A Contrarian Gives Thanks

Oct. 7, 2015: Families for Excellent Schools rally for equality

Italians can be quirkily superstitious souls. When written in Roman numerals, XVII, a.k.a. 17, can be re-arranged to spell VIXI, as in Latin for, “My life is over.” Funny thing, it’s not Friday the 13th that spooks those of Roman heritage as much as Friday the 17th. In fact, 13 is still considered to be a lucky number in many Italian quarters, especially in places like Monaco and Macau.

This week’s very American tradition has been given short shrift by the decorators at large who appear to have misplaced Thanksgiving on their calendars. How else could millions of Christmas trees magically appeared the minute the last Trick or Treat was posited on the West Coast?

To punctuate my dismay at the rush to the holiday races, I thought this week would be a good time to pause and give thanks for the many things for which we have to be grateful. For those of you who’ve wondered if I’ve ever seen a glass that’s half full, this proud to be of Italian American heritage henceforth offers out 13 optimistic observations starting with the markets and ending with what’s really the most important thing to all of us.

 

  1. Be thankful that some sanity has returned to credit markets. I think we all agree that five percent yields on junk bonds are a bit irrational. It is therefore reassuring to see yields pushing the seven-percent mark reflecting a more realistic risk/return tradeoff. High yield as an asset class has lost about four percent on the year. That’s not so bad considering the weakness in energy prices, which themselves have provided budgetary relief for many households.

 

  1. News that cracks have started to appear in some of the frothiest coastal housing markets can only be construed as good news to would-be first time homebuyers. At 31 percent of October sales, the ranks of first-timers have improved off their 26-percent December 2013 low. Getting back up to a ‘normal’ 40 percent all but requires home prices to fall, which will naturally follow a slowdown in sales. A bonus: home equity withdrawal has slowed providing evidence that Americans are better preparing for their retirement years.

 

  1. Location continues to matter in a country where doing business can be a challenging exercise. With that it’s heartening to see so many states competing for new business. A recent study found that the bulk of the 9,000 businesses that have relocated or diverted business from California over the past seven years have landed in the Lone Star State. Rounding out the top ten are Nevada, Arizona, Colorado, Washington, Oregon, North Carolina, Florida, Georgia and Virginia. Bear in mind, these are purely business decisions: the cost savings that resulted amounted to 20 to 35 percent.

 

  1. A good state in which to conduct business is not necessarily a good state in which to invest one’s hard earned savings. With that, we should be thankful for the opportunities presented in coming years in the municipal bond market. As weak states confront deepening pension challenges, it will be critical to have a strong municipal maverick in your corner. There will be great entry points when good credits get hit with headline contagion. A good primer to familiarize yourself with the lay of the land: http://mercatus.org/statefiscalrankings.

 

  1. Forget the gridlock in DC. New York City’s traffic gridlock has never been as intense as it is today. With that we should all be thankful for the powerhouse combination of Uber and Waze and all of the other apps we never knew would make our quality of life that much better, or at least more bearable. Give thanks that we remain a nation of innovation and a charitable one at that. Our collective entrepreneurial spirit can never be quashed.

 

  1. Despite near record valuations in you-name-the-asset-class, a few independent voices manage to be neither hysterical nor delusional about the markets’ prospects. I am thankful to call many my friends including Jim Bianco, Peter Boockvar, Arthur Cashin, Brent Donnelly, Philippa Dunne, Richard Hill, Doug Kass, David Kotok (and the whole Maine fishing crew, especially my capable and economically well-versed fishing guide J.R.), Michael Lewitt, Michelle Meyer, Oleg Melentyev, John Mousseau, Barry Ritholtz, David Rosenberg, Josh Rosner, Tiina Siilaberg, Liz Ann Sonders and Chris Whalen, among others.

 

I would add that I am deeply grateful for having had the privilege of working with Richard Fisher, David Luttrell, Zoltan Pozsar, Harvey Rosenblum, Jeremy Stein, Joshua Zorsky and Teresa Bermensolo-Cutler.

 

  1. In a world overrun by mad scientist central bankers, we should all be thankful for the Reserve Bank of Australia. There’s been no such thing as a perfect backdrop for monetary policymakers in recent years. The global economy has hurled from boom to bust and back again buffeted most recently by a commodity supercycle unwind. It would have been all too easy for Australian central bankers to respond by injecting stimulus into the economy. Leaning against the wind, however, was their chosen path. How very luxurious to have two whole percentage points at their disposal in the event of a true economic calamity.

 

  1. Our nation should be thankful to live in an “era of energy abundance,” basking in the riches we’ve produced on the path to independence. So says resident expert and friend Randy Randolph of Southern Gas Association. That’s not to say the Shangri la of energy independence is not in the cards. Achieving this ultimate goal requires a comprehensive and visionary energy policy that recognizes the eventual benefits of exporting and investing in a natural gas grid. In the meantime, the U.S. is the largest producer of petroleum and natural gas hydrocarbons ensuring a permanent shift in the balance of power on the world stage.

 

  1. The terrorist attacks in France have given politicians worldwide a new standard to which to aspire. French President Francois Hollande may not jump to mind as a national hero in this country but he should. Hollande’s immediate imposition of a state of emergency and declaration that the attacks were, “an act of war perpetrated by a terrorist army” left no doubt he’s a man of action. He’s taken advantage of the latitude availed him by the French constitution to attack Syria as it should have been long ago. Hollande has added that Assad cannot be part of the future and that the Kurds must be supported. Solidarity will not suffice, he rightly says. The world must act together. How can we not be thankful for decisiveness in the face of evil?

