Download On My Radar: Fed Stuck Between Three Rocks and a Hard Place

On My Radar: Fed Stuck Between Three Rocks and a Hard Place
cmgwealth.com/ri/radar-stuck-three-rocks-hard-place/
April 1, 2016
By Steve Blumenthal
“Now these monetary institutions are expected to continue producing miracles. But their ability to repeatedly pull
new rabbits out of their policy hats has been stretched to an increasingly unsustainable degree.”
-Mohamed A. El-Erian, The Only Game in Town
I walked through Chinatown in San Francisco last week. Block after block, store after store, all selling the same
stuff (t-shirts, trinkets, etc.). Each looked exactly like the other. Susan and I were heading to rent bikes and bike
across the Golden Gate Bridge. That was wildly fun (and so was the wine and calamari in Sausalito). Susan
asked, “How do they all survive?” The short answer is that not all will win. I tried to explain it to her this way.
Some pay rent, others a mortgage and maybe one or two own their business properties outright. Of course, there is
a skill to running a business (purchasing, quality, selection, services, etc.) but not everyone has the gift. Throw debt
into the mix whether it is a mortgage or high rent and your challenges become greater. Easy money has enabled a
lot of people to go into business. In the Chinatown neighborhood, it was restaurants and novelty stores. Debt
enables greater competition and greater competition puts pressure on prices and lower prices put pressure on
margins. Those with high debt and rent bills will be the first to fail.
Suppose the store owner who pays high rent or has a large monthly mortgage payment drops prices by 30%. He is
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desperate to gain market share. Desperate to grow his way out of his financial stress.
Consumers flock to the best price. Sales spike at the expense of the other stores. Profit margins are less and his
plan didn’t work for he or for the neighboring stores. Ultimately, those with high debts go bust first. Bankruptcies,
bank losses, it trickles down. Others follow, the strong survive and with fewer stores in the game, pricing and profit
margins improve. A new economic cycle follows.
Debt creates a level of complexity that when excessive it slows growth and adds to the downside of an economic
cycle. Whether it is government debt, corporate debt, record high consumer credit card debt, record high global
sovereign debt, record high emerging market debt or record high investor margin debt, what is clear, is that debt is
excessive everywhere – thus the fragile state of the global economy.
I believe we need to recognize that we are dealing with a global debt deleveraging cycle that has happened many
times in history, but it tends to occur maybe just once in an individual’s lifetime. To this end, I point you to a great
research piece titled, “How The Economic Machine Works” by Ray Dalio and his team at Bridgewater Associates.
Have your children and grandchildren read it. I think it can help us all be better investors.
Last week I wrote about the détente agreement made in mid-March at a meeting in Shanghai between the
European Central Bank, the Japanese Central Bank, the Chinese Central Bank and the Fed. I tried to explain to
Susan that the global situation is really like the store owners problems when the guy across the street cuts his prices
by 30%.
In simplistic terms, one country can instantly cut its prices by manipulating its currency lower. The hope is that
global consumers will buy from its country. The hope is that it can gain growth, at the expense of its neighbor, and
grow its way out of debt and towards greater economic prosperity. The purpose of the meeting was to negotiate a
truce.
The challenge is debt. We are all up to our eye balls in debt and smart guys pulling the monetary levers think they
can fix the mess. So back to that complexity thing. A strong dollar slows U.S. growth and profits for our multinational corporations. It drives capital into the U.S. and out of emerging markets. When the nearly $10 trillion in
emerging market debt comes due, if the dollar is 30% higher (like it has grown over the last several years) the
borrower must pay back to U.S. banks and lenders 30% more. Borrow $8 trillion, and pay back $10.4 trillion. If
China lowers versus the Yen and the Euro, what does that do to global capital flows, global sales and debt owed?
What does it do to other Asian or Latin American borrowers who thought they were getting a deal expecting the
dollar to move lower? At the time, it looked like the dollar was heading lower, not 30% higher.
Currency wars are where countries manipulate their currencies to gain a trade advantage, like the example above,
at the expense of the other store owners (countries). Their intentions can be domestic and they should be, but the
ripple effects can be significant. Add in sizable debt and they can cause major disruption and crisis.
The Fed agreed to backtrack on the rate hike thing with Janet Yellen sounding more dovish than she has since
taking office. That is a major change from her comments in December and January.
So the big four store owners that account for roughly 70% of the global GDP got together and agreed “that monetary
policies involving a currency devaluation by the Europeans and Japanese, or monetary policies involving currency
appreciation by the US, would be counterproductive.” (See David Zervos of Jefferies section in last week’s OMR
here.)
