STALL SPEED : Any Geo-Political, Economic or Financial Event Could Trigger a Market Clearing Fall
As we reported last month, Global Economic Risks have taken a noticeable and abrupt turn downward over the last 60 days. Deterioration in Credit Default Swaps, Money Supply and many of our Macro Analytics metrics suggested the global economic condition is at a Tipping Point. Though we stated "Urgent and significant actions must be taken by global leaders and central banks to reduce growing credit stresses" nothing has occurred even after the 19th disappointing EU Summit to address the EU Crisis. Some event is soon going to push the global economy over the present Tipping Point unless major globally coordianted policy initiatives are undertaken. The IMF recently warned and reduced Global growth to 3.5%. This is just marginally above the 3% threshold that marks a Global recession. This would be the first global recession ever recorded. The World Bank is "unpolitically'projecting 2.5%. The situation is now deteriorating so rapidly, as to be impossible to hide anylonger.
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MONETARY MALPRACTICE : Moral Hazard, Unintended Consequences & Dysfunctional Markets - Monetary Malpractice has had the desired result of driving Investors into becoming Speculators and are now nothing more than low-odds Gamblers. There is a difference between investing, speculating and gambling. At one time these lines were easy to comprehend and these distinctive groups separated into camps with different risk profiles in which to seek their fortunes. Today investing has become at best nothing more than speculating and realistically closer to outright gambling.
The reason is that vital information is either opaque, hidden or manipulated. Blatant examples such as: the world of off balance sheet debt, Contingent Liabilities, Derivative SWAPS, Special Purpose Vehicles (SPV), Special Purpose Entities (SPE), Structured Investment Vehicles (SIV) and obscene levels of hidden leverage make a mockery out of public Financial Statements. Surely if we get our ego out of this for a moment we can see that stockholders are now nothing more than gamblers? What is worse is that the casino is rigged. With Monetary Policy now targeting negative real interest rates, it is forcing the public out of interest bearing savings and investing, and into higher risk vehicles they would have shunned historically. They have no choice as the Monetary Malpractice game is played against them.
There is an old poker player adage: "when you look around the table and can't determine who the patsy with the money is, it is because it is you." MORE>>
The market action since March 2009 is a bear market counter rally that has completed a classic ending diagonal pattern. The Bear Market which started in 2000 will resume in full force when the current "ROUNDED TOP" is completed. We presently are in the midst of of a "ROLLING TOP" across all Global Markets. We are seeing broad based weakening analytics and cascading warning signals. This behavior is typically seen during major tops. This is all part of a final topping formation and a long term right shoulder technical construction pattern. - The "Peek Inside" shows the detailed coverage available this month.
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Latest Public Research ARTICLES & AUDIO PRESENTATIONS
Iran is not blameless, and continues to provoke Israel through its support for Hamas and Hezbollah and through eliminationist rhetoric. But given the level of provocation from the Israeli and American side, it is astonishing that Iran remains free of nuclear weapons. Yet it is a fact that Iran is not armed with nuclear weapons, and it remains a fact that Iran has not attacked nor occupied any foreign lands since World War 2. Iran is not an expansionistic country.
As neocon provocateur Patrick Clawson essentially admitted in advocating for a false flag attack to get America to war, Iran is not likely to attack either the United States or Israel. So when it comes to drawing red lines, we in the West would do well to draw a red line around our behaviour — because right now, we in the West are the ones who are stirring up trouble by threatening to strike first.
9 - Iran Nuclear Threat
BOND BUBBLE - Avoiding Risk Make Have Caused a Bond Bubble
Domestic equity mutual funds have seen outflow after outflow which now amounts to a third of a trillion since 2010.
Here is what happened in the week QE3 was announced - from ICI:
a $4.8 billion outflow in the week Bernanke promised to never let stocks drop. It was the largest outflow since May. There has not been a single inflow into equities since QE3 was either hinted or formally announced.
EXAMPLE: Fidelity bond and money market assets now total $848.9 billion, more than half of the company's $1.6 trillion in managed assets. The company built an empire in the 1980s and 1990s on stock funds and star stockpickers like Peter Lynch. Fidelity's stock mutual funds held $761 billion at the end of June... The rise of bond and money market funds, including institutional assets, is a remarkable turn of events for Fidelity.
There were no surprises in the August Personal Income and Spending numbers, which came at 0.1% and 0.5%, respectively, on expectations of a 0.2% and 0.5% rise. Summarized: less income, more spending. This however, did not make the consumer income statement data any better: the bottom line is that adjusted for inflation, Real Disposable Income slid 0.3% in August, after a tiny 0.1% increase in July, the first such decline since November 2011, and as Bloomberg's Joseph Brusuelas says this is "another rough report for the consumer which doesn’t bode well for household spending going forward."
Which means Bernanke knew precisely what he was doing when he launched QE3, which all advocated of QE3 will now say was fully justified. There is one problem with that logic however: for QE3 to be justified, it would mean QE1 and 2 were. Well, last we checked the US is still in a major depression, and neither QE1, 2, nor Twist 1 or 2 have done anything to prevent today's ugly data. Surely, this time it will be different.
Finally, and as a result of the ongoing contraction in income, as expected the savings rate dropped from 4.1% to 3.7%: the lowest since May.
Spot the recovery in either the Real Disposable Income...