 

  1. Where is the American Dream? The answer to this question was demanded by thousands of single African American mothers who marched across the Brooklyn Bridge in October. Their plea was a simple one: Find the space to open more charter schools that outperform the public schools. Quit leaving so many American students behind. The stakes are enormous. According to a new study, one in five American families led by those with college degrees attain millionaire status by age 40. At a minimum, liberate future generations with the literacy to choose their path, whether it be vocational or a four-year degree. Closing the inequality gap for the greater good, for the country’s long term prosperity requires we educate each and every American and do it well. Be thankful for parents who have hit their pain threshold on their children’s behalf.

 

  1. Forget for a moment their colorful or not-so-colorful personalities. Ask yourself what it means that so many outsiders have garnered so much support in the current presidential election. It can’t be as simplistic as angry, uneducated Americans drinking spiteful Kool-Aid. That doesn’t capture the breadth of supporters. Perhaps Americans across the entire income strata have begun to sense that the present path has little to do with what our founding fathers envisioned.

 

  1. Life is funny in the way you don’t appreciate some of the most important episodes you’re taking a part in until many years later. With that in mind, I will never not be thankful for having taken a first amendment class in the year 2000 with Anthony Lewis and Vincent Blasi. The Columbia Journalism School academic experience, if you could call it that, left an indelible mark on my identity as a citizen of this country. Blasi’s greatest conviction: the abuse of official power to achieve an end is the gravest of sins. The remedy: a strong and well-financed media to always shine a bright light.Lewis, a man of many wise words, captured the very essence of what it is we all must hold dear and true and for which we must be ultimately thankful: “With one terrible exception, the Civil War, law and the Constitution have kept America whole and free.”

 

  1. The last, lucky 13th gift this Thanksgiving is the most cherished — family, faith and friends. They are the ties that bind, our past, present and future, both in this world and beyond.

 

I will add that I am thankful for you, those who have become loyal and steadfast readers over the past five months. The feedback has been humbling and endearing and I do give thanks knowing you take the time week in and week out. Happy Thanksgiving.

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Last Sighting at the Machus Red Fox

Machos Red FoxDid the mafia assassinate JFK? Was Jimmy Hoffa the man behind the setup? Does the government put fluoride in our water to gain control of our minds? Was the lunar landing staged in a Hollywood studio? Is Elvis alive? Is Paul McCartney dead? Did President Roosevelt plan Pearl Harbor? Does a lightbulb exist that never burns out? Has oil peaked? Are companies brainwashing us with subliminal advertising? Are the Freemasons intent on creating a New World Order? Did aliens land in Roswell? Is everything a conspiracy, including conspiracies themselves? Will we ever know?

Conspiracy theories are a form of high or maybe low mental entertainment. Still, perhaps it’s best to let all of those sleeping dogs lie and focus on what we do know. After nearly a decade on the inside of a highly secretive institution, a.k.a. the Federal Reserve, it came as quite a shock to have several theories assumed to be dreamed up by crackpots validated by fact. Not only are Federal Open Market Committee (FOMC) meeting minutes methodically manipulated, the actual transcripts of the meetings contain overt omissions.

Bear in mind, the Fed was never legally obligated to release the full contents of the audio-recorded transcripts. In fact, it wasn’t until 1993 that the central bank bowed to Congressional pressure to be more forthright about its deliberations. Even so, the five-year lag time (ahem) between meeting and transcript release provides ample time to ensure history is properly recorded.

According to the Fed website, the FOMC Secretariat is quite the taskmaster:

“Beginning with the 1994 meetings, the FOMC Secretariat has produced the transcripts shortly after each meeting from an audio recording of the proceedings, lightly editing the speakers’ original words, where necessary, to facilitate the reader’s understanding (emphasis added). Meeting participants are given an opportunity within the subsequent several weeks to review the transcript for accuracy.”

So the transcriber has leeway to ensure the public is not confused. And participants can make sure they really meant what they said over the ensuing five-year stretch.

News that transcripts are subject to redaction highlights the importance of what is permitted to remain in the public purview. Take this insightful suggestion, recorded as having been said by now Chair Janet Yellen in a transcript from the December 16, 2008 FOMC meeting: “We could also consider using the FOMC minutes to provide quantitative information on our expectations.”

In other words, the verbiage of the minutes can be deployed in the same manner as any other tool at policymakers’ disposal. That was presumably good news to the monetary powers that were as their traditional capabilities to relieve the stresses ravaging the economy were pressing their outer limits.

Consider the historic backdrop of the meeting; it cannot be underemphasized. The economy was in full-blown meltdown mode. Lehman Brothers had failed in September followed immediately by AIG being saved. The unemployment rate had hit 6.7 percent and was rising fast: it would peak at 10.0 percent nine months later. Investment activity was plunging as was the stock market on its way to its March 2009 lows. And those home prices the very same Fed authorities said would never decline on a nationwide basis were crashing. Meanwhile, most of the world’s economies were also in recession.

As for policymakers, they stood at the precipice of the unknown. Their conventional tool of positive interest rates had been all but depleted. Recall that Yellen’s words were said at the meeting at which interest rates were voted to the zero bound. Just days before, on November 25, 2008, the Fed had announced plans to begin purchasing up to $600 billion of securities backed by mortgages to try to loosen the vise of nonexistent mortgage credit availability. Unconventional policy had officially left the launch pad.

When the December 2008 meeting minutes were released, with their usual three-week lag, they painted a harmonious picture of camaraderie and congeniality. Take this case in point which elaborates on the collective thinking behind the crossing of the policy Rubicon:

“Participants emphasized that the ultimate objective of special lending facilities and asset purchases was to support overall market functioning, financial intermediation, and economic growth. Participants acknowledged that the effective federal funds rate probably would need to remain very low for some time.

However, they also recognized that, as economic activity recovered and financial conditions normalized, the use of certain policy tools would need to be scaled back, the size of the balance sheet and level of excess reserves would need to be reduced, and the Committee’s policy framework would return to focus on the level of the federal funds rate.”

It’s hard to believe that nearly seven years have passed lending new meaning to, “remain very low for some time.” As for the federal funds rate at which banks lent each other money in the overnight market, it’s become a financial relic few contemporary bond traders can contemplate.

