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By Stewart Richardson on 02/07/17 | Category - Central Banks

To view a PDF copy of this report, click here. 

We have been bombarded by Central Bank speakers in recent days. What does it all mean; if anything at all? Do we need to change our thinking on markets? These are serious questions for investors as we close out the first half of 2017. However, before we dive in, we want to step back and consider some previous things that central bankers have said at interesting economic and financial junctures in the past. The point of this is not simply to have a giggle at someone else's expense. We are simply trying to illustrate that central bankers can and do get things wrong. 

Is it because they are human after all? Or are they being duplicitous? Frankly, we suspect they are simply clueless to the bubble blowing effect that their policies have had in the last 20 years or so, and that the negative impact on both markets and the real economy can be devastating when these bubbles pop. Let's start with some quotes from Ben Bernanke around the time of the housing peak in 2005/2006.

"We've never had a decline in house prices on a nationwide basis. So, what I think is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don't think it's going to drive the economy too far from its full employment path, though." Ben Bernanke quote July 2005.

"Housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise." Ben Bernanke quote 15th February 2006.

As it turns out, Dr Bernanke was wrong. House prices did not continue to rise, or even stabilise. Shortly after his utterances, Nationwide house prices started to fall, and would only begin to stabilise after a 25% decline over 5 years. 

Chart 1 - US S&P CoreLogic Case-Shiller National House Price Index

By 2007, it had dawned on Dr Bernanke that house prices were indeed falling. However, he either truly believed that any problems were peculiar to the subprime market, and would likely be contained. Or, he had to try and hoodwink us and make us believe that everything would be ok, even though he was starting to get truly worried.

"Despite the ongoing adjustments in the housing sector, overall economic prospects for households remain good. Household finances appear generally solid, and delinquency rates on most types of consumer loans and residential mortgages remain low." Ben Bernanke quote 15th February 2007.

"All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system." Ben Bernanke quote 17th May 2017.

"At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency." Ben Bernanke quote 28th March 2007.

During the Summer of 2007, markets began to smell a rat. Two Bear Sterns hedge funds (investing in risky credit products and employing significant leverage) collapsed almost overnight. Equity markets took fright, resulting in a 10% decline in the S&P 500 into mid August. We have to suspect that Dr Bernanke was definitely getting more than a little worried by this time. His worst case scenario could have been playing out right before him and trouble in subprime lending was infecting the broader credit markets which could have proved contagious and spread to the equity markets. 

Chart 2 - The US Equity market in 2007 along with the Fed Funds interest rate
Being the great student of the Great Depression, with a belief that the Fed should have done much more during that time, Bernanke knew what to do. He had to start cutting interest rates just in case he was wrong, and at the same time continue to give the public impression that everything was ok; finances and the economy were sound and he had everything under control. And so it was that he cut the Fed Funds rate three times before the end of 2007 (for a total of 100 basis points) as the equity market major topping pattern was being formed.

According to the National Bureau of Economic Research (NBER) who are tasked with dating recessions, the US economy entered a recession in November 2007. These guys have the benefit of hindsight and are using data that will have been revised from the initial publication, sometimes quite dramatically. However, there were some who were forecasting a recession in 2007, and there were some reliable signals that the probability of a recession was way above zero; the shape of the yield curve for one. However, Dr Bernanke was in damage limitation mode. With the economy stuttering, he had to give out the battle cry; "Keep calm and carry on!"

"The Federal Reserve is not currently forecasting a recession." Ben Bernanke quote 10th January 2008.

"The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so." Ben Bernanke quote 9th June 2008

Chart 3 - US GDP Growth Y/Y % and the yield curve advanced by 12 months
The rest, as they say, is history. The US went on to suffer a financial crisis and the worst economic recession since the great depression, despite interest rates being cut to the zero boundary, $100s of billions of fiscal stimulus and trillions of fresh money injected into the financial system.

Now perhaps we are being a little unkind to Dr Bernanke. So, it was with a little amusement that we came across a quote this week from his predecessor, Alan Greenspan. Firstly, Alan Greenspan was perhaps the luckiest Fed Chairman ever, in that he was in charge during a period of economic expansion and stability unprecedented since the Second World War. We would suggest that this is down to structural forces such as demographics, globalisation and financialisation rather than his skills. And even though he would become known as "The Maestro", his skill in forecasting was poor prior to taking the job in the 1980's. For example, in early 1973, he said;

"It is very rare that you can be unqualifiedly bullish as you can be now" Alan Greenspan quote 7th January 1973. 

As can be seen in chart 4 below, he nailed the high within four days before the market fell by nearly 50%.

Chart 4 - the S&P 500 October 1972 to December 1974
Although it is more than a little fun to wallow in a bit of central banker bashing, there is a serious point to this. When central bankers speak, they are mainly speaking to financial market participants and academic economists. As such, they choose their words very carefully, and they are either trying to communicate upcoming policy (forward guidance) or tell us how good things are even when this may not actually be the case. From time to time, they also warn on this and that, and when they do, you know it must be bad as central bankers tend to be cheerleaders, not prophets of doom.

So what have central bankers been saying in the last week or so?. There has been a good dose of cheerleading, some forward guidance and some extraordinary hubris that only central bankers ever fall prey to. Let's start with Mario Draghi who really sent a shockwave through markets when he said that "deflationary forces had been replaced by inflationary forces". Although his speech can be characterised overall as balanced rather than hawkish, markets picked up on the hawkish sense of a new inflationary trend and assumed he was signalling a more urgent need to normalise policy. As a result, the Euro exploded higher, as did bond yields with equities falling quite sharply.

