Outside the Box
Credit Bubble Bulletin, by Doug Noland
July 9, 2004
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We are approaching the 2-year anniversary of the Greenspan/Bernanke “Great Reflation.” In terms of longevity, this reflation is rather long in the tooth. And it is the nature of orchestrated inflations to become increasingly destabilizing and unwieldy over time. This one is proving no different, although the reality that this has been a grander reflation after a prolonged series of escalating inflations suggests an extraordinary degree of unfolding Monetary Disorder.
The late-stage of Reflations can prove an especially trying time for equity investors and speculators. The general inflationary (company cash flow & profits) and liquidity (inflows & keen speculative interest) backdrops remain seductively enticing, while the experience of picking stocks and sectors takes on the challenge of walking through mine fields. Disappointment and unfulfilled expectations are an integral aspect of the topping process, although the bullish contingent would not be expected to give up without a heck of a fight.
From a broader perspective, earnings reports help to illuminate some of the consequences of Monetary Disorder. For almost two years now, a veritable deluge of liquidity has spurred both the Financial Sphere and the Economic Sphere. The monetary inflation driving stock prices (and financial asset prices in general) has been relatively uniform. Yet the same cannot be said for the real economy, as cumbersome liquidity and speculative flows engender widely divergent effects on sector relative prices, profits, spending and performance.
Especially with the recent slew of technology earnings disappointments, it is apparent that many companies and sectors are increasingly being cast aside by the Post-boom Boom. While disconcerting to those harboring illusions as to the true state of things, this is exactly what analysts should expect from an environment characterized by deranged lending, massive speculative flows, and resulting destabilizing system liquidity and spending (Monetary Disorder). Nonetheless, it is these days coming as a surprising disappointment to management and shareholders alike, having confidently anticipated that resurgent markets and a rebounding economy were indicating a return of the (perpetual) boom.
But this is not 1999 - the post-LTCM reflationary environment, where technology was the key sector within the real economy demonstrating the commanding inflationary bias (fueled by myriad bubbles - junk/telecom debt, syndicated bank lending, IPOs, margin debt, derivative leveraging, etc.). The inflationary bias today, stoked by the Great Mortgage Finance Bubble, is honed in on housing and asset-inflation induced household consumption, along with the industrial/commodity sectors benefiting from the weak dollar, rising prices and (overly) abundant global liquidity. Meanwhile, the revved up tech sector is poised to lead the process of disappointment.
Inflated expectations and wildly divergent sectoral performance create an important disconnect – and inherent source of instability. They are the consequence of a strong inflationary bias throughout the Financial Sphere, a bias that works innately to further destabilize the Maladjusted Economic Sphere. This is the fundamental nature of inflationary booms and why – at this stage of acute and cumulative Monetary Disorder - the notion that our system can and will “inflate our way out” of our debt problems is erroneous conjecture and dangerous policy.
And before I leave the issue of heightened stock market instability, I would like to touch further on the issue of Speculative Finance. Arguably, the retail investor and public mutual fund manager is no longer providing the marginal source of liquidity for the U.S. stock market – no longer the “price setter.” In this respect, the marketplace has evolved fundamentally over the past few years. That hedge funds, Wall Street proprietary trading desks, and derivative players have displaced long-term investors as the instrumental source of liquidity is, indeed, a defining characteristic of the Post-boom reflationary Boom. This development is today worth contemplating.
Generally, the commanding nature of speculative finance has been of little interest and, perhaps, relevance during the reflationary bull market. This, however, should change now that reflation and attendant asset inflation have begun to dissipate at the fringes. Recalling back to the late-90s stock market bubble, according to ICI data, equity funds received inflows of $944 billion during the 5-year period 1996 to 2000. The boom culminated during 2000, with “blow-off” flows of $260 billion. And, despite absolutely dismal market performance, 2001 experienced additional flows of $54 billion. Flows finally turned negative during 2002, but outflows totaled only $25 billion, or 0.89% of assets. Flows held up surprisingly well, a dynamic surely fostered by the Fed’s aggressive interest-rate cuts and attendant mortgage Credit excess. But, importantly for systemic stability, investors did “hold on.”
Today, I would strongly argue that the nature of market risk is significantly more problematic. First of all, one is hard-pressed to envisage a source of marketplace liquidity with anything comparable to the Mortgage Finance Bubble’s capacity to re-liquefy the household sector and financial system. At the same time, it is my sense that the marketplace is much more complacent now compared to the nervousness associated with the huge flows into equity funds in the late-90s.
When the current bull market succumbs to the bear, speculators (today’s “price setters”) will surely not “hold on” (that’s not what speculators do!). They will instead liquidate equity positions and hope to redeploy funds to other inflating asset-classes. And the speculators could very well take these actions in a panic, desperate to get ahead of the crowd. In regard to the U.S. equity market, there are already indications that flows are gravitating to outperforming foreign markets, currencies, and to better-performing asset classes (i.e. commodities). More alarming yet, a strong case can be made that 2004 is demonstrating “blow-off” characteristics with regard to hedge funds, proprietary trading, and derivatives – individually and in concert as the infamous “Leveraged Speculating Community.”
