The Pied Pipers Of Financial Markets – A Global Outlook For 2018

By now, we know that the Federal Reserve in America raised the Federal Funds rate by 25 basis points on 13 December to a level between 1.25 per cent and 1.5 per cent and that Janet Yellen, the current chairperson of the Federal Reserve, would be stepping down soon. Her successor, Jerome Powell, may chair the next monetary policy meeting of the Federal Reserve later this month or the next one in March.

Ten days before the Federal Reserve meeting, the Bank for International Settlements (BIS) released its last Quarterly Review for the year. Releasing the report, Claudio Borio, the chief economist for BIS told the media that if financial conditions had eased since the Federal Reserve began tightening in December 2014, then has there been any tightening at all? The answer is an obvious ‘No’ because risk premiums have become lower after the so-called tightening began. Why does this happen?

Borio has a succinct explanation:

“The very mix of gradualism and predictability may also have played a role. The pace of tightening has slowed across episodes, and it is now expected to be the slowest on record. And, scorched by the outsize reaction in 1994 - not to mention the "taper tantrum" in 2013 - the central bank has made every effort to prepare markets and to indicate that it will continue to move slowly. Indeed, today's experience is reminiscent of the repeated reassurance of the 2000s' "measured pace", except that the adjustment has been, if anything, even more telegraphed. If gradualism comforts market participants that tighter policy will not derail the economy or upset asset markets, predictability compresses risk premia. This can foster higher leverage (debt) and risk-taking. By the same token, any sense that central banks will not remain on the sidelines should market tensions arise simply reinforces those incentives. Against this backdrop, easier financial conditions look less surprising.”

Simply put, the more central banks try harder not to surprise markets, the more market participants become complacent, take on more risk and debt. Borio poses the question to central banks but he does not provide an answer as to what they should do although the answer is obvious. But, journalist James Mackintosh, writing for the Wall Street Journal, provided the answer, even before Borio posed the question.

On 16 November (more than two weeks before Claudio Borio made the remarks above), in the pages of the Wall Street Journal, James Mackintosh wrote that the Federal Reserve was poisoning the markets with predictability. He said that the best remedy to prevent investors from piling on excess risk that eventually hurts their wealth and the broader economy was to surprise them. Well, it is unlikely to happen and by the time you read this, you will have learnt that the Federal Reserve had raised the Federal Funds Rate by a quarter percentage point on 12 December 2017 for its last rate hike of 2017 and for the last monetary policy decision of Janet Yellen.

Asset inflation sets up future deflation

Neither the Federal Reserve nor any of the major central banks would spring a surprise on the financial market because they and the financial markets are prisoners of each other. They fear instability and wish to provide so much of stability that, in the process, they undo all their vain attempts at ensuring stability. Central banks would not mind springing a dovish surprise on the market (cutting rates more than anticipated by the market) but not a hawkish surprise (raising rates by more than market anticipation). That tells us something about the psychology of the times we live in. It is all about short-term and instant gratification and postponing pain. Please watch the brief 2-minute clipping of a long CNBC interview with legendary investor, Stanley Druckenmiller. He argues, correctly, that the surest way to bring about deflation is to stoke asset bubbles as central banks are doing, in the pretext of trying to stoke inflation in prices of goods and services.

Central banks can succeed in creating inflation only if the theory that inflation was a monetary phenomenon was true. In the end, it is only a theory. If inflation were more influenced by real factors like labour costs, the power of workers to extract higher wages, labour and capital productivity, technological developments, the level of competition in the economy, openness to international trade, etc., then it is wrong to entrust central banks with the task of managing inflation and setting monetary policy to do so. They would be better off managing credit growth, regulating the banking system and ensuring financial stability. Until such a rethinking happens, the world will be lurching from one crisis to another because asset bubbles carry the risk of turninga garden-variety recession into a full-blown financial crisis. The longer the bubble lasts and more pervasive the bubble is, the bigger the risk.

Bitcoin - the mother of all bubbles

Indeed, the clearest evidence of the folly of their efforts is the surge in the market price of Bitcoin, a cryptocurrency which is supposedly mined with a complex algorithm that it cannot be printed like central banks print money. But, its price has risen so exponentially that it makes a mockery of all claims to it being an alternative to the paper money printed by the central bank.