We said above that central bankers really only speak to financial market participants, and they seem to have created a nasty habit of watching how markets react to their forward guidance (and sometimes these comments can be seen as trial balloons), and if they don't like the reaction, they say so. And so it was with Draghis' comments, as literally 24 hours later, the ECB came out and said the market had "misjudged" Draghi's speech. Immediately, equity markets rallied, but more intriguingly, FX and fixed income markets did not reverse their initial move.

Chart 5 - German 5 year bond yield
The chart above shows the German 5 year bond yield, and it looks to us as though a 1 year + bottom formation has now been completed with the break above minus 30 basis points. The market is clearly maintaining serious thoughts that the ECB is on its way to reducing QE further next year, perhaps even ending it. Furthermore, if the ECB hints that they want to raise the deposit rate from the current minus 40 basis points back to zero initially, then German bond yields could move smartly higher at some point.

In a sign that the extraordinary policies pursued by the ECB (and BoJ for that matter) in recent years have been impacting financial markets globally, bond yields rose everywhere. So, although higher German yields did support the Euro, we are a little nervous about buying it against the US Dollar, partly as the Euro looks a bit elevated versus interest rate differentials (Chart 6) but also because there is considerable overhead resistance just above current levels (Chart 7). To get really excited about the Euro, we think Draghi has to step up and tighten policy by more than expected at their September meeting.

Chart 6 - EUR/USD FX rate and 5 year bond differential
Chart 7 - EUR/USD longer term chart showing resistance around the 1.15 area

Although Draghi captured most of the headlines, it is notable that fully seven G10 central banks have been talking recently either hawkishly, or in a manner which indicates that the next major move is away from extraordinary policies. Leading the pack is the Fed who are furthest along the normalisation process, and where the market is very much underestimating the amount of tightening if the Fed follow through on what they are saying. 

But what really caught our eye from the Fed last week were comments about how high asset values were and that "high asset values may lead to future stability risks" (Stanley Fischer). This is central bank speak for; we are now worried that our extraordinary policies have created significant asset bubbles, and a future bear market would hurt both financial markets and the real economy. Simply put, when central bankers are telling us that asset values are "somewhat rich" (Janet Yellen) and that they are worried about future stability, whilst at the same time raising interest rates and potentially reducing their balance sheet, we as market participants should be very worried. Our view remains that the Fed will continue to tighten policy until something breaks, either at home or abroad...we have pencilled in late 2017 for greater market troubles, with a topping process starting in the current timeframe.

Of course, even if the Fed are worried that they have created a massive bubble, they will be very careful in the way they manage markets, and they have to keep their cheerleading hat on at all times. And so we get to the hubristic central banking comment of the week, when Janet Yellen said that she doesn't believe that there will be another financial crisis in our lifetimes. How can she be so sure? And frankly, we beg to differ. Every episode when asset markets have become this expensive and debt this high have been followed by a financial crisis. 

The trigger for the crisis has always been falling asset values, and we now have a Fed that is acknowledging high asset values and yet are still tightening policy. We would humbly suggest that the chances of another crisis emerging from the next bear market in equities and credit are actually quite high, and perhaps the Fed are also worried about this privately, and are now trying to dig themselves out of a very deep hole with their policy tightening.

Which brings us to our last point, and the reason that many investors remain invested in risky assets despite the increasing warning signs. Many investors simply believe that during the next crisis, the Fed will be very quick to slash interest rates and print money - and why shouldn't they? After all, Fed governors have told us that this is what they expect to do. Perhaps the only issue at hand is how far the Fed will be happy to see equity prices fall before they step in - the so called strike price of the Fed put option. Is it a 20% decline? A 30% decline? Only time will tell.

We will leave you this week with perhaps the most gratuitous Bernanke quote we found;

"It is not the responsibility of the Federal Reserve – nor would it be appropriate - to protect lenders and investors from the consequences of their financial decisions." Ben Bernanke quote 31st October 2007.

This came literally days after the start of the bear market, and Bernanke is trying to tell us that it is not appropriate for the Fed to support financial markets, thereby protecting lenders and investors from the consequences of the financial decisions. The months ahead saw him do everything to protect lenders by being party to the bailout of a number of big banks and in the years ahead, he decided to print trillions of Dollars to buy assets in the hope that asset markets (assets held predominantly by the richest in society) would rise in value and this new found wealth would trickle down to the real economy. Frankly, the evidence suggests that the new found wealth has remained in the hands of the wealthy, and some would argue that Fed policies have not helped the real economy at all.

So, during the next crisis, we suspect the Fed to do the appropriate thing, and force feed liquidity directly into the real economy, thereby bypassing financial markets and allowing investors to live with the consequences of their financial decisions.

By Stewart Richardson on 14/05/17 | Category - Central Banks

To view a PDF Copy of this report, click here.

We have talked about central bank policies extensively in recent years, and let's face it, it's a really dry subject. Unfortunately for us, Central Banks remain very important actors in the financial markets, and subtle changes can have both visible and hidden effects. Perhaps the most obvious changes are being seen at the US Federal Reserve, but we also detect more subtle changes in Europe and Japan. Spotting these changes is the easy part. Understanding what impact they have on market prices, both short and long term, is the hard part. With that caveat, let's have a look at what's happening.