Not surprisingly, each FOMC minutes release is more anticipated than the last. With the markets and the economist community in sync with their expectation that the Fed is at its first major crossroads in nearly a decade, all hands are on deck.

Few doubts remain about the probability of the first increase in interest rates in nine years on December 16. Some had anticipated that the tragic assaults on the City of Lights would trigger panic in the markets sending the Fed to the sidelines. But that didn’t happen. Confounding many market watchers, the stock market rallied hard on the Monday after the attacks.

The Financial Times’ John Authers tweeted out the following in response to the surreal market behavior: “Paris attacks have had little or no impact on markets so far. Perhaps that’s a little worrying.”

Yours truly re-tweeted Authers’ post adding, “It is unsettling that nothing unsettles markets.”

God help us if the buoyancy in stock prices reflects anticipation that the European Central Bank will expand its own securities purchase campaign to offset the inevitable economic consequences of the terrorist attacks. When will markets wake up to the fact less just might be more in the end?

As for the Fed, it can and will take the opportunity of the release of the minutes of its October deliberations to crystallize its intentions. In deliberately subtle fashion, the lengthy minutes should lean away from an overemphasis on labor market metrics paying after-the-fact homage to the latest job creation figures.

By the opposite token, the persistent weakness in retail sales and manufacturing activity outside of the auto sector should be hinted at. The renewed decline in oil prices, which promises to shrink further the ranks of the handsomely compensated and keep a lid on inflation for a bit longer, can also be alluded to.

What the minutes can’t do is time travel in anticipation of future events. No acknowledgement of the attack on France can thus be on display.

The October meeting minutes are as good as the Fed’s last dance. On this stage, policymakers can reinforce the FOMC statement’s pointed message that December will mark lift-off barring a calamity in the economic data and/or financial markets.

It’s imperative to understand that the Fed is not alone in operating in obscurity. If anything, its international central banking counterparts are less transparent with regard to their decision-making processes.

But that doesn’t make business as usual all good and well. The decisions of central banks directly affect their de facto constituents, especially in a world in which they wield more power than elected officials. The individual contributors who are the building blocks of a country’s economic output can handle, and more importantly, deserve the truth.

Demanding accountability of the Fed is in no way borne of a conspiracy hatched by pot stirrers. It’s one thing for enthusiasts to relish in speculating what became of Jimmy Hoffa after that last sighting at Detroit’s Machus Red Fox restaurant. It’s a much more serious matter to be dismissive of the legitimate need to communicate clearly the method to the “magic” of central banking.

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An Open Letter to the Debate Team

debate imageDear Madame and Sirs,

“We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand.” In 1930, John Maynard Keynes worried about how economic events had unfolded following the 1929 stock market crash penned these words.

It is not often that John Maynard Keynes’ words grace these pages. That may have more to do with the exaggerated reputation the legendary economist has posthumously earned in a world flooded with central bank-generated debt. It is convenient, if not fully grounded, to credit Keynes with the inspiration to keep interest rates anchored at the so-called zero bound in the name of sustaining an economic expansion.

In truth, Keynes is probably spinning in his grave given the magnitude of what those in the financial markets have come to know affectionately as QE, for quantitative easing. QE involves central banks buying their country’s debt in various forms. The hope is that purchase proceeds will flow back into the economy by way of higher asset prices, especially those of stocks. Emboldened by the higher share price, corporations are thus incented to expand their businesses and workforces placing the economy on a self-sustaining path to prosperity that can then be weaned off central bank life support.

If only.

The above Keynes quote was reprinted in a 2009 Sunday New York Times book review of The Lords of Finance: The Bankers Who Broke the World. If Liaquat Ahamed’s seminal work resonated in 2009, it screams to be re-read in 2015. The ‘Lords’ referenced in the book title were the most powerful central bankers in history, that is, until now. The “delicate machine” Keynes cited was the global economy.

The crippled state of the political and economic landscape following World War I created an environment in which central bankers were able to establish an unprecedented power base. The more married the ‘Lords’ were to the gold standard, the closer to the brink the world economy drew. Gold stocks were concentrated mainly in America and France. This required other postwar economies such as England, where gold was scarce, to borrow to finance trade with the rest of the world.

The bottom line is there was simply not enough gold to go around. This necessitated those without it to borrow and to use the levers of interest rates and government spending to replenish their gold reserves. On the losing side was employment, which suffered the circumstances of the boom/bust-inducing policy.

Why the history lesson?

Dispensing with history has never been wise. Back in the 1920s, it was a deeper sin than that of hubris. The central bankers, whose decisions largely led to the Great Depression, were mired in myopia. Their marriage to a singular ideal to help the post-WWI economy recover succeeded only in bringing it to its knees.

History could well prove that today’s central bankers are even more infected with tunnel vision. A protracted overly-easy monetary policy has subjected the world economy to a damaging rollercoaster existence for nearly 30 years. QE is now seen as the antidote to cure all ills everywhere in the world.

Some $12.5 trillion into this global QE experiment, it is time for elected politicians to take back their leadership role, one they long ago abdicated to monetary authorities.