Paper money that is not backed up by gold or any other metallic standard becomes a medium of exchange because of the trust that governments and central banks enjoy among the public. But, bitcoin is a private creation and is unproven. Yet, investors, particularly from Asia, have embraced it far too enthusiastically not so much in the hope that it would replace their official paper currency but purely for speculative gains. According to newspaper reports, up to November, 80 per cent of the trading activity in bitcoin came from Asia-based investors. No government would give up its monopoly to create money without a fight. The only reason why the public loses faith in a currency is if it is deliberately debased eroding its purchasing power consequently. That has not happened yet. In fact, if the public were to lose faith in fiat money, they would opt for the stability and durability of the yellow metal. That the price of gold has declined ever since the price of bitcoin zoomed higher is the clearest possible indication that investors’ motives are ill-formed, ill-founded and purely speculative. It cannot but end in tears.

All assets that are perception driven eventually correct. It is a fact that central banks around the world – principally, the Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England and the People’s Bank of China – have made stocks too perception-driven assets. They used to be cash-flow (dividend) based. But, lately and particularly in the last 35 years, they have become more perception based. That is, returns accruing to investors from holding stocks have been driven by the expansion of price-earnings multiple rather than through dividends. That was not the case before. However, in theory, there is scope for investing in stocks to become an exercise in evaluating the cash flows that they would generate for investors over the holding period. But, that is not possible with gold or bitcoin. However, gold has been around for centuries and it has other uses. Bitcoin is different. Its use as a medium of exchange is possible only if sufficient numbers of people believe in it and if authorities do not disallow it. Therefore, it is for ever a perception asset. Perception assets rarely sustain their valuation because perceptions can and do change.

American economy well placed into 2018

Even though stocks are rich and expensive by most measures, the economy is unlikely to be the source of risk for investors. The economy is growing solidly, generating jobs and capital investment is picking up. Manufacturers’ new orders for non-defence durable goods excluding aircraft are growing this year after the stagnation of 2013-2016. Part of it is due to the global economic cycle and part of it is due to the deregulation efforts of the Trump administration.

Small business confidence level is at its highest since 1983. Yes, that is not a typo. Their hiring plans are at an all-time high (chart).

The official unemployment rate is 4.1 per cent and job creation per month is of the order of 200,000+ per month. The expected real GDP growth for the quarter ending December 2017 is 2.9 per cent (annualised). In the third quarter, corporate profits rebounded. While the economic growth story looks solid, there are some long-term risks. Auto sales will be declining for the first time this year since 2009. Personal savings rate is down to 3.1 per cent and real wage growth is rather anaemic. While recent productivity data suggests a revival, it has been rather bad for quite a long time.

In 2018, the Federal Reserve should hike rates three to four times totalling 75 basis points to 100 basis points. Currently, the yield curve (10-year US Treasury yield – two year Treasury yield) has stabilised at above 50 basis points. But, a sustained rise in the short-term interest rate could invert it by the middle of 2018 setting the stage for a meaningful economic slowdown in the second half of 2018 or in the final quarter of the year.

As for the stock market, while the valuation is rather rich – and, by some measure, the richest – the passing of tax reform legislation will provide a short-term boost on top of the gains made already in 2017. In fact, the year 2017 will be the first year that the S&P 500 will not have had a single negative month in 30 years. VIX, the index of volatility, has settled well below 10 per cent and investor complacency is high, as seen in the return of the retail investors to the US stock market. Therefore, notwithstanding the seemingly solid US economic prospects, we are rather sceptical of any meaningful gains for investors from American stocks at these levels over any horizon exceeding 12 months. Short-term gains are possible, however. That said, I can be wrong.

American stocks can rise so far as to become the biggest bubble of all times especially if the Federal Reserve develops cold feet on raising interest rates, under the new leadership. It was encouraging to read from the Federal Reserve meeting transcripts of 2012 that Powell took a dim view of excessive risk-taking in financial markets fostered by the monetary policy of the Federal Reserve. If he buckled under the pressure of conventional wisdom that provides short shrift to financial stability while focusing too heavily on inflation – over which monetary policy has little control – then, he would raise rates too little in 2018 or not raise them at all. Then, stocks can scale bigger heights. But, there is no doubt in my mind that the swifter and higher the ascent, the more painful and impactful will the eventual crash be.

China: the 800-pound elephant in the room

Last week, the International Monetary Fund released a report on China’s financial stability. The earlier assessment was in 2011. Some important points to note (words in italics are taken verbatim from the IMF report):

China remains bank-dominated. Credit to GDP exceeds the benchmarks by wide margins. In absolute terms, China already has the largest banking system in the world.

Financial assets grew from 263 percent of GDP to more than 467 percent in 2016.