First to Japan. In the immediate aftermath of the move to both QQE and Yield Curve Control (YCC) last year, we said that these policies goals were simply not achievable at the same time (SEE SEPT 2016 REPORT). The BoJ would simply not be able to expand its balance sheet by 80 trillion Yen a year and control yields out to 10 years (a target of zero was established at the time). What was not clear was whether in the pursuit of yield curve control, the BoJ would print more or less than 80 trillion per annum.

The first test of the yield curve control policy came in February when 10 year yields nudged above 0.10%. The BoJ promptly stepped in with increased bond purchases, and yields subsequently moved back towards zero. Since that increased intervention, BoJ bond purchases have slowed, as can be seen in the chart below (courtesy of MI2 Partners). Indeed, if BoJ operations continue at the current pace for the rest of May, purchases will fall below 8 trillion for the first time since October 2014.

Chart 1 - Bank of Japan bond purchases

So, is the Bank of Japan tapering? Testifying in front of the Lower House Finance Committee on Wednesday, BoJ Governor Kuroda said the BoJ's JGB portfolio is increasing "...at a pace of about JPY 60 trillion annually." Kuroda continued, "...we have not set a target of increasing monetary base by JPY 80 trillion annually as we did before." Although there has been no official change in policy, it certainly seems like the BoJ is tapering its bond purchases, as evidenced by both their buying of bonds and what the Governor is saying.

In Europe, we know that the ECB has reduced its bond purchases by €20 billion as of April this year, down to €60 billion per month. Furthermore, they have pre-committed to maintain this pace of until the end of the year. The market is very keen to hear from Draghi what his next move will be and when. There have been stories floating around that he may announce something next month. Personally, we think he will wait until September. Either way, the main point is that, with the European economy performing quite nicely at the moment, and core inflation trending back towards the "close to but below" 2% target, further tapering will be announced within the next four months or so.

The craziest central banks in the World today are the junior European banks, specifically the Swiss National Bank (SNB) followed by the Riksbank. Looking at the SNB, it is clear that they have a standing order to intervene in the FX market to weaken the Franc. Chart 2 below shows the SNB Reserves (accumulated via balance sheet expansion) alongside the EUR/CHF exchange rate (which is inverted).

Chart 2 - SNB Reserves and the EUR/CHF exchange rate
In the wake of the Macron win in the French Presidential elections, risks to the European project have been evaporating, at least in terms of financial market risks. This has led to quite a marked outperformance of the Euro versus the Swiss Franc, and we suspect that this will allow the SNB to take its foot off the accelerator and reduce its intervention quite significantly.

And so onto the US. We've remarked before how the Fed appears to have a different attitude from last year. Simply put, they appear to be very comfortable with two more rate rises this year, and there is widespread talk that they may start reducing their balance sheet before year end, with one or two calling for this to happen sooner rather than later. There are also one or two FOMC members who seem to want more than two more rate rises this year. All told, the Fed is beginning to look modestly hawkish for the first time since before the financial crisis.

For good measure, we will also note that the Peoples Bank of China (PBoC) is no longer increasing its balance sheet, which is at roughly the same level as two years ago (chart 3 below), and interest rates along the entire curve have been rising since late last year as Beijing tries to cool down a rampant credit machine.

Chart 3 - The PBoC balance sheet with 12 month rate of change
We have all major central banks changing policy at about the same time. Central Banks in Europe and Japan are simply easing off the accelerator, whereas in the US and China, there is a hint of hawkishness not seen for a long time. These are at least subtle changes taking place which we believe could be incredibly important during the second half of this year.

We have noted several times recently how the Fed, once it starts tightening monetary policy, usually continues until something breaks. Considering the lethargic performance of the US economy, this new found (but still modest) hawkishness is very interesting. Stepping back, although the ECB and BoJ will want to move with tiny baby steps, we also think that behind closed doors, there is a growing sense in policy making circles that negative interest rates may not be such a good idea. If true, we may see benchmark yields move back to zero during this tightening phase, unless/or markets have a tantrum.

Perhaps the trickiest balancing act is in China. The increase in debt in recent years, and the associated bad debts, are simply staggering. The boom/bust cycle that Beijing perpetuates in order to avoid financial crises is only storing up trouble for later. We don't know when that trouble will arrive but we suspect it will probably not happen until after the party congress in October.

What does this mean for markets? We propose to flesh this out in detail in the next few weeks, but simply put, we believe that risk assets such as equities and lower quality bonds are vulnerable to losses in the near future. This is not a prediction that these markets will go down immediately as trying to time such a move has been impossible in recent months. However, we can point to the low levels of volatility everywhere, the very narrow participation in the US stock market as well as the anecdotal evidence we have noted in our last two bulletins as strong warning signs.

For our part, in our multi-asset mandate, we hold some cheap put options that would benefit nicely from a 3% to 5% decline in US stocks in the short term. We remain long Indian equities for what we believe will be a structural bull market in the decades ahead. In fixed income, we own some high quality US bonds both outright and relative to European bonds. In the RMG FX Strategy mandate, we are modestly long of the US Dollar against selected emerging market currencies as we believe there will be a growing shortage of Dollars during the second half of the year. 

