Cyclical déjà vu

Though it might seem a churlish observation to make amid so much barely-suppressed exuberance about the prospect for the markets in 2013, in many respects the past twelve months have shown much the same pattern as has marked each of the preceding four years. Characterized by the grinding hysteresis which we foresaw as far back as the end of 2008, this has broadly materialized in the form of rallies which stretch from one year end into the succeeding spring before a sell-off occurs which then extends into late summer-early autumn, whereupon the cycle reverts to rally and so on round again. 

Each time the Groundhog recovery in asset prices has been based upon the delivery of a stimulus from one or other of the major central banks which has temporarily brightened sentiment – and even improved the macro numbers for a while – before what a physiologist would call a ‘tolerance’ of the credit injection has set in, the economic data has deteriorated, and the unresolved and unliquidated problems which still linger from the preceding Boom have surfaced again to frustrate the optimists. 

Last year began amid ever more undeniable evidence that China was suffering a mini crisis of its own, with profits evaporating, unpaid bills mounting, and trade stagnating,  while the disparities between Europe’s sorely-afflicted south and its better-placed north blew up in to surging sovereign spreads and a €1 trillion-plus mountain of blocked credits piled up across the T2 system.  A further hiccup was then suffered as the two main American political parties acted out their tired old kabuki over the dire state of the nation’s budget.

However, on all three continents, the Keystone Kops aboard the imperilled paddy wagon just managed to wrench the wheel over in time to avoid the looming cliff edge.

For their part, the Chinese did exactly what they assured us they were not going to do and launched a vast new wave of stimulus in order to ease the new regime into office. Eastward, across an increasingly tense stretch of sea, the soon-to-be-Premier of Japan browbeat the BOJ into conducting an escalating series of interventions while, the other side of the wide Pacific, the defeat-disheartened Republicans bent the knee to their triumphantly re-elected opponent and quailed at the thought of being blamed for slashing government spending while the cynically–opportunist Bernanke Fed exploited a patch of economic softness to go all-in with a promise of unlimited bond buying.  

In Europe meanwhile, ECB Chief Mario Draghi declaimed with a truly operatic flourish that he would ‘do whatever it takes’ to keep the cash flowing to the olive basket and so magically relieved the tension in the Eurozone in true Wizard of Oz style.

After a last lurch down around the time of the US presidential vote, the markets have responded with increasing enthusiasm to the realisation that disaster has been postponed once more (if, sadly, not definitively averted). Hope has sprung eternal as stock markets have rallied, junk and emerging market debt spreads have collapsed, volatility has been crushed, and the erstwhile safe havens – such as US Treasuries and gold – have begun progressively to lose their allure.

Alas and alack, as a reflection of the growing disenchantment with what have frankly been the disappointing returns offered by the asset class over the past eighteen months, commodities have taken a deal longer than the other ‘Risk On’ assets to respond to this perceived good news, only beginning to hold their own (on a relative basis) as the new year began.

And so, at January’s close, we found ourselves flushed with the glow of higher prices and complacent in the face of further central bank largesse. Adding to the urge is the undeniable fact that we are all heartily tired of sitting on a stockpile of boring old, precautionary cash for quarter after fretful quarter.

Around such intangibles a new consensus has formed that equities are king, bonds are dead, and commodities—if we must pay them any heed at all—are the things to buy to protect against those few dark clouds, no bigger than a man’s hand, which serve to remind us that central banks cannot go on indefinitely adding money to the system at or below zero real interest rates while budget deficits yawn in undiminished magnitude without risking a conflagration of values too awful to fully contemplate. 

The irony is, of course, that the thing most likely to blow these few wisps of cumulus up into a terrifying inflationary gale is simply that people come to express more and more confidence that neither this eventuality, nor its gloomy deflationary opposite, will come to pass and so the money which is currently only burning a hole in their trouser pockets is brought out to set light to the world at large.

While we must be careful not to be trampled in such a bullish stampede by standing too incautiously in its path, there are both flaws to the premises on which such a Blue Sky mentality has been founded and more immediate concerns that the eagerness to believe has become so widespread and the voices of dissent so lacking that everyone is already leaning over the starboard side of what has therefore become an alarmingly heeling ship, one all to ready therefore to be tipped overboard with the first contrary gust of wind.

