Picture for a moment the perfect irony
A flawless new beginning eclipsed by tragedy
The uninvited stranger started dancing on his own
So we said goodbye to the glowing bride and made our way back home
Out of nowhere
Like a bullet
From the night
Stunned and bewildered, cold and afraid. Torn up and broken, frightened and dazed.
Around 18 years old, and still living at home with my parents in Philadelphia, I took a road trip with a couple friends to Atlantic City. It was me, the twins, an outstanding guitarist, and a pair of cynics. We wanted to see a show on the pier, but before the show, of course, we had to try to sneak into the casino. In about 10 seconds flat the security team was escorting us out.
So we grabbed a slice of pizza and went to the magic show. The magician did all the typical stuff you see, like disappearing objects, cards sliding through panes of glass, scantily clad assistants getting chopped in half, and all the other cool stuff you expect from magic shows.
What we have now in markets is very similar. All of us represent the audience, and the central bankers of the world are the magician. Every magician needs an assistant, and the main stream financial press happily obliges that role.
To be sure, after the Fed meeting and announcement this week, we’ll see a rate hike in December. Because the Fed thinks the economy is actually accelerating into these rate hikes, they may step on the gas on that front next year with more than two additional hikes, though I doubt that. They’ll be sure to ramp up the bond selling program as expected, going to $60 billion per month by this time next year.
Also, the nominee for the new Fed chairman, Jerome Powell, has made several public statements regarding both the rate hikes as well as quantitative tightening, which may seem to be contradictory at a glance, but if appointed I don’t think he will deviate from the current plan. He may soften and become more dovish, and as events unfold the market conditions will force the hand of the Fed to become more dovish on monetary policy.
Aside from the concerns I’ve expressed in my prior posts, there are two issues of late that I think need to be addressed. One is consumer spending in the US. Despite recent consumer confidence data and other reports in the media about economic expansion, I don’t think it will be all it’s expected to be this holiday season. Especially because consumer debt is now rising 1) at a faster pace than consumer income, and 2) the consumer saving rate has fallen off to a rate below that of the Great Depression.
Further complicating the matter of consumer spending is the recent uptick in economic activity resulting from several natural disasters, including hurricanes hitting Texas, Louisiana, Florida, and Puerto Rico, and the wild fires in the San Francisco area. Sadly, people in these areas have lost considerable amounts of property, including cars, homes, clothing, furniture, etc.
As an outgrowth of these losses, insurance companies have made and will continue to make claims payouts. However, anyone who needs to replace personal property will not receive the full cost to replace what was lost, and they’ll have to take money out of savings or borrow on credit to fill their needs. Regardless of who is paying, disaster related purchases have contributed to a fleeting uptick in economic activity. In turn, as people in these areas spend their money on the bare necessities, they won’t spend extra on the holidays between Halloween and the end of the year.
The other concern is the announcement of Mario Draghi’s European Central Bank (ECB) and the new policy direction upon which it is now embarking. It’s a similar policy move to what is happening in the US, with the exception of two decisive factors. One is that the ECB is behind the Fed by over two years. And second is that eurozone economic conditions are much more splintered than in the US, with several countries lagging behind while others drag slowly forward. Political splintering is also intensifying, which may have very heavy impacts on ECB policies in the near future. For example, several “far right” candidates have gained ground or won elections, and then there is the secession movement in the Catalonia region of Spain as well as the Brexit.
In addition to the ECB moving toward a similar monetary policy as the Fed, the BoE just announced their own rate hike. In the past I said this would happen, that Fed and ECB tightening would embolden other central banks to follow suit. Especially the BoE and BOJ, but others may follow soon as well, like the BRIICS or other emerging markets. Remember, they follow along with American monetary policy very closely because they want to maintain currency pegs, even if unofficially.
One important matter I will not be addressing here is the tax proposal, found here. It’s just a proposal, and for sure the Senate will come up with its own wish list for tax reform. The final draft to be sent to the president is several weeks away. Additionally, I have my own set of tax reform recommendations, which you can read here. It’s not nearly as detailed or comprehensive as the House proposal, but I think some of my suggestions will do a lot more good for the economy, for the American people, and for the government. If nothing else, my ideas streamline and give real simplification instead of just talk.
