feeding frenzy, we continue to believe that a Swan is on its way bearing Orange. But if that’s not enough to dissuade the dip buyers, perhaps the impending arrival of the Red Swan will at least give them pause.

The chart below comprises a picture worth thousands of words. It puts the lie to the latest Wall Street belief that the global economy is accelerating and that surging corporate profits justify the market’s latest manic rip.

What is actually going on is a short-lived global credit/growth impulse emanating from China. Beijing panicked early last year and opened up the capital expenditure (CapEx) spigots at the state-owned enterprises (SOEs) out of fear that China’s great machine was heading for stall speed at exactly the wrong time.

The 19th national communist party Congress scheduled for late fall of 2017. This every five year event is the single most important happening in the Red Ponzi. This time the event is slated to be the coronation of Xi Jinping as the second coming of Mao.

Beijing was not about to risk an economy fizzling toward a flat line before the Congress. Yet that threat was clearly on the horizon as evident from the dark green line in the chart below which represents total fixed asset investment.

The latter is the spring-wheel of China’s booming economy, but it had dropped from 22% per annum growth rate when Mr. Xi took the helm in 2012 to 10% by early 2016.

There was an eruption as dramatized in the chart. CapEx growth suddenly more than doubled in the one-third of China’s economy that is already saturated in excess capacity.  The state owned enterprises (SOE) in steel, aluminum, autos, shipbuilding, chemicals, building equipment and supplies, railway and highway construction etc boomed.

It was as if a switch had been flicked on by Mr. Xi himself, SOE CapEx soared back toward the 25% year-over-year rate by mid-2016, keeping total CapEx hugging the 10% growth line.

However, you cannot grow an economy indefinitely by building pyramids or any other kind of low-return/no return investment – even if the initial growth spurt lasts for years as China’s had.

Ultimately, the illusion of Keynesian spending gets exposed and the deadweight costs of malinvestments and excess capacity exact a heavy toll.

If the investment boom that was financed with reckless credit expansion is not enough, as was the case in China where debt grew from $1 trillion in 1995 to $35 trillion today, the morning-after toll is especially severe and disruptive.  This used to be called a “depression.”

China Fixed Asset Investment

China’s propagated spurt in global trade and commodities was artificial and short-term. It was done to flatter China’s rulers at the 19th party congress.

Now that a favorable GDP glide path has been assured, China’s planners and bureaucracy are already back at it trying to find some way to reel in its runaway credit growth and bloated economy before it collapses.

Downside Surprises in China Are Virtually Baked In

The sell-by date has expired on this latest China credit impulse, as evident in the chart below. During the first quarter of this year, total social financing (bank credit plus shadow banking loans) reached the incredible rate of $4 trillion per annum. That’s nearly one-third of China’s entire GDP.

The figure scared the daylights out of leadership in Beijing, who have now moved forcefully to reel in China’s debt machine.

What is coming down the pike is the great China Debt Retrenchment.  Expect a global braking motion that will get underway once Mr. Xi dramatically consolidates his power at the 19th party congress.

China Total Social Financing

This has the potential to drastically weaken the global economy – and the impact on corporate profits should not be underestimated.

The Red Swan Has Now Gone Berserk

Half of the world’s GDP growth since the 2008 crisis has been in China, and that, in turn, was purchased by the greatest credit eruption in recorded history.

As China’s nominal GDP was more than doubling from $4.6 trillion in 2008 to $11.2 trillion in 2016, its national leverage ratio soared from 175% of GDP to 300% in less than a decade.

There’s reason to seriously doubt that Beijing can bring the Red Ponzi to a soft landing.  It cannot and will not permit the nation’s debt load to quadruple again during the next eight years, meaning that China’s days as the world’s ultimate stimulus machine are over.

China Red Ponzi Debt to GDP Ratio 2017

The fading of the most recent China growth impulse will soon reveal that most countries, to adapt Warren Buffet’s famous metaphor, have been swimming naked from a fiscal perspective. It has left the world vulnerable to a renewed wave of funding crises as the ECB and other central banks attempt to launch monetary normalization.

In sum, during the last 19 months the Red Ponzi propagated a false upturn in the global economy that is already decisively reversing. This comes at the same time that central banks of the major developed world economies are finally bringing their printing presses to a halt.

The major central bankers have finally recognized that at $22 trillion on central bank balance sheets have become egregiously extended.  China is the epicenter of the world’s two decade plunge into central bank monetary fraud and credit explosion.  They have deformed and destabilized the very warp and woof of the global economy.

So, yes, even as the Orange Swan stumbles toward the Donald’s White House, there is a Red Swan following closely behind.