The odd timing of the Fed's QEternity (given macro data, risk, financials conditions, inflation expectations, and equity valuations) provided some impetus for the markets which had anticipated Bernanke's action. The supposed 'safety net' which we suspect has now been used up - by market front-running from a lower than implied Fed Put strike - does however look in question as the US fiscal cliff looms and global growth concerns grow. However, as Deutsche notes, there remain a large number of hurdles ahead for Europe - and while many 'believe' that progress has been made, it seems now that the rubber is meeting the road, that path forward looks a little less clear - and hence risk-wary investors are unwinding peripheral ST exposure and reverting back to the core (or US MBS/TSYs).
So Far So Good...
But The Going Gets Tough From Here...
Spanish Government may want to stall OMT request until after regional election (October 21st)
Structural reform plans in Spain are to be presented very shortly - which could form the basis for an MoU
Italian Government currently delaying aid request to avoid losing momentum on reform implementation
Pressure on Italy likely to mount after Spain requests aid
Ultimately market pressure to dictate whether Italy requests aid before / after the election in early 2013
Greek program significantly off-track
TROIKA report delayed, don't expect decision until late Oct/Nov
The most likely outcome is an extension of the Greek program via tacit agreement that covers the larger up-front needs, with finding shortfalls discussed further down the road (e.g. Official Sector Involvement)
Euro zone PMIs surprised to the downside in September
Composite PMI down to 45.9, 8th month of contraction
Substantial drop in Services to 46.0 but moderate rise in Manufacturing to 45.5
Today's news that Finland, Germany, and Holland are not chomping at the bit to provide their capital is a large set-back for bank re-caps
It seems the road ahead is just as prone to mines as the road traveled and as we have seen again and again - while Germany (and her 'AAA'nxious friends) are happy to toe-the-line with jawboning and showing support verbally, once the need for real hard money comes to bear - it appears the faith is gone...
We remain cognizant of the odd timing of Ben's deliverance and wonder just what he knew that we do not yet...
Citigroup's macro risk aversion index just tested record lows (i.e. record high complacenecy levels with regard investors' view of macro uncertainty going forward). Coinciding as it did with Bernanke's all-in moment we wonder if we just saw the 'peak complacency' moment as the wall of worry was officially scaled only to find that the grass is indeed NOT greener on the other side. For sure, it would appear that all the talk of bearish sentiment as the driver of the nextt 'secular' leg in stocks seems just that - 'talk'.
While much attention has been paid to what Draghi has 'talked' about doing, what Bernanke 'is' doing, what EU Leaders 'are not' doing, and what US politicians 'will not' do - the world's risk markets remain on edge. Admittedly, for now, that edge seems biased to the 'we-believe' side of the fence. However, as Deutsche Bank notes, in their wonderfully succinct chart comparing the impact and probability of potential upside and downside risks to global markets, it is economic (or real!) data that should worry investors the most - though we still fear the Kubler-Ross 'denial' stage that in which Spain/Italy/Portugal/Greece remain mired.
the shift in (1) is over the past month
RISK - ASSESSMENT
3 - Risk Reversal
CHINA - Increasing Leverage is China's Way of Monetary Easing
“China’s economy is not just manufacturing, and there has been a general over-reaction to that sector’s problems. While CBB Q3 results confirm manufacturing weakness, our survey extends to retail, services, property, and other sectors. Most other sectors show more resilience and greater confidence than manufacturing.”
What is more interesting is that CBB reports a decline in the demand for credit in China, this even in the face of a loser monetary posture by the central bank. There may be a finite limit to China’s ability to absorb the disastrous decline in exports, but perhaps the west is over-estimating the importance of such a shock, both in political and economic terms.
Having worked in a number of “emerging markets,” the western fixation with government economic data in China and other nations always astonishes me. Jeffrey Sachs scandalized the Chinese government years ago by suggesting that the data was “too good to be true,” and indeed it was. Or as CBB put it in their Q2 report: “Astonishingly, virtually all economic analysis of China—even by the most high-profile China experts, macro- economists, investment Banks and hedge fund managers—still relies on this sorely limited set of state-sanctioned figures.”
So is China really imploding? My sense is that the reality is a lot more complicated than western audiences believe. Jim Rickards, who travels to Asia regularly, told me today that the CBB report which says that more credit may have lowered interest rates without increasing loan uptake “is completely consistent with the information I received in Hong Kong.”
Rickards adds: “This is why we should expect a decline in the reserve ratio and an increase in the loan to deposit ratio because those are both more powerful ways of stimulating lending than lowering rates. China cannot do QE because there's nothing to buy. Lowering rates does not work because of the asset-liability mismatch. So the only way to ‘ease’ in China is to increase leverage. That works.”
4 - China Hard Landing
ANALYTICS - CHINA - Shangahai Composite at 2008 Low Levels
Last night the financial press featured the decline in the Asia-Pacific markets: "Asian Stocks Fall on Investor Concern on Stimulus Effect" and "Asian shares fall on wariness over Spain" (more here).
Japan's Nikkei fell 2.03%, dropping it below the 9,000 level. But that's a line in the sand that the Nikkei has crisscrossed many times.
More striking was the 1.24% selloff in the Shanghai Composite. Why? The index briefly dipped below a more significant line in the sand -- its 2,000 -- hitting an intraday low of 1,999.48 before closing at 2,004.17. Will the 2,000 level provide support?