Let us (briefly) take China. Still in a policy hiatus due to the regime change and about to enter the macroeconomic purdah of the Lunar New Year, that has not precluded the Herd from wilfully taking as bullish a view as possible about likely developments there – even to the point that one senior analyst from a major bank could bring himself to tell his audience at a mining conference that to him the outlook for the commodity market was very much like it was in 2002 (from which secondary low, the reader might recall, it embarked on what some measures show was the best nine years in its history!) 

It seems that nothing will stop the idiot savants – as well as the consciously misleading – from plugging whatever numbers the state propaganda machine churns out straight into their ‘models’ in order to lend some spurious gloss of calculation to such pronouncements, no matter how unreliable, contradictory, or plain incredible these may be.

Take the Chinese GDP number for the broadest of these: Officially, last year’s nominal total came to CNY51.9 trillion, an increase of 9.8% or CNY4.6 trillion on 2011’s count. Yet, by adding up the individual data produced separately by the nation’s constituent 31 provinces and autonomous regions, we can calculate that the annual sum reached to CNY57.7 trillion (11% higher), and that growth accelerated to 11.1% yoy, representing an increment of CNY5.8 trillion which was a quarter larger than that given by the official tally. Spreadsheets, anyone?

By now it has become almost trite to compare the electricity stats with those for GDP or industrial production, yet we have a rather worrying disconnect in other areas of energy use, too. Industry up by a double-digit amount alongside a gain in refined oil product use of no more than half of that (5.2% yoy), of which diesel consumption barely ahead at 1.5%? Makes perfect sense to me!

Then we have the miraculous rebound in ‘profits’ posted in December (and we will risk a roll of the eyes by asking, once again, how can businesses even begin to compute earnings on a monthly basis?). Setting the seal on QIV’s auspicious rebound and so helping the Shanghai Composite to a further 8% gain, December’s winnings were supposedly a cool 68% greater than the average of the previous three months; revenues were no less than 13% higher and, hence, margins were reported to have jumped by half from 6.5% to 9.7%. Oh, for such levels of operational gearing in an expanding market! 

In the short run, what may come to haunt the China bulls is the fact that even this brief relaxation of policy has unleashed the same old dark forces of shopping basket inflation and property speculation. For example, the all-important pork price has risen by more than 10% in the past two month, prompting a release of supplies from the central reserve to try to quell the surge.

More worrying still – especially given the news that the much-bruited property tax will not now be rolled out across the country – land sales in China’s ten main cities were up by a factor of 3.6 last month from January 2012, according to the Shanghai E-house Real Estate Research Institute. Given that the area sold increased ‘only’ 77%, this also implies that the average price paid more than doubled. Stop-Go rules OK!

In light of this what would have been merely risible if it did not simultaneously display China’s increasingly belligerent response to foreign criticism alongside an utter lack of economic understanding, the mouthpiece People’s Daily this week carried an aggressive repudiation of assertions that the country’s monetary incontinence posed a threat to global stability.

Putting the cart firmly before the horse, the editorial argued that if a company had made a hypothetical land purchase ten years ago and if, on going public this year, that same land had been valued higher by a factor of 2,000 (sic!), if the central bank did not issue new money to the tune of around a quarter of that latest appraisal, the increase would be ‘just a bubble’!

No, really! We are not making this up as you can see here:- http://tinyurl.com/amzaczh

On top of this, the writer contended, ‘price reforms can also lead to a substantial increase in the demand for money’ since, he went on, if prices rise, both companies and consumers have to pay more, ergo more money is patently needed – a problem which is moreover said to be ‘unique to China’! Truly, to invert Milton Friedman, monetary inflation is everywhere a real side problem!

Heaping a cloud-capped Pelion of further confusion upon this already lofty Ossa of muddle-headedness, a separate justification for the deluge is apparently that while America’s attempts of the last four years at disaster recovery have naturally focused on its predominant, highly-leveraged financial sector – meaning that every new, FRB-printed dollar could be multiplied up sixty times (sic) – poor, old, metal-bashing China, by contrast, has been doomed to rely on a mere 4:1 multiplier to assist its key industrial base (the limitation being imposed lest it blew its companies’ balance sheets up to imprudent levels of gearing) and hence it had to keep its central bank’s printing presses fifteen times as busy as those of the Fed!