Generally speaking, our portfolios are positioned to benefit from a risk off type environment, but the amount of capital we are risking is still quite modest as imminent signs of market stress are only just emerging. If we are right that the second half of the year will see greater stresses emerging, we will be looking to add to our existing positions. Needless to say, our performance will be very different from those managers following buy and hold type strategies and of course the ubiquitous ETF industry. Or in other words, we offer potentially great diversification opportunities for active investors with a very well defined and controlled risk process. We look forward to fleshing out our market views in the weeks ahead.  

By Stewart Richardson on 24/09/16 | Category - Central Banks
"When the music stops...things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing,"
-Chuck Prince, CEO Citigroup July 2007
"There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen."
-Frederic Bastiat, 19th century French economist and author
"A reliable way to make people believe in falsehoods is frequent repetition, because familiarity is not easily distinguished from truth. Authoritarian institutions and markets have always known this fact."

-Daniel Kahneman
"Asset values aren't out of line with historical norms"

-Janet Yellen 21st September 2016
"The ultimate breakdown (or series of breakdowns) from this environment is likely to be surprising, sudden, intense and large."

-Paul Singer during a recent Bloomberg interview
There's a lot to cover this week, and unfortunately this will be a longer than usual commentary. We don't usually start with quotes as some other commentators do, but this week seems a bit different, so please bear with us as we dive into the maelstrom.
Last week was, in our opinion, a very important week for global central banking. If we are right, then investors really do need to think long and hard about how they allocate their money. In the short term, the markets have displayed a "risk on" tone, which nowadays means US Dollar down and everything else up. This knee jerk reaction does not chime with our longer term thinking one iota, but that's bubble investing for you - as Chuck Prince said in July 2007, as long as the music is playing, you've got to get up and dance. (For what it's worth, the S&P 500 made the first of what was effectively a double top within days of Mr Prince's now infamous comment before plunging more than 50%. Mr Prince retired on 4th November 2007.)
In his 2013 book "The Road to Recovery" Andrew Smithers explains in detail what he thinks is holding back the post Global Financial Crisis economy and offers up some thoughts as to what policymakers should do. We highly recommend everyone read it, especially our venerated central bankers. As Mr Smithers says, it is essential to analyse the causes of previous crises so that we do not repeat the errors that led to them.
Quoting from the book, "there have been three, and happily only three, examples of financial crises in the past 100 years that have caused severe and sustained losses of output;
  • The slump of the 1930s, which followed the Wall Street crash of 1929
  • The stagnation of the Japanese economy, which followed their stock market crash of 1990