Credit growth has vastly exceeded GDP growth, as interest rate and prudential controls have been circumvented by continuous financial innovation. The system has grown in interconnectedness and complexity.

The chart below shows that China’s bank assets were 310 per cent of GDP as of 2016. The chart also tells us that in 2013, it was barely 150 per cent of GDP. We should note here that the Financial Stability Report of the People’s Bank of China (PBoC) for 2017 puts the off-balance sheet assets of the Chinese Banking System at 109 per cent of on-balance sheet assets. That is another 337 per cent of GDP. So, in total (on and off-balance sheet) assets of the Chinese banking system equal 648 per cent of GDP, if PBoC calculations are correct.

Loans account for under half of bank assets (40 percent when the Big Four banks are excluded). For many medium-sized banks, the investment portfolio now accounts for half of total assets. These investments often include NSCAs held either directly or indirectly.

The Big Four are majority state-owned, while local governments have important ownership stakes in lower tier banks and — in many cases — exercise control. There is thus no substantial competition between fully private and publicly owned banks. Local government-affiliated entities own non bank subsidiaries and other intermediaries such as AMCs, though these holdings are rarely transparent. The state also controls a large share of other segments of the financial system, such as insurance companies, trusts, and securities companies, as well as the financial sector's largest borrowers: the pervasive nature of state control inevitably influences credit allocation. Potential conflicts of interest between the state as controlling or major shareholder and as regulator limit the scope for markets to operate efficiently and to reveal accurate pricing of assets and liabilities.

Over the past 10 years, the credit to GDP ratio has risenabove its long-run trend, and this “credit gap (Credit gap = Actual Credit/GDP ratio minus trend Credit/GDP ratio)” now reaches about 25 per cent of GDP, according to the Bank for International Settlements (BIS). This level is very high by international comparison, and already above levels consistent with a high probability of financial distress.

This is not a surprise since China has created an equivalent of around 26 per cent of GDP in credit every year since 2006 (chart). For example, in 2009 alone, China created credit equivalent to 40 per cent of GDP of that year. After declines in the ratio in 2015 and in 2016, this year, the ratio looks set to be 25 per cent of GDP.

Between 2006 and 2017, the cumulative Total Aggregate Financing (or, Total Social Financing or TSF as it is called by the PBoC) amounts to RMB160.6 trilion. Estimated GDP for 2017 is RMB81.1 trilion. Hence, the ratio of TSF to GDP is 198 per cent. Goldman Sachs estimates the amount of TSF to be RMB187.8 trillion and that raises the ratio to 232 per cent ( Source: ‘Above-expectation loan additions drove TSF recovery; M2 rebounded’, China: Banks, 12th December 2017, Goldman Sachs Equity Research). These numbers boggle the mind. They render China’s GDP growth meaningless because it is possible to generate GDP growth based on such massive infusion of credit. If the Federal Reserve were to raise the Federal Funds rate 75 to 100 basis points in 2018, then capital flows out of China will resume. China will continue to remain a potential source of big global systemic risk.

We should also note here that the United States, Japan and the Eurozone are turning the screws on China with respect to trade at the World Trade Organisation. The European Union and the United States are opposed to China’s application for ‘market economy’ status and the United States has initiated a unilateral (not triggered by any trade lobby) anti-dumping investigation into aluminium sheets imports from China.

China’s currency and assets pose risks rather than present opportunities for investors in 2018.

India: rising risks

The 10-year Indian government bond yield has risen by about 80 basis points since July (6.4 per cent to 7.2 per cent currently). It is because of the expectation of the government slipping in its fiscal deficit target (anticipated higher market borrowing by the government), partly due to worries over the collection of indirect taxes under the new goods and services tax (GST) regime. Partly, it is because the government announced a scheme to recapitalise banks that are majority owned by the government and an infrastructure spending plan too. Now, on top of these, the inflation rate has picked up. On 11 December, the government released the inflation data for November. The consumer price index rose nearly 5 per cent y/y, led mainly by housing and fuel prices. Given the current trend in the global price of crude oil, further upside risk is rather high for India’s inflation rate. The Reserve Bank of India did not cut interest rates in the meeting held on 6 December. Now, the market would start to worry if it would raise rates in the New Year rather than cutting rates.

India’s inflation problem is a result of its weak and inefficient production structure dominated by tiny farms and factories whose productivity is low and resources are inadequate. On top of that, the government’s structural reforms have had a short-term negative impact, disrupting supply chains. The withdrawal of high denomination cash announced last November have hurt the farm sector and informal businesses. Then, the implementation of GST from 1 July caught many small businesses off-guard and the country is still coming to terms with the new indirect tax and compliance. It will take at least two more quarters to stabilise.