Come on, folks. Add this to that they are making it up as they go, pause, test the waters, gauge the impact, pause,
invent, gauge, move forward: what the Fed has seen each time they signaled a rate increase is another round of
equity market turmoil. They saw what happened to the global markets (equity market turmoil) in August and again
in January when China devalued its currency. Dovish comments in March and it turned out to be one of the best
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market performance months on record.
It’s “All ‘bout that Fed”…
For now, the global four central bankers feel they can’t risk a Chinese currency devaluation or a stronger dollar. The
Chinese further devaluing (de-pegging) the yuan or the Fed raising rates will drive the dollar higher. Call it a truce
for now, but some store owners have greater debts and thinner margins than the others. It won’t be long before
someone becomes desperate and breaks the truce.
Zero-bound interest rates, QEs 1, 2 and 3. LTRO. Asset purchases. Negative interest rates. And that’s the
currency war. It is not just them against the U.S. It is all against each other. Debt is the significant problem.
The Fed is stuck between three rocks and a hard place. We have reached a highly fragile co-dependent state. We
tick forward but I personally believe someone will break the latest currency truce.
To get a sense for just one of the store owners, in this case, China, I share a great piece from RBS below. RBS
concludes, “Our previous view of China experiencing a ‘bumpy’ landing is changing. A ‘hard-landing’ is now the
most likely scenario. China’s slowdown is already impacting the global economy through the channels of growth,
trade, inflation, interest rate expectations and financial linkages. There is more to come on all these fronts.”
Scratch China from the global growth hope picture (at least for now). Japan is, in my opinion, nearing its end game.
Europe has its unique integration and political challenges and there too the debt is big.
The Fed is beyond thinking about domestic issues – employment and inflation. As Janet Yellen stated recently,
“The international situation poses a great danger to financial stability and thus should be a key factor in determining
the timing of future monetary policy moves.”
As David Zervos puts it, “These implicit agreements now allow the Chinese to carefully unwind their domestic
asset/debt bubble, and slowly decouple the CNH from the USD. Of course this is a fragile agreement, because if
any one party deviates, the peg breaks and the 1998 style fireworks begin.”
So I tried to explain this to Susan to which I think she got most of it. Complex. The business cycle involves billions
of people acting in their own self-interest. Business cycles go through periods of boom to bust and bust to boom. It
can be slowed but it can’t be stopped. We’ve seen two in the last 16 years.
Like early 2000 and 2007, don’t let the recent Fed-related gains trick you into thinking this time is different.
Valuations are way too high and probable forward returns are low. Risk is high.
Next week we’ll take a look at the March month-end valuations. They will come in higher.
Included in this week’s On My Radar:
RBS: China’s Economy: Slowing Distorted And Debt-Addicted
RBS: China’s Economy: Slowing Distorted And Debt-Addicted
Following is a great piece from RBS highlighted in bullet point format:
China – The problems behind the headlines.
China’s economy is:
Slowing — GDP growth has slowed more than the headline figures suggest, investment and production in
particular
Distorted – overly reliant on investment with little sign of rebalancing
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Distorted – overly reliant on investment with little sign of rebalancing
Debt-addicted – a post-crisis debt build-up that is proving hard to shake off
Coupled with ad-hoc and uncoordinated policy we believe China is more likely in a hard landing than a
‘bumpy landing’.
GDP growth – always on the money
China’s GDP growth figure always comes in remarkably close to target
And it’s never revised
By the admission of the Prime Minister GDP data is “unreliable”
It’s difficult estimating China’s ‘true’ growth rate
But a figure of around 3-4% seems reasonable.
But investment has slowed sharply
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China’s post-crisis investment boom is unwinding.
Demand weakness at home and abroad, as well as existing excess capacity, has dented manufacturing
investment growth.
The property market is starting to work through the inventory overhang. But property investment has stopped
growing.
And so has industrial production
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All the years of excess investment has left a legacy of excess capacity.
And the slowdown in investment means China’s heavy industries are having a tough time of it.
Electricity, cement and steel production are all experiencing y/y declines.
The disinflationary winds blow -5
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China has had periods of cooler credit growth. The problem is they are not sustained. The debt addiction is
proving hard to shake.
December 2015 saw strong credit growth with bond financing picking up.
The concern is that current borrowing is good money after bad, with a lot going to finance existing debts.
How can this debt build-up be pain free?
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$6.5bn per day – the rise in China’s non-financial private sector debt since the crisis.
As we have previously stated, a similar pace of debt increase in other countries has led to a financial crisis.
The burden of China’s debt build-up debt has led to a sharp rise in debt servicing costs.
The rise in corporate sector debt in China and Hong Kong is staggering.