As for those of you on stage this evening, ask yourself some difficult questions about righting the U.S. economy as you ponder winning the opportunity to be one of these new world leaders: 

  1. Under the assumption that the Fed has not killed the business cycle, how will you prepare for the recession that’s sure to challenge you as you cross the threshold into the Oval Office?
  1. Will you have the political will and wherewithal to direct future fiscal relief efforts to retrain workers who lose their jobs rather than indenturing them to a welfare state? Think of how much better off and proud millions of Americans would be today if they were still contributing to this great country’s economic wellbeing.
  1. Can you simplify the tax code once and for all? Can you pledge to retire Warren Buffet’s quip that his secretary pays taxes at a higher rate than he does? Can you put a nail in the coffin of the mortgage tax deduction for the wealthy? Can you take on the lobbyists?
  1. Can you rewrite our national energy policy? We already are an energy-independent nation. Invest in converting the country to a natural gas grid as a sign of respect for the sacrifice our fighting men and women make to protect our very freedom.
  1. How will you address the thorny issue of reengineering the Federal Reserve? Will you have the ability to bring Congress together to recognize that we’re not a third world country, that there is no ‘Ending the Fed’? By the same token, we’re not the same country we were over 100 years ago when the Fed was established; this must be reflected in a thoughtful revamping of the institution.
  1. Is your voice strong enough to be heard by a public that’s been brainwashed into believing living beyond its means represents a way out? Buying more house and car than what’s affordable just because it can be financed was probably not on the to-do list of our founding fathers.
  1. Should you be elected with interest rates still historically low, will you have the prescience to follow Austria, Canada, England, Mexico and Switzerland, to name a few, and borrow at maturities of 50 and 100 years to indemnify the nation’s balance sheet?
  1. On a related note, how can you work with the other branches of government to address the building risks in the public pension system? Pension portfolios are filled with investments that are not only overly risky but increasingly illiquid, placing pensioners in grave peril. The city of Denver has been reduced to cutting tulips from its budget to offset the need for greater pension funding. What happens when it’s more than flowers, when public services are on the cutting block?
  1. Saving the most difficult for last: What will you do to address the sanctity of the U.S. dollar? What is your vision for successfully tackling entitlement reform in the wake of so many others who have tried and failed? The Chinese are banking on political intractability as they envision unseating the dollar as the reserve currency.

 

Just imagine if you were the leader who could answer even half of those calls to duty. Tackle the seemingly impossible issues and you open the door to what really matters. Commit to reform the educational system that’s annihilated the American Dream.

Know that your challenge really does start with the Fed. Today’s central bankers are more powerful than at any time in history. Just as was the case in the Roaring 20s, they ‘Lord’ over their political underlings with the ultimate weapon of cheap money. Take the reins back. Lead fearlessly through an inevitable recession. In doing so, set the stage to maintain the country’s status as the superpower for generations to come.

Sincerely,

 

Danielle DiMartino Booth
President Money Strong, LLC

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Night Diving

The-Great-Blue-Hole

There’s little difference between deep faith and night diving. At the very least, the former is required to do the latter. This I discovered the hard way when my flashlight failed to provide even a glimmer of light after my descent into a pitch black depth of 60 feet. What had I gotten myself into? It certainly had sounded like the getaway of getaways for the young thrill seeker that I was then – 17 dives in 7 days off Long Caye in the crystal clear waters off the Belizean coast. The good news is I found my guide before a creature of the deep night found me. This thankfully helped to stifle the hyperventilating, which is never recommended when oxygen is a finite tanked resource. The better news is I was able to take in some of the wonders of nocturnal nautical nightlife which left me with some mean midnight cravings for crustaceans. Luckily such delicacies can be easily procured in the Caribbean. As thrilling as night dives can be, it was just as well that most dives were set under a blazing tropical sky.

Over the last seven years, debt issuers of all stripes have likewise basked in an idyllic, sunny setting, pampered by investors’ seemingly insatiable hunger for any security offering a yield north of nothing. What were once hyperbolic headlines are now so very ho-hum. Consider Exhibit One: Monday’s front page Wall Street Journal’s, “Corporate Bond Market Heats Up.” The newsworthiness gets stale after seeing the same explanation year in and year out – that issuance is surging thanks to “efforts by corporate treasurers to lock in low interest rates before a possible Federal Reserve interest-rate increase in December.” The end result of four consecutive years of record-breaking sales catalyzed by a perma-possibility is that outstanding U.S. corporate debt is closing in on the $40 trillion mark, which dwarfs the $27 trillion U.S. stock market.

These lofty figures have led market watchers and policymakers alike to angst about the true depth of the pools in which trades are executed in the vast fixed income markets. The truth is dangers may be lurking in what are perceived to be the safest waters. I can’t help but to bring Deutsche Bank’s Oleg Melentyev, who’s graced these pages in the past, back to help explain. A report he published a few months back came to mind as I read the Journal’s latest warning on the potential hazards brewing in the bond market. While the market is indeed “alarmingly fragile and increasingly subject to volatility,” the fragility is not necessarily as brittle as the headlines would have you believe.

Doom-and-gloomers relish in repeating the 80-percent decline in dealer inventories because it just sounds scary. While it’s true that dealer inventories are a fifth of their $250 billion 2007 level, if you clear your face mask you’ll see that while the numbers in the aggregate are kosher, sensationalistic claims should be taken with a generous pinch of sea salt. Generally speaking, there are two culprits blamed for the decline in reported liquidity – the financial crisis itself and the regulations that have made holding bonds more onerous for traditional dealers. But there is a third component to the equation that must be factored in so as to not mislead – the virtual disappearance of an entire class of fixed income securities – namely the reviled collateralized mortgage obligation, many of which harbored those toxic subprime mortgages. The absence of a rebound in these securities exaggerates the reported decline in fixed income inventories. Looked at a different way, the denominator has shrunk so it’s not fair to also not shrink the numerator before making any calculations.

Also in the not too bad news category is that liquidity disruptions are unlikely to originate in the much-feared junk bond market. Don’t get me wrong. Junk bond underwriting standards are rotten; but that’s always been the case as credit cycles mature. Along the same lines, there’s nothing new about the expectation that a fifth of CCC-rated bonds, the junkiest of the junk, will default within five years of being issued. Nor should the latest headlines out of Moody’s shock – that junk debt liquidity is at the lowest level in nearly five years. Despite the price of oil’s refusing to bounce back as the punditry commands, liquidity is hovering near its long-term average and remains two-thirds more abundant than it was in March 2009, when financial markets worldwide troughed.