What is interesting about this discussion by the Washington Institute For Near East Policy, a Neocon (Globalist) think-tank, is that its primary purpose is not necessarily to debate the current political elements of the Iranian question. They aren't contemplating the viability or morality of a war with Iran. Instead, they are attempting to devise strategies by which the government could CONVINCE the American public and the world that a war with Iran is the "right thing to do", even if it means fabricating their own justification. For them, the war is a forgone conclusion, and they will do anything to make it a reality.
Think tanks like this not only construct policy framework, but they also write the subversive talking points used in the mainstream media that manipulate the masses into acceptance of that framework. In the video below, there is no suggestion that Iran be left alone if the will of the public leans away from conflict. Instead, Patrick Clawson (who works frequently with the Council On Foreign Relations) openly suggests that a Gulf Of Tonkin style event be ENGINEERED (he uses the phrase "covert means") in order to force a war into being.
Consider for a moment the kind of person that it takes to nonchalantly present such a scenario; a scenario which would use the unjust deaths of innocent people (likely Americans) in order to trick the masses into supporting yet another meaningless war which will undoubtedly cost hundreds of thousands if not millions more innocent lives. Think about the moral relativism and dark-heartedness that is required to embrace this philosophy in the pithy and clinical way Clawson does. Now realize that our government today is heavily populated by men and women who think in exactly this manner. This is the rotten core of America's foreign policy on display for all to see. Take note and remember what is suggested here the next time a sudden "attack" is blamed on a convenient scapegoat like Iran and used as a primer for invasion...
Global trade volumes are slowing notably, and surprise surprise, Europe is leading the lag. Between the total lack of any sustainable trade advantage that the PIIGS suffer from (discussed here) and recent outlook cuts from FedEx and UPS (detailed here), it is not a shock that the following detailed charts of Import and Export volumes for China, US, Japan, and Europe are starting to drop notably. Just as we pointed out here, Europe remains the hub of around half of World Trade and as is clear, the myth of decoupling among the world's largest economies is smoke-and-mirrors as it is a lead-lag relationship that is now proven to be entirely un-decoupled as 'obviously' the import and export sides of the world's imbalanced economies show trade is falling in a hurry.
17 - Shrinking Revenue Growth Rate
INFLATION - Its There but the Government Doesn't Accout for it.
As America's mania with cell phones as an aspirational status fad hits new records every day, this borderline addiction to "thinner, longer" mobility and a sub-1 year upgrade cycle, is starting to extract its pound of flesh: average cell phone bills that have risen by over 10% in one year (from $1,110 to $1,226), even as total household spending rose by half, or $67. In a word: iNflation. It gets worse. As the WSJ reports, "spending on food away from home fell by $48, apparel spending declined by $141, and entertainment spending dropped by $126." Like a true faux status/gadget junkie, Americans don't care what other discretionary items are cut, even such "American staples" as eating out and watching movies, just so they can keep up with all the other Joneses sporting a brand new iPhone X+1, while everyone's credit card bill just gets larger and larger, and the collective wealth evaporates.
Families with more than one smartphone are already paying much more than the average—sometimes more than $4,000 a year—easily eclipsing what they pay for cable TV and home Internet. From the WSJ
Melinda Tuers, an accounting clerk at a high school in Redlands, Calif., said she already pays close to $300 a month for her family's four smartphones. She and her husband have cut back on dining out, special events and concerts to make room for the bigger phone bill.
"Policy choices made in the near-term will affect the economy for years to come. If not addressed, current debt and spending dynamics will probably lead to a reduced growth path, placing at risk expenditures on vital social programs and, over time, crowding out private sector borrowing that funds the gross private domestic investment necessary to boost productivity and living standards. Dollars spent on entitlements dwarf those spent on discretionary items such as education, and tower over net fixed business investment, which is partially responsible for greater productivity, business expansion and rising living standards. Periods with greater investment as a share of GDP are highly correlated with both faster economic growth and rising living standards. One risk to the U.S. economy is that rising entitlement spending will require the government to borrow from the finite amount of capital held by private savers, thus squeezing out private firms that need the capital to expand businesses and increase productivity."
Who needs private business when you have infinite toner cartridge and politicians who need to be reelected with promises of, well, everything.
The below chart comes from Morgan Stanley's latest Strategy Forum deck, and though it's simple, we suspect a lot of people haven't seen it yet, or really haven't made the connection between the chart and other big economic stories of the day.
Durable Goods orders expectations were pushed down to a dramatically low -5.0% after last month's dismal reading and the PMI data since but the print at -13.2% is mind-blowingly bad. Perhaps this is the sneak peek that Ben had? This drop is the largest since January 2009 when world trade had fallen off a cliff. It appears the seasonal-adjustments are the driver of the plunge as NSA is -7.2% (still very weak for August). We are sure there will be calls for the V-Shaped recovery from this but with a very different stimulus-environment around the world (i.e. jaded and soaked in much more debt), we suspect that will be less than forthcoming. The sub-indices were all weaker than expected but we note that defense -40% and non-defense aircraft orders plunged.
