3/5/19: The Rich Get Richer when Central Banks Print Money

The Netherlands Central Bank has just published a fascinating new paper, titled "Monetary policy and the top one percent: Evidence from a century of modern economic history". Authored by Mehdi El Herradi and Aurélien Leroy, (Working Paper No. 632, De Nederlandsche Bank NV: https://www.dnb.nl/en/binaries/Working%20paper%20No.%20632_tcm47-383633.pdf), the paper "examines the distributional implications of monetary policy from a long-run perspective with data spanning a century of modern economic history in 12 advanced economies between 1920 and 2015, ...estimating the dynamic responses of the top 1% income share to a monetary policy shock." The authors "exploit the implications of the macroeconomic policy trilemma to identify exogenous variations in monetary conditions." Note: the macroeconomic policy trilemma "states that a country cannot simultaneously achieve free capital mobility, a fixed exchange rate and independent monetary policy".

Per authors, "The central idea that guided this paper’s argument is that the existing literature considers the distributional effects of monetary policy using data on inequality over a short period of time. However, inequalities tend to vary more in the medium-to-long run. We address this shortcoming by studying how changes in monetary policy stance over a century impacted the income distribution while controlling for the determinants of inequality."

They find that "loose monetary conditions strongly increase the top one percent’s income and vice versa. In fact, following an expansionary monetary policy shock, the share of national income held by the richest 1 percent increases by approximately 1 to 6 percentage points, according to estimates from the Panel VAR and Local Projections (LP). This effect is statistically significant in the medium run and economically considerable. We also demonstrate that the increase in top 1 percent’s share is arguably the result of higher asset prices. The baseline results hold under a battery of robustness checks, which (i) consider an alternative inequality measure, (ii) exclude the U.S. economy from the sample, (iii) specifically focus on the post-WWII period, (iv) remove control variables and (v) test different lag numbers. Furthermore, the regime-switching version of our model indicates that our conclusions are robust, regardless of the state of the economy."

In other words, accommodative monetary policies accommodate primarily those with significant starting wealth, and they do so via asset price inflation. Behold the summary of the last 10 years.

19/12/18: Schroders' Lloyds deal signals more bank-asset manager tie-ups

My comment on consolidation in asset management industry and the Schroders' Lloyds deal via S&P Global Market Intelligence: https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/47696173.

17/11/18: Nine in Ten in the Red: Asset Markets YTD Returns Signal Risk Repricing

According to a recent research note from the Deutsche Bank, 89% of global macro assets are posting losses on year-to-date basis. This is the highest level of losses in more than a century.

Given the scale of financial risk mis-pricing in equities and bonds markets in the post-QE period, we are likely to witness more downward movement in the assets valuations in months to come. A gradual deleveraging that the market trends have been supporting so far remains highly incomplete and requires more pronounced re-pricing of assets to the downside.

Read more on this here: http://trueeconomics.blogspot.com/2018/11/161118-horsemen-of-financial-markets.html. 

16/11/18: The Horsemen of the Financial Markets Apocalypse

My column for the Manning Financial  is now available here: http://issuu.com/publicationire/docs/manning_financial_november_2018?e=16572344/65613030.

9/9/18: Populism, Middle Class and Asset Bubbles

The range of total returns (unadjusted for differential FX rates) for some key assets categories since 2009 via Goldman Sachs Research:

The above highlights the pivot toward financial assets inflation under the tidal wave of Quantitative Easing programmes by the major Central Banks. The financial sector repression is taking the bite out of the consumer / household finances through widening profit margins, reflective of the economy's move toward higher financial intensity of output. Put differently, the CPI gap to corporate costs inflation is widening, and with it, the asset price inflation is drifting toward financial assets:

This is the 'beggar-thy-household' economy, folks. Not surprisingly, while the proportion of total population classifiable as middle-class might be stabilising (after a massive decline from the 1970s and 1980s levels):

 Incomes of the middle class are stagnant (and for lower earners, falling):

And post-QE squeeze (higher interest rates and higher cost of credit intermediation) is coming for the already stretched households. Any wonder that political populism/opportunism is also on the rise?

15/6/18: Italian High Yield Bonds and Markets Exuberance

Nothing illustrates the state of asset valuations today better than the junk bonds tale from Italy. Here is a prime example from the Fitch ratings note from June 7:

"...longstanding Italian HY issuer and mobile operator WindTre sequentially refinanced crisis-era unsecured notes at 12% coupons into 3% area coupons by January 2018, despite losing cumulative revenue and EBITDA of 30% and 25%, respectively, and re-leveraging from 4x to 6x."