Members of Chinese People's Liberation Army based at the Hong Kong garrison march following Chinese President Xi Jinping's review in Hong Kong on June 30, 2017. Xi toured a garrison of Hong Kong's People's Liberation Army garrison as part of a landmark visit to the politically divided city. Anthony WALLACE / AFP
The Trump administration formally launched an investigation into trade practices that China allegedly uses to steal the intellectual property of U.S. companies.

First we controlled the election, next the presidency, now the stock market.

Beijing imposes restrictions to try to stem global buying spree that has included entertainment firms and football clubs

The Chinese government has served notice on the country’s foreign investment spree in football clubs, skyscrapers and Hollywood as it moves to curb rising levels of debt among domestic companies.

The announcement of restrictions in a range of sectors follows a buying spree around the globe during which Chinese firms and business tycoons have taken control of assets including Legendary Entertainment, the US film producer behind Jurassic World and Warcraft, buildings such as the Cheesegrater in London, and English football clubs including Southampton and Aston Villa.

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Having staked his reputation one week ago that the "bull market has come to an end", the jury is still out on Dennis Gartman's latest forecast, although one thing is becoming clear - the period of record low volatility has come to an abrupt end and the question is whether it now reverts (much) higher, or resumes its drift lower on more vol-selling and expectations that central banks will keep it all under control.  And while we wait and see which way risk inflects, in his latest overnight note, the "world-renowned commodity guru" is out with an even more bombastic prognostication: "this may well be one of the most important
days in the future of the equity markets for a very long while" as it will either confirm or deny a rather unique technical pattern.

Below is the key excerpt from his latest, overnight note, with whose contents - we must admit - we largely agree:

STOCKS HAVE AGAIN FALLEN UNANIMOUSLY…AND MATERIALLY in global terms and what had heretofore been a rare circumstance when all ten markets incumbent in our International Index have fallen has now become commonplace for this happened one week ago today and it has happened yet again. Indeed, in the course of the past week, we’ve now seen three such “unanimous” days, for on Tuesday stocks “unanimously” rose. Such “unanimous” days had, until this week, been a truly rare event and had in the past marked major turning points in the market, marking final periods of exhaustion to the upside or to the down. It is interesting that with all of these violent price movements, stocks in global terms as measured by our Index have move barely at all, for last week our Index was 11,168 and this morning it is 11,226, or 0.5% higher.


We do not and we have not “trusted” equity valuations for quite some long while, believing that the markets individually and collectively have gone to levels that are not justified by earnings or economic fundamentals. The one fundamental that has been at work over the past several years has been the monetary expansions by the main monetary authorities: the Fed; the ECB and the Bank of Japan. Those authorities are now preparing to end their experiments with QE, and if they not prepared to end them they are at least prepared to slow down the seriousness of their expansions. This we find disconcerting.


Further, as has been the historic case, equity markets do indeed turn for the better long before economies move upward and out of recessions, always fueled by monetary expansion. Also, they turn down long before those same economies fall into recessions and indeed are usually moving lower as those economies are moving to their best levels as capital is demanded for plant and equipment. That capital must be taken from somewhere and that “somewhere” is the equity market… especially if the monetary authorities are becoming “stingy” with monetary expansion. That is where we are today; the economies are doing rather well… not exceedingly so; just nicely, pleasantly, “plowhorsedly” so… AND the monetary authorities are preparing to tighten policy.


Yesterday, and several times over the course of the past several weeks, we’ve written… comically, we trust… about the fact that all news, whether political or economic… has been accepted as being bullish news. As we said here yesterday, it matters not, in recent weeks, if earnings are better or worse, they’ve been bullish. If war is feared or if peace breaks out, it’s been bullish. If the fear is of inflation or deflation, those fears in either direction have been accepted as bullish of share prices. This we found almost comical in nature and this we found disconcerting. We have tried… unsuccessfully we shall admit…to err bearishly of equities even as “Old Turkey’s” admonition otherwise range in our ears and clouded our thoughts.


However, the fact that we’ve had three “unanimous” days in a week gives us very great… bearish… pause. The fact that corporate debt here in the US has risen to all-time highs gives us pause. The fact that corporate tax receipts have been moving lower, not higher, over the past many months gives us pause, for we’ve learned simply that corporations pay taxes only on “real profits” rather than upon some of the “engineered” profits they report to shareholders and to analysts alike. We are gravely concerned that the numbers of delinquent auto loans… loans that have been extended over the years from three years, to four and to five and six!... are high and are rising. We are concerned about the stunning levels of college/university debts weighing down upon our nation’s young voters who are swayed to the politics of the Left by demagogues who promise loan forgiveness and further free college; but most of all we are concerned that the “punch bowl” of monetary expansion is about to be taken away, or shall at the very least be threatened or slowed. 