INDICATORS CYCLE GROWTH
CENTRAL BANKING MONETARY POLICIES, ACTIONS & ACTIVITIES
With global growth slowing, global trade tumbling, and earnings revisions falling rapidly, equity market outperformance has been (as we noted earlier) based on the Fed/ECB's largesse. The unanswered question is - how much is now priced in? Given recent 'stability' post-FOMC, it seems the follow-through is not there (especially if we look at sectoral performance) and based on David Rosenberg's estimate of Fed QE's impact on stocks, we think we know why. In the last three months, the S&P 500 has 'outperformed' the Fed balance sheet by around 220 points - which equates to a pricing-in of around 11 months of additional QEternity.
Via David Rosenberg:
As I have said in the past, there are six different factors that drive the equity markets at any given point in time, and in some periods, one or a few factors dominate, and in other periods, these same drivers can be on the back burner.
These six items are
sentiment, and the
They continue in the aggregate to provide a very murky picture, but the fact that the market has hung in following last week's massive gains tells me that the first two factors are dominant at the present time.
The Fed has bolstered investor confidence with its massive monetary easing, even if it doesn't work for the real economy - our research from the past three years shows that every $40 billion of QE boost (QE3 at a pace of this amount per month) to the Fed's balance sheet, as a static stand-alone event, adds about 20 points to the S&P 500. Then there is the fact that the hedge funds, in aggregate, have lagged so far behind this year that they will be forced into the market to avoid embarrassment - and redemptions - at the end of the year. We are hearing some hints of some asset mix shifts taking place among institutional investors too. Technicals, as far as I can see, are neutral (though improving over the past week) as is valuation though forward WE ratios are at the high end of the range for the past 20 months at 14x (and the Shiller cyclically adjusted multiple is 25% above historical norms).
Sentiment and fundamentals remain the two primary sources of downside risks. On the latter, operating profits are now declining in tandem with reported (GAAP) EPS and guidance overall is to the negative side and by a larger than usual margin (four to one). Analyst downgrades are outpacing upgrades. I look at FedEx as a cyclical bellwether and shipments are contracting. As for the former, the bull camp is getting crowded — problematic from a contrary standpoint.
At the June lows in the S&P 500, the Investor's Intelligence Survey flashed just 34% bulls — that number as of this latest week is up to 54.2% (from 51.1%). The bear share fell to 24.5% from 25.5% and is actually lower now than it was when the market was carving out an interim bottom in early June. Take note that the bull/bear gap has widened out to 29.7 points from 25.6 points last week and 7.4 points in early June (when sentiment was very low and the VIX was at 26 versus 13-and-change today) — a spread of over 30 in the past typically characterized an over-extended market ripe for a pullback: and bullish readings of 55% or higher in the past was a warning flag for those investors playing from the long side.
SHADOW BANKING - A Gaping $3.9T Hole in Consolidated Credit Growth
... at its core, the market, which despite all of Bernanke's attempt to the contrary, realizes that a centrally planned system is ultimately unsustainable, and quietly, behind the scenes, those who have shadow credit relationships are promptly unwinding them while they still can, and using the proceeds to invest into hard asset for the inevitable T+1 moment.
the more forcefully the Fed intervenes, the greater the implicit loss of confidence in the system, the greater the shadow deleveraging, and the more definitive is the ultimate destruction of the capital markets as we know them.
"Much credit growth was based on collateralized lending." Well, the collateral has now run out.
Some wonder why we have been so convinced that no matter what happens, that the Fed will have no choice but to continue pushing the monetary easing pedal to the metal. It is actually no secret: we explained the logic for the first time back in March of this year with "Here Is Why The Fed Will Have To Do At Least Another $3.6 Trillion In Quantitative Easing." The logic, in a nutshell, is simple: everyone who looks at modern monetary practice (as opposed to theory) through the prism of a 1980s textbook is woefully unprepared for the modern capital markets reality for one simple reason: shadow banking; and when accounting for the ongoing melt of shadow banking credit intermediates, which continues to accelerate, the Fed has a Herculean task ahead of it in restoring consolidated credit growth.
Shadow banking, as we have explained many times most recently here, is merely an unregulated, inflationary-buffer (as it has no matched deposits) which provides the conventional banking credit transformations such as maturity, credit and liquidity, in the process generating term liabilities. In yet other words, shadow banking creates credit money which can then flow into monetary conduits such as economic "growth" or capital markets, however without creating the threat of inflation - if anything shadow banks are the biggest systemic deflationary threat, as due to the relatively short-term nature of their duration exposure, they tend to lock up at the first sing of trouble (see Money Markets breaking the buck within hours of the Lehman failure) and lead to utter economic mayhem unless preempted. Well, preempting the collapse in the shadow banking system is precisely what the Fed's primary role has so far been, even more so than pushing the S&P to new all time highs. The problem, however, as we will show today, is that even with the Fed's balance sheet at $2.8 trillion and set to rise to $5 trillion in 2 years, it will not be enough.
Before we begin, we urge readers new to this topic to read some of the more pertinent posts we have written on the issue of shadow banking, as it is not a simple subject. Some of the more relevant ones:
For those who are somewhat familiar with the topic, but not quite, we believe a useful visualization of how traditional bank liabilities (defined simplistically and easily recreated using the Flow of Funds report using total liabilities at U.S.-Chartered Depository Institutions, L.110, plus total liabilities of Foreign Banking Offices in the US, L.111, plus Total Liabilities of Banks in US Affiliates Areas, L.112) which serve as the backbone of the entire US fractional reserve banking system, compare to US GDP is in order.