  • The Global Financial Crisis and economic weakness that followed sharp falls in share and house prices
Each occasion had its own individual characteristics, but they were all marked by the existence of high levels of private sector debt and were triggered by sharp falls in asset prices"
So, to paraphrase, the last thing centrals bankers should want is to allow both debt and asset prices to get too high, as there comes a point when neither are sustainable. Nobody knows what the exact trigger will be, but when asset prices start falling, the risk of a financial and economic crisis becomes very real indeed. As we all know, policymakers have been actively encouraging more borrowing as they have lowered rates to zero, and in quite a few cases, even negative territory.
As can be seen in chart 1 below, debt is higher today than it has ever been. There has been limited deleveraging in various household sectors (due to demographic factors in our opinion and not through choice), and in the financial sector (because of regulatory changes and household deleveraging), and this is a positive development. However, corporate debt has jumped sharply and Government debt only ever moves higher. Collectively, there has been no deleveraging which should be part of the post crisis healing process. Arguably, the global debt profile is consistent with the pre-crisis scenario outlined by Andrew Smithers.
Chart 1 - Global Debt to GDP
As regards the current valuation of financial assets, high grade bonds everywhere (Europe and Japan especially) are in the final stage of a 35 year bull market and most are in what can only be described as bubble like territory. In equities, the US market is by far the most stretched, and on non-earnings valuation measures, are trading at levels consistent with the bubble peaks of 1929, 2000 and 2007. For example, the chart below shows the enterprise value to Gross Value added (similar to revenue). As can be seen, the current market valuation exceeds that seen in 2007 and is on a par with the 2000 peak (a time that everyone acknowledges as the all-time bubble valuation extreme).
Chart 2 - Enterprise value to Gross Value added - comparable to 2000 peak bubble valuations
During her post meeting press conference, Janet Yellen said that asset values are in line with historical norms. Either she is repeating a falsehood, hoping that investors buy into that narrative, or she is simply ignorant of historical valuation measures that actually matter (n.b. the so called Fed model simply does not stack up as a reliable valuation measure over the long term).
Furthermore, all of our central bankers should be fully aware that stimulus can only bring forward future consumption to the present. If they are lucky, all bankers can do is smooth the cyclicality of the economic cycle, but what they cannot overcome are the structural headwinds that are now impacting the global economy. Therefore, we have to suspect that they know they are running policy far too loose, and this is extreme short termism. The resulting increases in debt and financial excess will cost us all dearly in the end.
So, we have record levels of debt and all major assets trading at or near bubble valuations. This is the set up for a financial and economic crisis unless policymakers change course and put in place policies that will 1) generate real GDP growth that benefits everyone, 2) lower debt levels and 3) smooth the financial transition from overvalued assets to fairly valued assets. However, policymakers are not likely to change course, because they are petrified that markets will react badly. They will continue with the policies that have brought us to the present over indebted and overvalued condition until they are forced to change or the financial bubble bursts.
Which takes us to the Bank of Japan. The initial fanfare with which their new policies were greeted is typical of bull market behaviour, however, the market reaction became more muted within just a few hours of the announcement. The two main changes were a move from QQE + NIRP to QQE with yield curve control. This will be achieved by controlling the overnight rate (currently set at -0.10%) and targeting the 10 year bond yield around the current level of zero per cent. Furthermore, it is widely expected that the yield curve control implies a steeper curve to help the banks. The second change is a commitment to let inflation run above 2% for a while in an effort to convince everyone about how serious they are on achieving their 2% inflation goal. At the same time, all previous policies will remain, including the Yen80 trillion a year balance sheet expansion.
In our opinion, these changes now increase the likelihood of some sort of policy failure, and so puts their credibility, diminished as it already is, at risk. Let's tackle the inflation commitment first. For over three years, the Bank of Japan has been aiming to get inflation up to 2%, and have failed, blaming exogenous factors like the large decline in oil. We doubt very much whether a strengthened commitment alone will suddenly ignite a little bit of inflation. Perhaps more fiscal stimulus, other than that already announced, will make a difference, but having had 26 supplemental budgets in the 26 years since their own financial crisis, any new fiscal spending plans will somehow have to be different in nature.
As for the new "yield curve control", this is where it gets interesting because, simply put, a central bank cannot target both bond yields and balance sheet expansion at the same time. Let's play with several scenarios to illustrate this.
First, let's assume that the 10 year bond trades with a near zero yield and virtually no volatility. In this scenario, it seem highly unlikely that the Bank would need to buy Yen80 trillion a year of bonds. In fact, we suspect that the Bank would soak up new issuance (about Yen 40 trillion including year 1 supplemental budget spending), but buying another Yen40 trillion may prove a challenge. Even if they do achieve both the zero bond yield and balance sheet target, who's to say that the sellers of the Yen 40 trillion of 10 year bonds don't simply buy longer dated bonds, thereby flattening the yield curve.
Second, current holders actually believe that inflation will reach 2% or higher, and rather than sit holding an asset with a negative real yield, decide to sell en masse to the BoJ. In order to maintain the zero yield for the 10 year bond, the Bank has to buy more than Yen 80 trillion, which may prove problematic. With their balance sheet already equal to approximately 90% of GDP, and 40% of outstanding debt, the BoJ is nearing capacity limits.
A third scenario is that a zero yield for 10 years is better than a negative yield in shorter maturity assets, and anyway, banks, pension funds have to hold Government debt to meet regulatory requirements. As such, the main holders of JGBs may decide to hoard what they have left which would mean the BoJ would fail to expand their balance sheet by Yen 80 trillion. Furthermore, what if the JGB hoarding leads to a falling 10 year bond yield? Will the bank of japan actually sell bonds to push up yields and actually shrink their balance sheet?
What strikes us is that in scenarios 1 and 3, the BoJ will be reducing the size of the QE, or a so called tapering which is a tightening of policy and not something they want. At the other end of the spectrum, they will have to go all out to maintain yield curve control, whilst they are already operating near capacity limits. In addition, under all three scenarios, they continue to play a dominant role in a market where liquidity is drying up fast. It's all very well trying to control the market, but at what long term cost, both to the BoJ's credibility and the efficacy of a free market?
Perhaps the outcome will be more benign, whereby the BoJ has control of the yield curve, is expanding its balance sheet as planned, remaining JGB holders are happy despite rising inflation and market liquidity remains ample. However, this is something that won't last forever. At best, the BoJ continues to buy a bit of time for politicians to implement deep structural reform in order to generate robust growth. At worst, investors lose faith in Japanese policies.
To take one last look at this policy tweaking by the BoJ. There have been quite a few commentators heralding the move to a steeper yield curve as being a great support to the banks, thereby removing one of the nasty effects of negative interest rates. Let's think about what they have done. They have set the overnight rate at -0.1% and have a current target of zero for the 10 year yield. I think we need to assume that the 10 year target yield will not rise any time soon, and so the only way to steepen the curve further is to cut the overnight rate. However, the negative rate experiment is not working and critics are getting more vocal. In the meantime, will this new yield curve control make a difference with current rates? Well, if we are right that the curve remains pretty flat because the BoJ can't cut the overnight rate by much and they are unlikely to raise the 10 year target, then this part of the new policy mix is actually a bit of a dud.
Chart 3 - The Japanese Yield Curve (10s less 2s)
We do have to entertain one more scenario with the BoJ. All of this is simply a cover for massive monetary financing, or helicopter money. They are keeping the yield curve at or below zero so that the Government can issue debt free of charge. They are committing to buying all new bond issuance so that it doesn't crowd out the private sector. They will keep doing this until inflation is stable above 2%.
Well, this may sound great in theory, but once you go down this route, there is no turning back. Why would anyone other than the central bank finance the Government? All private sector savings would focus on either equities and property domestically or overseas assets. The BoJ would absolutely break anything that is left of the Government bond market, and perhaps put the Yen into a terminal tailspin. Yet, in today's age of policy experimentation, nothing can be ruled out. However, it appears to us that the BoJ has actually continued to simply dig within the big hole it finds itself in. The chances of this grand experiment going wrong just gets bigger the more they tweak their experiment. There comes a point in time when the credibility of the BoJ receives a fatal blow, and that moment may not be that far away.
Which brings us back to the global landscape, and the following list of current news; 
  • The BIS and Moodys are highlighting the fragility of the debt fuelled growth policy in China 
  • The OECD lowered global growth forecasts
  • Both the OECD and UN are urging growth policies that benefit the masses rather than the few
  • The US election is beginning to loom large
  • The recent EU summit ended on a sour note
  • The latest rumours from ECB sources say that policy changes may only be tweaks
  • Messy geopolitics from the middle east, through Russia to China
So we have a policy shift in Japan that may well end up with QE being tapered, politicians calling for fairer growth, and all of the major macro risks (which were never solved) simmering near boiling point. For investors, the main prop to ever rising market prices were the hugely experimental policies delivered by the major central banks. As should have been expected, these policies failed to overcome the very real structural headwinds (eg demographics and poor productivity) and may be themselves deflationary as zombie companies are able to stay alive and savers simply save more to offset zero yields and therefore forego some current consumption.
Not that Janet Yellen can admit this, but the Fed along with her counterparts in the developed economies, has allowed debt to increase to even more unsustainable levels, and created bubbles in all mainstream assets. This combination is the precursor to financial and economic crises as outlined by Andrew Smithers, which will be triggered by a decline in asset prices. If central banks decide to or are forced to abandon their support of financial markets, and lose credibility, then it seems inevitable that financial prices will decline, most likely in a disorderly manner. And this is why the potential tapering that the new BoJ policies will lead to is such a big deal. If investors realise that policies are shifting away from supporting markets, and/or the BoJ loses credibility, then the risks escalate rapidly.
Our fear here is that there is very little that policymakers can do to avoid the crises that their policies have all but guaranteed. For years now, central bankers have been trying to buy a little bit of time and growth through extraordinary policies without any consideration for the long term effects. Frederic Bastiat would surely classify the current central banking cohort as bad economists. They fail publicly to admit that their policies have created a massive financial bubble, with Yellen following in the footsteps of her predecessor in claiming that bubbles cannot be predicted in real time. This is simply rubbish.
There are reliable valuation measures like market cap/GDP, market cap/GVA, tobins Q, Shiller CAPE which all indicate that the equity market is in or close to bubble territory. At best, investors can expect close to zero nominal returns from either a balanced (equity and bond) or equity only portfolio over the next 10 to 12 years with low volatility. At worst, we could see a significant bear market in financial assets, leading to economic hardship, ballooning fiscal deficits and massive pension problems. In this worst case scenario, will the geopolitical risks stabilise, improve or deteriorate?
In the big picture, the risks in our opinion have simply grown in the last few years, especially because central banks have allowed (even encouraged) debt to continually increase and have supported financial bubbles in all mainstream assets. The window of opportunity to change policies and generate an elegant deleveraging with stable markets and economic growth that benefits the many and not just the few is closing rapidly. We doubt very much that current policymakers can execute such a policy shift.   
Despite "risk on" kneejerk reactions to any policy shifts or dovish words from central bankers, the market structure is very fragile and fully/wholly dependent on investors faith that central bankers will continue to foster even greater bubble finance conditions. As Paul Singer, a very successful hedge fund manager recently said, the breakdown in markets will be surprising, sudden, intense and large. If he is correct, there will be no time for investors to react and protect their portfolios. The time for doing this is now whilst conditions remain relatively calm.

