“I know a bank where the wild thyme blows.” – William Shakespeare, A Midsummer Night’s Dream
When I wrote last week about the “wizards of awe,” I wasn’t referring to the heads of the globes biggest central banks – but maybe I should have been. Three weeks after the Bank of Japan (BOJ) reignited equities and convinced sellers to fear the bogeymen of the big bad central banks, the People’s Bank of China (PBOC) added fuel to the fire with a cut in its benchmark lending rate. European Central Bank (ECB) Mario Draghi had just put yet another dove in the coop before the PBOC surprise announcement, though it must be said Mario’s bird didn’t look any different from its predecessors: We’ll do whatever it takes, just you wait and see, we’re really going to do something big. Seriously.
And maybe the ECB will. Draghi did follow up with some purchases of asset-backed securities (ABS) later in the day. One wonders about the identity of the intended recipient of the gesture – the markets, or the Germans? It may well have been both.
The PBOC move came on the heels of recent data showing an easing of the rate of annual industrial production growth to 7.7%, the second weakest since 2009, and a purchasing manager index that retreated back to 50, which is neutral. While I don’t trust any of China’s data, I do accept the up-or-down movements as attempts to signal economic direction. All we know is that it’s softer – but not by how much (cf. a good discussion on Bloomberg).
The unexpected cut led to a flurry of enthusiastic predictions for not just more easing by the bank (which claimed the move was not a change in monetary policy), but an entire program of accommodation, including a collateral cut in reserve requirements next month. Many investors (including myself) were of the opinion that while the rate decrease may not matter much to an economy that could be in trouble, it will matter to financial markets. The rate cut itself is fairly small, but it may keep sellers fearful of the next leg at bay.
A good possibility is that China has all the empty buildings it needs and isn’t interested in trying to restart its investment boom, at least not yet. The cut could be more about the yuan fighting back against the weakened Japanese yen – and the euro, for that matter. The BOJ, ECB and PBOC have all employed appropriate discretion on the subject, but I don’t doubt for a moment that they are all keen on managing their currencies to what they feel are competitive levels.
Markets are herd-driven and I don’t doubt that they can continue to rise on monetary mania; I have seen more than enough late-stage rallies survive well past their sell-date fueled by little more than momentum, hot air and slogans. We are asking for serious trouble: the ends of these episodes can be quite damaging.
Time for a reality check. For a start, quantitative easing in the U.S. has mostly been good for the financial markets. The first two rounds were helpful in recovering from the crash, but studies from the Federal Reserve system itself indicate the last two rounds have done little to nothing for the real economy, apart from the Fed’s not-so-covert goal of financial stability above all (the Greenspan-Bernanke-Yellen put).
Besides inflating the value of all financial assets, QE has had several knock-on effects. In taking the policy lead and having the fortune of watching over an economy of restrained, yet stable growth, the Fed has made it possible for other central banks to copycat attack with aggressive policy measures. As the BOJ and ECB fell into line, investors have become infected with another episode of price invincibility (cf. global growth, the new economy, junk bonds, the nifty fifty and so on ad nauseum back to Irving Fisher’s “permanent plateau” in 1929).
The relative stability and asset market success provided by monetary policy have had the side-effect of seeing legislatures around the globe duck virtually all difficult decisions. Very, very little has been done to address structural problems. China’s biggest two problems are its property bubble and a weakened customer base bumping up against the country’s own higher cost base. Europe’s biggest problem is a frozen, half-built financial system that rules out fiscal transfers and competitive currency adjustments, sitting on top of a motley conglomeration of national structures, some rooted in the conditions of half a century ago. The result has been a glacial pace of adjustment and writing down of bad debt in both China and the EU, neatly mimicking Japan’s failed post-bubble policies.
The EU has further helped itself with a bucket of austerity programs designed more to punish than to cure. It’s a wonder the eurozone isn’t in even worse straits, but a global craving for yield, fed by an investor base that no longer trusts equities, took Draghi’s “whatever it takes” slogan at face value. Investors believed him for no better reason than because they wanted to buy more bonds (think of tulip mania). As for the U.S., it’s biggest problem is the lack of demand brought on by a vanishing middle class. None of these three leading economic zones have done anything to try to solve these problems.
Monetary policy can’t fix any of these problems – it’s actually making some of them worse. It can help depreciate currencies, but it can’t prevent the end of the business cycle, despite periodic beliefs in new eras and plateaus (“Fortress America” is becoming a new slogan). Business cycles still don’t last forever, and in fact rarely last more than eight years. What happens if the current one ends with the banks still all-in, or nearly so? What will become of our faith in central banking? It would not surprise me if legislatures, anxious to duck any blame, end up enthusiastically blaming the central banks and making matters even worse with ill-advised populist remedies.
In the fullness of time, the value of the financial economy always returns to the value of the real. Sometimes the return trip is from above, sometimes from below, and it often doesn’t stay long. But it always returns. Wall Street has never been comfortable with this idea – the hope at the end of every cycle (on Wall Street, the end is always two or three years from today) is that growth will somehow accelerate to redeem all promises (while prices somehow stop going up). It never happens. Repeat it again – it never happens. Sometimes we get credit bubbles that give cycles extra life, true. It’s a cure that’s worse than the disease.
