When Trapping Value ("TV") and I were discussing our partnership on the Wheel of Fortune, one of the points that we touched upon was how do we handle situations where we don't see things eye to eye? Some Marketplace services that are run by more than one moderator have adopted The Three Musketeers' motto "Un pour tous, tous pour un", always presenting one-unified opinion.
While I certainly respect the "One for all, and all for one" approach, this mostly applies to physical aspects/threats. However, when it comes to spiritual aspects, ideas and thoughts that are associated with the mind (and not with the body) - I very much encourage independence and pluralism.
Therefore, I've made it clear to TV that since in essence we do think alike (otherwise, we wouldn't be joining forces in the first place), when it comes to specific ideas, thoughts, opinions and even suggestions - I don't see any harm in us sounding more than one voice. If anything, I believe that our subscribers/readers can only benefit from hearing two professionals that don't always think the same way.
Truth must be said: We hardly ever find ourselves with completely opposing opinions. Even this article, representing something that we look at from different perspectives, is more cosmetic than real. Nonetheless, it's interesting to see how two people with the same general macro views look at something from different angles.
From Macro to Micro
Both TV and I agree that at this point in time there is no reason to abandon the bullish stance. We do, however, think that the bullish stance should now be more cautious than before and that a more defensive approach is needed. Nevertheless, we remain invested generally speaking.
In an article titled, "Is A Recession Coming? Keeping A Close Eye On This Very Reliable Indicator", that got published exclusively on our service recently, I've presented, among many other things, the following chart:
The following chart (from Bank of America Chief Investment Strategist Michael Hartnett) shows that not only does every Fed tightening cycle end with a financial "event", a polite banker word for crash..., ... but it also hints at what fed funds rate (and thus "when") the next crash will happen.
As you can see:
- The Fed typically hikes until something breaks.
- By end-18, the Fed will be 9 hikes into a tightening cycle.
- EM, credit, tech are all candidates in the cycle.
BofA'a conclusion: "Central bank liquidity = #1 driver of asset prices past decade." And the liquidity is almost over.
TV - who is a very nice and polite person not only when dealing with me - commented on the article and consequently there was a chain of comments dedicated to the importance (if anything) of central banks' balance sheets on the markets. Below I bring the first three parts of this chain:
Now, you have to understand that TV isn't only a very nice and polite person but also a top notch and thorough professional. Therefore, it was no surprise (though I wasn't warned in advance...) for me to see few days after, a fully-fledged article (on the free side) entirely dedicated to the topic we debated a couple of days earlier...
I must admit that TV's excellent piece, titled "Central Bank Balance Sheets: The Last Refuge Of Bears", almost had me convinced too... A well-written, very balanced and sound, piece by TV (as usual) that basically concluded that central banks' balance sheets is Much Ado About Nothing.
This is exactly why I named this piece, "Central Banks' Balance Sheets: The First (and Only?) Refuge Of Bears"; although principally, I agree bears have not much (tangible data) to hold onto right now (i.e., 2018; one year at a time...), I don't take the recent developments lightly. I definitely don't underestimate the power of the single most important element supporting the market since 2008 - that is central banks' willingness to pour money into the markets - can be the catalyst that may allow these market to fall more than 10%, as they did just four months ago.
Central Banks' Balance Sheets - Historic Data
Here are the changes of the balance sheets of the three leading central banks (Fed, ECB, BoJ) since 2007:
On an aggregate basis, the trio has now over $15T of assets sitting in their balance sheets.
TV is stating that "as a percentage of GDP, this appears to be a rather high number." That's an understatement... especially in the case of the BoJ.
TV keeps on saying that, as a matter of fact:
- The current ratio of Fed balance sheet to GDP is not a precedent. We have already seen >20% levels during the 1920s-1940s era ("while on the surface, we appear to be in uncharted territory, the US Federal Reserve has actually been close to these levels as a percentage of GDP around the Great Depression and World War II.")
- When the ratio fell sharply - between the years 1948-1970 (inclusive) - the annualized return of the S&P 500 was 13%! ("based on the single example we do have, of a large balance sheet and its unwind, we certainly cannot make the remotest jump that the unwinding will result in a calamity.")
What I can say about these enlightening data (it's hard - and unwise - to argue with facts...) is the following:
- It's obvious (at least to me) that during times of a great depression or a war - certainly two very extreme circumstances - extreme measures must be taken. However, we are in 2018 and I trust that TV agrees that 2018 doesn't fall under any of these categories.
- As TV notes, "We understand the problems with extremely small sample sizes, believe us we do." I'll go further to say that not only are we dealing with a small size but we also need to bear in mind that until 2008 we had six decades in which the Fed balance sheet was smaller than 10% of GDP. Putting it differently, it's not only the size that is problematic but also the context; since the end of WWII, it was clear to everyone at the Fed that even 10% is too much. True, it took them more than a decade to get there, but once they did - they never looked back and they never aimed at going back.
- Following a loss of 86.1% for the S&P 500 index during the 34 months between September 1929 to June 1932, it's quite expected that once the markets recover - the annual return would be quite nice. Therefore, the 13% annualized return, if put within the context of a 40+ year time frame - would look much different.
In any case, I'm not going to base my claim/s here on what is the "right" percentage out of GDP that the Fed balance sheet should end up in. Instead, what I'm looking at - and what makes me worry - is the noticeable high correlation between central banks' balance sheets and asset valuations.
Very High Correlation
The high correlation between central banks' balance sheets and asset valuations can't be disputed.
As the below chart, prepared by Yardeni Research, shows, there is a very high correlation between the total assets held by major central banks and the S&P 500 (SPY)
Furthermore, at the end of each and every QE program - the S&P 500 pulled back. More or less - it doesn't really matter; what matters is that the realization that a QE phase is coming to an end - always has a negative effect on asset prices.