Finally, we cannot help but note once again that recent conversations with the public about their “stock holdings” cause us very real concerns, for the public truly believes that in holding mutual funds and/or ETFs that they’ve little if any exposure to the vagaries of the stock market. We had that conversation last week with our “trainer” and friends in the business have written to us this week of the same conversations they’ve had with doctors, store clerks, plumbers, and teachers et al. The public is convinced that their holdings are insured against market risk and/or that they’ve no risk whatsoever. The public is wrong and therein is our greatest fear.


In our recommendations we are long of the “bluer” chip indices while we are short of the “higher tech/broader” indices instead; that is we are long of the S&P and we are short of the NASDAQ. The more aggressive among us might wish to be long of the Dow Industrials while short of the Russell 2000, but our positioning is that of an incipient bear market. For months, the tape has been “painted” as the broad market has  weakened even as the Dow has gone on to new highs. This will continue and those not involved in this manner should become involved today.


Finally, this may well be one of the most important days in the future of the equity markets for a very long while, for should the markets trade better and then close lower …and close hard upon their lows for the  week… it will be an ominous technical sign. The great Richard Dennis of past trading fame always taught his “students,” … the famed “Turtles” as they were called… to sell markets closing their weeks on multi-week lows. It was the singular rule that made him wealthy and it is a rule we always take very seriously to heart. Thus, we shall watch today’s action with much heightened interest… more perhaps than at any time in many, many months. the futures are trading higher as we write, but a lower close today shall not be pretty.

WASHINGTON, DC - JANUARY 22: Gary Cohn, director of the U.S. National Economic Council, arrives to a swearing in ceremony of White House senior staff in the East Room of the White House on January 22, 2017 in Washington, DC. Trump today mocked protesters who gathered for large demonstrations across the U.S. and the world on Saturday to signal discontent with his leadership, but later offered a more conciliatory tone, saying he recognized such marches as a "hallmark of our democracy." (Photo by Andrew Harrer-Pool/Getty Images)
The stock market is not going to crash if Gary Cohn abandons his White House post.

Since the July 26th 'nothingburger' FOMC statement, Nasdaq is down but bonds and bullion are higher as domestic politics and global war have trumped monetary machinations. All eyes in today's Minutes will be on any mention of inflation and the balance sheet. The Fed sees inflation "picking up over the next couple years" but this came before last week's dismal CPI/PPI data (and they noted "downside risks"), and confirmed that they will make a balance sheet move "at upcoming meeting."

Additional headlines:


However, The Fed is worried about inflation:


The key segments, courtesy of Bloomberg:

On the start of balance sheet unwind:

  • "Although several participants were prepared to announce a starting date for the program at the current meeting, most preferred to defer that decision until an upcoming meeting while accumulating additional information on the economic outlook and developments potentially affecting financial markets."

More on timing:

  • "Participants generally agreed that, in light of their current assessment of economic conditions and the outlook, it was appropriate to signal that implementation of the program likely would begin relatively soon, absent significant adverse developments in the economy or in financial markets. Many noted that the program was expected to contribute only modestly to the reduction in policy accommodation."

On inflation:

  • "Most participants indicated that they expected inflation to pick up over the next couple of years from its current low level and to stabilize around the Committee’s 2 percent objective over the medium term."
  • "Many participants, however, saw some likelihood that inflation might remain below 2 percent for longer than they currently expected, and several indicated that the risks to the inflation outlook could be tilted to the downside."
  • "Many participants noted that much of the recent decline in inflation had probably reflected idiosyncratic factors."
  • "Participants agreed that a fall in longer-term inflation expectations would be undesirable, but they differed in their assessments of whether inflation expectations were well anchored."
  • "A few participants cited evidence suggesting that this framework was not particularly useful in forecasting inflation. However, most participants thought that the framework remained valid, notwithstanding the recent absence of a pickup in inflation in the face of a tightening labor market and real GDP growth in excess of their estimates of its potential rate."
  • "Some participants expressed concern about the recent decline in inflation, which had occurred even as resource utilization had tightened, and noted their increased uncertainty about the outlook for inflation."

On a possible overshoot in the labor market:

"A few participants expressed concerns about the possibility of substantially overshooting full employment, with one citing past difficulties in achieving a soft landing."

On rising lending risks:

  • "A couple of participants expressed concern that smaller banks could be assuming significant risks in efforts to expand their CRE lending."