I don’t know exactly how all of this ends, but I do know that the further the financial economy drifts from the real, the longer and more punishing will be the return trip. The ratio of the stock market’s value to GDP is now over 130%, meaning it’s closing in on late 1999 levels and leaving only the year 2000 as the last hill to climb. It’s the other side of that hill I fear. In 2007, markets rallied ever higher – despite clearly weakening growth – on the hopes of Fed action, in this case interest rate cuts. The cuts came and were followed in short order by a recession and crash. It feels like we are engaging in a repeat performance, and I suspect that many traders believe it too. The fact that they’re willing to ride the wind higher until it gives out is because they are traders.
In the near term, equities are well over-extended and ready to back up a few feet. I don’t think the top is in yet on the stock market, though – that GDP ratio is almost certainly going higher first. We will probably see a slow but steady increase in volatility in the coming months, but the high for this quarter may also be still to come. Despite the reality of the annual rally between Thanksgiving and New Year’s Eve, it can be quite a bumpy ride, and the possibility of a late rally only making it back to Friday’s close (S&P just below 2065) cannot be excluded. Neither can S&P 500 2150, for that matter, and what with central bank fever, traders may decide it’s a good bet to test the 18,000 level on the Dow.
As markets spiral ever higher on the balloons of monetary mania, the U.S. economy is not accelerating, as I wrote last week, despite the vapid, tape-driven enthusiasm bubbling up in some prominent corners of the business media. It’s going at the same rate it’s had the last few years. The mood, however, feels very much like the fourth quarter of 2006, which suggests that the economy and stock market might in fact be good for three or four more quarters, give or take. And then we might find ourselves descending to a place we would very much regret. We don’t have to go there, but it’s the road we’re on and very few are trying to get off. But perhaps that’s a tale for the winter (though it feels like it’s already arrived in most of the U.S.); in the meantime, a Happy Thanksgiving to all.
The Economic Beat
It may seem hard to believe, but the report of the week was the November regional manufacturing survey from the Philadelphia Federal Reserve. The fact that it was also the strongest-looking of the week might have had something to do with its popularity; it helped fuel a big intra-day reversal on Wall Street.
CNBC’s Steve Liesman reacted to the reading of 40.8 – the highest since 1993 – by saying one shouldn’t extrapolate it to the national economy and then proceeded to do just that. By the time he was finished speaking, he had thrown in the existing home sales number and for good measure added three-tenths to the current GDP estimate of 2.7% for the fourth quarter. The economy is accelerating, he avowed, adding that “Fortress America” (the U.S. has decoupled from the global economy, in case you hadn’t heard) is still intact. Good grief.
He also added that none of the economists he spoke to could find any weakness in the report. I could think of many right away, starting with the fact that it’s a diffusion survey. The level of growth may not have improved at all since October; so long as it’s broader-based, the activity levels might be identical. In the second place, diffusion surveys are heavily influenced by sentiment – the election may have influenced the result. Third, it’s a peak number. I’ve been following the Philly Fed survey since forever, and freely predict that the index is going to trend back to zero before the end of 2015. Finally, there was indeed a quirk in the report: prices. Prices are the most reliable short-term indicator of activity, and the survey reported that both prices paid and received slowed. If those results are accurate, they do not reflect a booming economy.
The New York Fed manufacturing survey also reported an index increase, in its case not so large, from about 6 to 10. For that matter, the ISM national manufacturing survey for October, reported earlier this month, was a very elevated 59.0. However, industrial production in October fell 0.1%. The number was dragged down by mining and utility production, to be sure, but manufacturing only rose at a very modest pace of 0.2%. The divergence between such surveys and actual output has been going for much of 2014 and I have frequently called attention to it, but it’s a fact that seems to elude the touts on the business channels.
Homebuilder sentiment picked up with a reading of 58, one of the best of the recovery, and it was followed by relatively decent housing starts and building permits data the next day. Though starts missed consensus, the number was alright in a broad sense, and the year-to-date pace is running at about 9%, or about half of last year’s increase. Single family starts are growing at about a third of last year’s pace. The only sensible conclusion, I guess, is that the economy is accelerating.
The economy is accelerating for one group: the well-to-do. Existing home sales activity rose for the second month in a row, finally lifting the year-on-year comparison into the black for the first time this year. Activity was led by outsized (16%) gains in sales of homes worth more than $1 million.
The producer price index (PPI) eased its year-on-year rate to 1.5%, 1.6% excluding food and energy; the consumer index (CPI) was flat year-on-year at 1.7% while the non-food and energy component edged up to 1.8%. The latter has been between 1.5% and 2.0% for the last two years.
The minutes of the October Federal Reserve meeting were released on Wednesday, and while they are usually the occasion for some sort of rally, the minutes were so similar to the statement and the previous month that for once the market yawned.
Next week packs some headline-grabbing releases into a short period, chief amongst them being Tuesday’s release of the first revision of third-quarter GDP (consensus is 3.3%) and corporate profits. Housing is busy with Case-Shiller price data on Tuesday, and new home sales and pending home sales both released on Wednesday in a holiday-induced oddity. Wednesday packs in a lot of data into its morning session – beside the two housing reports, there’s October personal income and durable goods. It should make for a busy morning, as the afternoon session tends to be tame, though not as tame as during my youth, when it was quite safe to begin the long holiday weekend at lunchtime on Wednesday.
Thursday is of course Thanksgiving Day, one of the more revered holidays in the U.S., and all markets and financial institutions will be closed. Markets will also close early on Friday: 1 PM for stocks, 2 PM for bonds. Happy Thanksgiving!