Bernanke's Post-Stimulus Era: More Peril Than Promise

Includes: BAC, C, GG, JPM, KBE, SPY
by: Sean Daly

Nonetheless, most of the provisions of Title VII of the Dodd-Frank Act applicable to derivatives will automatically go into effect on July 16, 2011, regardless of whether the respective agencyrules are finalized ... Will July 16 open the floodgates to derivatives-based securities class actions? It will be interesting to see how the plaintiffs' bar responds to the expansion of liability potential in this critical area of the financial system. [1] Luke Green, Riskmetrics. com

After six straight down weeks, the market was technically short-term oversold and due for a bounce. This brief rally may be played for short-term gain but investors should take note that the markets are unlikely to evade the larger macro-economic horizon that is taking now shape.

From late 2008 to 2011, central banks worldwide put a total of $5 trillion dollars into the global economy. When QE2 ends in late June, that period of governmental stimulus will "officially" end.

Wednesday's Fed report essentially confirmed this termination, dimming all economic prospects for next two years without its usual hint of "new sugar."

And, despite all those trillions thrown at it, the world economy will still be facing three major challenges:

  1. An overheating Asia.
  2. A slowing U. S. recovery.
  3. An unresolved debt crisis in Europe.

Coping with these three challenges will dictate global growth in 2012 and how well the financial markets will proceed for the rest of the year. All three may have "global spillover effects" – to use the IMF's favorite new phrase – with a cascade of positive and negative feedback loops likely.

Adding to the turgid unease over dimmed economic prospects is a strange confluence of "important dates," deadlines that seem to underscore the general paralysis of U. S. and European governance at this point in history. Despite yesterday's confidence vote, June 28 is still the true deadline for a Greek austerity vote; July 16 is a frightening Dodd Frank tripwire for the CDS market; August 2 is "Debt Ceiling Day" in the U. S. capital. The net result: four whipsaw weeks. These dates will roil the summer's market action and set the general tone for the fall.

The historic reflation effort began decisively enough. First announced on Nov. 8, 2008, China's $586 billion stimulus was focused, effective and supported by all levels of government. It was routed directly into new capacity, real estate and ambitious high speed rail projects. This stimulus quickly ramped up demand in industrial metals, with copper prices rising as early as January 2009. By June of that year, the World Bank had raised its full-year growth forecast for the mainland from 6. 5% to 7. 2%. China was off to the races, effectively never going into recession.

Now 30 months later, Beijing is trekking the downside of that slope. M1 money supply has exploded over the past two years – going into stocks and (more pointedly) real estate, where many cities have surpassed 1990 Tokyo prices as a percentage of average national income.

(Click to enlarge)

China's growth is slowing but its inflation is intensifying. Goldman has lowered growth and upped inflation for both 2011 and 2012. As I recently discussed at the World Policy Institute, May's 5. 5% CPI was a 34 month high and June's inflation is expected to clock in at 6%. Beijing has increased lenders' reserve requirements to a new record and instituted aggressive, if erratic, price controls via the NDRC. But tamping down inflation is particularly difficult when it coincides with a political transition and some investors – most notably George Soros – thinks Beijing has lost control.

Bad loans made during the '09 stimulus era will soon start hitting the Chinese banking system hard. In an op-ed in the WSJ Tuesday, Carl E. Walter suggested that Beijing is considering assuming $300-450 billion in bad loans made to local government vehicles. With all eyes on Europe, this is precisely the kind of unforeseen black swan event that could stagger the market further.

Looking specifically at the commodity markets, the two year run-up spawned by stimulus liquidity rolled over in April/May. The drop suggested both speculative de-leveraging and demand destruction in the emerging markets, where inflation, rate hikes and tougher regulations are having an effect. Add in concerns about Brazil's consumer lending and you can see why the EEM is not only negative for the year but has broken its 200 MA.

In addition to an overheating Asia, the world economy faces the structural uncertainty of Europe. This past weekend policy makers failed to agree on a 12 billion-euro ($17 billion) bailout loan due next month to Greece, though the confidence vote yesterday makes it possible that Greece will pass the budget cuts.

A delayed debt repayment of Greek debt now looks likely but is particularly dangerous for many European banks which – at least according to a recent Colin Barr article in Fortune – appear to be operating with very dangerous leverage ratios:

The Germans aren't alone in Lehmanville: Belgian banks are using 30-1 leverage and French ones 26-1, the IMF numbers (see chart, right) show. All told, banks across the 17-country euro area average 26-1 leverage – double the ratio in the United States.

This swollen state of affairs starts to read uncomfortably like the set-up for the May '31 collapse of Credit-Anstalt. [4]

As Europe engages in a summer of very messy, very public horse-trading – complete with balaclava street festivals – expect the dollar is likely to rise within its multi-year channel.

(Click to enlarge)

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Looking specifically at the U. S. – after this rally – we see the S+P 500 (NYSEARCA:SPY) and treasuries pressured in July due to the end of QE 2, much as they were after QE1. This is now a "muddle through" American recovery that will be soundly tested by its unresolved deflationary drags – i. e. the worst unemployment in 70 years, limp housing and a choked-off money multiplier.

The following two graphs – by Jeffrey Gundlach and Clusterstock, respectively – paint a distinct picture of problems long denied but never evaded.

(Click to enlarge)

(Click to enlarge)

More recent economic data confirms the deceleration. May's ISM Manufacturing Index fell out of bed with the biggest drop in a quarter century. Weekly leading indicators have been falling since early April and GDP growth rates are being reduced for 2011 and 2012. How long this weakness persists will be of major consequence for confidence this summer.

Ironically, the U.S. may find itself better positioned than Europe and China to weather the downdraft with only a 10-20% correction, though U.S. banking exposure to Europe via its CDS positions remains a big X factor. Issues related to Basel 3 and Dodd Frank's Title 7 thicken the plot for the industry.

Despite a nice bounce since June 10, we continue to see the KBW Bank ETF (NYSEARCA:KBE) and banks like Bank of America (NYSE:BAC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS) and JP Morgan (NYSE:JPM) pressured during this watershed summer of uncertainty – though an intense relief rally could occur this fall if the industry is deemed to have evaded the worst of it.

Bernanke's muted speech will be the market's emotional linchpin this week, so it is likely to do no more than help gold and precious metals – now off their sell-off lows – to find short-term buyers. In terms of specific miners, Goldcorp (NYSE:GG) in particular is enjoying a stunning breakout.

Next week, all eyes will return to Europe.


[1] blog. riskmetrics. com/slw/2011/06/securit. . .

[2] online. wsj. com/article/SB100014240527023. . .

[3] finance. fortune. cnn. com/2011/06/20/europ. . . /

[4] In that case, for the sake of "stability," a strong bank was saddled with a smaller bank rendered insolvent. Despite new capital injections and a deal packaged by the smartest international financiers of the day, the bank would limp through 17 months, only to fall in May '31. The rest is, as they say, history.

[5] streetlightblog. blogspot. com/2011/06/ind. . .

Disclosure: I am long GG, JPM, UUP.