On policy uncertainty:

  • "Several participants noted that uncertainty about the course of federal government policy, including in the areas of fiscal policy, trade, and health care, was tending to weigh down firms’ spending and hiring plans."
  • "It was also observed that the budgets of some state and local governments were under strain, limiting growth in their expenditures. In contrast, the prospects for U.S. exports had been boosted by a brighter international economic outlook."

The now traditional commentary on equity markets and financial conditions.

  • Several participants noted that the further increases in equity prices, together with continued low longer-term interest rates, had led to an easing of financial conditions. However, different assessments were expressed about the implications of this development for the outlook for aggregate demand and, consequently, appropriate monetary policy.
  • According to another view, recent rises in equity prices might be part of a broad-based adjustment of asset prices to changes in longer-term financial conditions, importantly including a lower neutral real interest rate, and, therefore, the recent equity price increases might not provide much additional impetus to aggregate spending on goods and services.

On equity valuations:

  • "Participants also considered equity valuations in their discussion of financial stability. A couple of participants noted that favorable macroeconomic factors provided backing for current equity valuations; in addition, as recent equity price increases did not seem to stem importantly from greater use of leverage by investors, these increases might not pose appreciable risks to financial stability."

And the punchline as regards to stocks, confirming that the Fed may have to hike just to burst the stock bubble:

  • According to one view, the easing of financial conditions meant that the economic effects of the Committee's actions in gradually removing policy accommodation had been largely offset by other factors influencing financial markets, and that a tighter monetary policy than otherwise was warranted.

Of course, any confusion in these minutes can always be cleaned up next week at Jackson Hole.

* * *

Key conclusions:

  • As expected, September remains in play for balance-sheet announcement, though no specific timetable mentioned
  • Most FOMC participants preferred to announce the start of the balance-sheet runoff at "an upcoming meeting," while "several" were ready to go in July
  • Inflation debate deepens. Most officials expected inflation to pick up next couple years and stabilize around 2%; many saw chances inflation may stay below that level for longer than expected
  • Some Fed officials see scope for rate-hike patience, others caution a delay could lead to inflation overshoot
  • FOMC united against a loosening of financial regulations that would allow for risky practices;
  • The Fed is concerned about policy uncertainty hurting investment
  • FOMC discussed equities, agreed to monitor bank behavior; some concern expressed about small-banks' risk in commercial real-estate lending

*  *  *

Rate hike odds for December are around 42% - unchanged from the FOMC Statement in July...


Not what The Fed was hoping for...


The dollar is unchanged but bonds are bid...


Why is the FOMC considering raising rates again this year? Bloomberg notes one reason is concern about asset prices and the potential from the unwinding of a bubble. This could well have been debated, with, for example, Eric Rosengren of Boston particularly worried about commercial real estate, while Yellen has cited stock prices as being elevated.


Of course, that's not how the market sees it...


Full FOMC Minutes below:


President Donald Trump speaks to the media in the lobby of Trump Tower in New York, Tuesday, Aug. 15, 2017. (AP Photo/Pablo Martinez Monsivais)
Creating a million new jobs would likely bring down black unemployment significantly.
  • Scott Paul resigns on Tuesday after three high-profile departures on Monday
  • Trump bullish: ‘For every CEO to drop out, I have many to take their place’

The bosses of some of the world’s biggest companies are facing mounting pressure to quit Donald Trump’s high-profile business advisory council as a fourth executive resigned on Tuesday in the wake of the president’s handling of the fatal Charlottesville protests.

Related: Trump's erratic early morning Twitter retweets include one calling him fascist

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For all the recent concerns about an "imminent" nuclear war with North Korea (not happening, according to the head of the CIA), which prompted a stunned reaction from Morgan Stanley which earlier today observed the "70% rise in the VIX index over three days, 2% drop in global equities, and more than a few holidays disrupted", leading it to conclude "Well, That Escalated Quickly", the market continues to ignore the real risk: the upcoming central bank balance sheet taper which will have a dire and drastic impact on markets according to Citi's global head of credit product strategy, Matt King:

Markets seem optimistic that central bank plans to modestly reduce their support for markets in coming months can be achieved without disruption. We are not convinced.

Borrowing an analogy from developmental psychology, King compares the relationship between the Fed and the market to that between a (failed) parent and a child obsessed with their cell phone.

When other people’s children behave badly, the temptation is to presume it’s something to do with the parents. But then one day, even if you managed to avoid the terrible twos, your very own adolescent comes downstairs to breakfast with a look that could curdle the milk in its carton, fails even to grunt a response to your cheery good morning, and makes straight for their mobile phone. It shortly becomes clear that the mere fact of your breathing is something they find deeply offensive. Nothing in their previous twelve-or-so years of almost uninterrupted sweetness gave any hint of this. Where on earth did you go wrong?