Central Bank Flaws
Central banks around the world have driven their policy decisions based on flawed equilibrium modeling. Think Phillips Curve or Taylor Rule, for starters. The track record of our own Fed, since 1913, is abysmal, and most of their decisions, at best, cause unnecessary uncertainty. Even though they are trying to remove uncertainty with forward guidance, they are just replacing prior uncertainties with new uncertainties. In other words, if the Fed says they will hike in December and reduce its own balance sheet by up to $60 billion per month depending on the data, who knows if they will actually hold to that? And who knows what the data will look like six months from now? Markets are so manipulated at this point that the data the Fed is reliant upon is inherently manipulated and does not indicate real economic conditions. It only indicates the outgrowth of manipulations.
In 2014, James Rickards poignantly wrote in his book The Death of Money (p87):
Adam Smith and Friedrich Hayek warned of the impossibility of the Fed’s task and the dangers of attempting it, but Charles Goodhart points to a greater danger. Even the central planner requires market signals to implement a plan…The Fed relies on price signals too, particularly those related to inflation, commodity prices, stock prices, unemployment, housing, and many other variables. What happens when you manipulate markets using price signals that are the output of manipulated markets? This is the question posed by Goodhart’s law.
The central planner must suspend belief in one’s own intervention to gather information about the intervention’s effects. But that information is a false signal because it is not the result of free-market activity. This is a recursive function. In plain English, the central planner has no option but to drink his own Kool-Aid. This is the great dilemma for the Federal Reserve and all central banks that seek to direct their economies out of the new depression. The more these institutions intervene in markets, the less they know about the real economic conditions, and the greater the need to intervene. One form of Knightian uncertainty is replaced by another…uncertainty becomes pervasive as capital waits for the return of real markets.
Unlike Shakespeare’s Salanio, we can no longer trust what the markets tell us. That’s because those who control them do not trust the markets themselves; Yellen and the rest have come to think their academic hand is more powerful than Adam Smith’s invisible one. The result has been the slow demise of the market utility that, in turn, presages the slow demise of the real economy…
The same is happening now in Europe, as Draghi and the ECB have begun to mirror Fed policy. The ECB is now tapering its own QE program by reducing the amount of debt it buys every month. Just like in America, as the ECB reduces purchases it will also force the price of eurozone bonds to fall. After all, when you remove the demand, all else equal, the price must fall without another entity to pick up the very bonds that the ECB is no longer buying. Otherwise the price of those bonds will fall, and as the price of a bond falls, the interest rate on open markets will rise.
I am having some trouble, though, with Draghi’s ECB tapering. Why is he suddenly doing it now? Remember when he promised to do whatever it takes? On July 26, 2012, he spoke at the Global Investment Conference in London, saying, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” That sounds pretty aggressive to me. Even though it was five years ago, there is still pressure to keep rates low as well as maintain the status quo in its QE program.
As noted here, the market is already bringing eurozone rates higher, possibly forcing Draghi’s hand against his will. One reason is that the euro has strengthened against the dollar in the last 12 months, going from a low of $1.03917 on December 20, 2016, to as high as $1.20371 on September 9 this year. That’s good for Europe, but not good for its exporters. It also doesn’t bode well for the ECB’s single mandate of maintaining price stability, though I doubt Europeans will complain if their cost of living is falling.
You see, as they taper and then move on to QT, the euro will strengthen even more. Don’t think that Yellen is already tightening and the ECB is just trying to keep pace. The Euro has strengthened against the dollar all while our Fed is tightening. The Euro will only strengthen more.
The big picture with central banks is we now have three major players on the taper/QT boat. Will the BOJ jump on the bandwagon? How about some of those EM countries that maintain a dollar peg? Only time will tell.
Naturally, we should want to have a look at the data that the central banks of the world are examining, particularly our own Federal Reserve. In that vein, I have some new data as well as a reexamination of data that we’ve looked at already.
In July I posted a series of charts. So first let’s have another look, and these are straight from the St. Louis Regional Fed. The first chart was Bank Credit of all Commercial Banks, shown as the Y/o/Y percent change. In my screen shot you can see the October 18 number was 3.22834, and the regional bank is saying the number the next week was 3.2. That is down from 3.43346 in July. The new number paints a worse picture than four months ago:
The next chart is Commercial and Industrial Loans, All Commercial Banks, also Y/o/Y percent change. The June figure was 2.05374, and it now sits at 2.0. It’s also falling. Though it is up since July at 1.87246, the downward trend is clear.
The third chart was Real Estate Loans, All Commercial Banks. In July the expansion rate was 4.6%. August was 4.269%, and September is down further to just over 4.0%.
