Friday, October 13, 2017

The Bubble Economy Set to Burst?

Andy Xie, an independent economist, wrote an op-ed for the South China Morning Post, The bubble economy is set to burst, and US elections may well be the trigger:
Central banks continue to focus on consumption inflation, not asset inflation, in their decisions. Their attitude has supported one bubble after another. These bubbles have led to rising ­inequality and made mass consumer inflation less likely.

Since the 2008 financial crisis, asset inflation has fully recovered, and then some. The US household net worth is 34 per cent above the peak in 2007, versus 30 per cent for nominal GDP. China’s property ­value may have surpassed the total in the rest of the world combined. The world is stuck in a vicious cycle of asset bubbles, low consumer ­inflation, stagnant productivity and low wage growth.

The US Federal Reserve has indicated that it will begin to ­unwind its QE (quantitative easing) assets this month and raise the ­interest rate by another 25 basis points to 1.5 per cent. China has been clipping the debt wings of grey rhinos and pouring cold water on property speculation. They are ­worried about asset bubbles.

But, if recent history is any guide, when asset markets begin to tumble, they will reverse their actions and ­encourage debt binges again.

Recently, some central bankers have been puzzled by the breakdown of the Philipps Curve: that falling unemployment rates would lead to wage inflation first and consumer price inflation next. This shows how some of the most powerful people in the world operate on flimsy ­assumptions.

Despite low unemployment and widespread labour shortages, wage increases and inflation in Japan have been around zero for a quarter of a century. Western central bankers assumed that the same wouldn’t happen to them without understanding the underlying reasons.

The loss of competitiveness changes how macro policy works. Japan has been losing competitiveness against its Asian neighbours. As its population is small, relative to the regional total, lower wages in the region have exerted gravity on its ­labour market. This is the fundamental reason for the decoupling between the unemployment rate and wage trend.

The mistaken stimulus has the unintended consequences of dissipating real wealth and increasing inequality. American household net worth is at an all-time high of five times GDP, significantly higher than the bubble peaks of 4.1 times in 2000 and 4.7 in 2007, and far higher than the historical norm of three times GDP. On the ­other hand, US capital formation has stagnated for decades. The outlandish paper wealth is just the same asset at ever higher prices.

The inflation of paper wealth has a serious impact on inequality. The top 1 per cent in the US owns one-third of the wealth and the top 10 per cent owns three-quarters . Half of the people don’t even own stocks. Asset inflation will increase inequality by definition. Moreover, 90 per cent of the income growth since 2008 has gone to the top 1 per cent, partly due to their ability to cash out in the ­inflated asset market. An economy that depends on asset inflation always disproportionately benefits the asset-rich top 1 per cent.

There have been so many theories on why inequality has risen. The misguided monetary policy may be the culprit. Germany and Japan do not have significant asset bubbles. Their inequality is far less than in the Anglo-Saxon economies that have succumbed to the allure of financial speculation.

While Western central bankers can stop making things worse, only China can restore stability in the global economy. Consider that 800 million Chinese workers have ­become as productive as their Western counterparts, but are not even close in terms of consumption. This is the fundamental reason for the global imbalance.

China’s model is to subsidise ­investment. The resulting overcapacity inevitably devalues whatever its workers produce. That slows down wage rises and prolongs the ­deflationary pull. This is the reason that the Chinese currency has had a tendency to depreciate during its four decades of rapid growth, while other East Asian economies experienced currency appreciation during a similar period.

Overinvestment means destroying capital. The model can only be sustained through taxing the household sector to fill the gap. In addition to taking nearly half of the business labour outlay, China has invented the unique model of taxing the household sector through asset bubbles. The stock market was started with the explicit intention to subsidise state-owned enterprises. The most important asset bubble is the property market. It redistributes about 10 per cent of GDP to the government sector from the household sector.

The levies for subsidising investment keep consumption down and make the economy more dependent on investment and export. The government finds an ever-increasing need to raise levies and, hence, make the property bubble bigger. In tier-one cities, property costs are likely to be between 50 and 100 years of household income. At the peak of Japan’s property bubble, it was about 20 in Tokyo. China’s residential property value may have surpassed the total in the rest of the world combined.

How is this all going to end? Rising interest rates are usually the trigger. But we know the current bubble economy tends to keep inflation low through suppressing mass consumption and increasing overcapacity. It gives central bankers the excuse to keep the printing press on.

In 1929, Joseph Kennedy thought that, when a shoeshine boy was giving stock tips, the market had run out of fools. Today, that shoeshine boy would be a genius. In today’s bubble, central bankers and governments are fools. They can mobilise more resources to become bigger fools.

In 2000, the dotcom bubble burst because some firms were caught making up numbers. Today, you don’t need to make up numbers. What one needs is stories.

Hot stocks or property are sold like Hollywood stars. Rumour and ­innuendo will do the job. Nothing real is necessary.

In 2007, structured mortgage products exposed cash-short borrowers. The defaults snowballed. But, in China, leverage is always rolled over. Default is usually considered a political act. And it never snowballs: the government makes sure of it. In the US, the leverage is mostly in the government. It won’t default, because it can print money.

