ISSUES 2014 / PRUDENTBEAR.COM

Issues 2014

Doug Noland

January 3, 2014


Not the most bullish looking start to 2014. “The only thing that worries me is that there isn’t anything that you can worry about…” market pundit, CNBC, December 31, 2013

“They’re [the Fed] stopping asset purchases. You can take that to the bank.” Laurence Meyer, former Federal Reserve governor, CNBC January 2, 2014

My market thesis from a year ago was one of bipolar outcome possibilities. Either the expanding Bubble would burst or it would likely evolve into “How crazy do things get?” I posited that a bursting EM Bubble was a likely catalyst for a period of global “risk off.” I also foresaw the possibility that overheated markets might push a Fed retreat from its $85 billion monthly QE. While U.S. equities and corporate debt markets turned conspicuously overheated, the Fed erred on the side of ongoing extreme monetary stimulus. Things did in fact turn “crazy,” which significantly raised the likelihood of perceived low probability (so-called) “black swans” in 2014. I’ll attempt to make my analytical case.

The basic analytical premise is one of extraordinarily protracted Credit and speculative cycles (unlike anything since the Twenties). These interrelated Bubbles, repeatedly bolstered by aggressive monetary stimulus, foment latent financial and economic fragilities. Financial and economic Bubbles have evolved over years to encompass the world. Unprecedented financial excess has cultivated epic global imbalances and economic maladjustment.

Historic monetary inflation again sustained global Bubbles in 2013. But this came with major associated costs: these included an increasingly unwieldy Bubble in China and powerful Bubble Dynamics taking hold in U.S. equities and corporate debt (not to mention Japan or European debt and equities). Conventional analysis holds that global central banks have largely succeeded in spurring post-crisis system recovery. From my analytical framework, they have clearly made things much worse.

After beginning 1990 at $12.80 TN, Total U.S. (Non-Financial and Financial) marketable debt ended Q3 2013 at $58.08 TN. Over this period, hedge fund industry asset jumped from about $40 billion to end 2013 in the neighborhood of $2.7 TN. The Fed’s balance sheet has inflated from $315 billion to $4.0 TN. What’s more, global Bubbles have been inflating for so long that the backdrop is accepted as normal. The Fed and global central banks have aggressively intervened to the point where a strong perception holds that they have everything well under control. It has become conventional wisdom that the 2008 crisis was indeed the “100-year flood.” These are the type of market misperceptions that lay the groundwork for serious market crises.

Total Non-Financial Debt (NFD) ended Q3 2013 at $41.348 TN. For perspective, NFD began the nineties at $10.837 TN. Annual growth in NFD averaged $715bn during the robust nineties’ expansion before debt growth succumbed to extreme excess. During the Bubble years 2002 through 2008, average annual NFD growth surged to $2.320 TN, about triple the level from the nineties.

Fundamental to my Macro Credit analysis has been the thesis that prolonged Credit Bubbles inflate myriad price and spending levels throughout the economy. In the end, this inflation is unsustainable. Efforts to inflate out of deep financial and economic structural maladjustment risk systemic collapse. Importantly, prolonged Credit inflation creates systemic dependency to large quantities of inexpensive Credit/finance. I have posited that a self-reinforcing U.S. economic recovery would require in the range of $2.0 TN of annual NFD growth. NFD grew $922 billion in 2009; $1.373 TN in 2010; $1.382 TN in 2011; and $1.864 TN in 2012. Slowdowns in both federal and state & local borrowings will see NFD growth slow to about $1.60 TN in 2013.

One could argue that my fundamental thesis has by this point been proven flawed. The year 2013 saw record stock prices, rising home prices, record Household Net Worth, lower unemployment and an improved economic backdrop – all in the face of slower system Credit growth. But how much of this was the consequence of the Fed’s $1.0 TN injection of new “money” directly into the financial markets? I’m convinced it would be a much different world without QE3. Moreover, the Fed’s extra Trillion had unappreciated deleterious effects, notably by spurring “terminal phase” excess in securities markets while deepening systemic dependency to Fed “money” printing.