The real revelation in Melentyev’s analysis is that junk bond, or high yield (HY), liquidity should not be what’s keeping investors up at night. The proportion of outstanding junk bonds that are trading hands these days equates to 0.7 percent of the market size on an average day over the past year. Before calling out the Coast Guard, consider that that is only a 30-percent loss of trading depth since onset of the crisis.

Would it surprise you to learn that junk’s Ivy League-educated older brother, Investment Grade (IG), has seen a greater degree of deterioration? At 0.4 percent, IG trades appreciably less of its outstanding market on a given day representing a 50-percent decline in trading depth. That’s saying something considering that both markets have more than doubled since 2007. But size really does negate comparing the atrophied liquidity in the two markets: At $5 trillion, the IG market dwarfs that of HY’s $1.4 trillion, which demands that IG needs more, not less, when it comes to turnover in its market.

In the adding insult to injury department, the deterioration in liquidity has worsened for IG over the past year, falling from 0.6 percent to 0.4 percent while that of HY has improved from 0.6 percent to 0.7 percent. Pardon the death by numbers but sometimes it’s critical to appreciate what it looks like under the surface of the now-calm waters of these markets.

Retail investors in particular should pay heed to the disturbing details. The Journal story points out that bond mutual and exchange-traded funds now own 17 percent of corporate bonds, nearly double their share seven years ago. The article goes on to warn that the rise of large bond funds places small investors at risk of the same groupthink that plagues stock funds, that is managers chasing the same stocks which translates into highly correlated losses across funds when markets decline. The best news mined from Melentyev’s data actually refutes this claim. Whether you look at the largest 10, 20 or 30 funds, the proportion of total assets under management (AUM), as a percent of AUM in all funds, has declined notably since 2007, by about half in fact. “A less top-heavy structure of the market is a clear benefit to liquidity as it breeds lower correlation of flows and higher diversity of views being expressed on both sides of each trade,” Melentyev reassures.

That’s about the nicest thing you can say about high grade bond funds. In the years to come, we will all grow tired of hearing the term, “fallen angel,” which refers to an IG credit that’s downgraded to HY. There are some $71 billion in IG bonds that are trading as if they’ve been downgraded to junk. A recent Morgan Stanley report noted that this distressed cohort’s addition to the high yield market would boost the size of the junk market by seven percent. For the record, Morgan Stanley is more bullish on HY than it is on IG.

One of the outgrowths of declining liquidity is bond fund managers becoming creative to gain adequate exposure to corporate credit. The first rule of law for any mutual fund manager is you can only sit on so much cash. Deploying cash into specific credits can prove challenging if the targeted bonds trade by appointment only. Enter the $14 trillion credit default swap (CDS) market. CDSs are effectively insurance on credit securities, whether they be sovereign, corporate or asset-backed. An investor can buy a CDS on any company that will pay out in the event said company defaults on its obligations to hedge their position. That’s all good and well.

But what about bond fund managers, thirsty for liquidity, buying CDSs to gain exposure to a given credit? A great friend of mine gives this skirting technique a two-word vote: “No Bueno.” The how to goes like this – if you sell a CDS, you are making an opposite statement to needing insurance against a default, i.e. bullish on the credit. Implementing this strategy, a manager synthetically replicates a bond investment. The problem is these critters are risky and highly unpredictable. It’s not just the credit of the underlying company managers are betting on, it’s the risk that the insurer is also solvent, also known as counterparty risk. AIG circa 2008 anyone?

Because of the immensity of the CDS market and its infrastructure, the widespread adoption of CDS strategies has largely been limited to marquee bond funds which can rationalize the costs via economies of scale (if it sounds expensive, it’s because it is). A 2010 FDIC study found that large fund families tend to use CDS with a third greater frequency than smaller funds. Five years later, with liquidity further depleted, the trend is sure to have been more extensively embraced. The problem is funds who use CDS tend to be more volatile and have lower absolute returns given the additional risk and cost required to more actively trade in their quest for yield. In the words of credit legend Michael Lewitt, “Large bond funds continue to be a triumph of hope over experience that offer virtual nothing in the way of real (i.e. inflation-adjusted) returns and less-than-zero in the way of risk-adjusted returns when you look below the surface and discover that they are investing in all kinds of derivatives and taking other imprudent risks.”

Thank heavens investors can fall back on their ultra-safe government bond funds if all else fails. Or can they? While U.S. Treasurys are still by far the most liquid of fixed income markets, hence their designation as the world heavyweight reining risk-free asset champion, their degree of post-crisis liquidity evaporation also takes the top prize.
Some four percent of Treasurys’ outstanding market size trades hands every day, ten times that of IG bonds. However, that relatively robust level represents a 70-percent decline over the last eight years, which eclipses that of both IG and HY.

In other words, investors’ cherished assumptions about the safest assets in their portfolios could be in for a nasty wake-up call – in more ways than one. The first inkling that liquidity in the Treasury market was not as deep as widely perceived arrived over a year ago, on October 15, 2014. First things, first. Rather than prices flash-crashing downwards, they spiked upwards to the tune of a seven-sigmas – yields move opposite price; they collapsed in the blink of an eye.

The other implication is much more nuanced. Because the severe bond market disruption erupted in the least likely place, Fed officials are realizing they’re in a tougher position than they’d imagined. Policymakers have always known that raising rates after nine years could upset complacent markets. After the flash melt-up, the Fed must also grapple with the fact that not raising rates could communicate that after all of the stimulus that’s been deployed, the economy is still too frail to withstand a quarter-point increase in interest rates. Maybe that’s why Yellen reiterated to Congress that December is the imminent launch date.

