Courtesy of Pater Tenebrarum, Acting Man
We want to focus on a specific aspect of the current money supply expansion in this part. Price inflation, as well as investment and production will be discussed in a follow-up post shortly.
Let us consider the mechanics of past boom-bust cycles in the US. In “normal” booms, banks expand credit to companies and households, with the former employing the funds mainly for investment and the latter for consumption. Banks that don’t have sufficient reserves will borrow them in the interbank market (Federal Funds market), where the Fed stands ready to satisfy any excess demand for reserves that threatens to push the overnight Federal Funds rate above its administered target rate. In short, monetary inflation is driven by bank credit expansion and accommodated by the central bank. To the extent that the Fed-administered target rate manipulates market interest rates below the natural rate dictated by society-wide time preferences, this seemingly “harmonious” inflationary process will promote ever more malinvestment of scarce capital as well as overconsumption. Eventually the central bank becomes worried that the credit expansion may push consumer prices above its arbitrary target for CPI and begins to hike rates – then the artificial boom falters with a lag and a bust ensues. The central bank thereupon lowers rates again. Lather, rinse, repeat.
Image credit: mevans
As a rule, the impoverishment caused by this boom-bust cycle doesn’t leave society worse off at the end of the bust than it was on the eve of the boom. Instead, the outcome is simply a lot less satisfactory than it would have been without central bank intervention. During the boom, the stock market will attract a lot of investment as well. Stocks are titles to capital, and capital tends to become mispriced when interest rates are artificially lowered. These price distortions are then rectified during the bust. Falling stock prices don’t “cause” economic depressions. They merely mirror and/or anticipate changing economic and monetary conditions.
A Modified Boom
Since the 2008 crisis, the above described boom progression has been modified. After 2008, banks no longer lent money to companies and consumers and then went looking for the necessary reserves to back their lending up. Instead, the Fed actively pushed reserves and deposit money into the banking system in an attempt to motivate the banks to increase their lending. This was of course not the only motivation; as noted in Part 1, the big banks needed to be insulated against a burgeoning bank run, as they were de facto insolvent by late 2008/early 2009. Also, as Mr. Bernanke pointed out in a press conference in early 2011, pushing up asset prices was an explicit goal of the Fed’s QE policy.
The main difference between the post 2008 echo boom and previous booms is that normally, newly created money first reaches companies and consumers, while since 2008, it has first reached the accounts of the primary dealers and those of a few selected financial services behemoths like Fidelity and Blackrock.
It is quite similar in the euro area and Japan: Instead of commercial banks creating new money by lending to the non-financial private sector, central banks are pushing newly created money into the financial sector. We mentioned in Part 1 that some changes seem to be afoot recently (especially in the US), but by and large this is what has happened over recent years.
When all is said and done, the history books are likely to record this as one of the biggest, if not the biggest, asset bubble ever – click to enlarge.
We suspect that as a result, asset price inflation has been especially pronounced. Financial companies are likely to reinvest money they receive from selling assets to the central bank in other financial assets, as well as lending money to speculators. At the same time, many listed companies have been reluctant to engage in capital expenditures. They have instead used the strong decline in credit costs to borrow money for financial engineering purposes, as evidenced by the huge surge in stock buybacks in recent years. These buybacks have increasingly expanded the higher stock prices have risen (they were very low when stocks were actually cheap). This is probably not the best use of retained earnings or borrowed funds; it seems likely many of these buybacks will eventually look just as misguided as the record buybacks of 2007 looked about a year later.
The above suggests that the current boom will continue to evolve and eventually end in a slightly different manner from its predecessors. Unfortunately there is little experience with similar historical contingent circumstances. These circumstances are always unique, but the combination of characteristics of the current era is quite unusual. For instance, in spite of a large expansion in the money supply, inflation expectations have moved lower rather noticeably. We will have a little more to say about this in the follow-up article on inflation and production. Our main point is though that for a number of reasons, forecasting has become more difficult than it used to be.
