Non-sense Markets
Of recent times we have posted a number of economic articles all warning of market stresses. For example in one article the international ratings agency Fitch warns that in just the sovereign bond market, should interest rates rise back to levels seen in 2011, there will be about $3.8 trillion in losses incurred from present levels. $3.8tr doesn’t sound much does it? Well how does $3,800 billion sound? Perhaps a bit more, but however it sounds this is no small amount. When interest rates rise bond prices fall (bond holders lose money) which is the inverse of what has been going on in the past 6 years, falling interest rates driving bond prices higher (investors make money – on paper at least).
As everyone knows central banks have manipulated interest rates lower and lower over the past 6 years to the point that in 18 countries interest rates are not only historically low but negative. Yes you pay the bank to hold your money or if you are sovereign bond holder you effectively lose money to own an investment that pays you no return. Already we are told $11.5tr of sovereign bonds trade at negative yields. This was an unthinkable absurdity even just 10 years ago but it seems even New Zealand is heading toward this possibility. People only borrow and spend more when they are confident about the future, but by going negative, into uncharted territory, the policy actually undermines confidence. Now people are asking if rates are now negative just how bad is the overall economy doing to be in this position?
Why you ask? Well, economic growth globally (New Zealand excepted) is not as been claimed by central bankers, economists and commentators despite government agencies manufacturing positive news about employment, inflation and such so in an attempt to get economies growing at positive inflation producing levels once again the bankers are discouraging you to save your money. They want you to spend it and in so doing buy goods and services to produce economic growth. But there is a problem which we will come back to later.
In another newsletter (not posted) I read about the reasons why the U.S. stock market maintains at near record highs despite almost all economic indicators telling us that the U.S. economy is only barely growing, if at all, with many major companies closing dozens of stores, lay-offs in the thousands, bankruptcies exploding etc.
One of the explanations for this oddity is that corporate share buy backs now exceeds $7trillion (Companies buying back their own shares drives the remaining shares price higher) most occurring in the last 3-4 years. This trick works well but the real issue is that to do this companies are adding a lot of new debt to their balance sheets because right now money is cheap, interest rates low, it costs virtually nothing to do this. But it is not backed up by increased earnings, indeed it disguises ‘real’ earnings per share so that Price Earnings Ratios (PE’s) indicate that while ratios are stretched they are not outlandishly so. It is a long term disaster manufacturing.
Take International Business Machines Corporation (NYSE: IBM), for example. The company’s management team has taken on billions of dollars in debt to buy back stock (at much higher prices), while the business itself implodes. IBM’s revenues have been in decline for years! The balance sheet has become bloated and the quality of cash flow has deteriorated, indeed the company is cannibalising itself from within.
Source: Dent Research
The question to be asked is how long will this continue?, because if it does change and interest rates rise there will be market carnage. More than that share buybacks are the easiest way to manipulate earnings per share and the reality is that U.S. corporate EPS have been in a downward trend now for the past 5 quarters.
So, look out KiwiSavers! If you are average Joe KiwiSaver you are going to get hammered because the vast majority of KiwiSaver money is not ‘saved’ in the commonly understood sense of the word – it is invested into these manipulated markets.
Another feature of today’s manipulated ‘markets’ is the explosion of financial derivatives as the means of taking bets and investing. Derivatives are the creation of banks used to trade almost anything and they create massive leverage. Most financial news reports you see on TV come from trading floors where you see hundreds, maybe thousands of computer screens glowing, a banker on one screen taking a bet against a banker on another screen on the other side of the world. A bet (investment) of $1,000.00 may actually have a face value of million dollars and worse still the derivatives market is pretty much unregulated. Things get out of hand quickly and we read that Deutsch Bank alone has derivatives exposure amounting to about $60 trillion, much more than German GDP, while it’s ‘reserves’, if any, are a tiny fraction of this exposure.
Central bankers have painted themselves into a corner from which they can not escape without setting off some unanticpated calamity. Raising interest rates off these negatives sets off losses in the bond markets. Raising interest rates also immediately makes all the borrowings of corporates more expensive to fund and profits evaporate. Raising interest rates also makes sovereign debt more difficult for governments to honour and so less is available for schools/hospitals etc. Indeed the U.S. government can’t afford interest rates at 4%pa, the debt mountain is just too large to fund – and “we don’t have a country left” – quote D. Trump.
