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The problem with the European Union has never been a lack of stimuli

By David Scott | Monday 24 December 2018


22.12.18.     Source - Trustnet
Source - S&P

The shift to tighter monetary policies in the West is weakening credit markets and over-indebted emerging markets face headwinds from rising borrowing costs and dollar shortages, therefore investors need to focus on their response to financial stresses in an era in which policymakers will be constrained. This means that the “everything bubble” is deflating and the fact that it is happening relatively slowly should not blind investors to the threat. The world is dangerously underestimating how hard it’ll be to deal with the fallout once reality, which has been suspended for ten years, reasserts itself.

Frothy markets cant disguise the warning signs. The shift to tighter monetary policies in the West is putting pressure on global equity and property values. Even more critically, it’s weakening credit markets. Over-indebted emerging markets face headwinds from rising borrowing costs and dollar shortages. At the same time, investors are underestimating how disruptive trade conflicts and sanctions could turn out to be. That’s not to mention rising non-financial risks — from the legal difficulties of the US administration, to the UK’s Brexit debacle, to political instability in France, Germany, Italy and even Saudi Arabia. Uncertainty will impact the real economy, primarily through the wealth effect of declining asset values and a reduced supply of credit.

Investors need to start focusing on how best to respond to a new crisis. The choices are more limited than many realize. Historically, central banks have needed to slash official rates as much as 4-5% in order to offset the effects of a financial crisis or an economic slowdown. That’s why former US Federal Reserve Chair Janet Yellen talked about the need to raise rates in good times — to provide room to cut when necessary.

Yet, even after recent US interest rate hikes, the Fed has nowhere near enough room to cut rates that much without going negative. In Europe and Japan, where rates are already less than zero, easing would require substantially negative levels, which would likely be politically impossible. Even current levels are controversial. Negative rates are a disguised way of writing down debt; they penalize savers and weaken the banking system. Fiscal policy doesn’t offer much of an alternative. In most major economies, it’s already pro-growth albeit to differing degrees. The US government deficit is forecast to rise to $1 trillion as a result of tax cuts and higher public spending, according to the Congressional Budget Office. Most economies are pushing against high and rising government debt levels, as well as substantial unfunded liabilities for pensions and health care. Reversing the planned reduction of central bank balance sheets and restarting quantitative easing isn’t an option everywhere. The Fed can easily purchase government bonds given the increasing financing needs of the US government. But the European Central Bank is restricted by the capital key that governs the proportion of each EU member’s bonds that can be purchased. The Bank of Japan is already buying more than the government is issuing in new debt. In theory, central banks could aggressively expand the asset classes they buy to include corporate and bank debt, or real estate trusts and shares. The ECB, BOJ and the Swiss National Bank have already implemented such programs. But the ECB’s losses on bonds of troubled retailer Steinhoff International Holdings NV show how risky such a strategy can be.

Ultimately, central banks might have to resort to QE variations such as "helicopter money". Originally a thought experiment of Milton Friedman, the government would print money and distribute it to the public to stimulate the economy. To make it palatable, the measure could be packaged as a way to rationalize welfare systems by reducing frictions and administration costs.

Helicopter money would at least deflect criticism of QE programmes as favouring the wealthy and exacerbating inequality, as benefits would accrue to a wider spectrum of the population. Direct intervention, such as lending to or investing in businesses, or taking over banks and large parts of the economy to restart activity, are also possible. Those would be awfully desperate measures, however, which points to the real problem.

Since 2008, governments and central banks have stabilized the situation without fundamentally addressing high debt levels, weak banking systems and excessive financialization. Growth and inflation won’t recover until they’re dealt with. The surprise is that this comes as a surprise to policymakers, given that Japan’s experience since 1990 highlights the limits of available policy tools. In any new crisis, then, policymakers are likely to be badly exposed. Central bank purchases of real estate and equities, helicopter money and more direct intervention could well fail to boost economic activity. That would contribute to a collapse in confidence in authorities, as the sight of governments forced to print money and throw it out of the window or take over markets increases people’s anxiety about the future.

There is already a crisis of trust - a democracy deficit - in many advanced economies, accompanied by rising political tensions. A loss of faith in the supposed technocratic abilities of policymakers to manage economies will compound these pressures. The political economy could then accelerate towards the critical point identified by John Maynard Keynes in 1933, where “we must expect the progressive breakdown of the existing structure of contract and instruments of indebtedness, accompanied by the utter discredit of orthodox leadership in finance and government, with what ultimate outcome we cannot predict.”