More than anything the chart above, which shows the amounts of traditional bank liabilities and GDP on the same Y axis, confirms one simple thing: economic "growth" is only and nothing more than an increase in systemic credit, aka money creation (just as Ray Dalio observed a few days ago). The problem with traditional bank liabilities is that for the most part they have corresponding money aggregates in the form of M2, which in turn is primarily fungible deposits, as an opportunity cost. And, as Germans living in the 1920s recall all too well, putting meaningless theory aside, deposits, when escaping the fractional reserve system and used to pursue hard assets, are the primary driver of such unpleasant monetary events as hyperinflation.
The nuisance that are "deposits" is also why the banking system is desperate to prevent bank runs, which are not so much a threat to systemic liquidity: any central bank can and will step in and guarantee all the banks' viability overnight if it has to, as it did at the peak of the financial crisis, but an asset allocation decision to shift out of an asset equivalency system built upon faith, and into a mode of hard asset ownership, based on lack of faith in the system (it also explains why the Fed hates when you use your cash to buy "worthless" and cash-flow free hard assets as gold, silver, copper, crude, etc). Of course, what happens with asset prices should $9 trillion in deposits suddenly exit bank vaults and seek to purchase "stuff" would make even the Hungarian hyperinflationary episode, in which prices doubled every several hours, seem like a walk in the park.
So how to fix this? How to ensure economic growth without the threat of inflation at any corner should a central planner make a false move leading to an uncontrollable bank run and deposit outflow? Simple: create a representation of money without the actual money, i.e., M2 equivalents, whether currency in circulation, or even electronic deposits.
Enter the shadow banking system, which is simply the traditional banking system however without the deposits and without the threat of monetary redemptions from the banking system (and the threat of a collapse of fractional reserve banking): it is quite simply, the essence of bank transformation funded by "faith", or a system in which credit money is created, but without an offsetting money equivalent unit. It is a system in which assets and liabilities are essentially the same concept, interwoven in a daisy chain of rehypothecated ownership claims, and in which every incremental layer of credit money creation serves to ultimately boost the nominal quantity of credit money in circulation.
What this does is it allows for near infinite credit-money expansion within a financial system, without a threat of inflation. It does, however, not prevent the threat of a deflationary collapse should faith in this same system be shaken, and counterparties demand to be made whole on their exposure, which incidentally peaked at $21 trillion in 2008.
But by far the biggest threat with shadow banking, which perceptive readers have already grasped is nothing but the greatest ponzi scheme ever conceived, is that it works brilliantly in an environment of increasing leverage, but should deleveraging commence, is an asset price black hole, as the entire Schrodinger Asset/Liability Function collapses in on itself upon the realization that there are no real asset at the end of a rehypothecation chain. In other words, the moment a liability is accelerated, due to maturity, request for deliverable or any other inverse "faith" transformations, the jig is up.
As the second chart below shows, one of the primary reasons for the surge in US capital markets beginning in 1980 is not so much the "great moderation", which was certainly a necessary but not sufficient condition for Dow 36,000, as much as that starting in roughly June of 1982, when shadow liabilities crossed the $1 trillion line for the first time and never looked back, the US shadow banking system became a more and more prevalent form of credit money creation, until it overtook traditional liabilities in 1995 in terms of total notional. While traditional liabilities have historically matched GDP dollar for dollar, when one throws shadow liabilities into the mix, one can see a distinctively different picture: the one below.
But where did all those extra trillions in credit money created via Shadow intermediation end up if not in the economic growth of the US? Why in its capital markets of course! This, ironically, makes sense from a symmetrical point of view. Recall that shadow liabilities, by their nature, are not inflationary as they do not have matched monetary aggregates: the US Stock market is also, at least according to the US government and the economic canon, is ot viewed as being part of any inflationary measurement, even though all it really is deferred purchasing power: for example, if everyone is long AAPL and if everyone manages to cash out at the very top, when the market cap of AAPL is $1 quadrillion (for illustrative purposes), all that cash would then exit the capital market and compete with other former AAPL shareholders for physical goods and services. It is in this sense that the S&P merely is a conduit to the latent inflationary build up that infinite credit money creation can lead to. Implicitly, and as a rational benchmark, this boils down to creating infinite purchasing power based on "faith" in a world of very finite goods and services. Not to get cute about it, but when an infinite purchasing power meets an immovable and very finite universe of goods and services, what one gets is hyperinflation. But that is irrelevant in the topic at hand: we will write more on that in a different post.
As noted above, it all worked great for nearly 30 years... and then Lehman brothers hit. What happened next can only be classified as an epic collapse in shadow banking as all the faith in the system had been extinguished and counterparties, unsure if anyone would be standing tomorrow, demanded an acceleration on their credit, liquidity and maturity transformed liabilities, irrespective of what state or what penalty such acceleration would entail. And this is where the Fed comes in.
The chart below shows the total amount of shadow liabilities broken up by constituent parts since the 1960s. What is obvious is the exponential surge in notional, hitting a peak of just shy of $21 trillion in Q1 of 2008, and then going straight down.
More important, however, is the sequential change in liabilities within this "shadow" system: having grown every quarter for decades until June 2008, things changed rapidly with the end of Lehman brothers, and much to the chagrin of the Fed, have not improved 4 years later. In fact, as the chart shows, the peak draw down in one quarter was a stunning $1.5 trillion in credit money deleveraging in one quarter! This is an amount that all else equal, would have caused an epic collapse in either US GDP or the stock market, as trillions in credit money were taken out of the system. Remember: credit money is fungible, and 'fractionally reserved.' All said, there has been over $6 trillion in deleveraging within shadow banking since the Lehman collapse.