One can illustrate this by considering the real estate boom that expired in 2007/8. It was not necessary to be au fait with Austrian economic theory to see that this boom would end very badly indeed. Even an arch-Keynesian like Nouriel Roubini managed to correctly guess that it would blow up. Clearly, it was not overly difficult to make a fairly accurate forecast by combining economic theory and historical understanding in this instance. Even the usually elusive question of timing wasn’t fraught with too much uncertainty. For instance, the first yield curve inversion was recorded in 2006, a warning sign indicating that things were likely to get dicey within a time span of 6 to 12 months.
In February of 2007, several sub-prime lenders suddenly went belly up. Although these bankruptcies were widely ignored, they were another warning sign indicating that the boom’s denouement was getting quite close. Moreover, house prices had actually peaked in 2006 already, concurrently with the Bank of Japan undermining global excess liquidity by shrinking its QE-bloated balance sheet by 25% overnight.
The 2002-2007 boom was like a text-book illustration of Austrian business cycle theory. Rates were artificially lowered by the central bank, a massive expansion of bank credit focused on a sector that can be analytically equated with the capital goods sector occurred, enormous price distortions accompanied by an ever more pronounced heaping of leverage upon leverage (with the associated progressive decline in the creditworthiness of borrowers) took place, and large price increases in non-specific resources far removed from the consumer stage (i.e., commodities) was recorded. All of this left the banking sector dangerously overstretched. Eventually, the boom was stopped in its tracks by one rate hike too many. It was easy to see what was happening and how it would eventually end, even if the precise chain of events characterizing the bust and its extent could not be firmly predicted (incidentally, the same was true of the tech sector focused boom of the mid to late 1990s).
Due to the somewhat non-traditional nature of the current echo boom, it is more difficult to make a forecast. For instance, we already know from experience that the traditional yield curve inversion signal likely won’t happen, due to short term rates being pinned at or near zero by central banks (in some cases even less than zero). Japan has experienced six recessions and bear markets since 1989, and only the very first one of them was preceded by a yield curve inversion as the chart below illustrates. Simply waiting for this signal probably won’t do.
Five of the past six recessions/bear markets in Japan were not preceded by a yield curve inversion (Japanese recession periods are indicated by the green rectangles) – click to enlarge.
The fact that there is no specific sector of the economy that can be pinpointed as the chief beneficiary of the boom (contrary to the technology and real estate sectors in the two preceding major booms), it is not so easy to discern where precisely the most important fault lines of the bubble edifice are. There are a number of sub-bubbles in quite a large number of industries – ranging from the biotechnology sector to sub-prime auto loans, to name two of the more egregious ones. It is difficult to guess at the how and when the boom will end this time. So far, the safest bet was to simply rely on money supply growth and ZIRP keeping it afloat.
Given that an increase in commercial bank lending is keeping money supply growth at a fairly high level in the US and that the ECB is about to embark on an unprecedented pumping spree after euro area money supply growth has already accelerated for many months, one would normally have to assume that asset price inflation will just happily continue, and it may well do so for a while yet.
Although the ECB cannot print dollars (in a roundabout way it actually can, since the swap agreement it has with the Fed allows it to create euros and swap them for freshly printed dollars “as needed”), its monetary pumping nevertheless has affects asset prices in the US as well. Those selling bonds to the ECB have to ponder what to do with the proceeds. Buy more bonds with negative yields to maturity in Europe? Many are probably tempted to buy US treasury bonds or US stocks instead (to the extent that regulations allow them to do so). Similarly, the BoJ’s pumping has been an incentive for Japanese investors to increasingly buyforeign assets, not least because they want to offset the yen’s rapid devaluation – this in turn leads to additional pressure on the yen.
However, there is also a boom in European and Japanese stocks, and these markets are attracting investors from all over the world as well. It was recently reported that fund managers currently hold the biggest allocation to European stocks in the history of the BofA/Merrill Lynch fund manager survey. The chart below illustrates the situation. It is probably not too big a surprise that when these allocations are at extremes, they often prove to be contrary indicators. A high allocation is not necessarily a sell signal, but when new record highs are reached, one should probably exercise a modicum of caution. The last time this happened it was not really the most opportune time to buy European stocks (although it took still about 9-12 months for the market peak to be reached).