We imagine central bankers must feel similarly underappreciated every time markets fall into similar bouts of grumpiness. Like any parent, their initial instinct is to blame some sort of “external shock” – Eurozone sovereigns; weakness in emerging markets; a drop in oil prices; too much time spent hanging out with undesirable hedge-fund types. Like any parent, we think they would do well to focus less on eliminating potentially malign influences from the playground, and more on examining what in their own behaviour has left their offspring so fragile in the first place.

In yet another fantastic piece released over the weekend, Citi's chief global strategist, King again - very patiently - explains why the markets and central bankers have misunderstood QE so profoundly, this time comparing it to the act of weening one's offspring off cell phone dependence:

Misunderstandings over the effects of QE seem to us almost as large as the gap between how parents think their adolescents ought to feel and how they feel in practice. If you tell your teen you are going to reduce their screen time steadily down to zero because you are worried it’s affecting their behaviour, they do not simply sit there full of fond gratitude for the day you gave them a phone in the first place. At some point, they snap. This may not be justified, but a combination of habituated expectations and peer comparison means it is what happens in practice.


Central bankers’ ideas about QE seem likewise to owe more to an academic view of an ideal market than to the drivers of the price movements we see on our screens every day. Of all the tens of academic and central-bank papers assessing the impact of QE and other central bank liquidity injections, not one considers the (really rather obvious) approach which is our favourite: simply adding up the global total value of securities purchased by central banks each month (Figure 1) and then comparing it with the spread movement in credit or the price movement in equities (Figure 2).

The chart below - shown previously - is one of our favorites, and demonstrates the direct impact of central banks on asset prices:

And as discussed before, it is what happens next that is most troubling:

Hardly surprising, in his latest piece Matt King once again focuses on the same point he has been pounding the table on for the past year: "why we think markets will once again prove surprisingly sensitive in coming months." His arguments: 

  • First, we argue that in assessing potential dependence on QE, central banks have largely been looking in the wrong places and at the wrong metrics: QE works globally and in terms of the flow of CB purchases, not in terms of the stock, and exhibits stronger relationships with risk assets than with government bonds.
  • Second, we argue that the primary mechanism through which QE has had an impact is an enormous squeeze on the net supply available to absorb private investors’ savings – and that following QE1, relatively little has fed through to the real economy.
  • Third, we argue that central banks would be able to make a smooth exit either if fundamentals had improved so as to justify risk assets’ lofty valuations, or if those valuations were not so lofty in the first place – but demonstrate that neither of these is the case.
  • Finally we look at the conclusion we think central banks ought to draw – and contrast it with what seems likely in practice. It can be tough to do the right thing as a parent.

While much of the above has been covered extensively here before, with the critical topic of flow's dominance over stock first explained all the way back in 2012 in "The Stock Is Dead, Long-Live The Flow: Perpetual QE Has Arrived" an article which led to the correct forecast of QE3, and QE in Japan and Europe, we'll comment more in depth on point three, while touching on bullet point 2, the "net supply" argument (further discussed two months ago in "BofA: "If Bonds Are Right, Stocks Will Drop Up To 20%"). The argument here is simple, and logical: the more securities central banks soaked up from the market, the further they pushed investors into risky assets. Here is King:

What happens in any market when you get steady net demand but zero net supply? Prices go up – regardless of the fundamentals. It sounds trite, but isn’t that exactly the pattern we’ve had across markets the past few years – be they govies or credit or equities or EM or real estate (Figure 12)? 2015 was an exception, but of course that’s exactly the period when net supply to markets did increase thanks to the drop in EMFX reserves, meaning that money that was previously being crowded into risk assets ended up absorbing increased net supply in govies.

With central banks vowing to reduce their balance sheets, the net supply to markets will increase significantly, resulting - obviously - in lower prices and higher yields (this was also discussed in "If The Fed Sells Treasuries... Who Will Be Buying? Answer: "Other.""

While the above is also hardly new, the key observation made by King in his latest piece is that not only do fundamentals no justify valuations, not only have investors been herded into risky assets at the guidance of the Fed (creating another bubble), but that "valuations are sky high", and once the Fed's training wheels come off, what happens next will be unpleasant:

The ... reason we think the transition will be difficult is simply that the starting valuations are so high already. It would be much easier for fundamentals to take over from central bank liquidity if the valuations across markets they needed to justify were not close to the highest we have ever seen. Credit spreads have basically been tighter only in 2007 (a level which many investors thought would never be revisited). Equity volatility is at its lowest since the 1950s. The cyclically-adjusted P/E ratio on the S&P has been higher only twice: at the height of the dot-com bubble in 2000, and in 1929. Those with long memories are already fretting about valuations across the board and warning investors against being greedy.