Which brings us to the point of this post.
In Q2, as per the just released Flow of Funds report, the deleveraging continued. In fact, between money market funds, GSEs, Agency Mortgage Pools, Asset Backed Security Issuers, Funding Corporations, Repos, and Open Market Paper, also collectively known as "shadow banking liabilities", in the second quarter the US saw another $141 billion in deleveraging take place, following the $164 billion in Q1, or a total of over $300 billion year to date.
This took the total amount in shadow liabilities to $14.9 trillion for the first time since 2005. It also means that as of right now, the shadow banking system, which continues to deleverage, and the traditional banking system's liabilities, which continue to grow primarily due to reserve creation by the Fed during periods of unsterilized QE (such as right now courtesy of QEternity), and which amounted to a record $14.9 trillion as well, have reached parity.
This is a historic inversion point for three main reasons:
As the shadow banking system delevers, the Fed has no choice but to relever traditional bank liabilities, via reserve injection to keep the system at least at equilibrium, if not leveraging at the consolidated level. In both Q1 and Q2 the Fed failed to generate the all critical credit releveraging, as first $110 billion in Q1, and then $58 billion in Q2 credit money exited the closed system via maturities without being rolled over, redemptions, conversion into hard assets, etc.
Paradoxically, it is precisely due to its action, with which the Fed continues to remove faith in the US financial system as a standalone entity and one that can function effectively without a central bank backstop at every corner, that the ongoing deleveraging within the all critical shadow banking system - the one monetary conduit which as noted above is the closest thing to a inflation-free lunch due to the lack of immediate inflationary threats - continues. As noted above, so far in 2012 there has been $300 billion in deleveraging here alone.
Completing the Catch 22 loop, the Fed, which is cornered, will continue to do what it does, reflating traditional liabilities, creating reserves, deposits, and currency, all of which have an exponentially greater inflationary propensity that the circular liabilities continued within shadow banking, and which eventually will breach the dam door of inflationary expectations leading to an epic surge in priced in and/or concurrent inflation.
Visually, this can be presented as follows:
The chart above shows what the consolidated deleveraging - combining shadow and traditional banks - since the Lehman collapse. All told there is still a $3.9 trillion hole that need to be plugged for the 'market' to simply return back to its 2008 peak credit levels. But what is truly a slap in the face of the Fed, and what confirms that the more the Fed "acts" the more it shoots itself in the foot, is that the last time we did this analysis, the hole was "only" $3.6 trillion. In 6 short months, the Fed's relentless intervention in markets, managed to force the deleveraging of over quarter of a trillion in additional credit money!
It also explains why the Fed knew long ago, that it would have to engage in a relereving program that offset at least the continuing deleveraring in shadow aggregates: first $40 and then $85 billion a month sounds about right, and is an amount that will at best keep the system at its current state as opposed to actually growing it.
And while one does not have to be a rocket scientist to have grasped by now that all the Fed does is self-defeating, what the above analysis does do is provide a primer to all those Economy PhD's who still fail to grasp how the modern economy works, specifically why so far the inflationary surge has been deferred.
In short: the more the Fed actively relevers using conventional conduits that spur the threat of inflation, and the more that shadow conduits delever, the greater the risk that inflation will finally come to roost. Because that $3.9 trillion in incremental reserves (and recall that already both BofA and Goldman, following our example, determined that the Fed will need to do at least another $2 trillion in QE, which means much more in reality) that will be created to offset the ongoing shadow deleveraging will simply pump up various asset classes, until the hard asset spillover finally hits, and no matter how much SPR jawboning, no matter how many CME margin hikes, no matter how many Saudi rumors of increase crude production, prices of hard assets will finally explode.
We can at this point say that an inflationary surge is an absolute certainty if not for one thing: if somehow the deleveraging in the shadow banking system is finally offset (and with the GSEs now in runoff mode this is a virtual impossibility), and Bernanke can take his foot off the gas, then there may still be a chance. However, as noted, 4 years in, this has not happened, and it will not happen for one simple reason: at its core, the market, which despite all of Bernanke's attempt to the contrary, realizes that a centrally planned system is ultimately unsustainable, and quietly, behind the scenes, those who have shadow credit relationships are promptly unwinding them while they still can, and using the proceeds to invest into hard asset for the inevitable T+1 moment.
The bottom line paradox here is that the more forcefully the Fed intervenes, the greater the implicit loss of confidence in the system, the greater the shadow deleveraging, and the more definitive is the ultimate destruction of the capital markets as we know them. Of course, there is still a chance that Bernanke will step back and realize what he is doing. However, since all Bernanke is, is a pawn of those whose wealth is conserved in the US equity tranche, it means that it is now, and has been for the past 4 years, impossible for him to stop.
And in not stopping, Bernanke has sowed the seeds of not only his, but everyone else's destruction.
* * *
Finally, and confirming the above observations have some basis in actual reality, is the following chart from Citi's Matt King, who implicitly summarizes everything said above as follows: "Much credit growth was based on collateralized lending." Well, the collateral has now run out.