When I think back on my week in Belize, I remember that other than that faulty flashlight scare, my second most enduring underwater memory was made diving the Great Blue Hole, a huge submarine sinkhole just minutes away from Long Caye. Take my advice, if you do find yourself in a Belizean boat about to take the plunge into that world famous watermark, heed your guide’s warning not to dive deeper than 100 feet. This will prevent us exchanging notes about mind-altering 130-feet-down subaquatic experiences that deludes one into wanting to pet the cute and cuddly hammerheads circling the forbidden depths. All digressions aside, perhaps it’s time bond investors understood that the deep dive their portfolios have taken into what they think to be the protected waters could just be populated with sharks in guppies’ clothing.

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Shining a Light on the Fed, Danielle DiMartino Booth in DCEO Magazine

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“Analyst Danielle DiMartino Booth is making national waves with her criticism of the Federal Reserve, which she says has addicted the U.S. to the “heroin” of low interest rates.” — By GLENN HUNTER FROM D CEO NOVEMBER 2015

Late this summer Danielle DiMartino Booth, a maverick market analyst and outspoken critic of the Federal Reserve System, was one of a dozen women attending an annual, invitation-only retreat for finance and economics influencers in a remote area of far eastern Maine. The 60 guests at the exclusive “Camp Kotok” meeting at the Leen’s Lodge fishing camp at Grand Lake Stream, less than 20 miles from the Canadian border, included some of the nation’s most prominent economists, money managers, and market strategists.

For several days the guests fished for small-mouth bass, broke bread, and hotly debated economics and monetary policy—all mostly off the record, with a “what happens in Vegas, stays in Vegas” understanding. Attending what she calls the “shadow Jackson Hole” retreat every August, as DiMartino Booth has for the last five years, is a coveted—and welcome—respite from the contrarian analyst’s usual routine. “That’s the beauty of Maine; there’s not much Wi-Fi reception there,” DiMartino Booth says. “It’s the only time I truly unplug.”

Attending the retreat is also a measure of her standing among the nation’s most perceptive minds in finance and economics. A former Wall Street salesperson and “macro strategist”—she played that dual role for investment bank Donaldson, Lufkin & Jenrette in New York—the San Antonio-born DiMartino Booth, 45, served from 2006 until this year as a key adviser to Federal Reserve Bank of Dallas president Richard Fisher, the widely respected inflation hawk who stepped down from his post in March. She’d caught the Fed’s eye while writing a controversial daily business column for several years for The Dallas Morning News. There, DiMartino Booth was a lonely voice of reason about the easy-mortgage boom, which she argued was introducing “systemic risk” into the entire financial system. For her efforts, she was roundly criticized as an anti-business spoilsport and a “nattering nabob of negativism” (including, full disclosure, by yours truly). As it turned out, of course, her critics were wrong and she was right.

These days DiMartino Booth is continuing to rail against the Fed’s cheap-money policy, as well as the institution itself. (It’s opaque and “bloated,” she says, with “delusional” leadership.) She conveys these views as the chief market strategist for The Liscio Report, a pricey newsletter for institutional investors, and with interviews and commentaries for the likes of CNBC, Bloomberg TV, Fox Business, the Financial Times, and The Wall Street Journal. Through her various megaphones she contends, in a nutshell, that by “artificially” keeping short-term interest rates at near zero since the 2007-2008 financial crisis, the Federal Reserve has “criminalized” saving, “enabled and financed and underwritten” the soaring and unsustainable national debt, worsened income inequality, and propped up short-term corporate profits at the expense of productive, long-term business investment. At the same time, she argues, the Fed’s easy-money policy has allowed politicians in Washington to borrow and spend more, creating a “veneer of prosperity” when, in fact, the “country as a whole is still weighed down by a tremendous amount of economic stagnation.”

As a result, DiMartino Booth says, the nation’s central bank has been “boxed in” by its zero-interest policy—no matter how much it might want to let rates rise to their natural levels, say, to 3 or 4 percent. “They’ve been so low for so long—the heroin, if you will, the drug, of low-interest rates—it’s become really hard to take the patient off the drug,” she says. “They’re trying to get out of a canyon this time.”

Wall Street Roots

Over lunch one August day at Penne Pomodoro, an Italian restaurant in Snider Plaza, DiMartino Booth keeps one eye on her iPad, where she’s called up The Wall Street Journal’s market data page as she picks at her flounder picata, mashed potatoes, and mixed vegetables. The stock market has been plummeting this morning, and she wants to track just how far it drops before it rebounds, if it does.

“For the record, I didn’t eat my mashed potatoes,” she says, glancing up from the screen and smiling. Since leaving the Fed in June she’s been trying to lose a few pounds, conscious of the way the TV camera gives the illusion of extra weight. That’s important, because one of her main preoccupations these days is elevating her national profile as an economic expert, including on television. Liscio, where she’s one of three equity partners, gives her a primary writing platform for an audience of influential investors. Besides the broadcast appearances, she’s also been speaking to various business groups: to a brokerage company in Las Vegas, in Philadelphia to NASDAQ, to a money-management firm in Orlando.

Watching the market while she eats is nothing new for DiMartino Booth. She says she picked up the habit on Wall Street, where she landed after earning a BBA from the University of Texas at San Antonio and an MBA in finance and international business from UT-Austin. (She also has a master’s degree in journalism from Columbia University.) On Wall Street, “we were never allowed to go to lunch,” she recalls. Instead, she ate at her desk, eyes glued to a Bloomberg terminal or to CNBC. Today she has nine TV sets at her house in University Park, where she lives with her husband, John, a packaging executive, and children William, 11; Henry, 9; and 7-year-old twins Caroline and John Jr. It’s indicative of her drive that, even while the twins were in the hospital’s neo-natal intensive care unit shortly after their birth in late 2007—“they weren’t quite baked,” she explains—DiMartino Booth continued to write a daily briefing for Fisher as the Great Recession approached. When the housing bubble finally burst—just as she had predicted—her stature was bolstered at the Fed, where academic economists—not analysts with real-world markets experience like DiMartino Booth—dominate the policy discussion.

