I’ll restate my thesis as concisely as I can (not my strong suit): The deeply maladjusted U.S. “Bubble” economy requires $2.5 Trillion or so of net new Credit creation to stem systemic (Credit and economic Bubbles) implosion. Only “government” (Treasury, agency debt, and GSE MBS) debt can, today, fill the gigantic void created with the bursting of the Wall Street/mortgage finance Bubble. The private sector Credit system is severely impaired, and there is as well the reality that the market largely lost trust (loss of “moneyness”) in Wall Street obligations (private-label MBS, CDOs, ABS, auction-rate securities, etc.). The $2.0 Trillion of U.S. “government” Credit creation coupled with the Trillion-plus expansion of Federal Reserve Credit over the past year has stabilized U.S. financial and economic systems.
The synchronized global expansion of government deficits, state obligations, and central bank Credit amounts to an historic government finance Bubble. Markets have thus far embraced the surge of debt issuance. This U.S. and global reflation will have decidedly different characteristics when contrasted to previous Fed and Wall Street-induced reflations.
First off all, the most robust inflationary biases are today domiciled in China, Asia and the emerging markets generally. The debased dollar has provided China and the “developing” world Credit systems unprecedented capacity to inflate (expand Credit/financial claims without fear of spurring a run on their currencies). Asian and emerging markets are outperforming, exacerbating speculative inflows. Things that the “developing” world need (energy/commodities) and want (gold, silver, sugar, etc.) should demonstrate increasingly strong inflationary pressures. Their overflow of dollars provides them, for now, the power to buy whatever they desire.
Here at home, the post-Wall Street Bubble financial landscape ensures the old days of the Fed slashing rates and almost instantaneously stoking mortgage Credit, home price inflation and consumption have run their course. Accordingly, the unfolding reflation will be of a different variety than those of the past – and, importantly, largely bypass U.S. housing. This sets the stage for a lackluster recovery in consumption and economic revival generally. Household sector headwinds will likely be exacerbated by higher-than-expected inflation (especially in energy and globally-traded commodities), higher taxes and rising interest rates.
There is a confluence of factors that expose the market to an upside surprised in yields. The bond market has been overly sanguine, emboldened by the prospect of the Bernanke Fed maintaining ultra-loose monetary policy indefinitely. Bond bulls have been further comforted by the deep structural issues overhanging both the U.S. financial system and economy. However, massive government Credit creation has, for now, put systemic issues on hold. Especially in Asia, unfettered Credit expansion creates the backdrop for a surprisingly speedy economic upsurge. The weak dollar plays a major reflationary role globally, while also raising the prospect for inflationary pressures here at home. Massive issuance, global economic resurgence, heightened inflation and a weak currency are offering increasingly tough competition to the bullish “forever loose policy” view.
Meanwhile, fixed income must gaze at the feverish equities market with disbelief – and rising trepidation. The bond market discerns incessant economic impairment, a historic debt overhang, 9.4% unemployment, and begrudging recovery. An intoxicated stock market ganders something altogether different, with the Morgan Stanley Retail Index up 61% y-t-d, the Morgan Stanley High Tech Index up 47%, the Morgan Stanley Cyclical Index up 52%, and the Broker/Dealers up 45%. The bond market has been content to laugh off the silly equities game. The chuckles may have ended today.
My secular bearish thesis rests upon a major assumption: The U.S. economy is sustained by $2.5 Trillion (or so) of new Credit. Only this amount will stem a downward spiral of asset prices, Credit, incomes, corporate cash flows and government finances. On the other hand, if forthcoming, the $2.5 Trillion of additional – chiefly government-directed and non-productive - Credit will foment problematic Monetary Disorder. In simplest terms, another bout of Credit inflation leads further down the path of unhinged market prices, destabilizing speculation, and unwieldy flows of finance.
The stock market has become illustrative of what we might experience in the way of Monetary Disorder. Speculation has returned with a vengeance, galloping blindly ahead of fledgling little greenish shoots. Those of the bullish persuasion contend that the marketplace is, as it should, simply discounting a rosy future. I would counter that problematic market dynamics have taken over, with prices increasingly disconnected from reality. In short, the market is in the midst of one major short squeeze.
There are myriad risks associated with the government’s unprecedented market interventions. Likely not well appreciated, policymaker actions have forced the destabilizing unwind of huge positions created to hedge against systemic risk (as well as to profit from bearish bets). This reversal of various bear positions has created enormous buying power, especially in the securities of companies (and sectors) most exposed to the Credit downturn. The reversal of bets in the Credit default swap (and bond) market has certainly played a role. Surging junk bond and stock prices have fed one another, as the highly leveraged and vulnerable companies provide phenomenal market returns. The markets are today throwing "money" at the weak and leveraged.
The resulting outperformance of fundamentally weak companies spurred short covering more generally, creating a dynamic whereby heavily shorted stocks became about the best performing sector in the equities market. This dynamic put significant pressure on so-called market neutral strategies that have proliferated over the past few years. The strategy of attempting to own the good companies and short bad ones is faltering, likely causing a flow out of these strategies - and a self-reinforcing unwind of positions. The “bad” stock soar and the “good” ones languish.
There’s nothing like a short squeeze panic to get the markets’ speculative juices flowing. Many will say all’s just fine and dandy – let the fun and games continue! My retort is that the stock market is indicative of the current dysfunctional financial backdrop. At the end of the day, the financial system must be capable of effectively allocating finance and real resources throughout the economy. I would argue that this is not possible for a system that congenitally misprices risk and distorts financial asset prices. Today’s stock market will inherently finance mainly speculative Bubbles and fragility. And the core systemic problem, the maladjusted "Bubble economy," well, the financial backdrop only worsens the situation.
I have great confidence that government finance Bubble dynamics ensure ongoing distortions in the markets’ pricing of risk and, as well, a continued misallocation of resources (financial and real). And it is increasingly clear that the stock market is embroiled in this problematic dynamic. But that is a dilemma for another day, as surging stocks fan optimism and risk embracement – not to mention forcing many into the stock market with both nostrils plugged. And speculative equities and Credit markets will spur increased economic output in the short-run.
Everything has been extraordinary; the boom, the bust, policymaker interventions, and now the bear market rally. I wish I could see some mechanism in the works that will help kick our system’s addiction to easy Credit and commence the inevitable process of economic adjustment and restructuring. Instead, I see confirmation everywhere that policy and market dynamics are working in concert to sustain the existing financial and economic structure. I have huge doubts it will work and no doubt about the risks of failure.
"forcing many into the stock market with both nostrils plugged."
I luv the J. Swift reference. Noland is pure awesome.
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