From the most recent Merrill Lynch fund manager survey: a record allocation to European equities – click to enlarge.
Thus far investors could rely on central bank policies keeping stock prices elevated. The fact that very high equity allocations in general have persisted for quite some time has not kept prices from levitating higher. Note though that something very similar occurred during the last market cycle.
Global equity allocations have been persistently high for the past several years, which is a similarity to the 2004-2007 period – click to enlarge.
We are not sure how much future money supply growth will be required to keep pushing asset prices higher. Obviously, there is no fixed relationship involved, but as a general rule of thumb, past market peaks have occurred well after money supply growth had peaked and had been slowing for some time. At some point it always declined below a threshold that was not knowable in advance. Given that US money supply growth has seen its last interim peak at approx. 15.7% year-on-year in August 2011 and has since declined to the current range of 7% to 8%, it is possible that this threshold is actually already close in the US, but much will depend on whether the recent acceleration in bank lending growth continues.
We are wondering which of the many potential problems out there could end up derailing the party. We would suggest that given the diffuse nature of the bubble, there is a good chance the problem will eventually come from one or more widely unexpected directions. When looking at the charts in the Merrill Lynch fund manager survey, we noticed something that could at least prove be helpful in ruling certain things out. One of the questions fund managers are asked is what they believe to represent the greatest tail risk at the present time. The answers to this question seem to have a strong tendency to turn out to be wrong. Consider for instance the replies given in April 2011 in this context:
In hindsight it is clear that “commodity price inflation” was nothing to worry about. Commodity prices as measured by the CRB index reached their post 2008 crisis peak in the very week the survey was taken. It took a while longer for market concerns over EU sovereign debt to dissipate, but that crisis peaked out half a year later and led merely to a brief (but scary) correction in the stock market in the summer of 2011 – click to enlarge.
Actually, not even “other” turned out to be a problem. That people were moaning about the danger of “premature fiscal tightening” in a year which the second highest federal budget deficit in the history of the US was produced is actually quite hilarious in hindsight. Needless to say, municipal defaults and Chinese real estate turned out to be among two of the best-telegraphed non-problems of the year as well.
What can one actually learn from this? The biggest concerns were focused on topics that frequently made headlines at the time. It was impossible not to be aware of them. This confirms the old adage that “what everybody knows isn’t worth knowing”. Managers of big funds as a group aren’t in possession of any unusually deep insights. These professionals are just as much subject to herding as the much-belittled retail investor. Often they are using the most superficial information to rationalize their decisions (the recent overweighting of EU equities due to the ECB’s QE announcement is a good example of this. It may be an idea that will work for a while, but could anything be more obvious?).
We can therefore look at the current set of replies on tail risks in order to learn what will very likely not upset the apple cart anytime soon. Here it is:
We can hereby rest reasonably assured that neither major geopolitical crises, nor euro-zone “deflation” will have any discernible effect on the markets – click to enlarge.
There are two oddities in the above list: the Fed “falling behind the curve” is certainly not even a potential risk for stock markets at this point. On the contrary, the Fed getting religion and finally hiking rates is. The last reply on the list has us stumped. In what way can “equity bubbles” be considered a “tail risk”? Asset price bubbles are basically the given situation already, and these replies should be about what could potentially derail them. There is no risk that a bubble will form; it has already happened.
We’re not exactly averse to worrying about debt defaults in China ourselves – certainly there is great potential for China’s economy to suffer a sizable setback. However, it is something people have worried about forever, and all of them (including ourselves) have made the mistake of underestimating the degree of control China’s government has over the system (especially the banking system), as well as the entrepreneurial spirit that is a big driving force in China’s economy. Entrepreneurs in China are nowadays facing far fewer regulatory obstacles than their counterparts in the nominally capitalist West (we refer you to a Bill Bonner missive on the topic for some color on this point). This is an immensely important factor when it comes to an economy’s resilience and growth potential.