And a stunning admission by one of the world's biggest banks: investors - its clients - have effectively given up on valuation as a metric:

Many investors we speak to seem almost to have given up on valuation as a metric. Rather like real estate in London or New York or Hong Kong, they are resigned to it: it may look expensive on paper, but the price is what it is, and they buy anyway. Several told us they would rather lose lots of money in company with the rest of the market than underperform slightly in a continuing rally and then suffer a fall in assets under management as investors moved elsewhere.

The implications, also discussed previously, are profound - one could call it the bubble to end all bubbles:

Indeed, much has been written about the wave of money migrating away from active managers towards ETFs and passive index funds. In a market rallying with low single-name volatility, the only way an active manager can outperform is by throwing caution to the wind and ensuring that they are long risk relative to the index. If large numbers of managers adopt the same strategy, it will inevitably render the market vulnerable.

While King's missive against central bank manipulation touches on many more critical points, his assessment of what happens next is troubling for those who believe that central banks will keep market under control:

As a general rule, it is probably easier to reduce teens’ dependence on phones if you have not been through multiple iterations of previously trying to do so, only to give in when they then responded badly. Depending on how you add up the various episodes of global QE, in markets we are either still on iteration #1 (our global central bank liquidity metric has remained permanently positive since 2009), or conversely at least iteration #10 (three episodes of QE + Twist in the US, two distinct periods from the ECB, two from the BoE, and at least two prolonged ones from the BoJ). While at a global level there has never been any attempt to reduce the size of central banks’ securities holdings, on each occasion to date that even the flow of purchases has been reduced, first markets and then the economy have faltered to the point that central banks have given in and come back with more liquidity still.

The punchline: the impact on markets resulting from all the above would be rather devastating: at least a 100bps blow up in IG credit spreads and a 30% equity selloff:

If the historical relationships shown earlier were to hold, the relatively modest reductions planned by the Fed and likely from the ECB over the next year, coupled with the surprisingly large reduction we have already seen in purchases from the BoJ since the shift to yield targeting, would be consistent with IG credit spreads widening some 100bp and global equities selling off 30%.

Meanwhile, the Fed continues to exist inside its ivory tower, in which Yellen went so far as to say on the record two months ago that there will not be another financial crisis "in our lifetimes." In this context, we leave you with the following memorable passage from King:

Central banks have tended to ignore such risks – indeed, with Janet Yellen memorably stating she considers another financial crisis unlikely within our lifetimes – in part because they are less convinced of markets’ deviation from fundamentals than we are, but also in large part because their very definition of financial stability is one which is centred on the banking system. Stability is equated directly with leverage; if there is less leverage, there can be no risk to stability. The other factor which has helped valuations reach this point is that no one can quite imagine the specific sort of trouble the market will get itself into.


“What’s the catalyst?” we are often asked. Yet as with your children, if you wait until you can already see what sort of trouble they’re involved in, there’s a good chance you’re responding too late.


Our best guess is some combination of market sell-off associated with investor outflows. With some over $800bn having gone into fixed income mutual funds over the past five years, of which over $500bn having gone into some form of IG credit fund, it would not be especially surprising to see some combination of elevated valuations and higher real yields on deposits or other safe assets cause investors to decide to take profit. Yes, there might well be some form of external trigger (concerns about conflict with North Korea?), but this in itself might well be unrelated.


With debt/GDP at record high levels across most economies, it would be similarly unsurprising if negative wealth effects caused the resultant sell-off in risk assets to feed through to the real economy. Just because the rally in markets did not boost growth as much as central bankers were hoping does not mean that a sell-off would not affect it negatively: indeed, the fact that the benefits of market gains are narrowly distributed but losses might well be socialized means that increasing debt may well be automatically increasing the likelihood of an asymmetric reaction.


Note further that we are therefore fully expecting markets to move first, and the economic reaction to follow only thereafter. It is not that we see higher interest rates leading to a spike in corporate defaults leading to outflows and an investor sell-off; it is that default rates have been suppressed (relative to their historical relationship with GDP growth, and relative to corporate leverage) by the supply-demand imbalance and wave of investor inflows allowing corporates to roll maturities and abandon covenants, and that a reversal of those inflows – whatever its cause – might lead to the expectation of increased defaults thereafter.