Working up a full head of steam, the author closed this truly Swiftian self-parody with one last, glorious volley of logical howlers, by asserting that the crisis-averting increase in money supply has increased the risk (but only the risk, you will note) of debt expansion before the authorities became ‘scared’ enough to tighten policy and thus to usher in a ‘slump in domestic stock markets, a surge in loan demand, persistently high interest rates, and such financial risks as usurious loans, shadow banking, and trust loan expansion.’

Well, yes, but surely those were merely the unfortunate side effects of an attempt to address the dangerously building excess before the system exploded under its own pressure? No, this hero of socialism-with-Chinese-characteristics confidently concludes, ‘…the greater risk lies in an increasingly weak real economy.’ 

And this is the spokesman for a preternaturally-gifted ruling elite which is supposed to be reforming and rebalancing its economy in a ‘scientific’ manner and whose rarefied heights of dispassionate calculation we benighted Westerners cannot ever hope to match? Heaven help us all!

But if the ongoing suspension of disbelief regarding China is one of the great enormities of the current mini-bull market, the effort to disregard the sorry history of Japan’s last two decades by a semi-mystical appeal to the half-remembered exploits of eighty years ago is surely the other.

For now it seems, after twenty-plus years of evergreening loans while covering whatever real verdure there was in swathes of economically otiose concrete, the ‘one more heave’ generalship of the LDP will finally enact all of Paul Krugman’s wildest fantasies by further unbalancing its budget – this time with the untrammelled assistance of the central bank – and thereby repeat Finance Minister Korekiyo Takahashi’s feat of ‘rescuing’ his country from the clutches of the Great Depression.

That Takahashi’s real achievements are still somewhat moot is, of course, besides the point even though debate still rages about whether it was his 60% devaluation of the yen in late 1931; his reliance on proto-Keynesian pump priming and his insistence that the BoJ monetize at least some of the resulting deficits (not a small fraction of which were incurred by the country’s simultaneous annexation of Manchuria); his elimination of the capitalists’ ‘wasteful competition’ via his promotion of industrial cartelisation; or whether it was simply that the wider world was already coming out of the worst of its trough by the time his policies were being put into effect. Suffice it to say that a multitude of PhD dissertations and many a professorial citation count still depends on the construction of intricate counterfactuals about this episode, together with the conducting of exhaustive econometric testing of this ultimately untestable dispute.

We should perhaps first pause to take note that Takahashi is an unlikely hero, given that he once declared, in reminiscence of his mentor: ‘After two days of talking with Maeda, I realized that my concept of the state was shallow. The state was not something separate from the self. The state and the self were the same thing.’  Mussolini would have been proud of him. 

Moreover, this particular ‘genius’ seems to have subscribed to the same old canards of the underconsumptionist school, with all of its superficial appeals to the so-called circular flow mechanism. Hence, we have this pronouncement from the lips of the great man:-

If someone goes to a geisha house and calls a geisha, eats luxurious food, and spends 2,000 yen, we disapprove morally.  But if we analyze how that money is used, we find that the part that paid for food helps support the chef’s salary, and is used to pay for fish, meat, vegetables, and seasoning, or the costs of transporting it. The farmers, fishermen, and merchants who receive the money then buy clothes, food, and shelter. And the geisha uses the money she receives to buy food, clothes, cosmetics, and to pay taxes. If this hypothetical man does not go to a geisha house and saves his 2,000 yen, bank deposits will grow, but the efficacy of his money will be lessened. But he goes to a geisha house and his money is transferred to the hands of farmers, artisans, and fishermen. It goes in turn to various other producers and works twenty or thirty times over. From the individual’s point of view, it would be good to save his 2,000 yen, but when seen from the vantage point of the national economy, because the money works twenty or thirty times over, spending is better. 

No wonder his shade is being summoned as the tutelary deity of what is inevitably being termed ‘Abenomics’. Martin Wolf must be positively beaming with delight. 