RBS raps up their thoughts on China as follows:
Forget equities, look at policy
2016 has been marked by falls in China’s currency and equities.
The equity sell-off tells us little about China’s wider economy. But the policy response does.
In recent months economic policy in China has been reactive, ad-hoc and seemingly uncoordinated between
state institutions.
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And more fundamentally it shows there is a reluctance on the part of the authorities to let the market have the
And more fundamentally it shows there is a reluctance on the part of the authorities to let the market have the
final say in the setting of prices in the economy.
The problems with pushing ahead with reforms
Policy makers’ reluctance over market reform reflects two things
1. Conflict within the Chinese Communist Party (CCP) about reform. Vested interest groups appear more
entrenched than previously thought.
2. Letting the market have the final say in the setting of prices too readily conflicts with the CCP’s aims of
social stability and therefore the primacy of the Party.
Authorities struggling with macroeconomic management and crisis mitigation more than previously thought.
This gives us less confidence the CCP can do/ will do the right thing when it comes to reform and cleaning up
the banking sector.
…and finally
China’s debt binge — which has yet to begin unwinding — remains too readily dismissed by the consensus.
Our previous view of China experiencing a ‘bumpy’ landing is changing. A ‘hard-landing’ is now the most
likely scenario. (SB: emphasis mine)
China’s slowdown is already impacting the global economy through the channels of growth, trade, inflation,
interest rate expectations and financial linkages. There is more to come on all these fronts.
We will elaborate more on this view and the impact it will have on the UK and global economies in a future
release.
Click here for the full piece:
http://www.valuewalk.com/2016/03/china-economy-slowing-distorted-and-debt-addicted/?
utm_source=mailchimp&utm_medium=email&utm_campaign=EMAIL_DAILY&utm_content=quick_link&utm_source
=ValueWalk
Ok – you get the point… complexity. Can the Fed hold the gang together? I have my doubts. I don’t think they
can. Don’t for a second underestimate the risk imbedded in the current system.
Personal Note
The Fed’s afraid to tighten and they probably should be as the global economy is near or in recession. The markets
reacted poorly from the taper tantrum in May 2013 to every hawkish comment to the December rate hike. A second
hike at this point may cause a major sell-off.
Frankly, I’d be far less concerned about risk if valuations were attractive. To that end, I’ve just concluded a white
paper, The Total Portfolio Solution. Hopefully, we’ll have the piece back from our publisher next week. I can’t wait to
get your feedback. In one of the sections of the paper, we sort all median P/Es into five categories ranging from
least expensive to most expensive. I shared this in last week’s Trade Signals but bear with me as I post it again.
Here is what the returns look like in each category (note that the subsequent 10-year annualized returns were best
when valuations were in quintile 1 and declined as valuations became expensive. We sit well into quintile 5 today):
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And here is what the risk looks like (note how much less the risk was in quintile 1 vs. 4 and 5):
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And a slightly different look on downside risk from GMO based on Shiller PE:
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I don’t know when the impact of Fed policy and the other big three, but I do believe the Fed is stuck between those
three rocks and a hard place. If valuations were favorable, big deal… hold and grind it out for the 10-year returns
would likely be good. That is just not the case today. We are in a global debt deleveraging cycle – one in which
most of us have never seen before.
Ok, if you are reading this in the morning, grab a coffee and jump on in. If you are reading it in the evening, grab a
great glass of wine or your favorite drink and don’t get depressed.
There are ways to make money and you can and should hedge your equity exposure. I have a few home run type
of risks I’m personally trading but that is my home run money. I saw it building in 2007 and 2008 and I don’t want to
miss out this time. Like back then, even being right doesn’t mean you’ll make money.
If you watched The Big Short, you know some traders got in early and couldn’t take the declines that occurred on the
way to a very big win. So I’m budgeting an amount I can afford to lose with the balance of my wealth broadly
invested in our diverse strategies.
All the very best to you and your family.
With kind regards,
Steve
Stephen B. Blumenthal
Chairman & CEO
CMG Capital Management Group, Inc.
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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Chairman and
CEO. Steve authors a free weekly e-letter entitled, On My Radar. The letter is designed to bring clarity on the
economy, interest rates, valuations and market trend and what that all means in regards to investment opportunities
and portfolio positioning. Click here to receive his free weekly e-letter.
A Note on Investment Process:
From an investment management perspective, I’ve followed, managed and written about trend following and
investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable
rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that
are included within a broadly diversified total portfolio solution.
My objective is to position in line with the equity and fixed income market’s primary trends. I believe risk
management is paramount in a long-term investment process. When to hedge, when to become more aggressive,
etc.
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