Issues 2013

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“The Federal Reserve is heading in the wrong direction. What the central bank describes as ‘unconventional monetary policy’ is creating dangerous bubbles in asset markets that will lead to higher future inflation and is supporting the explosive growth of the national debt.” Martin Feldstein, Wall Street Journal, January 3, 2013

I applaud Dr. Feldstein’s intentions, but the poor soul has a problem: the marketplace is rather smitten with Bubbles and doesn’t these days have an inflation worry in the world. Might as well be another Mayan prophesy. Indeed, Feldstein’s warning these days resonates about as well as my (repeated) warnings of Bubbles and bipolar outcome possibilities. But here it goes, nonetheless: the financial system, as we know it, is doomed on December 21, 2013.

In all seriousness, it is difficult to imagine a backdrop more poised for the extraordinary. Bolstered by unprecedented global monetary radicalism, the global Bubble gathered important momentum in 2012. This ensures that the dysfunctional “risk on, risk off” (“roro”) speculative dynamic turns only more unwieldy in 2013. Policy measures guarantee that the historic “crowded trade” in international risk markets will only more forcefully crowd the manic crowd on one side of the crowded boat – or the other.  This implies fatter “tail risks” – with emphasis on the “s” – the plural – of left (Bubbles burst) and right (inflating Bubbles turn much more unwieldy) “tail” developments.

Let’s start with a little “right tail” pontification. In simplest terms, how crazy could things get this year? I recall how crazy the SE Asian Bubbles turned in the fateful post-Mexican bailout year of 1996. Then NASDAQ almost doubled in the crazy, post-LTCM bailout speculative melee of 1999. And when the Fed made it clear that it would disregard mortgage and housing Bubbles, excesses grew exponentially – 2004, 2005, 2006… until the Bubble finally began to collapse under the weight of subprime Credit craziness in 2007. The long history of speculative Bubbles favors the scenario where they end in self-destructive “blow-off” excess.

According to Bloomberg, “Hedge funds on average climbed 1.6% through November, lagging global stocks by almost tenfold as managers were whipsawed by market reaction to the economic and political events…” While not repeating the losses suffered during a challenging (“roro”) 2011, the hedge fund industry overall badly lagged global risk market gains in 2012. Those that tried to judiciously manage risk again suffered the consequences. “Don’t ask why, just buy!” won the day. 

Twenty Thirteen will see thousands of hedge funds locked in a rather ferocious fight for survival. Human nature would dictate that managers will increasingly err on the side of dismissing risk – determined (for many, desperate) to instead participate in every rally. They may be dragged kicking and screaming, but an ongoing equities rally would force even the more bearish hedge fund, mutual fund, and sovereign wealth fund managers – along with enterprising traders everywhere – to jump aboard. Moreover, 2012’s policy-induced market divergence (weakening fundamentals vs. inflating securities prices) pretty much pulverized those aggressively positioned short global risk markets. This fomented market dislocation, whereby stock prices turned increasingly detached from fundamentals. Importantly, if typical sources of selling pressure (i.e. the “bears,” “market neutral” players, hedging strategies, etc.) have backed away, the marketplace becomes only more susceptible to market dislocations and speculative “blow-off” excess.

At the same time, a low tolerance for losses will remain a latent issue. An even greater propensity for performance-chasing and trend-following dynamics would seem a safe bet. But the dilemma of “weak handed” traders will continue to leave markets vulnerable to sudden (think “flash crash”) market downdrafts. Moreover, I suspect that many of the more sophisticated market operators are in this to play “blow-off” excesses for all they’re worth – yet with one eye planted on the exits. I’ll paraphrase hedge fund titan Leon Cooperman’s apropos comments this week from his CNBC interview: In the hedge fund industry, if you’re early you get killed. And if you’re late you get killed.

The Masters of the Universe, naturally, believe they will identify bearish catalysts ahead of the crowd. But as the Masters’ assets under management swell to unimaginable dimensions, they’ll have reason to fret more about market liquidity and the tactics of fellow Masters. But for now, with the world awash in liquidity and the Draghi Plan having smothered European “tail risk,” they may be keen to keep playing – for “dancing.” “Right tail” happenings are not a low probability scenario.