“Ph.Ds are from Mars, and she’s from Venus. They don’t speak the same language,” says Harvey Rosenblum, who hired DiMartino Booth in 2006 and retired seven years later as the Dallas Fed’s executive vice president and director of research. “But if you’re in an organization where everybody has the same point of view, you’re in a danger zone.”

DiMartino Booth, Rosenblum says, is “a natural skeptic; it’s part of her personality. She’s got a natural tendency to dig deeper. She also brought with her a network of friends, a small army of friends, other data. She added value.

“She brought a fresh approach, thinking out of the box, in a period when we needed it,” Rosenblum goes on. “You can’t look at the world through [an economic] model. You need a different mix of analytics. I’m glad we had her in the room to look at what was actually happening in the marketplace.”

While most of the Fed’s 12 district governors rely on the New York Fed for their market intelligence (that’s where Wall Street is located, after all), Dallas’ Fisher, a former money manager who was a member of the Federal Open Market Committee, which decides monetary policy, wanted his own independent analysis. So he says he asked DiMartino Booth—who “could get information out of a rock”—to be his eyes and ears.

“There are many brilliant economists at the Dallas Fed and throughout the Federal Reserve System. However, none that I had access to were trained from a financial markets perspective,” says Fisher, who’s now a senior adviser at Barclays bank. “I wished to have my own direct line to financial markets and a different perspective. Thus, I decided to augment the collective brain power of my economic advisers at the Dallas Fed and the briefings from the New York desk with Danielle, who I would deploy to New York frequently to meet with and listen to (but never give my opinion to) various financial operators, comb through analysts’ reports, and closely follow the financial press, then keep me advised both through oral briefings and written reports.

“It helped that having had experience as a financial journalist, Danielle speaks and writes crisply and with wit—attributes I greatly appreciate,” Fisher goes on. DiMartino Booth “performed superbly, and helped me and the Dallas Fed provide a fresh perspective at FOMC meetings. I attribute some of our success in putting the Dallas Fed on the map to Danielle.”

As an independent analyst and commentator, DiMartino Booth continues to visit Wall Street on a regular basis. “What do you do when you go to New York?” I ask during one of our many interviews. “I visit with people,” she explains. “I ask them, ‘What’s happening in your market?’ I’ll go talk with the real estate handler with Morgan Stanley, for example, and I’ll say, ‘How is your sector doing?’ … And then I’ll go down the street to the next one, some credit analyst, and I’ll say, ‘What worries you? Any pockets of risk bubbling up? Any areas of over-valuation? Is everything hunky-dory?’ I’ll go until I’ve covered every asset class, then I hit rewind and start all over again.”

This boots-on-the-ground approach has helped shape her controversial views. “I’m completely off the rails,” DiMartino Booth says, almost proudly. “I’m saying things about the Fed that no one else is.”

An Exchange About the Economy

But what is it, exactly, that she is saying?

By raising rates to their “natural” levels, I ask, playing the devil’s advocate, wouldn’t everyday people be hurt, because it would become more expensive to borrow money? “Well, there’s expensive, and then there’s normal,” DiMartino Booth replies. “It’s a crime in this country to save money, to be conservative, to be in your retirement years and try to [increase] your portfolio, what little portfolio you have. Retirees don’t have the option of going down to Bank of America and putting their money in a five-year CD.”

Because the rates are so low? “Yes. The rates are so low that savers have been punished for years and years,” she says. On the other hand, “I don’t know why anybody should have the right to have a 2.5 percent mortgage for 30 years. It actually puts borrowers in a bind, because they end up buying more than they can truly afford, because they’re basing it on a very false level of interest rates.”

By keeping rates near zero, though, hasn’t the government maneuvered somewhat adroitly past the Great Recession, with a relatively low unemployment rate, for example? While Texas has done well, she answers, high-tax states like Illinois, California, and New York have not, and many states have stagnant economies. As for unemployment, “You have 93 million Americans who are out of work who could be in the workforce,” she says. “I would call that nearly a third of the population who could be working who are not working, out of the labor force entirely. Then there’s the third that is this growing population of people who are part-time—some of them involuntarily, some voluntarily. (Think of a millennial part-time Uber driver.) Then think of the final third as being true, full-time workers, highly productive. They have all the pricing power when it comes to wages, while the other two cohorts have none.”

But, the unemployment rate is still around 5 percent, I say. “Sure it is, because they don’t count these people,” DiMartino Booth replies. “It’s very conveniently measured. Trust me; I’ve been hanging around economists for the last nine years. You can measure anything any way you want.”

Even though the national debt is around $18 trillion—about 100 percent of the country’s GDP—we still seem to be clipping along in decent shape, I say. And, to the extent that debt contributes to “over capacity” in various industries, doesn’t that lead to lower prices, which benefit consumers, and especially retirees? “Well, you’d like to think in terms of higher wages as well. That’s the flip side,” she responds. “We do not have declining wages, by any stretch. But, every generation of Americans has been able to successfully make more than their parents did—up until 2006. That’s when this trend line was broken. … The fruits of [low rates and the Fed’s quantitative easing policy] have flowed mainly, by a great majority, to the wealthiest Americans, who have access and exposure to the financial markets.

“The national debt is a huge problem,” DiMartino Booth goes on. “When I hear politicians brag about reducing the [annual budget] deficit, it makes the hair on the back of my neck stand up, because it’s been enabled and financed and underwritten by extremely low interest rates. If rates were at a more historically ‘normal’ level—3 or 4 percent, call it—you would see a doubling in the deficit overnight. We have not killed the business cycle, but easy monetary policy provides that illusion.

“It’s the exact same situation with corporate earnings,” she continues. “There are numerous studies that corporate earnings have been boosted by 25, 30 percent … and Corporate USA has never carried the amount of debt that it is carrying now. Corporations are buying back their shares—we call it financial engineering—and they’re buying other companies, engaging in mergers and acquisitions.”