Our own thoughts on this matter should need little exposition so let us content ourselves by citing the wise words of a man who is being sacrificed to this kami of inflationism, outgoing BOJ head Masaaki Shirakawa. In a speech given almost two years ago, he pointed up the dangers of overplaying the supposed similarities between 1930s Japan and the country of the 2010s before issuing a stark warning regarding the dangers of embarking upon a like  course to that followed on that earlier occasion:-

As many of you know, Mr. Takahashi was assassinated in 1936 by militarists when he was trying to stop ever-growing demand for military spending, and the course of events led to the eventual rampant inflation. I would argue that the introduction of the scheme of the Bank’s underwriting of government securities itself paved the way for eventual ballooning of fiscal spending, precisely because the scheme lacked the checking process through the market mechanism.

We often use the words of ‘entrance’ and ‘exit’ to discuss the conduct of monetary policy nowadays. In that terminology, we should interpret that the ‘entrance’ of the introduction of the Bank’s underwriting of government bonds in the early 1930s led to the ‘exit’ of the failure in containing growing demand for fiscal expenditure. In retrospect, we should note that the Bank’s underwriting of government bonds started as a ‘temporary measure’.

Though Mr. Takahashi stated that he issued government bonds by a means of the Bank’s underwriting just temporarily in his address at a Diet session, history tells us that it was not temporary. 

For reference, the toxic legacy of a government debt of 200% of GDP (sound familiar?), a vast monetary overhang, and shrunken markets eventually cast the defeated nation into a rapid inflationary whorl. After a one third reduction in 1946 as a result of that year’s currency conversion and capital levy, money supply shot back up by a factor of six between the end of that year and 1951/2, as official wholesale prices rose one hundredfold (even if the more representative black market ratio was closer to a more proportionate fivefold).

As a noted economist of the time, Martin Bronfenbrenner, remarked:

no serious attempt was made… to control either the volume of currency printed or the volume of bank deposits created to support not only the Government deficit but also the similar deficits of private firms

We can only hope that the contemporary Japanese will not suffer too much from what seems to be an active programme of decontrolling such an efflux.

And what of those hoping for a mercantile boost for Japan as the currency falls at its second fastest rate of the past generation? Well, perhaps it will turn out not to be the smartest thing to prosecute a policy guaranteed to increase input costs from abroad during a period when the country’ trade gap is the highest on record, when the terms of trade have already fallen by a fifth over the cycle, and when the ratio of imports to national income has only briefly been exceeded at any time in the modern era for the four quarters leading up to 2008’s global peak. 

Rather than waiting in vain for some instant miracle, it would be as well to  heed the caution of Toshiba Executive Vice President Makoto Kubo who told a press conference recently that:

The semiconductor-related business will benefit from a weak yen, but the rapid fall in the currency will increase costs because it uses a massive amount of electricity.

Or might we be led to doubt by noting, as was long ago remarked:

…‘because each farmer and the situation in each farm village differs, it would be wrong to impose a comprehensive relief program. Each region has its unique disease. We must begin by investigating these sicknesses and applying the correct cures. If we scatter money uniformly from the centre to the regions, we cannot eliminate the diseases.

Who said that, you ask? Why, a certain beatified inflationist by the name of Korekiyo Takahashi.

Back in that other Sick Man of the global economy, there has finally been a minor test of the complacency which has increasingly categorized the European scene.  Naturally, since Draghi’s deus ex machina nothing very concrete has been achieved, for all the endless summitry and fevered shuttle diplomacy, as joblessness has climbed, state indebtedness has worsened, and business confidence has further eroded.

Cyprus is only the latest to be – or not be, depending on the swing of the political weathercock – a potentially ‘systemic’ problem. Italy is on the verge of another Dantean descent into political chaos as the same-old, derivatives-enabled fudging of the account books to which the Japanese were so prone has come to haunt the Urprovinz of European banking. This, even though the cynic might enquire as to why a (quasi-)private European bank shouldn’t do what so many of its sovereign overlords once did with the help of exactly the same sorts of TBTF pirates to ensure that they met the Maastricht criteria for euro-entry? 