And the "wrong horse" is precisely what all those who come up with convenient, three letter goal-seeking theories to justify an ideological bent, are focusing on. If instead of reading 1980s textbooks, all those "modern market" thinkers were to grasp just what it is that drives the market, we might still have a chance.
TECHNICALS & MARKET ANALYTICS
STUDY - Markets Show Strong Correlation With QE Policy
It would appear from this final chart that a great deal of the current market is pricing in Fed action - as more than a year of rolling returns are now negative if it were not for the actions of Bernanke...
QE3 is more like a longer but lighter version of QE1 Extension (given its size and composition) and as Morgan Stanley's Adam Parker points out, despite two outsized weeks of MBS buying the impact had a much more positive affect on HealthCare and Financials than on Technology and Discretionary sectors (though with oil prices already high this time - the negative feedback into the economy and equity markets is potentially different). However, as we noted recently, it seems fundamentals matter less than ever as S&P 500 return correlations to the Fed balance sheet are as high as ever and while hope springs eternal, unconventional policy remains a far more statistically significant driver of equity performance than European sovereign spreads, jobless claims, or even earnings revisions. Critically, the S&P 500 would be dramatically lower given over a year of rolling six-month negative returns if we adjust for the Fed's exuberance - and the symmetry of market-to-Fed reactions bodes ill for any deceleration in balance sheet expansion.
So it's QEternity or bust.
The Fed's effects on equity markets over the past two decades have been short-term in nature, highly dependent on the size of the move, and most importantly, symmetric - boding ill for any future balance sheet contraction or even reduced easing.
So far, the announcement of size and composition of QE3 looks like a light version of the QE1 extension
...during the QE1 extension, which at present seems most relevant to the QE3 announcement, Health care performed best, discretionary worst.
...but the 26-week rolling correlation of the change in the Fed’s balance sheet and the S&P 500 return was highest during QE2, and lowest last December when European tail risk began to decline.
...as we have commented many times recently, fundamentals and economics don’t matter when unconventional policy (or even dovish language) is being deployed. Sadly, there is some evidence this is right, given that since the start of QE, initial claims and earnings revisions, among other things, have been less associated with S&P 500 returns – and in the case of earnings revisions, perversely associated with S&P500 returns.
S&P 500 changes do not appear to be driven by changes in fundamentals; they have been inconsistently related to market returns during the QE periods and have generally been insignificant market return drivers.
Rather stunningly, over the past 26 weeks, two-thirds of the S&P 500 returns could potentially be explained by the Fed’s balance sheet changes...
and it is quite possible that
performance of the market would have been negative without the unconventional policy...
It would appear from this final chart that a great deal of the current market is pricing in Fed action - as more than a year of rolling returns are now negative if it were not for the actions of Bernanke...
What Might Be Different This Time?
One big potential difference between today and prior periods of unconventional policy is the price of oil. Will QE3 drive further commodity price inflation? And, if so, will there be negative feedback into the economy and equity markets? We suspect so given the fragility fo global growth.
Global economic fundamentals are awful, bearish divergences are occurring everywhere, investor sentiment is nearing bullish extremes, political risks remain high and last week's market performance can be summed up in four words - 'lack of follow through'. As Gluskin Sheff's David Rosenberg explains, more than two-thirds of the rally points the stock market has enjoyed since the summer-time lows occurred around central bank policy announcements. So the market is really a one-trick pony here, breathing in the fumes of central bank liquidity.
David Rosenberg, Gluskin Sheff: BUMPY ROAD
What the stock market lacked last week can be boiled down to two words — follow through. It's as if all the QE and then some got priced in the week before. Not even the ballyhooed introduction of the iPhone 5 managed to elicit much excitement. It was interesting to see the Dow fail to hold onto its early gains on Friday and close with a 17 point loss and to see the sector leaders narrow to a group of defensives like health care and telecom services_ The financials and materials segments were very soft and yet in the past these were the major beneficiaries of Quantitative Easing. For the week, the S&P500 dipped 0.4% — which was not supposed to happen. What was supposed to happen, as the elites told us, was that the lagging hedge funds were going to throw in the towel and chase this market. Everyone expects this to be a major source of buying power.
Alas, but at what price level?
At the same time, what if the bulls who lucked out this year because they hung onto Ben Bernanke's arm decide to take profits or at the least lock in their gains? Or what if there is no progress made on the fiscal front and we go into year-end with the gnawing realization that top marginal capital gains tax rates will be heading back to 43.4% on January 1 from the current 15%? It may be a widely-held view but it is no slam dunk that we finish off 2012 with the double- digit returns — twice what is normal — that have been posted thus far (for more proof, have a look at Money Managers Take a Timeout From Stocks in today's WSJ. And the best quote goes to "nothing the Fed has done has increased earnings expectations').
Further on the political front, it shouldn't be lost on those who are proponents of capitalism that President Obama now enjoys a 49% approval rating — it is up six points in the past year (and election handicappers should note that this is the exact same mting that George W. Bush had at this same juncture of the 2004 campaign — which he won handily against another gaffe-prone opponent).
Interestingly, prices are up impressively this year, but trading volumes are down around 20%. Yet another non-confirmation.
And its not as if the equity market has been rallying off news at it pertains to the fundamentals like the economic data and corporate earnings. Indeed, more than two-thirds of the rally points the stock market has enjoyed since the summer-time lows occurred around central bank policy announcements. So the market is really a one-trick pony here, breathing in the fumes of central bank liquidity.