Conventional analysis holds that the financial markets respond to economic fundamentals. The economy drives the process, with most seeing higher stock prices as confirmation of an economy now largely rehabilitated and operating normally. My Macro Credit and Bubble framework takes a differing approach: The “financial sphere” chiefly dictates the behavior of the “economic sphere.” Considering the Fed’s prolonged rate and QE measures - and resulting inflating asset markets (perceived wealth) - the performance of the underlying economy has been notably unimpressive. And while the bullish view sees an economy with mounting momentum, for 2014 I would suggest focusing first and foremost on latent financial fragilities (global and domestic).

From a top-down Macro Credit perspective, I see little prospect for U.S. Non-Financial Debt growth getting anywhere close to the $2.0 TN bogey in 2014. At least in the near-term, the federal deficit is not expected to expand significantly. It could also be another frugal year for state & local governments. Financial conditions in muni finance have tightened meaningfully. Taper issues will likely continue to weigh on the sector, with a potential market problem with Puerto Rican debt a festering issue.

Although Household mortgage debt turned positive in Q3 2013, I doubt the Household sector is about to commence another borrowing binge. Big stock market gains and rising home prices have bolstered consumer confidence and spending in the face of tepid income growth. At the same time, it would appear that the multi-year benefit from refinancing mortgages has run its course. While spending does enjoy some current momentum, there’s a decent case to be made that consumer expenditures are unusually vulnerable to an environment of higher market yields and weak equity markets. I would expect weak bond and equities markets, if they materialize, to bring resurgent housing inflation to a brisk conclusion in most markets. Any meaningful tightening of corporate Credit would likely impinge already weak growth in compensation.

The U.S. corporate debt market stands prominently near the top of my list of “Issues 2014.” Corporate debt growth will come in near 9% for 2013, the strongest pace since 2007. I have argued that U.S. stock and corporate debt were primary beneficiaries of QE3. Throughout 2013, corporate debt fed off of Bubbling equities, QE liquidity overabundance and powerful yield-chasing speculation. Especially after last year’s excesses, corporate securities markets could be the most vulnerable to an abrupt change in sentiment and marketplace liquidity. There has been $5.0 TN of corporate debt issuance since the ’08 crisis – and there’s a case to be made that much of this Credit is significantly mispriced in today’s marketplace.

Our experimental central bank has in only five years inflated its balance sheet from $900 billion to $4.0 TN. All along the way, I have viewed Fed measures as confirmation of my Bubble thesis, while the bulls have seen confirmation of the view that central bankers won’t tolerate a crisis.

Our central bank’s expanding policy experiment has more recently included unemployment and inflation targets. It is commonly believed that monetary policy can readily impact employment and consumer prices. I would contend that it is certainly within the Fed’s power to manipulate interest rates lower and inject liquidity into the securities markets. Last year provided a historic example of how the Fed can indeed freely create and deploy “money.” It is, however, within the realm of (often whimsical) “animal spirits” to determine its effects upon financial markets. And, yes, this loosening of financial conditions at least in the short-run does stimulate the markets and spending. As we’ve witnessed, extreme monetary stimulus can pull the unemployment rate somewhat lower.

But how about consumer prices? I actually believe there is a major misperception when it comes to the power of contemporary central banks to dictate an aggregate price level – a misconception with potentially important implications for securities prices. In contrast to the traditional central bank printing press that distributed paper currency throughout the real economy (generally raising prices), the contemporary electronic printing press injects liquidity directly into securities markets. The paramount inflationary impact is on securities prices and issuance.

As a rough proxy for total outstanding marketable debt, I tally outstanding Treasuries, MBS, Corporate bonds and muni debt. I then add the market value of equities for a proxy of “Total U.S. Marketable Securities.” According to the Federal Reserve data (Z.1), 2007 ended with total marketable debt securities of $27.5 TN and equities of $25.6 TN, for combined Marketable Securities of $53.1 TN. As a percentage of GDP, Marketable Securities ended 2007 at a then record 378% of GDP. This compares to $6.2 TN of Marketable Securities back in 1985 at 148% of GDP; $18.8 TN of Marketable Securities at 254% of GDP in 1995; and $43.35 TN of Marketable Securities at 343% of GDP to end 2005.

