wknd notes: Stability Breeds Instability

“If voting made a difference, they would make it illegal,” tweeted Julian Assange, Agitator in Chief, tucked tightly into the Ecuadorian Embassy, his home of five years. Madrid had just arrested nine Catalonian democratically elected parliamentarians, charged with rebellion, sedition and embezzlement. 90% of Catalan voters who defied Spanish riot police, voted for independence. Catalonians are not alone in the world. 92% of Iraqi Kurdistan’s voters demanded independence. But no sooner had celebrations settled down than Iraqi (and Iranian) Shiite troops seized control of their capital. Massoud Barzani, Kurdistan’s leader, just resigned. A prolonged civil war has begun. Both Kurdistan and Catalonia represent existential threats to the establishment, its political elites, entrenched economic interests, patronage networks. So naturally, the empire strikes back. In the face of rebellion, that’s what it does. Always, everywhere. And rebellion brews throughout the west. Neglecting to honestly address the profound challenges of ageing populations, declining birthrates, and insolvent entitlement programs, western political elites ceded authority to unelected central bankers in the hope that their policies would magically restore prosperity. The result has been levels of inequality unseen since 1929. Then Brexit shocked Britain’s establishment, terrifying the elite. Make no mistake, had they known the ultimate outcome of that vote they’d have been made illegal; if not overtly, then covertly, demanding a supermajority. In Europe, feeling the centrifugal pull of the fringe parties, the elite now seek more rapid integration to forestall union disintegration, voters be damned. And in America, Trump prevailed despite the extraordinary efforts of the establishment (Republican and Democrat) to undermine his rebellion. Now Senator Elizabeth Warren acknowledges that Hillary Clinton rigged the democratic primary, robbing Bernie Sanders’ impassioned rebels of a fair vote. Thus begins a civil war within the Democratic party. And the repudiation of America’s elite. 

Week-in-Review (expressed in YoY terms): Mon: Japan retail sales +2.2%, reports that Kuroda will be reappointed for 5yr term, Moody’s critical of South Africa budget speech, EU economic confidence 16yr high, German CPI -0.3 to +1.5% (retail sales +4.1%), Italy upgraded by S&P, UK consumer lending +10%, Manafort arrested by Mueller probe, personal spending largest mthly increase since 2009, S&P -0.3%; Tue: China manu PMI -0.4 to 51.6 (employment 49.0 and services PMI -1.1 to 54.3), China and South Korea agree to reset relations, BOJ rates/QE/10yr target unch (-0.1% rates, 80trln Yen/yr asset purchases, and +/- 10bps 10yr), EU unemployment -0.1 to 8.9% (2009 low), EU GDP +0.2 to +2.5%, EU CPI -0.1 to +1.4% (core -0.2 to +0.9%), Mexico Q3 GDP +1.7%, Canada mthly GDP & IP contract in Sept, CME to launch Bitcoin futures, 150mm Facebook users in US subject to Russian-made content, NYC terror attack kills 8, S&P +0.1%; Wed: Nikkei jumps 1.9%, NZ unemployment -0.2 to 4.6%, Brent crude 2yr high, Dax jumps 1.8%, UK home prices +0.2 to +2.5%, Fed rates unch at 1.00-1.25% (indicates Dec hike), ISM manu -2.1 to 58.7, S&P +0.2%; Thur: EU PMI manu 58.5, BOE hikes for 1st time in a decade by 25bps to 0.50% (dovish statement calls for 2 hikes over 3yrs), German unemployment unch at 5.6% (26yr low), Trump nominates Powell as Fed Chair, latest budget proposal reduces mortgage and state tax deductions, Vanguard US inflows top $300bln YTD (exceeding 2016 record with 2mths to go), Tesla delays production and gov’t budget cuts subsidies (stock tanks), Bitcoin break $7k, Q3 productivity +3% (unit labor costs +0.5%), S&P unch; Fri: China tightens rules on outbound M&A activity, China PMI services +0.6 to 51.2, UK PMI services +2.3 to 55.6, Venezuela seeks $89bln debt restructuring, Canada employment surges 35k, US payrolls +261k (unemployment rate -0.1 to 4.1%, underemployment rate -0.4 to 7.9%, labor force participation -0.4 to 62.7, avg hrly earnings -0.4 to +2.4%), ISM services +0.3 to 60.1 (2005 high), S&P +0.3%; Sat/Sun: Saudi Arabia’s Salman orders mass anti-corruption arrests, Saudis intercept Yemeni Houthi missile, Lebanon PM Hariri resigns (cites Iranian assassination concerns), Broadcom plans $100bln bid for Qualcomm.  