The global economic fundamentals are awful. China's industrial sector is in decline_ France's PM I data is at a 41-month low, and while Germany did manage to pull off an upside surprise, the whole euro area now has its manufacturing sector behaving as though it is 2009 all over again_ Italy just sharply cut its economic growth forecast (and the stock market there was clocked for a 4% loss last week), shortly after the Japanese government downgraded its own assessment of the economy. Declines occurred in U.S. household employment, real wages, Industrial production and core retail sales. In other words, this is not QE1, when the recession was coming to an end. This is not QE2 or Operation Twist when the economy stopped looking as though it was going to do a "double dip-. No. this latest round of central bank manipulation is happening at a time when there is no sign of an imminent turnaround in the economy, and the weakness has gone viral. The real problems for investor risk appetite comes if we see signs that inflation is heading higher which will limit what the Fed can do, or if we see the economy falter which would then expose Bernanke as the non- wizard that Toto exposed behind the curtain and the Fed as pushing on a string.
Investor sentiment is not at a bullish extreme yet, but it's getting there — at just over 54% bullish sentiment in the latest Investors Intelligence survey. The wedge between the bulls and bears is flirting with the 30-percentage-point spread that typically signals interim market tops.
Earnings expectations are far too optimistic and destined to come down. The consensus has operating EPS accelerating to a 13.4% growth rate in 2013 from 5.4% this year. But with margins at cycle high levels (9.4%, rivaling the 2006 record, just as the market was about to put in its last gasp to a new high) ;and 30% above long-run norms, it will be difficult to see EPS growth that strong absent a return to vigorous corporate pricing power. And with the P/E multiple for the overall market already back to the high end of the range for the past two years, what I see at best is a sideways moving market from here. Some pundits will use interest rates as an excuse, but the weekend WSJ provided some nifty insight showing that the market multiple historically was 12x when the 10-year real bond yield was negative (versus around 14x now).
I don't know but a 12x multiple on a forward earnings stream that will likely be flat around $100 in the coming year doesn't sound like a market that has a whole lot of upside from here (or until we get another announcement from a major central bank).
There are various non-confirming developments taking place, and Dow Theory advocates know exactly what I am talking about as the Dow Transports slumped 5,9% this past week, the largest decline since November of last year That this ultra-cyclically sensitive sector is down 2,2% for the year at a time when the S&P 500 is up 16% is one of the great anomalies for 2012.
The railroad stocks not only sagged 7% last week but were also the fourth worst performer in the IBD's 197 industry group. This is a warning sign, make no mistake, underscored by the last week's guidance cuts by both FedEx and Norfolk Southern,
As someone from Miller Tabak put it to the WSJ this weekend:
This is a major divergence that should not be ignored. It tells me the risks of being in the market at these levels is growing. The Transports are the first major index to reflect an underlying change in the market. The market is now saying 'yes, the economy does matter'. You can't close your eyes and buy everything anymore.
Pretty heady stuff.
China is another anomaly as its stock market suffered its steepest decline in nearly a year as the Shanghai index closed last week at its lowest price since 2/2/12. It is down 8% for the year, and this is likely important insofar of what it is pricing in for ther world's second largest economy. It's more that just the islands dispute with Japan and the looming political transition - profits there are in a recesion, having comntracted 2.7% this year and the diuffusion mneasures of industrial activity flashed an 11th month in a row of receding manufacturing sector.
And what about Europe. Yet another non-validation. The stock market there, with an 11x forward multiple, 20% below normal, is close to telling us that the recession is getting worse. Since Super Mario embarked on his newest bond buying program in September 6th, Spanish two-year bond yields - the benchmark for global risk trades - have jumped 40 basis points.
What makes QE3 different and maybe even less potent than its predecessors is that the trend in global economic activity is still down. In the prior QEs, activity was already reviving and actually this may have played a more significant role in stimulating investor 'animal spirits' than the actual liquidity boost. Let's not also forget that earnings, both operating and reported, are now contracting sequentially. And the ISM is in a multi-month sub-50 pattern. This was not the case during these other QE episodes and serves up a greater hurdle for market performance this time around.
Today, the FAO's food index is at 213... and rising. Netherlands-based Rabobank recently published its own analysis, forecasting further rises in food prices well into the 3rd quarter of 2013. Whenever the UN Food and Agricultural Organization (FAO)'s global food price index climbs above 210, conditions ripen for social unrest.
Throughout history whenever people have struggled to put food on the table for their families, social unrest has been a common consequence.
Whenever the UN Food and Agricultural Organization (FAO)'s global food price index climbs above 210, conditions ripen for social unrest.
DEMAND: From a demand perspective, world population is growing at an extraordinary rate... plus the rise of billions of people from developing countries (especially in Asia) into the middle class is quickening demand for resource-intensive foods like beef.
SUPPLY: From a supply perspective, drought, soil erosion, and reduction of available farmland all put significant pressure on global agricultural output.
MONETARY: the enormous amount of paper currency being printed in the world is finding its way into agricultural commodities.
Bottom line, if the analysis is correct and food prices continue to rise, agriculture will be one of the best investments of the decade. As Jim Rogers has said so many times before, it will be farmers driving Maseratis, not stock brokers. Plus, you will have secured yourself a steady, reliable supply of food.
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