I estimate that “Marketable Securities” ended 2013 at approximately $68.15 TN – fully $15 TN, or 28%, greater than the record level heading into the 2008 crisis. As a percentage of GDP, total Marketable Securities have almost reached 410% of GDP. I estimate that Marketable Securities inflated an unprecedented $6.65 TN in 2013 (waiting for Q4 data).

The average stock (Value Line Arithmetic) inflated 38.4% during 2013. The Consumer Price Index is expected to be up about 1.2%. The Fed’s Trillion dollar “money” printing operation clearly had a huge impact on equities prices, but not so much when it came to general consumer prices. There is understandable worry that the Fed is laying the groundwork for future inflation. Yet, is it possible that the Fed’s monetary operations could actually be having a perverse impact on prices outside of securities and asset markets? This could prove a major Issue 2014.

I would like to be clear on this: I am not arguing that disinflationary forces are the prevailing risk. The overarching risk remains central banks accommodating unsustainable global Credit and asset Bubbles. The Fed and global central banks’ “deflation” fight has and will continue to only exacerbate Bubble risks. And, importantly, myriad Bubbles are creating an increasingly dangerous gulf between inflated securities prices and disinflationary forces gathering momentum in real economies. This schism is a major Issue 2014.

I would contend that central banks these days have minimal control over consumer prices. Much more important is the atypical nature of contemporary economic output, with myriad services, drugs and medical procedures, digital downloads, various media and entertainment, and an incredible array of technology products creating a virtually unlimited supply of things to readily absorb purchasing power. “Globalization,” especially the (global Bubble-induced) incredible increase in manufacturing capacity throughout China and Asia, has also had a profound impact on the general pricing backdrop.

When the Fed these days injects $1.0 TN of new “money” into the markets, various forces are unleashed that actually work against its goal of higher consumer price inflation. Fed liquidity certainly worked to sustain a boom in manufacturing capacity throughout China and Asia. Prolonging the U.S. Credit Bubble also ensured a further redistribution of wealth to society’s more fortunate. The end result is that the Fed’s Trillion dramatically inflated stock prices with little of this “money” distributed generally throughout the real economy. Segments of the economy begin 2014 in a spectacular boom, while vast sections of the country and society face ongoing stagnation.

The bullish view holds that equities these days reside in this extraordinary “sweet spot” of low market yields, low inflation and expanding profits. The U.S. recovery has finally reached takeoff speed. The future is bright and such a backdrop is deserving of generous market valuations.

My analytical framework views the world from an altogether different perspective. Inflating securities markets mask that central bankers are actually losing their war. Experimental monetary policies have fomented dangerous asset Bubbles, while exacerbating financial imbalances and economic maladjustment. Disinflationary pressures globally are an increasing risk to corporate profits and Credit quality more generally. This is especially pertinent today in China, Asia and the emerging markets (EM). There, Credit continues its rapid expansion, while global overcapacity builds for too many things. Equities generally should trade at a significant discount to traditional valuations, while Credit spreads would reasonably reflect an increasingly risky financial and economic backdrop.

Last year saw cracks in EM Bubbles and the initial phase of revaluing EM securities. In a world of central bank-induced over-liquefied and highly speculative markets, trouble at the “periphery” only worked to spur excess at the “core.” U.S. (and “developed”) securities markets Bubbles, in particular, fatefully diverged from the global trend of heightened instability and mounting disinflationary forces.