Give this a thought, folks:

1. We expect rates to rise in the future on foot of ECB unwinding its QE, the Fed hiking rates and monetary conditions everywhere around the world getting 'gently' tighter;
2. Euro is set to weaken in the longer run on foot of Fed-ECB policies mismatch;
3. WindTre issues replacement debt, increasing its leverage risk by 50%, as its revenue falls almost by a thirds and its EBITDA falls by a quarter;
4. WindTre operates in the market that is highly exposed to political risks and in an economy that is posting downward revisions to growth forecasts.

And the investors are piling into the company bonds, cutting the cost of debt carry for the operator from 12 percent to 3 percent. 

Per FT (https://www.ft.com/content/31c635f4-64df-11e8-a39d-4df188287fff): "Lending to corporates rose 1.2 per cent in the year to February 2018, according to the Bank of Italy, and the average interest rate on new loans was 1.5 per cent — a historic low."

Say big, collective "Thanks!" to the folks at ECB, who worked hard to bring us this gem of a market, so skewed out of reality, one wonders what it will take for markets regulators to see build up of systemic risks.

12/5/18: Bubbles or Gartner Cycles? Tech is in it, again...

Nice visual on Gartner-maturity curve structure of sentiment driven fads in sectoral valuations:

7/4/18: Markets Message Indicator: Ouuuuch... it hurts

An interesting chart from the VUCA family, courtesy of @Business:

'Markets Message Indicator', created by Jim Paulsen, chief investment strategist at Leuthold Weeden Capital Management, takes 5 different data ratios: stock market relative performance compared to the bond market, cyclical stocks performance relative to defensive stocks, corporate bond spreads, the copper-to-gold price ratio, and a U.S. dollar index. The idea is to capture broad stress build up across a range of markets and asset classes, or, in VUCA terms - tallying up stress on all financial roads that investors my use to escape pressure in one of the asset markets.

Bloomberg runs some analysis of these five components here: https://www.bloomberg.com/news/articles/2018-04-03/paulsen-says-proceed-with-caution-across-many-asset-classes. And it is a scary read through the charts. But...

... the real kicker comes from looking back at the chart above. The red oval puts emphasis on the most recent market correction, the downturn and increased volatility that shattered the myth of the Goldilocks Markets. And it barely makes a splash in drawing down the excess stress built across the 'Markets Message Indicator'.

Now, that is a scary thought.

18/11/17: The Road Ahead: EchoChamber Podcast

It was my pleasure, recently, to record a podcast with excellent Tony Groves @Trickstersworld . The link to the podcast is here: http://www.broadsheet.ie/2017/11/14/the-road-ahead/. Enjoy!

22/10/17: Leverage risk and CAPE: Why Rob Shiller Might Be Wrong

Rob Shiller recently waxed lyrical about the fact that - by his own metrics - the markets are overpriced, yet no crash is coming because there is not enough 'leverage in the system' to propagate any shocks to systemic levels.

The indicator Shiller used to define overpricing is his own CAPE - Cyclically Adjusted PE Ratio - and the indicator does indeed flash red:

CAPE is defined by dividing the S&P 500 index by the 10-year moving average of index components' earnings. The long-run average of CAPE is 16, and the index currently sits above 31, making the current markets valuations trailing those of the dot.com bubble peak (using recent/modern comparatives).

So the markets are very expensive. But what Shiller says beyond this mechanical observation is very important. His view is that these levels of valuations are 'sustainable' in the medium term because there is very little leverage used by investors in funding these levels of stock prices. In the nutshell, this says that if there is any major correction in the markets, investors are unlikely to be hit by massive margin calls, triggering panic sell-offs. So any correction will be short-lived and will not trigger a systemic crisis.

All fine with the latter part of the argument, if we only look at the stock market brokerage accounts leverage, ignoring other forms of leverage.  And we can only do this at a peril.

Investor is a household. Even an institutional one, albeit with a stretch. When asset prices correct downward, income received by investors falls (dividends and capital gains are cut) and investor borrowing capacity falls as well (less wealth means lower borrowing capacity). But debt levels remain the same.  Worse, cost of funding debt rises: as banks and other financial intermediaries see their own assets base eroding, they raise the cost of borrowing to replace lost income and capital base with higher earnings from lending. Normally, the Central Banks can lower cost of borrowing in such instances to compensate for increased call on funds. But we are not in a normal world anymore.