A positive development for economic growth is the new Insolvency and Bankruptcy Code. Many errant corporate borrowers are paying back and deliberate defaulters are being banned from bidding for their own assets when financial institutions and creditors bring assets to the market to recover their dues. Further, the government has announced a massive recapitalisation of banks. The actual infusion of capital has not happened yet. But, once it is done, credit growth should resume.

Clearly, India’s GDP growth bottomed out in the first quarter of the current financial year 2017-18 (April to June) at 5.7 per cent. It rebounded to 6.3 per cent in the second quarter. It should continue to improve as the country adapts to GST and as banks resume lending to credit worthy borrowers. However, India will find it difficult to scale growth rates above 7 per cent as structural constraints bind. India lacks the production structure to produce on a scale that would enable high growth rates combined with moderate inflation.

Bloated corporate balance sheets with debt and impaired bank assets have meant that capital formation has sunk to very low levels (chart). In nominal terms, the ratio of Gross Fixed Capital Formation to GDP ratio was around 26 per cent in the second quarter of 2017-18 (July–September). Without the revival of an investment cycle, sustained high growth rates in India are infeasible. Sporadic high growth will be punctuated by rising inflation and rising current account deficits.

Therefore, on balance, India’s macro risks dominate opportunities in 2018. Both the currency and the stock markets are vulnerable to losses rather than gains the coming year.

Japan: a stable option for investors

We admit that we had not written much about Japan lately although we have maintained a small exposure to Japan stocks. In hindsight, it could have been more. Japan has been through the debt cycle since 1989. Its companies are flush with cash and its households are not in debt (as in Korea). It has huge international assets. Dividend yield in TOPIX stocks is 1.8 per cent compared to the 10-year JGB yield of around 0.05 per cent (5 basis points). Clearly, Japan stocks have done well. MSCI-Japan Investable Market Index has performed well since 2012 with the exception of 2016. YTD returns in 2017 are 19.5 per cent. Hence, it is somewhat late in the current cycle to lift exposure to Japan stocks. But, clearly, it is a more solid economy than many others in the advanced world. Its public debt is high. But, others have closed in and have even exceeded Japan’s public debt levels, both in absolute size and as a ratio of GDP.

Europe: over-rated and over-valued

Europe lost much of its sheen due to the stalemate that German elections produced in the second half of the year. Germany is yet to form a government. France is off the front pages and that is good news while Spain appears to have gotten the situation in Catalonia under control, for now. Italy has been the surprise positive story for 2017 in terms of economic growth. But, as we have discussed in the past newsletters, IMF has acknowledged that Eurozone countries have not done anything to improve their public finances, taking advantage of historically low interest rates and asset purchases by the European Central Bank. Much of the improvement in Eurozone economic growth and asset prices is clearly due to the unprecedented monetary accommodation provided by ECB. For ECB to exit from them will prove a lot harder than it has been for the Federal Reserve.

Final remarks

This is what we wrote at the end of 2016:

In sum, in 2016, risks materialised but stock markets and investors chose to whistle past them. It still is a matter of time before they wake up to the laws and loss of gravity. I expect the outperformance of US bonds and gold to resume in 2017.

This is what we wrote at the end of 2015:

We expect that global political and economic risks would come to a head in 2016. Put differently, the risk that the year would prove to be a rather long one than a normal one is higher, in our view.

Gold has performed moderately well in 2017 but has clearly lost to Bitcoin. In 2016, risks materialised (Brexit, Trump Presidency) but markets shrugged them off and, more importantly, China looked like imploding at the beginning of 2016. But, once again, massive credit infusion and a timid Federal Reserve saved China. China’s credit binge received ample support from the European Central Bank and the Bank of Japan too in the last two years.

No fundamental analysis can stand up to the force of such massive sums of money that feed investors’ myopia, greed and speculative instincts. However, central bankers are encouraging reckless risk taking and leading investors up the garden path that ends in an eventual crash. In that sense, they are the pied pipers of financial markets and investors. Indeed, the path looks more dangerous than it ever did – even more than it did in 2008.

Even the usually staid and sober John Authers at the Financial Times wrote on 8 December, “The bitcoin is only an absurd appendage to what is already a “bubble in everything.” There is nothing more to be said.

I wish all the readers a happy, healthy and prosperous New Year!