Central banks rule! We’ve seen it in 2013.
They’ve accomplished the impossible: separating stock markets from the economies they’re based on. Oblivious to the real economy in the US, the S&P 500 soared nearly 30%, the largest gain since the dotcom-bubble days of 1997, the Nasdaq 38%. The German Dax jumped 25%, hopping from record to record, though the German economy has stalled since late 2012. The French CAC 40 rose 18% though the French economy is mired in stagnation, with a record number of people out of work. The Nikkei soared 56.7%. And investors expect another glorious year with nary a cloud on the horizon to muck up their picnic.
Alas, after a long phenomenal run, the bond market took a hit. On the last day of the year, 10-year Treasuries dropped, and yields spiked to 3.04%, the highest since mid-2011. The Barclays Treasury Index is down over 2.6% for the year. More broadly, the Barclays US Aggregate bond index is down 1.92% for the year, the first loss since 1999 and the worst since 1994.
It all started in May when gentle taper suggestions were transmogrifying into the taper tantrum. After all hell had broken loose in the credit markets, the Fed pulled in its tail in September – only to start barking again in December. For bond investors, the writing is on the wall. But stock investors haven’t seen it yet.
All eyes are riveted on stimulus. Nothing else matters for the markets, as we’ve seen in 2013. But the US and China are making noises about turning down that stimulus, not because they’re worried about consumer price inflation or that their economies would run too hot – that would be wishful thinking – but because of asset bubbles. When bubbles pop, and they always do, it gets ugly; and the bigger the bubble, the uglier it gets. But preemptively unwinding this massive stimulus by the two largest economies in the world has consequences.
“Even if no financial turmoil emerges, some assets are likely to come under strong pressure,” writes economist Andy Xie, in his article, When the Giants Unwind (Caixin). That would be the best-case scenario. The other scenarios? Various degrees of turmoil. He goes on in his rosy manner:
After the 2008 financial crisis broke out, I predicted widespread monetary and fiscal stimulus all around, and such stimulus wouldn’t bring back sustainable and sound growth, eventually leading to another crisis. I also predicted that stimulus advocates will blame the failure on insufficient stimulus. My predictions are coming true halfway there. Another financial crisis will make them whole.
The amount of stimulus in the US after 2007 has been enormous. No-holds-barred deficit spending by the Federal Government added over $8 trillion to the national debt, nearly doubling it in six years! And the Fed printed over $3 trillion, more than tripling its balance sheet. All this moolah inflated asset prices to the point where household wealth increased 60% from the crisis low and is now 21% above its prior peak in 2007 – “a level considered a bubble that led to the 2008 financial crisis,” Xie reminds us.
Turns out, most of that wealth is owned by a small group of people. How many benefited from the stock market bubble? 10% of the population in the US own most of the stocks. When the Fed set out to inflate stocks, it made a deliberate decision to artificially enrich these people. The other 90%? They’re still mired in an economic downturn, with employment and real wages below pre-crisis levels.
The Bloomberg Consumer Comfort Index, which tracks the economic outlook of various demographic groups, reflects that beautifully. Only those making over $100,000 per year are feeling positive about the economy. Those below it, even those making $75,000 to $99,999, are negative about the economy. The less they make, the worse they feel. It cuts across all ethnic groups, educational levels, and geographic regions, whether they’re homeowners or renters, male or female, old or young, employed or unemployed (depressing chart). It’s an indictment of the Fed-engineered “recovery.”
Stimulus in China has been enormous as well, mostly related to lowering of credit standards that led to a 175% increase in M2 money supply since 2007. Much of the growth was based on local governments going on a borrowing binge and splurging on construction projects, goosed by breathtaking property speculation.
“As local governments control all the land supply, they have been able to raise revenues from selling land and borrowing money with land as collateral,” Xie writes. “These two are the main channels for money supply to turn into expenditure.”
It led to economic growth, but the effectiveness of this binge has been declining recently. While economic growth data are “still impressive, they are small in comparison to monetary growth,” Xie writes. And if that relationship between ballooning stimulus and declining economic growth persists, “hyperinflation is likely.”
Neither China nor the United States has built a sustainable growth dynamic with stimulus. As the stimulus side effects – bubbles and rising leverage – become the main show, unwinding stimulus becomes urgent. This is why both countries are likely to take tightening steps.
But it’s going to be tricky, and possibly very messy.
Unwinding stimulus is usually a dangerous business. One never knows how much hot air the stimulus has created. When it leaks, it could cause a big explosion. For example, the Fed’s tightening cycle in the past usually triggered an emerging market crisis. As the United States itself isn’t on a strong growth path, the risk at home is substantial.
During the summer taper tantrum, the currencies of Brazil, India, and other countries went through a mini-crash though the Fed just palavered about tapering. When the Fed finally gets serious about it and a fraction of the $3 trillion to $4 trillion in hot money pulls out, “the shock to the monetary condition in some emerging economies could be severe enough,” Xie explains, “to trigger a banking crisis.”
For the lopsided and wobbly US economy, the wind-down of QE is fraught with peril.
The improving labor market is due to declining wages for the reemployed. Hence, its contribution to demand is limited. The stock market could be 50% overvalued. The Internet sector is a vast bubble similar to what happened in early 2000. If the bubble pops, it may lead to reduction in corporate capex, which could pull the economy back into recession.
And if a financial crisis re-breaks out, either in the US or elsewhere, the Fed would jump right back, wreaking the same havoc it has been wreaking. And that, Xie writes, would push the US further toward stagflation.
I predicted that stagflation is the ultimate outcome for the global economy. Most of the United States’ nominal GDP increase since 2007 is due to inflation, which already fits the description of mild stagflation. If the Fed is forced to back off from tightening, more pronounced stagflation is not far off.
On the Chinese side, the government is trying to tighten by curtailing local government borrowing binges. But local governments are not interest-rate sensitive, and raising rates has no impact. As worried banks pulled back from lending to them in 2013, local governments switched to the shadow banking system. They “depend on the perception that provinces and, ultimately, the central government will bail them out if they can’t repay their loans,” Xie says.
This perceived guarantee has made them palatable to the shadow banking system, where private companies borrow at low interest rates offshore and lend to local governments at high interest rates. “Unless the bailout responsibility is clarified, China’s credit bubble would continue.”
But if the central government does clarify a tough no-bailout policy, the credit market would react with a vengeance. The shadow banking system would refuse to roll these loans over, and credit would dry up, triggering a financial crisis. If the central government forces banks to step in, it would amount to an indirect bailout of local governments – because the central government would then have to bail out the banks.
So tamping down on all this craziness is going to be messy. The global economy has become physically addicted to the fiscal and monetary stimulus of the US and China. Reducing the dosage is going to impact not only asset prices and emerging market currencies but also the broader global economy – and will, Xie writes, cause it to slow in 2014.
Thanks to the Fed, institutional speculators can borrow short term at near-zero interest rates and gamble with this money around the world. This is the hot money. When liquidity dries up, or credit gets more expensive, or anything else spooks these speculators, the hot money doesn’t get repatriated from the emerging markets or go anywhere else. It “just vanishes,” Xie writes. And that will be another moment of truth. The same principle applies to numerous asset classes in the US that have been inflated by speculative money that had been borrowed short term at near zero cost. This money too might just “vanish.”
In that case, fasten your seatbelts. And Happy New Year.