The Chinese Credit system and economy are major Issues 2014. After years of runaway Credit and capital investment, the Chinese economy suffers from excess capacity across various industries. This is particularly problematic for what has become a highly leveraged economy. Corporate borrowing costs have begun to reflect this backdrop, with rising risk premiums a serious issue for highly indebted corporations. Their highly fragmented and opaque local government sector is an accident in the making. The same is true for China’s ballooning “shadow bank” and its tinderbox of Trillions of risky Credits bound with the (“moneyness”) perception that Chinese authorities will ensure safety and liquidity. Especially after again failing to confront its escalating problems 2013, I believe China will be a major global concern throughout 2014. I see all the necessary elements for a major financial crisis.

Over the past year, it appears Credit continued to grow in excess of 20% in China, Brazil, India and elsewhere throughout EM. This supports my view that the unfolding EM Credit crisis is in an early phase with the more significant economic effects yet to manifest. It’s worth noting that Asian markets have begun 2014 on the downside. Equities opened the year weak, while bond yields and CDS have moved higher. Thailand equities were hit for 5% on the first trading day of the year, while Indonesian yields jumped 53 bps (to 9.0%) this week.

The New Year begins where 2013 left off, with troubling social tensions and political uncertainties. Turkey is an important EM economy with very serious political, financial and economic issues. But my scan of the world sees a troubling backdrop conducive to ongoing social and political instability. Developments throughout the Middle East continue to appear ominous. The global Bubble has fatefully raised societal expectations in China and throughout EM. I fear escalating tensions between China and Japan, and see Japan’s yen devaluation as aggravating the situation. It may have been “enrich thy neighbor” to Bernanke in 2013, but it will be an increasingly contentious “beggar thy neighbor” in 2014.

I would include Europe as a major Issue 2014. Almost ironically, cracks in EM worked to the benefit of European markets in 2013. Speculative flows buoyed Italian, Spanish, Portuguese and Greek bonds, as "hot money" exited faltering markets in Brazil, Turkey and elsewhere. And even in 2014’s initial trading sessions, periphery eurozone bonds were global outperformers. A major question for 2014 will be how periphery European markets trade in a global “risk off” (or at least less risk-on) market dynamic. With little headway made in reducing debt throughout the region, the risk of a self-reinforcing (“debt trap”) rise in market yields remains. And if global financial conditions do tighten, the markets might begin taking a dimmer view of French fundamentals in particular.

Powered by a resurgent U.S. economy and strengthening European recoveries, the conventional view holds that the global economy is on an uptrend. I would focus instead on Chinese, Asian and EM vulnerabilities. While economic activity is today supported by generally extraordinarily loose financial conditions, this backdrop would appear vulnerable.

I believe there is today a consensus within the Federal Reserve System to wind down its balance sheet operations. But I also think they were serious when they were talking “exit strategy” with the Fed’s balance sheet about half today’s size. Federal Reserve policy is undoubtedly a major Issue 2014.

For at least the past six years, analysis of monetary policy has been fundamental to analyzing financial markets. Is the Fed’s balance sheet on its way to $10 TN? After expanding holdings to $4.0 TN, will it be possible for the Fed to now extricate itself from monetary inflation and market intervention/manipulation?

There will be major consequences if the Fed does this time follow through with its plan to taper purchases throughout 2014. Market participants have been trained to assume any bout of market weakness will have the skittish Fed quickly reversing course. I expect, however, that the Fed’s clumsy handling of its 2013 taper communications – and the frothy response in equities and corporate debt markets to Fed back-peddling – will have the Yellen Fed thinking twice before responding to the first flurry of market taper tantrums.

The return of potentially mercurial “risk on, risk off” market dynamics is an important Issue 2014. The Fed still likely has at least another $500 billion QE in the hopper, while there is as yet no indication that the Bank of Japan is pondering a QE reduction. So, for now, prospects remain for significant monetary inflation. But will it be ample?

Hedge fund industry assets are said to have reached $2.7 TN. But this is only one segment of the expansive “global leverage speculating community.” I have over the years referred to an expanding “global pool of speculative finance” as an important consequence of “activist” central banking and their monetary inflation. The conduct of this “pool” is a major Issue 2014.