The next two charts once again are Consumer Loans, All Commercial Banks. First is the sheer amount of loans, which is now up from $1.37 Trillion to $1.39 Trillion. As you can see, the trend is not moving in the right direction, and I’ll say more on that soon. And though it’s obscured here, borrowing looks like it’s accelerating.
Here is the same chart, but using the same metric as prior charts, Y/o/Y percentage change. This is now beginning to accelerate as I already mentioned. Only time will tell if this will become a new trend. If it does, there are negative implications behind it. Again, I’ll explain that soon.
Automobile Loans, All Commercial Banks follows the same pattern, however, we see a small uptick in September. Remember though, that was likely because of natural disasters, and that is why the trend remains clear. Even the Fed itself says as much.
Commercial Real Estate Loans, All Commercial Banks also follows the same pattern. July showed a 7.5% growth rate, which was down from 11.5% growth the prior fall. That same growth rate is now down to 6.7%.
The next chart is the final chart that was included in my July blog posting. It’s all consumer revolving debt, i.e., credit cards. It clearly peaked in the fourth quarter 2015, and I don’t think that is happenstance. Recall that the first rate-hike of the cycle began at the same time. It stands to reason that consumers began paying down their credit card debt in anticipation of the interest rate rising. And that is why we see it fall from 320% increase Y/o/Y in 4Q15 falling to a -47% decrease in 2Q17.
In 3Q17, the -47% went back up to -17%. The first thing I attribute that to is the same as before, post disaster spending. People just don’t have the cash on hand in the amounts needed to make up the difference between their insurance claim check and what they really need to spend to replace what was lost. I’ve been the recipient of those checks, and you only receive market value. Meaning, if your car was already 6 years old, and it’s worth about $7500, that’s what you get. You won’t get the original $15,000 you spent so that you can buy a new car. For my second reason that I don’t think spending is going to climb, please keep reading.
The Emerging Picture
We can see from these charts that the Fed’s own data is showing a very bleak picture. But are we set to see a turnaround now, or are things about to get worse?
It’s a good thing you asked, because I have some answers.
As noted in this article by Danielle DiMartino Booth, the US consumer accounts for about 18% of global GDP. She also says that US consumers have taken on too much debt of late, and it will prove unsustainable. I would add that as interest rates rise, the unsustainability of that debt will crash down on US consumers very hard. As we’ll see, the average American is paid less than the cost to live, and their current spending is outpacing earnings.
In fact, in this same article, DiMartino Booth also shows consumer credit card borrowing outpacing wage growth by double. When this happens, that credit card borrowings outpace wage increases, it is an early warning sign of stress.
Compounding the problem of rising credit card debt is a falling savings rate. It’s not the effect of people putting cash into bitcoins and thinking that because Bitcoin went up, they don’t have to save. And it’s not the same with equities. People don’t think to themselves, “You know, if stocks are going up like this, I just don’t have to save anymore.” In fact since 2008, we know that most of the cash that was on the sidelines then is still on the sidelines now. According to this article, over half of all Americans have no money in the stock market, quoting from Bankrate, Gallup, and the Federal Reserve itself.
Yes, Americans are staying away from the stock market. In fact, most Americans probably don’t even have any money to put in at all. In this article, we see savings for what it is. The gap between the cost of living and disposable income is widening at an accelerating rate, and at the same time savings is plummeting. This article uses other sources but tells us the same story - that savings is plummeting - and even though spending was up in September, that was probably just related to post hurricane expenditures. It’s worth clicking the link to see the charts in both articles.
Combine this with rising revolving credit, and the picture is crystal clear. Americans don’t have enough money to live, they’ve tapped out their savings, and now they’ve shifted to relying on credit cards to fill the gap. It actually looks pretty similar to prerecession action in 2008. And I’ve got news for you. As interest rates rise on their credit cards, their ability to pay for stuff will get even harder, and we will begin to see rising credit card defaults (and other loan defaults as well) and bankruptcy petitions. Credit card debt can be seen here (and a whole bunch of other eye-opening numbers too), and it’s now over $1 trillion.
If Americans aren’t in the stock market, where are they? And why is the market surging to new highs almost daily? As noted, most Americans are spending down their savings. Those savings are currently, on average, under $6000 per family. If you eliminated the combined net worth of Bill Gates, Warren Buffett, and Jeff Bezos, that number cuts in half. Add in just a few more from America, from the Forbes top 20, for a total of nearly $800 billion for just a few men and women, and 85% of American households have about $1000 in savings or less. So realistically, most American families have literally no savings. That’s why credit card balances are rising and why people don’t have any money in stocks.