Now let's look at the Fed balance sheet as a standalone.
As you can see from the below chart, when we look at the long term, it certainly looks as if the Fed balance sheet hasn't grown much since the end of QE3
However, if one is looking at recent years (since 2015; shortly after QE3 ended), it's evident that the balance sheet stopped growing. Nonetheless, it's also evident that it hardly has been reduced either. We are now (end of May 2018) only about 4% below the peak (at circa $4.52T in early 2015).
My advice is, therefore, to focus on the (admittedly very) short period since the Fed announced Tapering.
Even so, thus far, the pace (of reducing the balance sheet) has been slow and quite frankly insignificant. $50B is not much more than 1% of the Fed balance sheet; nothing to report home about.
So if neither the past century, nor the past two years, are of significant-enough data/information to be based on, what are we left with?
My answer is simple: Let's look forward. Not only that stocks usually/mostly trade based on forward-looking views/assumption, but if things go according to the Fed's plans - this is what we all should expect in the near future.
As the below chart suggests, if the Fed sticks to its original place, in a matter of 6.5 years (till end of 2024), the balance sheet may shrink substantially. How substantial? How about over 90% below current levels?
Ok, I get it. You don't believe the Fed. You're not alone...
So let's look at a much shorter period. Is the end of Donald Trump's first presidency term short enough? Because if it is, by the end of 2020, the Fed's total holdings will be about 40% lower than they are today.
To make a long story short, my point in this article is that when it comes to central banks/Fed balance sheet(s), I'm not looking at history (irrelevant), nor am I basing my theory/fear on the "right" percentage to GDP that the Fed balance sheet is supposed to land at. There's no such number.
What I am looking at is the path that the Fed itself has announced on, a path that will see the balance sheet shrinking significantly in the upcoming years.
At the end of the day, I think that this is where the articles of TV and myself differ. It's not actually the opinion we differ about, but what we are looking at. While TV looks at history and what it may imply, I ignore history (when it comes to this specific matter) because I don't see how we can learn anything from the past when what we are dealing with has never occurred before; not under the current circumstances we're facing.
One can certainly doubt the path, as scheduled by the Fed. One can certainly argue that the circumstances may change along the way - and fairly quickly - forcing the Fed to diverge from the path. Those are legitimate arguments - arguments that in full disclosure I believe myself... - but they are shifting the focus of this article from what it is about: There is a reason to fear of a reduction in central banks' balance sheet (should they stick to their current scheduled plans...)
Speaking of which (i.e., sticking to plans...), it's my firm belief that the ECB will find it hard to stick to its plans. While there are legal issues for the ECB to back off its plan - I find it hard to believe that they will stop their very own QE as they plan in September this year.
In the series of articles that I published last week (see links below), I touched upon the problems and threat that the European banking system (EUFN) is facing.
- Part I: USD Vs. EUR
- Part II: American Vs. European Banks
- Part III: Deutsche Bank Vs. JPMorgan
- Part IV: Diversification And Emerging Markets
I strongly believe that should the ECB stick to its plan - it may be a kiss of death, especially for the debt markets. After all, in a drying market where the ECB was the main - and in some cases the only - buyer of European government bonds, it's hard to see anyone stepping in when the largest buyer/holder is moving to the sidelines.
I mean, how likely is it that those who backed off from Italian bonds over the last couple of years will decide to do so right when the ECB is stepping aside!?
So Japan is printing money as if there's no tomorrow... The ECB is supposed to stop buying sovereign debts in a matter of few months... And only the Fed seems to be on a clear path. For now...
Perhaps the best illustration of how things in Europe are, is by looking at last week's action in Wall Street Week. While Apple (AAPL), Amazon (AMZN), Facebook (FB) and Netflix (NFLX) traded at all-time highs, Deutsche Bank (DB) traded at all-time low...
In a quite shocking move, it has been reported that Italy’s largest bank, UniCredito (OTCPK:UNCFF, OTCPK:UNCFY, OTCPK:UNCRY) is plotting to merge with French rival Société Générale (OTCPK:SCGLF, OTCPK:SCGLY).
Although some may view this as a bold move, I'm afraid that the end result isn't going to be what many hope. Combining one bad bank with another bad bank doesn't create a new, bigger, good bank...
Last but not least, the SNB = Swiss National Bank.
Let me make it clear: It's neither the size nor the holdings that deserve my (or your) attention; it's the shift, the principal, the set of mind.
The fact that a conservative-solid central bank has becomes one of the world's largest hedge fund...
The fact that a conservative-solid central bank has more than doubled its exposure to equities over the past 6-7 years...
The fact that a conservative-solid central bank is now one of the largest shareholder in many blue-chips...
...is, in my book, a reason to be mindful, worried or to raise an eyebrow at the very minimum.
TV claims that the world's total assets is the right gauge against which central banks' balance sheets should be measured. I'm not arguing with this.
TV claims that the SNB's total holdings are no more than a tiny drop in an ocean of assets, containing a sea of buybacks. I'm not arguing with that either.
TV claims that since 2008 there is no evidence for a "transmission mechanism" between the Fed balance sheet and Treasury bond prices. Even with that I'm not arguing.
All I'm saying is that a major element that took us all the way up here, over the past decade, can be an element that may take us down from here.
Let's not forget that when we talk about the Fed unwinding its balance sheet, the balance sheet if only one aspect of tightening monetary policy we are witnessing these days. The other, as important aspect, is this:
I wouldn't dare underestimate the power of tightening as much as I didn't like to stand in the way of the expansion train during 2009-2017.
While TV's title implies that central banks' balance sheets might be the bears' last refuge, I believe that, if anything, it may be bears' first refuge; after all, there haven't been many refuges along the way except for this one:
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