The dust is slowly settling after Wednesday’s FOMC rate decision, and more importantly the following press conference where Chairman Jerome Powell literally talked the market down. The Fed still paints a rosy picture for growth in 2019, with GDP expected to rise by 2.3% (though down from 2.5% in Sept), inflation firmly under control with their estimate of preferred PCE measure actually falling to 1.9%, while the outlook for jobs remains robust. The Fed Funds rate was lifted by 25bp to 2.25-2.5%, taking it to the lowest internal estimate of ‘neutral’. The dot plots signalled a median of two further hikes for 2019, rather than the three the FOMC was projecting in September.

On the face of this outlook, the market reaction may seem strange, but the press conference revealed that the Fed was perhaps not quite as confident in its outlook as the statement initially suggested. Powell acknowledged the risks to the economy were broadly balanced, as he stated that by being at the bottom-end of a neutral rate stance the Fed could be more patient over future hikes and that every hike was now data dependent. Before answering several questions, where he knew his comments might appear negative, Powell repeated the Fed’s positive view on the economy, but then went on to let the markets know there was downside to its forecast too. He said there was “significant uncertainty about the ultimate destination of any further rate increases”.

Another interesting comment was that the winding down of the Fed’s balance sheet was “on auto pilot”, and that the primary tool for the Fed going forward was monetary policy. This was good news for anyone worried about the Fed dumping securities onto the market, and served to underpin US Treasuries. For those concerned about the Fed being too hawkish, the constant shrinking of $50bn a month may well have been another worry. Powell said he was not worried about recent market volatility, nor the level of Treasury yields, as this was just a case of market behaviour during a risk off phase. However, he did acknowledge there had been a tightening of financial conditions as a consequence. I would agree, as recent credit spread widening has been significant and have probably had the equivalent effect of another rate hike. On the tightening of financial conditions, Powell commented that the Fed was going to review introducing a countercyclical buffer for the banks in the coming months, but made it clear no decision had been made. If introduced this would be another source of tightening and consistent with an ageing cycle.

All told, the market does not share the Fed’s same rosy outlook for the economy, and the market is worried the Fed may be making a mistake by tightening conditions too far and too quickly. Looking at the market’s reaction overnight and reflecting on the last couple of months, we think investors are broadly carrying too much risk into what they think may be a slowdown; they have been dumping risk assets, and simultaneously buying more ‘risk-free’ assets such as US Treasuries. We expect this trend to continue, sending Treasury yields lower still in the months ahead. We also think it likely that the Fed will wind in its forecast for two further hikes in 2019, as the reality of a less rosy economic picture emerges and the other sources of tightening have an impact alongside the nine hikes already conducted in this ageing cycle. While the Fed could certainly reduce, or even eliminate, their rate hike campaign, the extraction of liquidity is a much more problematic issue. Combined with still elevated valuation, weaker economic growth, and declining profit growth, it is highly likely that serious losses lie ahead for the unprepared. Trend Carefully - Global Financial Markets At Critical Point
The main reason why the ECB quantitative easing program has failed is that it started from a wrong diagnosis of the eurozone’s problem. That the European problem was a demand and liquidity issue due to previous years of excess. The ECB had been receiving tremendous pressure from banks and governments to implement a similar program to the US’ quantitative easing, forgetting that the eurozone had been under strong government stimuli since 2009 and that the problem of the euro-zone was not liquidity, but an interventionist model.

After 2.6 trillion euro purchase program and ultra-low rates:

1. Eurozone PMIs are atrocious. The euro-zone index falls from 52.7 in November to 51.3 in December, well below the consensus forecast of 52.8. More importantly, France’s PMI plummeted from 54.2 in November to a 34-month low of 49.3.
2. Unemployment in the euro-zone, at 8%, is double that of the US and comparable economies. Youth unemployment rate remains at 15%.
3. Economic surprise has plummeted as the ECB balance sheet reached 41% of GDP (vs 21% of the Fed).
4. More than 900 billion euro of non-performing loans remain in the banking system, which keeps a trillion euro timebomb in its balance sheets. A figure that represents 5.1% of total loans compared to 1.5% in the US or Japan.
5. Deficit spending is rising. Government debt to GDP has risen to 86.8%.
6. The number of zombie companies -those that cannot pay interest expenses with operating profits- has soared to more than 9% of all large quoted firms, according to the BIS.
7. Sovereign states have saved around one trillion euro in interest expenses, but have spent all those savings. Today, almost no eurozone country can absorb a modest rise in interest rates, and Italy, Spain, France, Portugal, Slovenia, and others are demanding more spending and more deficits.
8. There is no real secondary market demand for eurozone sovereign bonds at these yields. At the peak of its quantitative easing program, the Federal Reserve was never the sole buyer of Treasuries. There was always a relative secondary market. In the Eurozone, the ECB has been 7 seven times the net issuances of sovereigns. No investor is likely to buy eurozone sovereign bonds at these yields once the ECB steps down.
9. Eurozone growth and inflation estimates have been revised down again in December. Industrial production has fallen sharply.
10. Trichet, the ECB’s predecessor to Mario Draghi, had lowered interest rates from 5% to 1%, injected billions into the economy, buying sovereign bonds in 2011.

What has the ECB been successful at?

·  Keeping the euro alive. Not a small success. The risk of break-up has been contained but not eliminated.
·  Maintaining government spending at low rates. However, at the expense of savers and salaries.
·  Generating a sense of euphoria in financial markets, with high yield and sovereign bonds soaring.
·  Wages in the euro-zone have increased below inflation since QE launched and into the third quarter of 2018. In fact, low inflation has been the biggest unintended success of the ECB. It could have been worse.
·  The biggest “success” of the ECB has been the massive bailout of governments at the expense of savers.

Mario Draghi has been reminding governments on a regular basis that they needed to implement structural reforms, use the period of low rates to deleverage and repeating constantly that his monetary policy experiment will not work without reforms. No one listened and they have gorged on cheap money that attracts and leads to very bad decisions.

A Never-Ending Government Stimulus

With public spending averaging over 46% of GDP, an annual deficit of over 1.7% on average, and 86% debt, talking about austerity is like eating a box of cakes and calling it “diet”The tax burden in this period has been raised throughout the EU (with honourable exceptions, such as Ireland) with an average tax hit of 45% for workers and 40% on companies.

The EU has been a Keynesian stimulus machine before, through and after the crisis.

1) A massive stimulus in 2008 in a “growth and employment plan”. A stimulus of 1.5% of GDP to create “millions of jobs in infrastructure, civil works, interconnections and strategic sectors”. 4.5 million jobs were destroyed and the deficit nearly doubled.
Between 2001 and 2008, money supply in the euro-zone doubled.
2) Two massive sovereign bond repurchase programs with Trichet as ECB President, interest rates down from 4.25% to 1% since 2008. Poor Trichet. Trichet purchased more than 115 billion euros in sovereign bonds.
3) An additional mega stimulus from the ECB, in addition to the TLTRO liquidity programs with Draghi, which has taken sovereign bonds to the lowest yields in history and purchased almost 20% of the total debt of some major states.

The problem of the European Union has never been a lack of stimuli, but an excess of them.

As government expenditure and unproductive investments multiplied, overcapacity remains at levels of 20% and the constant errors of interventionism leave the euro-zone after the biggest monetary experiment in its history with the same high tax wedge and obstacles to the productive sectors. The end of the ECB QE leaves the euro-zone in a weaker position than it was in 2011. Because fiscal stimulus has been exhausted and the ECB, with its balance sheet at 41% of the euro-zone GDP and ultra-low interest rates, has also exhausted its monetary tools. The end of QE does not just show the failure of the ECB’s policy. It highlights the failure of governments’ to enact meaningful reform.
Source - The Daily Shot
Source -  Pictet