Weekly Close: S&P 500 +0.3% and VIX -0.66 at +9.14. Nikkei +2.4%, Shanghai -1.3%, Euro Stoxx +0.7%, Bovespa -2.7%, MSCI World +0.4%, and MSCI Emerging +1.5%. USD rose +2.6% vs Turkey, +2.4% vs Brazil, +1.7% vs Russia, +0.9% vs South Africa, +0.7% vs Sweden, +0.4% vs Sterling, +0.4% vs Mexico, +0.4% vs Australia, +0.4% vs Yen, and flat vs Euro. USD fell -20.4% vs Bitcoin, -0.8% vs Indonesia, -0.8% vs India, -0.3% vs Canada, -0.2% vs Chile, and -0.2% vs China. Gold -0.3%, Silver -0.2%, Oil +2.8%, Copper +0.4%, Iron Ore -0.3%, Corn +0.2%. 5y5y inflation swaps (EU -1bp at 1.66%, US -7bps at 2.23%, JP -3bps at 0.33%, and UK -3bps at 3.37%). 2yr Notes +3bps at 1.62% and 10yr Notes -7bps at 2.33%.

Oct Mthly Close: S&P 500 +2.2% (7th mthly rise) and VIX +0.67 at +10.18. Nikkei +8.1%, Shanghai +1.3%, Euro Stoxx +1.8%, Bovespa +0.0%, MSCI World +1.8%, and MSCI Emerging +3.5%. USD rose +6.4% vs Turkey, +4.9% vs Mexico, +4.2% vs South Africa, +3.4% vs Brazil, +3.3% vs Canada, +2.8% vs Sweden, +2.3% vs Australia, +1.4% vs Euro, +1.4% vs Russia, +1.0% vs Yen, +0.9% vs Sterling, and +0.7% vs Indonesia. USD fell -34.6% vs Bitcoin, -0.8% vs India, -0.6% vs Chile, and -0.3% vs China. Gold -0.8%, Silver +0.1%, Oil +5.3%, Copper +5.6%, Iron Ore -5.7%, Corn -3.0%. 5y5y inflation swaps (EU +4bps at 1.66%, US -4bps at 2.24%, JP -6bps at 0.31%, and UK +2bps at 3.43%). 2yr Notes +12bps at 1.60% and 10yr Notes +5bps at 2.38%.

Manufacturing PMI (high-to-low): Switzerland 62/61.7, Germany 60.6/60.6, Netherlands 60.4/60, Austria 59.4/59.4, Sweden 59.3/63.7, United States 58.7/60.8, Czech Republic 58.5/56.6, Hungary 58.3/59.3, Italy 57.8/56.3, UK 56.3/56, France 56.1/56.1, Spain 55.8/54.3, Norway 54.5/52.3, Canada 54.3/55, Taiwan 53.6/54.2, Poland 53.4/53.7, Japan 52.8/52.9, Turkey 52.8/53.5, Singapore 52.6/52, Greece 52.1/52.8, Vietnam 51.6/53.3, Brazil 51.2/50.9, Russia 51.1/51.9, China 51/51, Hong Kong 50.3/51.2, India 50.3/51.2, South Korea 50.2/50.6, Indonesia 50.1/50.4, South Africa 49.6/48.5, Mexico 49.2/52.8. Services PMI: Sweden 61.4/63.8, Ireland 57.5/58.7, France 57.4/57, UK 55.6/53.6, US 55.3/55.3, Germany 55.2/55.6, Russia 53.9/55.2, India 51.7/50.7, Australia 51.4/52.1, and China 51.2/50.6.

Equilibrium: “Long lasting adjustments occur when large imbalances need to be cured,” said my favorite strategist. “They require decisive policies, without which you can become trapped.” He turned to Tokyo. “70% of Japanese corporates pay no taxes because of the loss-carry-forward from 30yrs ago.” Policy makers never allowed the 1989 collapse to properly cleanse. “This is incredibly inefficient and the government knows exactly what to do.” But no one has the will. “So you end up with this perpetual ho hum outcome, lifted and lowered by the global cycle.” 