By Stewart Richardson on 18/09/16 | Category - Central Banks
"We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful."
 - Warren Buffett
For several weeks, we have intended to write about some of the structural issues that we believe are both important to long term investing, and also being pretty much ignored by policymakers. The problem with fundamental analysis is that by its very nature, the output from such analysis can only be used by long term investors. Yet, at the same time we need to understand that successful long term investors need to know when to bet against the crowd.
For a number of years now, central bankers have fought tooth and nail to prevent anything that even hinted of financial crisis. As their policies have become more extreme, so markets have become more dislocated from the underlying economic reality. Investors everywhere have become much more short term in their thinking and increasingly worried about under-performing if they bet against the crowd. We will get around to covering the serious fundamental analysis that we prefer writing about, but today we will slip into the crowd and consider the short term ramifications of the Fed and Bank of Japan meetings next week.
First up, it is widely expected that the Fed will make no change to policy. We do concur with this widely held view, and any excitement will be because of what chair Yellen says in her press conference. Unfortunately, Yellen's public appearances tend to either create confusion or, if markets are selling off, simply encourage reflexive buying of risk as she coos dovishly. With markets still relatively well behaved, she is likely to tell us how well the domestic economy is doing, how they need to be vigilant to risks (especially those overseas ones), how they think the next move will be to raise rates but that rates will remain low in the long term.
To be utterly frank here, knowing how the market will react to Yellen's utterances is not entirely clear to us. Even if we knew exactly what she was going to say, we are not sure whether we could use that information to make money. Perhaps when markets become so misaligned with fundamentals, and central banks are pursuing such extreme policies, price action becomes so erratic that trying to trade around central bank meetings is becoming counter-productive.
Several hours before the Fed, we will have the outcome of the Bank of Japan meeting. What is so interesting is that Governor Kuroda has promised to announce the results of a comprehensive review of their policies. Despite not meeting their goals, the review will not admit any failings and current policies will remain in place at a minimum. Indeed, the debate appears to have moved onto how they can increase stimulus further, and it would appear that the great new idea is to steepen the yield curve. To do this, they may cut the overnight rate further into negative territory and concentrate the JGB purchases in shorter maturity bonds.  
Although a steeper yield curve is a positive environment in theory, we really are talking about fiddling whilst Tokyo burns here. To achieve a steep enough yield curve to make a difference, they either cut the overnight rate deeply into negative territory, which may prove to be counter-productive. Or longer dated bond yields rise a lot (price falls), which may well impact global bond prices sufficiently to cause a more widespread sell off, as we described last week.
Although the smoke signals from the Bank of Japan appear to be leaning this way, it also appears that not all members are on board. The committee appears divided. As with the Fed, the Bank of Japan has seen erratic market action post recent meetings regardless of whether they have eased policy or not. Again, we are not sure we could make money trading Japanese markets even if we knew today exactly what the BoJ would do and/or say.
So for the next few days, we feel like we are being held hostage by Central Bankers who look more and more like the Wizard of Oz just before his cover is blown. Our tendency remains risk off in our portfolios as we believe that's where the fundamentals suggest we should be positioned, however, our conviction is lower than usual. We look forward to reverting to some serious fundamental analysis in the weeks ahead and hope that it offers some value in an increasingly distorted financial environment.      

