Zero Hedge – 23/02/10
David Roche, former Head Of Morgan Stanley Research And Global Strategy, and currently president of Independent Strategy shares perspectives that should be read closely by any bull who believes that there is anything else to this market rally than pure liquidity driven euphoria riding on the coattails of the Fed’s Quantitative Easing program. Deconstructing one by one all the myths that make up the arsenal of every pundit who appears on CNBC to talk up their book, Ro che concludes « Of course, the insider game between financial institutions and the central banks can go further. But we do not want to be a part of it because it is unsustainable. It is as finite as QE. » And QE is ending in one month, at about the same time when Greece will have to bailed out as its money will finally run out. About 30 days and counting.
First, on the « V-shaped » recovery:
The US economy has to have a V-shaped recovery for the current valuations of equity, oil and commodity to hold. That will not happen for the following reasons. First, consumer income will increasingly be determined by wages, not fiscal handouts. Disposable income will fall as the handouts fade (Figure 2). Despite the manifest profligacy of the US authorities, they cannot repeat their generosity without completely blowing out the fiscal arithmetic and suffering a foreign buyers’ strike for US treasuries. Household savings rates have risen only because government leverage has been transferred to households and used to heft consumer thrift. They will have to rise further and then they will become a net subtraction to consumption. The latest June figures for personal income and consumption showed the biggest fall in income in four years as government handouts fell out of the equation. The savings rate also declined.
Second, there is no need yet for corporations to invest because profits are still lousy and spare capacity is through the roof. Also, the rundown in inventories, to be followed by a restocking (which is supposed to spark an explosion in manufacturing output), will be much less powerful than anticipated because inventory to sales ratios are not lean (Figure 4). Most important, inventory cycles only spark generalised economic recoveries if they lead to job creation and increased corporate investment. Neither is likely because this is a cycle like no other.
Third, the credit machine is impaired and so is demand for credit. This is not only because there are piles of bad debts still to surface from consumers, commercial real estate and highly-leveraged corporate players. The other key reason is that the recent improvement in bank financing is down to central bank money. Wholesale debt markets are only dribbling finance into the banks. Is it really conceivable that the central banks will be able to double or triple their balance sheets to finance a credit-driven consumer recovery while the banks game the central banks to make mega profits? We doubt it.
Fourth, none of the core problems that caused the credit crisis have been addressed. Consumer leverage is worse now that it was then (Figure 7). So is bank leverage. The leverage party cannot be repeated. The savings deficit countries (the US, the UK) must see a return to thrift (which will cap consumer spending). One driver of higher household thrift in deficit-ridden countries is that households and corporations realise that the wrecked balance sheets and budgets of the government sector can only be paid for in one way, down the road — with their money.
The excess savings economies (Japan, China, Europe) are likely to go on being just that (how they invest the savings in the post-dollar standard world is another matter —and that’s bearish for the dollar. This means slow global growth.
Some simple math from Roche.Credit crises end when the economy starts to grow without credit. Credit only expands later (Figure 9). This can happen because, in a credit contraction, the price of assets and goods and services can fall dramatically. Near 90% of the people keep their jobs and work income, so the mass of consumer purchasing power only falls by the amount of unemployment and wage decline.
Households lose about 20% of their wealth. But if the price of things (either stuff in the shops or investments) falls by more than the combined contraction of wealth and income, they have become cheaper in terms of the ability of most households to buy them. Those with money do so. They don’t borrow to buy or invest but they have the cash. Those that don’t are still busy paying down their debts. But the ‘haves’ can have enough purchasing power to move the economy off the bottom. This sort of recovery is self-sustaining. Note government has little to do with it!
If we are wrong on markets it will be because we are wrong on the economy. The markets cannot advance or stay where they are unless the economy fulfils their dreams. If we are wrong on the economy it is because the ‘natural’ recovery described above takes hold.
And a key observation:
After much flaying of our collective souls, we do not think this natural recovery will happen. The reasons are that government interference has prevented prices adjusting as they should. This holds for everything from real estate to equities and consumer products (because government continues to finance excess consumer demand.
As government solvency worsens, households will also be less willing to spend because they know they will have to bail out the government through higher taxes later. Therefore, the twin springs of the natural recovery are broken.
So what is the source of the irrational exuberance? Simple – the Fed’s printing press, and the resultant cash which banks are stuck with which needs to be reinvested into risky assets.
Why are asset markets going up if it so obvious they shouldn’t be? It is too facile to say it’s all down to central banks printing money because most of that money is being hoarded in banks and not being lent onto corporations or individuals.
The secret lies elsewhere. When central banks operate ‘quantitative easing (QE)’, they buy assets outright from financial institutions to expand the money supply. Individuals are not a part of the process. And the mutual fund and ETF figures tell us they are not part of the rally either.
What happens is that the financial institutions sell their treasuries and asset-backed securities to the central bank and get cash or a deposit in return. The Fed now owns 3% of outstanding stock of US treasuries and 12% of agency (mortgage debt). In sum, that adds up to well over $1trn. [these numbers are now stale and have to be revised upward materially].The financial institutions that previously owned these assets now have cash (Figure 13). They don’t want to hold all this cash because it earns little. So they have been reallocating something of the order of $400-600bn to equities (and additional amounts to other risk assets). That is what is driving the rally in these assets. And it tallies more or less with the amount of money needed to move the market the way it has.
Individuals and even hedge funds have played a very minor role. Indeed, individuals have been ploughing their money into bonds and using their cash to pay down debt. One way we could be wrong on markets is if individuals surrender and start buying lots of stocks.
Of course, the insider game between financial institutions and the central banks can go further. But we do not want to be a part of it because it is unsustainable.
It is as finite as QE. Of course, it hurts like hell every day. But so did being a year and half early in predicting the credit crisis.
It is this precise bubble that Bernanke has promised is not happening. Yet it is, and not only in the US, but in China, whose own comparable economic situation, via the dollar peg, has doubled the dry powder available to the world’s two largest central banks. Alas, it also means that just as the rally was liquidity driven on the way up, so it shall implode under its own weight. The question of course is when: As Roche notes: « Is it really conceivable that the central banks will be able to double or triple their balance sheets to finance a credit-driven consumer recovery while the banks game the central banks to make mega profits? » Well, the US already has, and it can not much more. China is already in a liquidity contraction phase, and Japan is irrelevant. Europe is finally realizing it is collapsing in a deflationary environment, so the ECB may very well be the last entity to provide liquidity. However, with the PIIGS situation reaching crisis proportions, we are confident, that very soon it will be every central bank for itself in Europe. When that happens, the scramble for the exit will be amusing, and so will be the lack of the HFT bid that we have all taken for granted for so long.