On the other hand if interest rates don’t come back to some sort of ‘normalisation’ where money once again has a positive price paid for borrowers, savers continue to be fleeced. By not allowing markets to normalise way back in 2008 where recession was barely avoided using TARP, QE, money printing and all the other jiggery-pockery that central banks unleashed then ‘saving for our retirement’ is a waste of time too. Indeed it threatens the existence in retirement of the entire baby boomer western population.
This is why I suggest that markets are not going to be allowed to crash, even though there is no logic any more and many traders say they are ‘lost’. Also a crash is very bad for the manipulators as well and should they have not already salted away ill begotten gains into expensive property, cars, art, jewellery and the like, they too will have their own day of reckoning should markets throw up.
Your dilemma is to continue to trust that markets don’t revolt but all the while central banks continue to print money and purchase & eliminate the non performing debt banks have on their books the game goes on, everyone cheers. It’s not that the market is ingesting new money from investors, the only significant player these says are central banks buying bonds and stocks using printed money. The risk is that something unforeseen happens in the derivatives trades. This unregulated area could just explode and drop into a black hole. Only then you will find out who was swimming naked and who had their togs on.
But back to the problem that is an economic force so powerful that all the trickery of central bankers of the world can’t fix and don’t understand despite their own graphs showing the problem clearly and their biggest fear – Deflation.
The billions amongst us who are baby boomers (I am one) do not spend money at levels we used to do when we were raising our children, buying bigger houses and new expensive cars etc. That massive consumer market is therefore tightening due to the withdrawal of our spending power because we don’t need to buy more stuff, indeed we are in the process of getting rid of stuff. The problem won’t be solved with negative interest rates encouraging us to spend. That era Mr Central Banker is over and finished with but they don’t understand or get it.
A good financial indicator of the magnitude of the problem is the velocity of money M2 graph. The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy. But, the problem is M2 in the U.S. is in a death spiral with the latest calculation showing M2 at its lowest level now since the late 1950’s. Here is the link Link: https://fred.stlouisfed.org/series/M2V
What this means is that despite the trillions of new money that has been printed by central bankers worldwide, Euro, USD, GBP, Yen, Renminbi or whatever currency, citizen Joe Average is not and has not benefited from the so called ‘trickle down’ approach central banks believed would occur. The people are not spending and remain cautious and on the sidelines of markets, apart from what they consider is their savings for retirement, their KiwiSaver, 401k and similar superannuation models which is money (taken from their pay-packets) they give to some else to ‘look after’ for their retirement. There will be some really upset people if markets erupt!
For years now it’s been self-evident: market rules no longer apply. Technical analysis – useless. Fundamental analysis – useless. Asset allocation models – useless. The only thing that now matters is whether or not a stock, bond, or ETF is favoured by a central bank. Period. Yet, far too many veteran advisers or seasoned business people are still viewing many aspects of these markets through a prism of 10 years ago. Those days are long gone. Yet, people are acting (or hoping) that there is still some sense of normalcy still residing within. I’m sorry – there isn’t. Regrettably for all of us the markets can stay irrational much longer than one can remain solvent. Add to that “irrational central bankers”.
So the dumb game does on, the corner they have painted themselves into tightens daily. Meanwhile our savings for our retirement is threatened by a possible market explosion that is only held at bay by unthinkable (ten years ago) market actions of central bankers who have become the only force of substance in markets globally. Pity it’s an untested experiment, they don’t know what they are doing.
More importantly what do you do about your KiwiSaver account-your retirement fund? Is there a strategy ready should a rout develop. Will your adviser trot out the usual line of responses about ‘thinking about the long term’, ‘diversification is the best way to minimise losses’, or ‘your fund manger knows best’ and other perhaps historically reasonable responses. This is acting in their own interest to retain ‘funds under management’ (meaning they get paid fees from your account). Your fund manager certainly will, they are being rewarded handsomely by fees from KiwiSaver (Total fees are now over $NZ1 billion pa!) OR will your adviser recommend another pathway to preserve your wealth, will they act in your interest and have in place a strategy to survive the potential carnage in markets that have disguised the real economic forces in play?
The odds are your adviser doesn’t even know the issues. I contend the financial advising industry is so sidelined by compliance issues that they no longer look at what is really going on in markets – where they have invested your money. This has been going on now for years. But its worth while to go and ask them first, then go with your gut feel.
Malcolm Eves 09/08/16