With little fanfare, the broader U.S. equity market this week pranced to all-time record highs. Already 3.5% higher in just the first three sessions of 2013, the S&P400 Mid-Cap average enjoyed a “break out” right through 2011 and 2012 double tops. The small cap Russell 2000 (up 3.5%) also traded to a new all-time high to begin 2013 trading. It is, as well, worth noting that the Goldman Sachs Most Short Index gained 3.9% in the first three sessions of the year, indicating an ongoing “squeeze” and market dislocation. Curiously, the “New Normal” investment return framework continues to be popular in marketplace pontification circles. Yet last year again supported my “Newest Abnormal” thesis of risk market Bubbles and returns detached from underlying fundamentals.

The last thing the world’s fragile economy and financial apparatus need today is a period of “blow-off” excess. Indeed, it is integral to my (and others’) Bubble analysis that the downside of a Credit Cycle is commensurate with the excesses of the preceding boom (I owe the crux of this analysis to the late Dr. Richebacher and other “Austrian” thinkers). A “right tail” beginning to 2013 would only increase the probabilities of a “left tail” end. I’ll posit that 2013 is a year of fat tail risks, believing that the backdrop contains an unusual confluence of factors that would seem to increase the probability of the blow-off boom and bust scenario.

For the past two years, I’ve viewed the unfolding European crisis as a possible/likely catalyst for a problematic bout of de-risking/de-leveraging. I believe the worst of the crisis is still to come, although the current respite could prove somewhat less fleeting than the others. The economic diagnosis is terrible – and 2013 could see the “core” French economy particularly susceptible. The region – certainly including its bloated banking system - will continue to battle with Trillions (and counting) of suspect financial claims/debt. The political backdrop will continue to deteriorate. Italian politics will make for good drama.

Especially if the situation continues to stabilize, I would expect a more cautious ECB to reconsider its expanded mandate. If Spain does request a bailout, the markets will see the OMT (Outright Monetary Transactions) in action. Who’s getting favorable treatment and how the pie is being divided will ensure recurring stresses and fractures. I still don’t believe the euro makes it. Yet Draghi changed the rules and altered the backdrop. His bold plan to use the ECB printing press to backstop the markets changed short-term speculative dynamics.

The speculating community covered their European shorts and commenced building long exposure. This (certainly including the powerful short squeeze) incited robust financial flows into the region’s bonds, equities and currency. Such a backdrop opens the possibility that the resulting dramatic loosening of financial conditions proves constructive to confidence and even the real economy, along with further inflating securities markets. And these things tend to take on a life of their own, with unpredictable consequences.

At the same time, this dynamic only exacerbates systemic risk to future de-risking/de-leveraging. The global response to last year’s worsening crisis was integral to increasingly unwieldy market Bubble dynamics all around the world. Moreover, Europe now – with the leveraged players back on the long side - becomes only more acutely vulnerable to a reversal of speculative flows and associated de-leveraging dynamics, a crisis of confidence and capital flight. The proverbial can was kicked – and indeed this time it appears a pretty good wallop.

Last year saw the faltering European economy and banking system increasingly impinge global growth, especially in China, Asia and the “developing” economies more generally. Importantly, this pressured Chinese authorities, again, to accommodate dangerous Bubble excess. And such an historic Bubble will simply brush aside timid policymaking. The estimated 50% year-on-year growth of China’s so-called – and now enormous - “shadow banking” complex is rather text-book late-cycle “terminal” excess. The consensus view is that Chinese authorities have the situation well under control. I’m not convinced. Twenty twelve was a year when the world became more aware of the depth of corruption in China. I fear there is unappreciated financial, economic and social fragility associated with what could be one of history’s most degenerate financial Bubbles.

Bursting Bubbles inflict social hardship and provoke a search for scapegoats and villains. We’ve witnessed this sad dynamic come to life in Europe. I fear for future Chinese and Japanese relations. The disputed island issue heated up in 2012, with Chinese protests against Japanese products having a meaningful impact on Japan’s frail economy. The return of Japanese Prime Minister Abe assures an intense focus on fiscal and monetary stimulus. It also comes with a harder line toward China.

So in a year where I see extraordinary global uncertainties, a surprisingly unstable Japan has potential to play a prominent role. It’s my view that the yen and Japanese economy were major beneficiaries of the Chinese boom.  This dynamic has reversed, with unclear ramifications and risks. The new government has a mandate for aggressive stimulus. The world now watches the yen weaken meaningfully, while watching nervously for cracks in the nation’s incredibly bloated (and mispriced) bond market. I will now monitor Japan closely, with the view that it has (rather briskly) moved up the list of potential “global government finance Bubble” weak links.