Meanwhile, unlike in the dot.com bubble era, investors/households are leveraged not in the investment markets, but in consumption markets. Debt levels carried by investors today are higher than debt levels carried by investors in the dot.com and pre-2007 era. And these debts underwrite basics of consumption and investment: housing, cars, student loans etc (see https://www.bloomberg.com/view/articles/2017-10-18/don-t-rely-on-u-s-consumers-to-power-global-growth). Which means that in an event of any significant shock to the markets, investors' debt carry costs are likely to rise, just as their wealth is likely to fall. This might not trigger a market collapse, but it will push market recovery out.

An added leverage dimension ignored by Shiller is that of the corporates. During the crises, cash-rich and/or liquid corporates can compensate for falling asset prices by repurchasing stocks. But corporates are just now completing an almost decade-long binge in accumulating debt. If the cost of debt carry rises for them too, they will be the unlikely candidates to support re-leveraging necessary to correct for an adverse asset prices shock.

I would agree with Shiller that, given current conditions, timing the markets correction is going to be very hard, even as CAPE indicator continues to flash red. But I disagree with his view that only margin account leverage matters in propagating shocks to a systemic level.

14/10/17: Happy Times in the Rational Markets

Two charts, both courtesy of Holger Zschaepitz @Schuldensuehner:

In simple terms, combined value of bond and stock markets is currently at around USD137 trillion or 179% of global GDP. Put slightly differently, that is 263% of global private sector GDP. There is no rational model on Earth that can explain these valuations. 

Since the start of this year, the two markets gained roughly USD15 trillion in value, just as the global economy is now forecast to gain USD3.93 trillion in GDP over the full year 2017. Based on the latest IMF forecasts, the first 9.5 months of stock markets and bonds markets appreciation are equivalent to to total global GDP growth for 2017, 2018, 2019 and a quarter of 2020. That is: nine and a half months of 'no bubbles anywhere' financial growth add up to thirty nine months of real economic activity.

Happy times, all.

15/5/15: Monetary Titanic & Bubbles Troubles

Food for thought this morning - two links:

• HSBC's research warning that the monetary policies-based liquidity pyramid is shaky: http://finance.yahoo.com/news/hsbc-thinks-world-economy-titanic-120044852.html?soc_src=mediacontentstory&soc_trk=tw and that this time around, the shakes are systemic. Key point here: Central Banks are out of ammunition, while economy is not anywhere near being on solid footing.
• Meanwhile, MoneyWeek spots three bubbles (the UK-centric property bubble is not unique to London, but is present in a large number of economies, from Canada to Australia and beyond): http://moneyweek.com/three-bubbles-that-are-ready-to-pop/

Note, first link above cites low worker productivity. Here's a slide from my recent (this week) presentation on same: 

And here is my view on the Irish property bubble (in development, but not yet fully manifested):

What is interesting about the Irish property markets is that whilst price and activity levels are not yet at concern points, the rates of increases in commercial rents and declines in yields, and rates of rises in residential property prices in Dublin are clearly fuelling a massive hype by real estate agents and the media. This is hardly consistent with a 'healthy' market.

I will be speaking about the financial valuations bubbles, focusing on M&As and strategy for avoiding these, next week at http://rebel.alltech.com/ so stay tuned for slides on that next week.

07/11/2011: Don't blame 'Johnny the Foreigner' for Western markets collapse

Global current account imbalances have been at the forefront of policy blame game going on across the EU and the US. In particular, the argument goes, savings glut in net exporting (mostly Asian) economies was the driving force behind low cost of investment flows around the world, producing a credit creation bubble via low interest rates. The deficit countries - the US, EU etc - have thus seen easing of lending conditions and world interest rates fell. The credit boom, therefore, was fueled by these savings surpluses, increasing risk loading on investment books of banks and other lenders and investors in the advanced economies.

Much of this orthodoxy is rarely challenged, so convenient is the premise that it is the Chinese and Indians, etc are to be blamed for what has transpired in the West. The mechanics of the process appear to be straight forward with current account imbalances going the same way as the causality argument - from surpluses in the East to deficits in the West.

A recent paper from the Bank for International Settlements, authored by Claudio Borio and Piti Disyatat and titled "Global imbalances and the financial crisis: Link or no link?" (BIS WP 346, May 2011), however, presents a very robust counter point to the orthodox view.