It’s not just Main Street staying out of the market either. Bloomberg is reporting that mutual fund managers are loading up on cash, even as stocks continue to surge to new highs. They are holding cash positions of 20-40% in many cases, and as much as 79% in cash in the most extreme case. Ok, so most fund managers can’t even match the market, and you have to pay their fees for below average returns. I get that. Warren Buffett is sounding the warning bells too, suggesting here that investors are “playing with fire.” And several other renowned money managers are sharing that sentiment in The Big Story.
Where are all the gains coming from? Yardeni Research published these charts just a few days ago. First is share buybacks on a quarterly basis, which is a direct result of historically low interest rates. It peaked at the end of 2015, and that makes sense because that is when rates started to climb. Not only does this indicate that shares are rising because of buybacks, but I think it also indicates companies in trouble. Why would a company borrow money to buy back their shares if they borrow the same money and invest in growing the company?
The second chart, published in the same report, shows the total stock issuance minus buybacks. It shows net issuance is falling. This contributes to higher earnings per share, even if company earnings are falling. In other words, if earnings are falling slower than share counts, then it makes it look like EPS is increasing. But it’s an accounting lie, and probably comes with the excuse “Anyone can just look at our public financial statements and see that earnings are falling. We aren’t hiding anything.”
Even though it’s sad that people don’t have anything in savings, it’s actually a good thing they also aren’t in the stock market. Over half of gains this year in the market can be attributed to the FANG trade. Valuations are in the stratosphere by every measure, but it’s not supported by fundamentals. What supports these valuations is just share buybacks because of cheapened easy money policies at the Fed. But don’t take my word for it. Have a look at this picture of the Russel 2000. Valuations (yellow) are rising, but earnings (white) are falling!
Interest rates at this time are still too low to encourage saving. Savers want to be able to save their cash, earn a return, and outpace the inflation rate. If the inflation rate is higher than the interest they earn, if the interest is too low, or both, savers will do something else with their cash.
Related to the falling savings rate is the flattening of the yield curve, and the low savings rate compounds this issue. When the yield curve flattens, it means that the gap between interest rates on longer term borrowing versus shorter term borrowing is closing. Typically, we want to look at the 10-year treasury vs. the 2-year, or the 10-year vs the 3-month. Since October 27, the 10yr-2yr spread has fallen from 83 bps down to 68 bps (November 7, 2017 – St Louis Fed). In the last three months, the range has been 75-90 bps, so this marks a tragic turn for the worse.
Remember that banks want to borrow on the short end and turn the cash around by lending out on the long end. (And again, the savings rate relationship here is that savers aren’t saving, so banks should have less to lend out than they otherwise would like to lend. More momentarily.)
Under normal circumstances we want the spread to be at least 250-300 bps. The tighter that spread becomes, though, the less likely banks are to lend. If banks aren’t lending, it makes it harder for businesses to expand when there is a lack of organic growth that makes the business capable to self-fund that expansion. This flattening of the yield curve has never failed to predict a recession, usually about 12 months in advance.
When banks don’t lend, we would expect their excess reserves to increase. That’s the cash they keep on hand above and beyond what is required by Federal banking policy. Fed data shows excess bank reserves now over $2.17 trillion, and the general trend is that number is growing. In fact as you look at the chart, you will notice that excess reserves look to be nonexistent until May 2008 when it begins to levitate. As the yield curve flattens, we should expect excess reserves to grow at an accelerated pace.
So $2.17 trillion sitting in bank vaults isn’t getting lent out, banks are making more interest on that cash by leaving it on reserve (116bps) than they would if they lend it (68 bps). The additional problem is that banks are now earning a return-free risk on that cash because the BLS is now tracking inflation at 2.2%. In other words, banks would rather leave cash in excess reserve and lose 94 bps, rather than take the risk of lending it out for a return
For a central bank that is desperate to create inflation by manipulating the economy with monetary policy, it’s doing a really poor job. Inflation is an increase in the money supply, but when the Fed says it wants inflation they really mean increased prices. The target is 2% per year. In order to really get an increase in prices we need to see a combination of three factors. If one is left out, we won’t see the price increases that the Fed so desperately wants. First is like I just said, an increase in money supply, which is accomplished through monetary policy as well as bank lending (both are in reverse as shown above). But just increasing the supply doesn’t do any good if it sits in bank vaults. It has to be circulated, which is measured by the velocity of money. And finally, if in general we don’t anticipate prices to rise, nothing will happen. The circulation increase only happens if we think prices are going up.