When the speculators wanted to get short European debt in 2012, those markets almost buckled under selling pressure and attendant illiquidity. The Draghi backstop and global QE convinced the speculating community to be long European debt - and markets boomed. If the speculator community moves to aggressively short EM, those markets are in serious trouble. And in a world of trend-following and performance-chasing trading behavior, when the “crowd” goes long you have an unstable Bubble and when they go short it turns to painful bust.

As an analyst of Bubbles, I know that the timing of their bursting is highly unpredictable. They tend “to go to unimaginable extremes – and then double!” Yet they do inevitably burst and the longer they inflate the more problematic the bust.

The global “leveraged speculating community” is a key Issue 2014. As one of the more conspicuous beneficiaries of monetary inflation, there is today way too much “money” involved in this “crowded trade.” Global securities speculation has thrived on central bank liquidity, and winding down QE should significantly alter this game.

Going back almost 20 years to the 1994 bursting of the “bond” Bubble, leveraged speculators have enjoyed reliable market backstops. Acting as quasi-central banks, the GSE’s aggressively expanded their holdings (balance sheets) to accommodate speculative deleveraging in 1994, 1998, 2000, 2001 and 2002. Since the 2008 crisis the Fed has generously provided its balance sheet as a powerful market backstop – and risk premiums adjusted accordingly. And then a very important development occurred in 2013: Rather than backstopping the markets, the Fed’s Trillion dollar asset expansion incited risk-taking and speculative leveraging. If the Fed does indeed plan on wrapping up its balance sheet operations, what does this mean in terms of a future market backstop?

To what extent global monetary policies have incentivized risk-taking and leverage is unknown. I suspect the amount of speculative leverage in global markets is enormous. How much has been borrowed at an almost zero interest rate? How much in depreciating yen? These will at some point become crucial issues.

The Fed commencing tapering has changed the risk vs. return calculus for leveraging in fixed income. Cracks in EM Bubbles and the reversal of “hot money” flows away from EM have also fundamentally altered EM central bank demand for Treasuries, bunds and other sovereign debt securities. The backdrop would seem to ensure a much less favorable backdrop for speculative leveraging. And, potentially, a deleveraging backdrop could easily sop up much of the Fed’s tapered QE.

I don’t believe it would take all that much for worsening EM problems and some deleveraging in global fixed income to evolve into a rather serious bout of global “risk off.” And I’ll add that there’s a rather fine line between the (2013 scenario) “core” benefiting from stress at the “periphery” - and deterioration at the “periphery” spurring de-risking/de-leveraging “contagion” that begins insidiously gravitating toward the “core.”

I suspect large amounts of speculative leverage have amassed in higher-yielding corporates and MBS. I’ll assume myriad popular derivative trades incorporate leverage. I’d be shocked if the yen short and “carry trade” are not at this point enormous. There was even chatter in late-2013 of T-bill spread trades leveraged 50-100 times. From my experience, things are generally worse than I suspect. The Fed hopes its “forward guidance” puts a ceiling on market yields. However, the year 2014 could actually see supply and demand again begin to dictate the cost of finance – something that would involve one huge change in marketplace behavior.

Generally, leverage would be a focal point of attempts to assess systemic fragility. But I’ll return to my rough estimate of $68 Trillion of U.S. “Marketable Securities.” I believe misguided Fed (and fellow global central bank) monetary inflation has inflated financial asset prices generally. Indeed, the key Issue 2014 may be the almost across-the-board mispricing of U.S. securities markets. And we saw a glimpse back in May/June of how destabilizing flows can quickly unfold when market participants suddenly realize their perceived low-risk funds and strategies are at risk of significant losses.

Market Bubbles turn unwieldy near their conclusions. I fully expect unwieldy global markets throughout 2014: Bubbles inflating, deflating and vacillating. Greed and Fear and speculation run wild. Policy confusion and acute market uncertainty. At this point, conventional analysis seems particularly oblivious, which increases the risk of the proverbial “black swan.” And when it comes to Bubbles and “black swans,” I tend to see bursting Bubbles (i.e. “black swans”) as high probability outcomes. What tends to make them so-called low probability events is only the uncertainty of their timing.