According to authors, "The central theme of the Excess Savings (ES) story hinges on two hypotheses: 

(i) net capital flows from current account surplus countries to deficit ones helped to finance credit booms in the latter; and 

(ii) a rise in ex ante global saving relative to ex ante investment in surplus countries depressed world interest rates, particularly those on US dollar assets, in which much of the surpluses are seen to have been invested. 

Authors' objection to the first hypothesis is that "by construction, current accounts and net capital flows reveal little about financing. They capture changes in net claims on a country arising from trade in real goods and services and hence net resource flows. But they exclude the underlying changes in gross flows and their contributions to existing stocks, including all the transactions involving only trade in financial assets, which make up the bulk of cross-border financial activity. As such, current accounts tell us little about the role a country plays in international borrowing, lending and financial intermediation, about the degree to which its real investments are financed from abroad, and about the impact of cross-border capital flows on domestic financial conditions." In other words, looking at current account deficits and surpluses, tell us little, in authors' view, about the financial flows that are allegedly being caused by these very current account imbalances.

This kinda makes sense. Imagine a MNC producing goods in country A, selling them to country B. Current account will record surplus to A and deficit to B. But the MNC might invest proceedings in country C via a fourth location, country D. Net current account position becomes indeterminate by these flows. Thus, per authors, "in assessing global financing patterns, it is sometimes helpful to move away from the residency principle, which underlies the balance- of-payments statistics, to a perspective that consolidates operations of individual firms across borders. By looking at gross capital flows and at the salient trends in international banking activity, we document how financial vulnerabilities were largely unrelated to – or, at the least, not captured by – global current account imbalances."

The problem arises because in traditional economics framework, savings (income or output not consumed in the economy) is investment. But in the real world, investment is not saving, but rather financing - a "cash flow concept… including through borrowing". Thus, per authors', "the financial crisis reflected disruptions in financing channels, in borrowing and lending patterns, about which saving and investment flows are largely silent." So ignoring the difference between the savings and investment financing, the current account hypothesis ignores the very nature of imbalances it is trying to model.

With respect to the second hypothesis, "the balance between ex ante saving and ex ante investment is best regarded as determining the natural, not the market, interest rate. The interest rate that prevails in the market at any given point in time is fundamentally a monetary phenomenon. It reflects the interplay between the policy rate set by central banks, market expectations about future policy rates and risk premia, as affected by the relative supply of financial assets and the risk perceptions and preferences of economic agents. It is thus closely related to the markets where financing, borrowing and lending take place. By contrast, the natural interest rate is an unobservable variable commonly assumed to reflect only real factors, including the balance between ex ante saving and ex ante investment, and to deliver equilibrium in the goods market. Saving and investment affect the market interest rate only indirectly, through the interplay between central bank policies and economic agents’ portfolio choices. While it is still possible for that interplay to guide the market rate towards the natural rate over any given period, we argue that this was not the case before the financial crisis. We see the unsustainable expansion in credit and asset prices (“financial imbalances”) that preceded the crisis as a sign of a significant and persistent gap between the two rates. Moreover, since by definition the natural rate is an equilibrium phenomenon, it is hard to see how market rates roughly in line with it could have been at the origin of the financial crisis."

In other words, the second hypothesis above confuses the observed market cost of capital - interest rates charged in the market - for the equilibrium natural rates that prevail in theory of balanced goods and services flows. The latter do not really exist in the market and cannot be referenced in investment decisions, but are useful only as benchmarks for long term analysis. Natural rates are "better suited to barter economies with frictionless trades" while the market rates are best suited to analyzing "a monetary economy, especially one in which credit creation takes place". And the market rates are driven by largely domestic (investment domicile) regulation, monetary policies, market structure, etc. In other words, market rates are caused by the US, EU etc policies and environments and not by Chinese trade surpluses.

The main conclusion from the study is that while current accounts do matter in economic sustainability analysis, "in promoting global financial stability, policies to address current account imbalances cannot be the priority. Addressing directly weaknesses in the international monetary and financial system is more important. The roots of the recent financial crisis can be traced to a global credit and asset price boom on the back of aggressive risk-taking. Our key hypothesis is that the international monetary and financial system lacks sufficiently strong anchors to prevent such unsustainable booms, resulting in what we call “excess elasticity”."

The former means, frankly speaking, that bashing China et al is not a good path to achieving investment markets stability and sustainability. The latter means that hammering out a new, more robust risk pricing infrastructure back at home, in the advanced economies, is a good path to delivering more resilient investment markets in the future. No easy "Johnny the Foreigner made me do it" way out for the West, folks.