Though this may only comprise the latest of a long line of financial imbroglios, the political repercussions stretch further, not only by giving the irrepressible Silvio Berlusconi one last chance to strut his hour upon the stage, but in calling into question either or both of the competence and integrity of the current head of the ECB, a man who happened to be in office with the local central bank at the time. With an even more socially-incendiary corruption scandal having recently erupted in Spain – implicating many of the kingdom’s nomenklatura in a seedy little brown envelope scheme – it may be that another round of drama will ensue in the Eurozone after months of spread-tightening quietude.

Conversely, unease among the moral hazard jockeys has been sown by the steps taken by the Dutch government in taking over the failed mortgage company SNS Reaal (no, property crashes are not just an Anglo-Latin phenomenon). As part of this, at long last – almost five years too late, some might say – the subordinate bond holders have been made to share the pain of a bail-out. So, finally, someone has had the cojones to follow the lead of the doughty Danes and intrepid Icelanders and put a great, fat slug of risk back from whence it should never have been removed. 

Adding to the general angst, Germany and Finland have seized upon the action to join the Netherlanders in calling for the good and great to advance the implementation of a tougher rescue regime from the formerly proposed temporal wilderness of 2018 to a politically imminent (if still Augustinian ’Not yet, O Lord’) starting point of 2015 – though why this should happen any later than a week next Wednesday is beyond us!

Ironically, all this has blown up as the banks have brashly repaid some €130-odd billion of last year’s LTRO funding – a close and suggestive mirror of the €125 billion reduction in the big four TARGET2 creditors’ balances (and, hence, of the  EUR130 billion drop in Spain and Italy’s debits) which has taken place since the summer. Given that the euro has itself become the forex market’s new RORO bell-whether, a disruption in Spanish and Italian asset markets, Eurobanking stocks, or the currency itself could therefore see a widespread series of interlocking liquidations if confidence is not quickly restored.

It’s nice that such doubts resurface when US equity margin debt has hit its highest dollar amount since the 2007 top (indeed, it may well be a good deal higher than these December figures, given that the last three weeks have seen what look like record, pro rata inflows). Moreover equity mutual fund liquid assets have hit their own record low-equalling proportion of total assets and a multi-year low one of market cap: the bullish combo of high leverage and a reduced margin of safety has only previously been matched in the blow-off high of summer 2007. 

Notwithstanding the fact that S&P reported that the credit quality of leveraged loan and high-yield bond issuers is deteriorating, with downgrades outnumbering upgrades for the first time since 2009 and with the growth in debt outpacing that of cash flow for U.S. leveraged-loan issuers, junk bond yields have hit a record low while EM bond spreads stand at their narrowest since 2007. Volatility in stock and bonds, oil and gold, have also gone off the bottom of the chart thereby implying that no-one wants to buy protection in what is seen to be an unimpeded one-way path to the sunlit uplands where bogies are made by all and sundry, skilled or no.

Yes, we have clear signs of a breakout (at long last) from the channel drawn off the 2011 high which has been constraining industrial commodities (though neither these nor the broader CCI combo have yet quite breached the pennants drawn off their 2008/9 extremes) and, yes again, we can project up from this to new cyclical highs if we measure from the 2009 lows via the intervening consolidation; and, yes, ‘overbought’ can easily become more ‘overbought’ until a shock to sentiment occurs but, but, but….  the danger must surely be that everyone has already positioned so far for this best of all possible worlds, so well ahead of the expected CB largesse upon which much of this has been predicated, that disappointment looms even if its trigger remains to be determined. 

What we have to try to gauge is whether this is really the long-awaited easy money blow-off move, or whether we will once again be nursing our disappointments, come the Dog Days of summer. If the market can shake off the last few days’ attack of nerves then we might at least muster the confidence to play an extension of this tactical rally before we have to decide upon its candidacy for the much more significant role presaged by the likes of no lesser mortals than Ray Dalio and Bill Gross.

If, conversely, the few, hardy sellers win this particular round, we can resign ourselves to having nothing better to which to look forward than to suffer another tedious bout of up-and-down, cyclical déjà vu