By Stewart Richardson on 31/07/16 | Category - Central Banks
We want to try and cover a few areas this week. According to the headline data, the US economy remained weak in Q2 and the European economy slowed a bit. There are grounds for both optimism and pessimism, but with the bias always these days towards dovishness, we expect Central Banks to remain primarily in easing mode with the US Federal Reserve on the side lines.

Let's start with a look at the US GDP report. In the second quarter, the US economy grew at 1.2% (Quarter on Quarter, Seasonally Adjusted Annual Rate) compared to 0.8% in the first quarter (revised lower from the previous estimate of 1.1%). On the surface, this was a poor report, indicative of an economy operating at stall speed. Chart 1 below shows both the quarter on quarter and year on year changes in GDP since 2010, and what can be seen is that the US has not seen 3 such consecutively low quarterly growth numbers since the end of the last recession. In year on year terms, the current 1.2% growth rate is now back to almost the lowest level since the end of the recession.

Chart 1 - US Real GDP since 2010
If we take a step back, and look at nominal GDP now going back to the 1980s, we can see that the year on year growth rate is at levels associated with recession. Indeed, the current 2.4% growth in nominal GDP is the slowest since the end of the last recession. Now, we doubt that the Fed needs much excuse to refrain from further rate increases, and ahead of the election we can see how they can hide behind the very mediocre GDP numbers.

Chart 2 - US Nominal GDP growth (year on year) and the Fed Funds rate
As noted above, there are grounds for both optimism and pessimism for the US. On the optimistic front, the consumer revved into life in Q2 with Personal Consumption Expenditures (PCE) seeing the second best quarter since the last recession, as measured by contribution to GDP. Offsetting this strong consumer performance was a dreadful corporate performance as measured by Gross Domestic Private Investment (GDPI). The optimists will argue that GDPI will likely rebound after such a weak quarter, and assuming that the consumer remains as robust, we can look forward to much better economic output in the second half of the year.

However, what if the rebound in GDPI is disappointing, and the consumer suddenly hunkers down again? What caught our eye was the decline in the personal savings from 6.1% in the first quarter to 5.5% in the second quarter. Is this a sign of confidence about their future prospects, spending income they expect to receive tomorrow. Or have consumers dipped into savings yet again to sustain current lifestyle despite little prospect of a pay rise ahead?

As far as we are concerned, it could go either way. The risks from abroad remain, and any new strength in the Dollar would quickly become a headwind again. Furthermore, although inventories did decline in Q2, there is room for a further decline after many quarters of inventory building. On an optimistic note, it would appear as if year on year corporate revenues were basically flat in Q2 after five consecutive declining quarters. If this stabilisation marks the beginnings of an improvement for the corporate sector, we should expect Gross Private Domestic Investment to either stabilise or improve.

Our best guess at this stage? We guess that the data will show a modest improvement in the US economy in the second half of the year, but likely not sustainable. We expect the economy to continue growing well below pre crisis growth rates and the risks of a recession will remain elevated in 2017.

Moving onto central bank meetings, as expected, the US Federal Reserve made no changes to policy, and very few changes to their statement, albeit inserting a sentence noting that near term risks have diminished. As noted above, we can easily envisage the Fed remaining on the side lines until after the election in November.

The other main central bank meeting last week was the Bank of Japan, where market expectations of more stimulus were disappointed. With a pre-announced fiscal stimulus of approximately US$275 billion (more than 5% of GDP) expectations were high that the BoJ would work alongside the Government and expand stimulus. In the event, the only actions were to increase their buying of equities via ETFs and to increase US Dollar liquidity lines. 

Not only did these actions fall well short of expectations, but we simply do not see the economic benefit of a central bank buying equities. Ok, the supporters of such policy will argue that this is designed to increase investor confidence which will help the economy. In practice, we do not see this happening, and even if there was the tiniest economic benefit, the long term costs will outweigh any benefit. For example, if the BoJ becomes the buyer of last resort in equities (as they have in the bond market), what will equity holders then think when/if the BoJ announces an end to their equity purchases? We doubt this would be a positive, and the BoJ now risks being unable to reverse a policy that is economically unjustified.

What kind of saved the day for the BoJ was the announcement of a review for the next meeting of how they can reach their 2% inflation target quickly. This is central bank speak for, ok we haven't hit our target after three years of trying, so we are preparing plans for more of the same in the hope that it will work. With Kuroda telling us that he is legally prevented from employing "helicopter money" (we suspect that this will change in time), the market now expects more QE and perhaps another rate cut to even greater negative rates in September.