Personally, I put more gas in my tank if I think the price will be higher by the time I’m on empty. I’d rather pay less right now instead of more next week. Who doesn’t want to buy the same stuff for a lower price? “Oh yeah, I love paying more for the stuff I need,” said no one, ever.
Which factor, if any, is now missing? Well, the Fed has certainly helped to create an inflated money supply, though now they are doing the reverse with higher interest rates and quantitative tightening. And excess reserves are increasing, instead of being lent out. In general the only thing most people think is going up these days is the stock market and real estate prices, Bitcoin, and maybe fine art or other collectibles. And certainly the velocity of money is in free fall, though as Fed data shows (click the link), 3Q17 showed an insignificant uptick.
Again, there were several hurricanes that hit Florida, Puerto Rico, Texas, and Louisiana, as well as wildfires in San Francisco. Without the spending after those events, the trend in velocity of money is rapidly slowing. In fact the velocity of money is so slow that in 2011 it hit a low of 1.65, a low that wasn’t seen since 1964. And it’s been creeping lower since 2011, with velocity now at all-time record lows of 1.427.
In other words, banks aren’t willing to lend, velocity of money is in free fall, and the Fed is tightening money supply on two fronts. This will cause a massive deflationary environment, and when asset prices fall, no one in their right mind thinks prices will rise on their food, clothes, and gas. Especially in a tightening cycle, we would expect the dollar to strengthen against other currencies, causing prices on imports to fall.
After such a brief intro, I’m anxious to give my recommendations. There should be no surprises here, because it doesn’t differ from anything I’ve been saying. And I’ll keep it brief this month; for more details you can look back at my prior postings.
Before I recommend any positions, you have to ask your broker, financial planner, or whomever you speak to, “How will all this rate hiking and QT all over the world affect my stock and bond positions? How about my REITs and MLPs? What about my other positions?” If the answer is “Don’t worry about that, you’re holding everything until maturity,” then you might consider if that advisor has your best interest in mind or only their Mercedes payment. If their answer is any blow off, then you might consider whose interests they really have in mind.
What you want to hear is something along the lines of, “I’m really glad you asked, and many of our clients are asking the same question. We’re taking a proactive approach with everyone to make sure that we not only protect what you have, but also to look for real opportunities to possibly grow your wealth. Let’s get together to review your situation and your goal, and I’ll be able to make a couple smart recommendations from there. When can we meet in the next week?”
And now for some bull moves in the anticipated bear market…
First is to get out of the stock market. I don’t think it matters if you leave a small portion in, but take out profits before tax loss season gets into swing, and also you’ll want to have cash available for any major opportunities that may come your way.
Which comes to the second recommendation, which is to have lots of cash available. This will protect from any stock or bond losses, and like I said it will give you an ability to seize opportunities when they come your way.
Next is a small short position in banks. I didn’t repeat it here, but I have said in the past that as emerging market debt defaults begin to rapidly increase, banks who lent in dollars will see sinking profits or even losses.
Fourth, a small position in selected defense stocks that are positioned to profit and grow, and then share those profits in the form of dividends with shareholders. The world is volatile in several regions, and President Trump is in the midst of building up the military again.
Fifth, a small position short on stocks will hedge anything you have left in the market, and if stocks plummet as I suspect they will, you’ll be set to profit handsomely.
And finally, at this time a position in physical gold bullion and gold mining companies is mandatory for everyone. 10% is a good start, and I highly recommend that you 1) avoid numismatics, and 2) read my blog on all the scams and shams when buying bullion.
If you like what I have to say, even just one word, please click on the “follow this author” button and also the please “like” this article. That will help other people to see my work, and it will cause me to have a profound feeling of gratitude as well. Please don't hesitate to share in your social media page too.
Disclaimers: The contents of this article are solely my opinion, and do not represent the opinion of this website or its owner(s). You are cautioned to do your own research before making any investment decisions of your own. This is neither intended to be, nor should it be construed, as an offer or solicitation to buy or sell securities, or any other investment product available. I reserve the right to act upon my own advice at any time, including in regard to any security, insurance, or investment of any type herein.
Circular 230 Disclaimer: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax-related matter(s) addressed herein.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.