In somewhat of an adaptation of 2012, I see an increasingly synchronized global Bubble now at risk to multiple “weak links.” Europe remains fragile, while China, Japan and the “developing” economies have turned increasingly vulnerable. In “2012 in Review,” I noted the troubling dynamic of rapidly decelerating economic booms in the face of ongoing rampant Credit expansion. This dynamic implies vulnerability – but it more than anything engenders major uncertainties. Many “developing” economies are demonstrating late-stage Bubble dynamics. As such, if the global financial “system” proceeds into a potent “risk on” period, the “developing” world’s loose monetary backdrop might induce a reflexive spurt of activity. At the same time, unrelenting Credit excesses foment fragilities that ensure a painful downside cycle.

Warnings by a few of unfolding “currency wars” resonate. The major currencies, of course, all have major issues. Our currency is suppressed by the prospect of endless QE, although the dollar is these days in the running to on occasion win the least ugly contest. In a world or unleashed central banks and unleashed speculators, one would expect unstable “hot money” financial flows – between currencies; between developed and developing economies; between stocks and bonds, various assets classes and individual stocks and sectors. A pronounced “risk on” move might be met with a surprising jump in sovereign yields. The potential confluence of heightened inflation concerns, waning demand for safe havens, greater demand for Credit, and overall policy uncertainty could prove problematic. The Fed’s convoluted policy approach seems to beckon for market confusion and unsettled conditions.

As a “Bubble economy,” I view the U.S. situation as also highly uncertain. With astounding monetary policy largess and attendant loose financial conditions, I do not dismiss the scenario where the U.S. recovery gains momentum. Housing and autos are in a cyclical upturn, which should support accelerating private-sector Credit growth. So long as corporate Credit conditions remain ultra-loose, the slow but steady increase in employment should continue. Unrelenting fiscal stimulus continues to bolster consumption. And, importantly, inflating assets markets continue to support household spending.

I have repeatedly stated, “I’ll believe fiscal austerity when I see it.” Phase one of the “fiscal cliff” drama has passed with austerity a most notable no show. Yet the big battles lie ahead: debt ceiling, sequester and “continuing resolution.” It could get bloody. I would not be surprised by a government shut-down. The ratings agencies will confront difficult decisions. The markets will face crosscurrents and major uncertainties. Especially if the markets proceed on their merry speculative way, there will be pressure to ignore risks and assume eventual political capitulation, compromise and resolution. And this is precisely the backdrop with the potential to create the greatest instabilities.

Market participants have become increasingly numb to all varieties of risk. Monetary policy now runs the show. Chairman Bernanke has already stated that he would respond to “fiscal cliff” headwinds with additional accommodation. And the Fed this month commences its $85bn monthly QE program. “Printing”-induced numbness virtually ensures that speculative markets resist the process of discounting future negative outcomes. Indeed, today’s unmatched fiscal and monetary policy environment assures that markets become only more gamey and dysfunctional. Twenty thirteen would seem poised to provide an even larger kitty to be enjoyed by those betting most successfully on the course of policymaking and market reactions.

So, U.S. policymaking feeds the Bubble while at the same time creating a systemic weak link. Fiscal policy has become so contentious, and I wouldn’t be surprised if the course of monetary policy becomes an increasingly heated issue as well (especially if “risk on” spurs bubbling markets and a stronger recovery). And the more securities prices diverge from fundamentals – and the deeper (rank) financial speculation impairs the markets’ pricing mechanisms and the economy’s resource allocation processes – the greater the systemic vulnerability to myriad shocks.

I’ve noted a few of the more conspicuous “weak links” that might derail the global Bubble in 2013. But it could easily be – most likely will be - something unforeseen – “out of left field.” Last year saw an escalation of myriad global geopolitical risks. The so-called “Arab spring” took a troubling turn. Syria disintegrated, and the Iranian nuclear issue seemed to almost come to a head. It was also a year of devastating drought and super storm Sandy, along with unnerving weather developments around the globe. I would expect speculative markets to try to disregard geopolitical and other issues, although I would also posit that this only increases the vulnerability of a major negative development to incite a big, revengeful “risk off” backlash.

The backdrop would, at least for this evening, seem to support the scenario where markets resist responding to negative developments until they’re clobbered over the head with them. It’s an interesting juncture for a global bullish pandemic. And a most unfortunate time for history’s greatest Bubble. 

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About Douglas Noland