All of this brings us to the next couple of quarters or so as being pivotal for global policymakers. Japan is in an impossible situation and it seems that markets are losing patience. If the BoJ launches another huge stimulus package in September, and the markets react poorly, then the BoJ could sustain an irreversible hit to their credibility. In the US, if the economy recovers, then surely the Fed have to raise rates and risk a financial market sell off. If the economy doesn't recover, then surely it is so close to stall speed that recession risks rise quite quickly.

So, from an economic and central bank perspective, the next couple of quarters would appear to be very important. Furthermore, the political agenda alongside Brexit and potential China concerns will keep life very interesting. To date, financial markets continue to ignore any and all risks and seem happy to suckle on the monetary policy teat. We are very unsure as to how long markets can continue in this vein, although we have to admit that they have remained more resilient than we have expected for a long time now. We continue to see no value in mainstream assets for buy and hold investors (time horizon measured in years). From a trading perspective, we continue to believe that a flexible approach suits the current environment, especially when trying to control risk. We have backed away from our bearish views modestly in recent weeks but we are keenly watching for signs of a bearish reversal.   

By Stewart Richardson on 03/07/16 | Category - Central Banks
Markets really have been on a roller coaster ride since the Brexit vote. Major equity indices have enjoyed a remarkable rally the last few days predicated we believe on hopes for a further round of monetary easing and perhaps some fiscal stimulus as well. Bond prices have risen as the economic outlook dims and the hunt for yield continues. Precious metals have also performed strongly as some investors hunt out protection from increasingly extreme central bank policies. Can all of these assets continue to rise together?

The actions of central banks are increasingly distorting financial markets. Negative interest rates and QE in Europe and Japan have resulted in approximately US$12 trillion of bonds now trading with a negative yield. This distortion has forced investors to hunt for yield which has driven yields down in all Sovereign bonds as well as corporate bonds regardless of credit quality. Unless the world economy is heading into a Japan like lost decade (which is certainly a possible outcome in our opinion), Government bonds represent utterly disastrous value for investors. 

Chart 1 - Selected 10 year bond yields since 2005
The increasingly extreme policies of central banks seem to be worrying some investors. Nobody knows the true long term consequences of such policies and there are some who believe that the current negative rates and QE are actually doing more harm than good. However, at every negative turn, central bankers simply continue to do more of whatever it takes, regardless of the long term risks. Having been in a bear market for more than four years, it would appear that the price of Gold has turned a corner this year and embarked on a new long term bull market.

Chart 2 - The price of Gold since 2005
So what of equities? It appears that traders are excited enough about more Central Bank stimulus to drive prices higher in the short term. However, valuations in the US are extremely stretched, negative rates and QE in Japan and Europe have hardly helped in recent months and corporate cash flows will surely get hit hard in the event of a global recession. 

With the risks more obvious in UK/Europe at the moment, investors have been rerating US equities relative to the rest of the World. How expensive are US equities? On some measures, they are in bubble territory (not quite as expensive as at the height of the dotcom boom) and just as expensive as in 2007. What is remarkable is looking at the median stock valuation as opposed to the average. The next chart shows the Median price to revenue of S&P 500 components (courtesy of John Hussman), and as can be seen the median stock is now the most expensive ever in history.
Chart 3 - Median Price / Revenue Ratio of S&P 500
John Hussman really does produce some powerful analysis for long term investors. Recently, he took Warren Buffets previously favourite quick stock market measure of market capitalisation to GDP, and changed it to Corporate Gross Value Added to GDP. This is shown in the chart below (in blue and inverted) alongside the subsequent actual 12 year annualised nominal returns (in red). The correlation between this measure of market value and subsequent 12 year returns is 93%; a truly remarkable statistic. Investors need to accept that the total nominal return for buy and hold investors (12 years on this basis) is going to be about 2% before fees and slippage. The potential for a very damaging bear market during that 12 year period is very high.
Chart 4 - Corporate Gross Value-Added to GDP
So, with US stocks so expensive, where should investors look? Well, our simple view is a US bear market would impact global markets to varying degrees. There is little doubt that Emerging Markets offer somewhat better value than the US, however, these economies remain very vulnerable in the event of a global shock. Europe also looks better value than the US, but the structural headwinds and rising political risks make it hard to be too optimistic in the short term. Perhaps the Bank of Japan can kick-start their equity market with more stimulus later this month? We'll see.

We also worry that investors have become far too complacent about lower quality corporate bonds. In the US, the Junk Bond ETF yields about 5.8% and the expected default rate this year is 6%. We do not expect robust returns from this asset class either.

It appears to us that central banks have distorted financial markets to such a degree that there really is very little fundamental value in buying many mainstream assets at this juncture. And yet, we have markets rallying strongly this week on hopes for more central bank stimulus - policies that have failed to generate robust economic growth and only seems to be increasing inequality which seems to be at the heart of the disgruntled electorate in many develop countries. 

The main question has to be whether markets have started a multi week rally similar to that seen between February and April when central banks unleashed another round of stimulus. Or, is the current four day rally simply a quarter and squeeze that will soon peter out? We are very much leaning towards the latter although it seems that anything is possible in today's distorted market place and so we have to be careful about being too bearish at this stage. 


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