The most likely cause for the bubble to burst would be the rising political tension in the West. The bubble economy keeps squeezing the middle class, with more debt and less wages. The festering political tension could boil over. Radical politicians aiming for class struggle may rise to the top. The US midterm elections in 2018 and presidential election in 2020 are the events that could upend the applecart.
This is a great comment from a very intelligent economist who obviously knows the major macro forces at work, shaping the global economy.

Xie is right, asset inflation/bubbles have been the focus of central banks. Why? Because central banks don't care about underfunded pensions, millions retiring in poverty, all they care about are big banks and making sure their big private equity and hedge fund clients are in good shape to continue paying them big fees.

Of course, many big US public pensions (and other pensions) have been getting squeezed by large hedge funds and private equity funds charging them hefty fees for a long time, contributing to the unprecedented rise of inequality.

Importantly, large, poorly governed US public pensions getting squeezed on fees as their funded status continues to deteriorate are exacerbating rising inequality (Canada's large, well-governed pensions pay hefty fees too but they also do a lot of direct investing through co-investments lowering overall fees and are for the most part fully-funded even if they're piling on the leverage).

You might think asset inflation in public and private markets is a good thing for all pensions. It is up to a certain point as long as interest rates don't keep plunging to record lows.

Remember, and I keep emphasizing this, pensions are all about managing assets and liabilities, but the duration of assets is lower than the duration of long-dated liabilities, which means a drop in rates disproportionately impacts pension deficits, even if assets keep rising.

But when deflation hits the US, it's game over as we will suffer the worst bear market ever, and it will send rates and asset values plunging, effectively destroying many chronically underfunded pensions.

I keep warning you, the pension storm cometh, and it will be ugly. If you think US pension storms from nowhere are bad now, just wait till the real storm hits us.

I know, Amazon shares (AMZN) are now trading over $1,000 and NVDIA's shares (NVDA) keep defying logic, going up, up, up, just like the rest of the stock market (SPY) (click on images):




Good times! Nothing can stop these central bank-controlled markets. Janet in Wonderland and her global colleagues are in control (or so they want you to think), which is why Jim Chanos and other short-sellers are losing money this year as markets melt up.

Is it time to party like it's 1999? Are we on the cusp of a major parabolic market breakout that will last a couple of more years?

Before you get all excited, let me share with you what one astute hedge fund manager I know, Dimitri Chalvasiotis, sent me last Friday after the close:
Volatility Adjusted SP500, as of Friday’s closing metrics, has reached an historic extreme printed a handful of times since 1971. In other words, going forward, either SP500 declines in value or SP500 realized volatility rises. Rare (mathematical) juncture in time/price (click on image).

In other words, get ready for some rock 'n roll, the silence of the VIX won't last forever, and even if markets keep melting up, all that's happening is downside risks are mounting.

I told you before, I can trade small biotech companies like a lunatic, and likely make great returns (and be stressed out of my mind), but all my money right now is in US long bonds (TLT) which is my highest macro conviction trade going forward (click on image):


As you can see, US long bond prices have been choppy lately as reflationistas talk up Trump's tax cuts and infrastructure spending program.

But with global inflation in freefall, I'm not worried one bit, and think we have yet to see the secular lows in bond yields. I'm not the only one, Van R. Hoisingotn and Lacy Hunt of Hoisington Investment Management wrote another great Quarterly Review where they note the following on the Fed's quantitative tightening (click on image):


Friday's US CPI misses initially weakened the US dollar (UUP) but it came back strong and I think it might retest its weekly lows or just keep surging higher from these levels (click on image):


All I know is what I told you last Friday still stands, as you navigate through these prickly markets, be careful, downside risks are mounting, don't get pricked when you least expect it.

"Leo, that's all fine and dandy but my benchmark is the S&P 500 and as long as it goes up, I'm underperforming and risk losing my highly lucrative portfolio manager job. I simply can't risk underperforming these markets for another year."

I hear you, brothers and sisters, the risks of a melt-up are very real in these central bank controlled markets where hedge fund quants rule the world, but I watch these markets like a hawk and see bubbles everywhere across public and private markets.

So, hold on to your bitcoin hats, and let's get ready to rumble because all it takes is one piece of negative news no one is expecting to send these markets crashing.

By the way, while most macro gods are still in big trouble, Ray Dalio and the folks at Bridgewater are betting over $700 million on the fall of Italian financials.

Mamma Mia! Take that Jim Grant!


In all seriousness, I've been warning everyone that Italy will make Greece and even Spain look like a walk in the park (keep shorting euros here and stay short!).

So, is the bubble economy set to burst? I don't know but listen to professor Richard Thaler who just won the Nobel Economics Prize for his 'nudge' theory setting the foundations for behavioral economics.

Below, Thaler spoke to Bloomberg's Amanda Lang back in June 2016 on misbehavior in economics. Interestingly, if you have a 401(k) plan at work, there’s a good chance that you’re saving more for retirement because of Richard Thaler.

This week, Thaler said these markets make him nervous as vol is too low. You should all heed his warning as the Undiscovered Managers Behavioral Value Fund he helps manage has almost doubled the S&P 500's gains since the beginning of the bull market.

Hope you enjoyed reading my comment. I want to end by thanking the few who subscribe and donate to this blog via PayPal on the top right-hand side under my picture (view web version on your smart phone). I appreciate it and simply want to thank you for your financial support.




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