Now that the world’s central banking cartel is taking a long-overdue pause from printing money and handing it to the wealthy elite, the collection of asset price bubbles nested within the Everything Bubble are starting to burst. The Central Bankers of the world, particularly, the ECB and the Fed are hoping they can gently deflate the bubbles they created, but this is just fantasy. Bubbles always burst badly; it's their nature to do so and Economic suffering and misery always accompany their termination. Every bubble is in search of a pin and history shows they always manage to find one. History also shows that after the puncturing, commentators obsess over what precise pin triggered it, as if that matters. It doesn’t, because 'cause’ of a bubble's bursting can be anything. It can be a wayward comment by a finance minister, otherwise innocuous at any other time, that spooks a critical European bond market at exactly the right (wrong?) moment, triggering a runaway cascade. Or it might be the routine bankruptcy of a small company that unexpectedly exposes an under-hedged counterparty, thereby setting off a chain reaction across the corporate bond market before the contagion quickly spreads into other key elements of the financial system. Or perhaps it will be the US Justice Department arresting a Chinese technology executive on murky, over-reaching charges to bully an ally into accepting that unilateral US sanctions are to be abided by everyone, regardless of sovereignty. The point is: it doesn’t really matter what the pin actually is. The fatal trigger is often something completely unexpected and impossible to have predicted, so obsessing over what will end the Everything Bubble is wasted time.
Rather than the "pin", what's important to focus on is the "pop" is what will the aftermath be. The duration and height of a bubble is directly correlated with the scope of the destruction its bursting will wreak, as is the number of asset classes that get caught up in the mania. It's more productive to focus our energy on where the damage is going to occur, what path it's most likely to take, and how bad the losses will be -- so that we can position ourselves accordingly in advance for safety and, for the more adventurous, profit. We have never seen anything like the current bubble we are in. Stocks, bonds, real estate, fine art, etc -- nearly everything has been inflated to all-time highs. When this Everything Bubble pops, the pain is going to be wide-ranging. Every bubble requires two essential inputs to fuel its rise:

a compelling story

ample credit

If either is missing, no bubble. Price bubbles are not financial phenomenon, but rather psychological constructs born and nurtured in the human brain stem. Greed and fear -- that’s what drives bubbles. Greed on the way up and then fear on the way down. But neither has much influence without a tempting story and a lot of easy credit. In their all purveying self-belief the world’s central banks are now pursuing their third, largest, and most ill-considered attempt to defeat the business cycle by replacing it with a credit cycle. The fact that the prior two credit cycles blew up spectacularly doesn't seem to be deterring them in the slightest. A rather minor business cycle slowdown in 1994 was fought with a tidal wave of new credit under Greenspan. That ultimately resulted in the Dot Com Bubble crash of 2000, but the lesson went unlearned.  Instead the Fed concluded that the idea was sound, but that it was simply not taken far enough. The elite cheerleading squad fully supported a doubling down, and the media unquestioningly went along with the program. So then Greenspan and Bernanke created the Housing Bubble 1.0 by offering the world’s credit markets a price of money so low it couldn't be refused.
Housing was the story, and the Fed supplied the credit. As predicted by a scant few of us, that all blew up spectacularly in 2008. And no constructive lessons were drawn from that experience, either. With the political cover to "save the system" (from the problems that it created!), Bernanke, Yellen, Kuroda and Draghi then led the most aggressive, coordinated central bank bender in all of human history. $Trillions and $trillions were printed up, and many times that amount were leveraged and loaned throughout the banking and speculative finance conduits. We live in a world awash with credit. $250 trillion in debt. 4 times that amount in unfunded liabilities and a mind-bogglingly massive amount of tangled financial derivatives roughly the same size as both those debts and liabilities put together. Perhaps it will be another institutional failure like Lehman Brothers.  Or maybe a sovereign default.  Just "printing less" is causing the major stock indexes to stumble, while plunging the peripheral emerging markets into bear market territory. 

For now, the Fed and ECB lack the political capital to resume printing anytime soon. The Bank of Japan hardly has the muscle to muster anything more than temporary speed bump on its wind-down. And China increasingly has less and less motivation to help the US financial elites by rescuing their markets for them.  Besides, the Chinese authorities have their own massive collapsing bubbles to contend with right now. All this is as recession indicators are piling up faster and faster now. The Greed Is Now Gone and the recent market volatility is just the beginning of the downslide. There will be many starts and stops along the way, but soon there will be a shock that wakes people up and scares them badly. Quantitative easing did not “cure” the financial crisis. The financial crisis came from incentivising excess risk and debt with central bank policies. Quantitative Easing did exactly the same and made the ultimate resolution a much bigger and harder exercise. 2019 is looking primed to be The Year that the price of easy money is paid back.
Source - gold and

David Scott is an Investment Manager & Market Commentator at Andrews Gwynne

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