The current reflation, in so many ways, differs from those that preceded it. The Great Mortgage Finance Bubble and the ballooning of a global pool of speculative finance are certainly two important facets. The ballooning of global central bank balance sheets is a third that doesn’t get the attention deserved.
To this point, Asian central bankers have been content to balloon their holdings of U.S. Treasury and agency securities (although the discerning Chinese authorities appear increasingly determined to use dollar liquidity to buy hard assets including crude oil, commodities and machine tools/heavy equipment). I would posit that global central bankers have viewed their huge dollar purchases over the past year or so as more a response to a temporary market dynamic than the commencement of massive ongoing dollar support. But with persistent dollar weakness (chronic imbalances), this view and their analysis as to long-term dollar soundness is due for thorough reevaluation.
While it gets little attention, the ballooning of central bank balance sheets with dollar instruments over the past couple years is one of history’s spectacular monetary inflations. Ironically, it has to this point also been one of the least outwardly problematic (inflation having been recycled right back to the expansive U.S. bubbles). But what is the endgame for historic inflation? At what point do central bankers become fearful and introspective, then move toward the rational course of “diversify” away from dollar exposure? And how might they attempt to procure true economic wealth for their citizens as opposed to electronic dollar balances (IOUs)? What might they consider acquiring, and what would such a shift in central banking – and the inflationary process - all mean?
And while I do not expect central banks to attempt to liquidate dollar positions anytime soon – there would be such limited liquidity – I do expect government authorities (Asian, in particular) to step up their effort to buy “things” other than U.S. bonds. When I contemplate the potential list of things that they might be able to buy in such size to absorb sizable quantities of dollar liquidity, the obvious non-perishable non-obsolescence ones come to a short list of oil & energy products (a strategic energy reserve) and metals. Surely it was coincidence, but energy and metals prices performed very well this week with a soft dollar.
There has been a prevailing view that strong commodities prices were the result of inflated Chinese demand and speculative buying from the hedge fund community. The thought has been that price gains would prove ephemeral; a Chinese “hard landing” and speculator deleveraging would put commodity markets at risk of collapse. Well, perhaps there’s more to this (inflation) story than meets the conventional eye.
I feel compelled these days to attempt to “think Outside The Box.” Today’s environment is characterized by truly unprecedented non-productive U.S. Credit creation and unprecedented U.S. current account deficits. Consequently, there is an unparalleled global pool of speculative finance, seemingly beginning to gravitate away from underperforming U.S. financial instruments. There is, as well, unparalleled global central bank expansion of dollar holdings. And there is, today, clear potential for an unfolding dynamic I will this evening refer to as “too many dollar balances chasing limited quantities of real ‘stores of value.’” I am suggesting that the environment increasingly beckons for contemplating the potential for some truly extraordinary financial and economic developments – developments that would turn conventional analysis upside down.
I read analyses regarding the appropriate interest rate to stabilize the U.S. economy, but there is simply no rate that would rectify the U.S. financial and economic Bubbles. There is, as well, some interesting discussion regarding the U.S. and Chinese economies and the global ramifications for potentially concurrent downturns. But such analysis seems to me premature, while disregarding more pressing global financial issues. And there continues to be much contemplation and hypothesizing with respect to the ongoing “inflation vs. deflation” debate. At the same time, I read very little analysis regarding what I regard as the critical factor – the value of our currency. The dollar is key to so many things.
This week I saw indications of flows consistent with increasing dollar nervousness. The dollar, U.S. stocks (especially the more speculative ilk), and Japanese equities in particular were under selling pressure. The energy and metals groups were especially strong, and the “commodity” currencies outperformed. Curiously, both the cyclical and defensive indices – comprising some companies with the potential to benefit from weaker dollar - held up well. However, financial stocks – especially the securities firms and multi-national “banks” – performed as one might expect in an increasingly risky financial environment.
At this point, it is at least prudent to ponder (“outside the box”) how the world might change in the event of an abrupt and potentially disorderly dollar decline. I reckon global central banks would have little immediate alternative than to support the dollar, purchases they would at least initially use for buying Treasuries (but watch out for those Credit spreads!). And as much as the dollar would benefit from higher short-term rates, the Fed would likely look with only greater trepidation at the unknown consequences associated with a deleveraging of the U.S. Credit market. Some stocks and equity markets would benefit, but U.S. and global equities would generally suffer an understandable bout of “fear of the unknown.” Asian central bank monetization would, baring financial dislocation, likely further stoke the regional boom. The Chinese economy, with its pegged-currency, could face unwanted and destabilizing stimulus. And the imbalanced U.S. Bubble economy could be – by artificially low mortgage rates, a weak dollar and acute Monetary Disorder – jostled into a terminal phase of economic confusion and disarray.
And, in such circumstances, it does not take a wild imagination to envisage a global flight to “stores of value,” including aggressive energy, metals and commodities procurement. Panic buying of the limited number of perceived safe currencies would be expected. And, really, I don’t think it requires a dangerous mind to daydream about a wild commodities bidding war, one pitting the enterprising speculators against panicked central bankers. But I’m getting ahead of myself…
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