An emerging market crisis is possibly a credible threat as well, mainly if the US dollar should continue to rise (see further below as to why). On the other hand, emerging markets are currently largely shunned by investors according to Merrill’s survey. This would actually argue for a resurgence in their fortunes, especially as many EM stock markets are by now quite cheap relative to developed markets.
Proximate and Ultimate Causes
Mark Spitznagel has recently quite rightly argued that the eventual bubble denouement should not be called a “black swan” at all, since it is, or rather should be, known that there is a bubble and what has been instrumental in its creation. He demonstrates the price distortions in the market with the help of the Q ratio, which we have recently briefly remarked on as well. He differentiates between the “ultimate cause” – which is the manipulation of interest rates and the money supply that has created the bubble – and the “proximate cause”, namely the trigger event or events that will likely precede the bursting of the bubble (as we have previously pointed out, Mark Spitznagel is quite a successful investor in spite of his skeptical view of the bubble’s sustainability. We just mention this to establish that his critical missives definitely aren’t a case of sour grapes).
Anyway, we like to think about potential “proximate causes” for the simple reason that if one manages to find out what they might be, one stands a better chance of identifying these future trigger events if/when they occur. With respect to possible “left of field” events that could intrude on the happy asset inflation party, there exist a number of areas of vulnerability that are currently not receiving as much attention as the probably deserve.
One possibility is that excessive government debt will turn out to matter after all, since there is currently such a widespread conviction that it won’t. Following the calming of the euro area debt crisis, it seems no-one is really concerned about the topic anymore. Both the euro area and Japan are potential hot spots in this respect, even though Greece’s hopeless situation has only recently been laughed off by market participants.
Complacency about Japan’s debtberg specifically has probably never been higher than it is today – ironically, the country’s debtberg has never been greater either. Here is a chart from a recent McKinsey report about the global expansion in public sector leverage since 2008 we have shown before:
There has been an explosion in public debt since the 2008 crisis, while households have deleveraged somewhat – click to enlarge.
Confidence in corporate debt probably should be put on the endangered species list as well, considering that the expansion in corporate debt was almost as large as that in public debt in recent years (see also “A Dangerous Boom in Unsound Corporate Debt” for more details on this topic).
Corporations have also loaded up on debt – click to enlarge.
Another batch of interesting data we have recently come across has been published by the BIS a short while ago. The charts below show dollar-denominated debt owed by non-banks outside of the US. It seems to us that this is also a highly vulnerable cog in the bubble machinery, given the recent strength in the US dollar. All in all, this particular debtberg amounts to a heft $8.7 trillion, of which only 2.3 trillion have been funded by US investors and banks – the remainder are dollars lent from dollar deposits held outside of the US.
Dollar-denominated debt owed by non-bank borrowers outside the US – click to enlarge.
There are undoubtedly many more things we could come up with, but in our opinion the major Achilles heels of the echo bubble remain debt, the valuation of assets employed as collateral, and the ability to earn sufficient income to service the debt.
Even though the boom is in some ways unique, there are still many parallels to other inflationary booms of the post WW2 era – chiefly among them a vast credit expansion. This is no doubt where the main vulnerabilities of the boom can be identified.
We will discuss the questions we personally find most interesting in the third and final installment of this series though. Namely, 1. why “price inflation” has so far failed to rear its head, and how it might develop in the future, and 2. how and why developments in the real economy and may or may not limit asset price inflation.
If one looks at the recent divergence between e.g. US macro-economic data releases and the US stock market, one may well find it hard to believe that there are any fundamentals beyond monetary pumping that matter to asset prices. Up to a point this is actually true, but it won’t always be true. Monetary pumping has real economic consequences – and precisely when its effects appear to be positive on a superficial level, a lot of structural economic damage actually occurs. Stay tuned.
Charts by: BigCharts, St. Louis Federal Reserve Researchm, B of A / Merrill Lynch, McKinsey, BIS