Equilibrium II: “This is where Japan finds itself today,” continued the same strategist. “A cyclical upswing and a renewed excitement about Abenomics, but not much changes until they really address the structural issues.” Only Japanese banks are really cheap; trading at 50% of book. “But banks have no loan demand for as far as the eye can see. And the firms that could borrow, invest, and create disruption by wiping out inefficient supply chains are prevented from doing so by government policy to forestall the cleanse of something that happened 30yrs ago.” 

Flush: “We have few big structural imbalances in the US,” he said. “Admittedly there are large generational imbalances but these won’t be cured today.” Entitlements, pensions, states, and municipalities are tomorrow’s problem. “US imbalances are really just financial.” The bank and residential real estate flush from our last crisis has left both in better balance. Student loans are a problem, but not systemic. Same for auto loans. “But we’ve had this financial engineering cycle of buybacks, ETFs, passive strategies, leveraged quant investing, crowding.”

Flush II: “The thing about flushing the excesses of financial engineering is that it can happen quickly,” he continued. “You saw that happen in 1987 for instance. And like then, it need not have a massive impact on the economy.” For financial engineering to take down an economy, its unwind needs to devastate large balance sheets. And it’s not clear where that would happen today. “The next cleanse will be sharp, deep, fast, and will feel like the end of the world, but it won’t be. It’ll slow economic growth for sure, but 18mths later we’ll be back near the highs.”  

Surrender: “The giant miss in this cycle has been the duration of financial repression,” he said. The Bank of England had just hiked rates for the first time in a decade. Doubling them to 0.50%. Faced with an inflation rate of 3% and 5yr/5yr inflation swaps priced at 3.4%, the BOE estimated just two more 25bp interest rate hikes in the coming 3yrs. 10yr government bonds yield 1.26%. For years, every incremental increase in inflation expectations has led to lower real yields. “Financial repression has been so beaten into investors that they appear to have given up.” 

Yoda: “There is no one left at a bottom and no one left at a top,” said Yoda, high in the Rockies, autumn fading, peaks dusted. “Value investors bought the S&P 500 down to 800 in 2009, yet it fell to 666.” That last panic leg found the final seller. “The search for the final buyer has begun,” said Yoda, the market’s biggest S&P 500 local, stepping carefully, deliberate, staff in hand. “We’ll find him, he’s up ahead, dashing for the summit with tax reform fever, just as central banks step slowly away.” A gust swept down the slope, dry, cold. “Most forget that low to high, the S&P rallied 70% in 2009. This is how markets move most when there’s no one left.” 

Anecdote: “The most common example is a ball sitting atop a hill,” she said, polished accent, hint of condescension. “Locally stable, but one nudge and it’s all over.” She drove terribly fast, discussing Minsky Moments; the idea that persistent stability breeds instability. “Naturally each cycle is different in key respects, and that’s because you’re far better at preventing past problems from recurring than new ones from arising.” I smiled, amused, insulted. “Despite knowing this all too well, you humans remain inexplicably fixated on the rearview mirror. And this blinds you to all manner of hazards ahead.” She initiated a few perfect turns of the Tesla, dodging a squirrel or two, tumbling, unhurt. “The source of instability in this cycle is your dissatisfaction with ultra-low bond yields.” $8trln of sovereign debt carries a negative yield, still our central bankers buy. “You should logically respond to this historic rise in valuations across asset classes with a reduction in your expectations for future returns.” I nodded. “But instead you respond with indignation.” So I explained to her that without robust growth and a compounding stream of uninterrupted 7.5% returns, our entitlement systems will implode. They probably will anyway. And lacking the stomach for an honest accounting of this predicament, we prefer to pretend it doesn’t exist. “Is this humor or sarcasm?” she asked. “Both,” I answered. “Fascinating, anyhow, you then demand that we algorithms produce mathematically impossible returns. So we apply leverage, which makes nearly anything possible, even at valuations that are 99th percentile in all of human history. The more leverage we apply, the more stable your system appears. The flatter your hilltop. Naturally, we ensure that today’s leverage looks different from yesterday’s disaster, recognizing your powerful aversion to repeating recent mistakes.” And I stared out the window, lost in thought, fall’s kaleidoscope whizzing by. 

Good luck out there,

Eric Peters