This pattern may seem surprising, but of course it is exactly what happened in 2000 and 2007. It is not that a weakening economy precipitated a sell-off in the NASDAQ, or that a sudden recession dragged down the US housing market; it is that the bursting of each market bubble dragged down the economy. On each occasion it took a lower level of real interest rates to make investors change their minds about the assets they’d been buying and head for the safety of cash; on each occasion there was a higher level of debt across non-financial sectors.  


Now, there is more debt still.

Tension is more likely to spark a US trade war with Beijing than a shootout with Pyongyang. China’s debt bubble will burst, with major consequences

Full marks for timing, Mr President. Last week marked the 10th anniversary of the start of the biggest financial crisis since the Great Depression, making it an appropriate moment for Donald Trump to threaten North Korea with obliteration.

One of the few achievements Trump can point to in his first six months in office is that shares on Wall Street have been steadily rising since his election victory last October. The “fire and fury” remark and the inevitable counter blast from Kim Jong-un gave the markets pause for thought. But not much more than that.

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By Steven Englander, head of research and strategy at Rafiki Capital Management

I propose a microeconomic rationale for why macro wage performance is so weak, despite tight labor markets. The idea is that we are getting paid less for our job-specific knowledge because technology is making it easier to replace us without major loss of productivity with less skilled workers. The implications for markets:

  • Flattish Phillips curve and low wage inflation continue for an indefinite period
  • Living standards may increase because of lower price relative to wages, not higher wages relative to prices
  • Monetary policy will have to get on with dealing with a low inflation economy -- this means setting aside obsessions about balance sheet reduction and setting up the facility to use fiscal policy as needed when the zero bound is approached
  • It’s relatively positive for equities in innovating sectors
  • Long-term bond yields will be driven by monetary policy fears, not long-term inflation worries
  • Short-term policy rate moved will be capped by the sensitivity of the economy to interest rates which may not be large. Note that this cuts both ways – both tightening and easing may be ineffective.

The thought experiment

My idea is that wages are driven by how scared your boss is that you are going to leave. If replacing you, retraining your successor and waiting for him to climb the experience curve is costly, he will pay a lot to keep you from leaving. If you are a cog in a wheel, then he won’t care much.

Imagine an economy of a bus driver, a taxi driver, a cook, a translator, a baby sitter, a doctor and a foreign exchange strategist.... Conceptually you can measure average job specific content by asking the following question: if you randomly reallocated jobs among these workers how much would productivity fall? For example, if the FX strategist was given the cook’s job and the cook became a doctor and the doctor a taxi driver and so on, what would happen?

Say in Economy A, there is specific knowledge or character traits needed: a bus driver needs the specifics of driving a bus safely, a taxi driver knowledge of the street grid, the translator an excellent command of relevant languages, the baby sitter some proven degree of responsibility, the cook of recipes and technique, the doctor the body of medical knowledge, the FX strategist how to say ‘current account’ and so on. Now imagine the chaos and productivity loss, if the random reallocation occurred and none of the occupants of new jobs had the required skills.

Now, say in Economy B, the bus is programmed to avoid dangerous manoeuvres, all taxi drivers have a GPS (unlike NYC where none seem to), the translator has automated translation at his fingertips, the baby sitter is aware the house and liquor cabinets are cameraed, the cook has a set of packets to mix (or almost equivalently the packets are sent to your home for you to mix), the doctor a diagnostic program and the FX strategist a chatty virtual assistant that can say ‘current account’. If a random job reallocation occurred in this economy the productivity loss would be much less. My conjecture is that wages would be lower
because there would be no need to bid to retain workers if they were readily substitutable, or if the same jobs could be filled with less specialized workers with no major productivity loss.

Wage compression is very likely to be a feature in Economy B relative to Economy A – that is, the premium one receives for job specific knowledge and experience would fall. If you throw in a bit of capital saving technological progress from the sharing economy and economies of scale from the low marginal cost of replicating many IT-based innovations, you could end up with a kind of immiserization of parts of the skilled and semi-skilled working classes.

Evidence is partial, but it is not straight forward to test this speculation. Figure 1 shows wage levels in selected industry groupings. Note that wages in motor vehicles and parts (bright blue) started way above over industries, but is now average for durable goods (red line) and below education and health services (green line) which started way below. Motor vehicles and parts are now way below the average wage in the private sector, having started above 50% higher in the 1990s.

In Figure 2 we index these industries to 100 in 2000. We note that wages in leisure and hospitality (light blue) and education and health (green) have both grown faster than in durables manufacturing (red) and above the average for all private industries. Vert similar patterns emerge if we index to 2011.

So wages have grown slower in high paying industries, faster in low paying industries and the net is the mediocre observed wage growth. What isn’t consistent is Atlanta Fed wage evidence that suggests the quit rate is back to normal for this time of the cycle and the wage premium for quitters is as high as it was in the early 2000s. The other side is that the Atlanta Fed data shows the gap between increases of skilled and unskilled workers as having narrowed.

Macro/market implications

The problem for central banks is that we know little of what triggers such shifts in labor market power, how long they last and what ends them. As long as these shifts persist, the Phillips Curve will look flatter in  two-dimensional Unemployment Rate/Wage Inflation space. A well-specified wage equation that account for such structural changes would have a steeper inflation/unemployment trade off than one without the term but capturing the effects we discuss above is not so easy.

The type of technological progress would imply lower price pressures because the wage weakness would be transmitted in part into prices. (Full disclosure, you have to believe that there is an unmeasured component of actual productivity change here, although it may show up as quality-adjusted labor productivity, rather than standard output per-worker or worker-hour).

These disinflationary pressures may be hard to fight. Combine this with investment that is not overly responsive to interest rates and you have a situation where getting the inflation that you want may be impossible without risking undesirable levels of asset price inflation. It sounds as if the Fed is already there. There is nothing inevitable about this outcome, but it emerges easily if the disinflationary pressures are strong enough and the interest rate responsiveness is low enough.

One policy response is to live with it. Ultra-low inflation countries such as Japan and Switzerland have done just fine by many measures and the zero bound becomes an issue in a recession, not during an extended recovery. By ignoring it you have some ability to rein in asset market exuberance, but you are compromising on inflation and possibly activity targets.

This does not necessarily stop you from raising rates, but you are faced with a dilemma. If raising rates is effective you end up with the downturn you wanted to avoid, if raising rates is ineffective you are fooling
yourself in thinking that the margin versus the zero bound means that you are all clear in the next downturn. Being able to raise policy rates to three percent without tanking the economy very likely means that you can cut them in the next recession, you won’t have much of an impact. Hawks would argue that reducing the risk of a financial market bubble reduces the risk of a recession down the road.

It seems to me that whichever way you turn, fiscal policy has to be taken out of the doghouse. Post election, Fed officials reversed their pre-election love affair with fiscal policy, arguing that the economy does not need it. One might say that if the inflation undershoot turns out to be persistent, fiscal policy will become even more necessary to offset structural pressures. And if you think that high liquidity is contributing to asset market ebullience, then a bit of fiscal stimulus combined with monetary tightening can maintain activity and unwind some of the asset market pressures.

Modest long-term price pressures are probably positive on the fixed income side. Long-term disinflationary pressures and modest investment will keep downward pressure on long-term bond yields even if the Fed tightens at the short end in response to fiscal policy. The use of fiscal likely means being more relaxed about the size of the balance sheet. Debt-to-GDP would have to grow both cyclically and structurally, but debt servicing may not grow very rapidly because of the low inflation and the Fed’s interest income being recycled back to the Treasury. Short-term policy rates may swing around a lot versus stable but relatively low long-term rates.

The central bank could take a hard line and maintain or shrink the balance sheet even as fiscal expansion was put in place. Still, it would hardly help macroeconomic stabilization if government finances were called into question, so willy-nilly it is likely that the balance sheet would absorb some of the debt incurred via fiscal policy.

Caveat emptor – this analysis is pretty long term. In the short to medium term, I expect central banks like the Fed and ECB to try and follow up their rhetoric with liquidity tightening and for this to be reflected in long-term rates. Only if/when it turns out that the tightening is unsustainable will the forces I discuss above come into play.

On the equity side, if you can replace a skilled worker with a less skilled worker that is an attractive proposition. It is not as exciting as booming demand but it still reaches the bottom line. The social consequences are mixed. It is possible that this reduces the returns to certain types of training and education, both specialized and generic, but overall demand for relatively undifferentiated blue-collar labor will go up as will their wages. Improvements in living standards are likely to come via lower prices than higher wages. This is hardly the American dream. However, it is often difficult to put together policies that efficiently offset technological forces to provide distributional equity, and if other jurisdictions are not so focussed on distribution, you can end up with the worst of both worlds. It is possible that workers will drift to occupations where differentiated skills can earn a higher return – so maybe fewer doctors and lawyers but more dancers with the stars.

If you look at any central bank econometric model, the demand side has decades of development, the supply-side and particularly the modelling of technological change is primitive, distribution is virtually  nonexistent and asset market bubbles a problem because they should not exist in the model world. These secondary issues have become first order issues. Unaddressed they mean incomplete policy regimes and surprising and disappointing outcomes.

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