Because the rates are so low, CEOs are merely taking advantage of the cheap money, aren’t they? “Get cheap money, go buy a company, fire half the workforce, consolidate, realize those beautiful synergies, blah, blah, blah,” DiMartino Booth says. “But in terms of productive investment in the long-term future of the country, not so much.”

Can you blame them, I ask, for capitalizing on the current environment? “If I’m Joe Q. CEO and interest rates have been at zero since 2008 and I’m trying to grow the company,” she replies, “am I really gung-ho to make a huge commitment to the future if I’m worried that I can’t look down the road and tell you what the operating environment is going to be once interest rates start to increase? Is it going to slam the housing sector? Is it going to cause another recession? So, should I be more conservative and just sit on my hands and wait for that eventual day to come when the Fed normalizes rates and, in the meantime, buy back more shares so that I can juice my earnings on paper, so that I can pay myself a higher bonus? The cycle feeds on itself, and it’s ‘all good!’ If you’re Joe Q. CEO, you’re between a rock and hard place.”

In terms of the stagnating wages since 2006, doesn’t globalization have a lot to do with that? “It has a lot to do with it, but that’s the easy answer,” she replies. “That’s why we’ve had several jobless recoveries. … At the same time, companies are trying to figure out how to better automate their processes all along the line. It’s not so much that jobs are being sent offshore, but, three human beings are being replaced by a machine. I see it in my husband’s industry—industrial packaging—where they’re able to take four people off the factory line and replace them with a machine that can fold boxes, close them up, put the tape on, send them down, and have the merchandise dumped into them.”

So, should we not be doing this? “You’re not going to stop progress or innovation,” DiMartino Booth answers. “But, the investment we need to make in the future is going to take a long time to bear fruit. I’m talking about science, math, the STEM subjects. That’s the gulf, the vacuum. That’s the great sucking sound in this country—the roots of our children’s education, educating future generations to be world-class innovators, Silicon Valleys coast to coast. Let’s bring it. We need smarter ways of tackling our education system, smarter ways of tackling healthcare, smarter ways of tackling our [physical] infrastructure problems.”

And, the Fed’s easy-money stance has been an impediment? “Yes. I think the Fed has been complicit— not in a malicious way. I would say the Fed has been the chief enabler, the facilitator,” she says. “So, there should be a timeline limit to how long policymakers can be ‘well-intentioned’ in their decision-making framework. [We needed to say], ‘Wait a minute, we’ve got a lot of silly investing going on, and there will be a price to pay.’ Whether the price is Congress abdicating all of its responsibility to policymakers … who provide the groundwork, via very low rates, to paint the veneer of prosperity, which works until it stops working. And then we go into another crisis, which is what we’ve been doing for cycle after cycle after cycle.”

The Fed, for its part, of course, sees things much differently. Interest rates have been held down so long mainly because inflation’s in check and the U.S. and global economies have been relatively weak, policymakers argue. And, raising rates could have hobbled whatever recovery has taken place since the Great Recession. In a March blog post hosted by the Brookings Institution, where he is a distinguished fellow in economics, former Fed Chairman Ben Bernanke argued that low rates are part of a long-term trend and necessary to be “consistent with the healthy operation of the economy.”

Recalls Rosenblum, the former vice president at the Dallas Fed: “When the post-crisis plan was put into place in December 2008, I was in the room. At that time, we didn’t believe zero percent interest rates would be around one year later—let alone seven or eight! We’re just in a very unusual environment. It happens once every 20 or 30 years, when you have global recession.”

In September, the central bank declined to lift its benchmark rate even by an expected 25 basis points, citing concerns about the global economy. But a few days later the Fed chairwoman, Janet Yellen, said a hike was likely this year. DiMartino Booth, not surprisingly, was pleased. The choice is “either hike now and hope the recession is shallow,” she said, “or stay on hold, and the financial imbalances grow to such an extent that we have another crisis.”

Meantime, the maverick analyst and proven soothsayer has her own personal plan for growth. Heading into next year’s election, DiMartino Booth says her goal is to become a national thought leader, helping voters by “shining a bright light” on the Fed’s outsized role and connecting the dots for them. “I’d like to open the black box for the average Joe, so they can vote people into office who can make better decisions on behalf of the economy,” she says.

Is this smart, ambitious woman having an impact? “Can’t tell yet,” says Fisher, the former Dallas Fed chief. “But I know her—and she will.”

http://www.dmagazine.com/publications/d-ceo/2015/november/danielle-dimartino-boot-dallas-fed

Dallas-Fed-Photo.1_CourtesyDallasFed

RX FOR THE FED    Danielle DiMartino Booth’s five-point prescription for improving the
nation’s central banking system.

  1. Bring in outsiders. 
    “This is No. 1 on my prescription for guiding the central bank back to Planet Earth,” she says. “The Fed is a bloated institution overrun by economists and academics. It needs more individuals who have experienced the results of policy, who can raise objections to unintended consequences, who can recognize excesses building within financial markets.”
  2. Decentralize the concentration of power in New York and Washington, D.C. to reflect the changing economy.
    “The fact that there’s now a consensus within the Fed to strip regional chairmen of their influence shows how delusional the leadership has become.”
  3. Reshape the regional bank structure to better reflect the less industrialized country we have become.
    “Today, states like Texas and California are massive engines of growth for the national economy. That should be reflected in votes at the Federal Open Market Committee meetings.”
  4. Reexamine inflation metrics.
    “Find a way to incorporate asset inflation and reduce the central bank’s mandate to one singular purpose: safeguarding the buying power of the U.S. dollar.
  5. Let nature take its course.
    “Markets by their nature are supposed to be volatile. Zero interest rates mean you never clear out the detritus. Recessions might have been deeper, the financial losses might have been greater—for some—but the economy would have been stronger in the end.”
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P = qe² (?)

Forget Milton Friedman and John Meynard Keynes. What would Albert Einstein say about quantitative easing? Maybe he would say that it really is all relative. Maybe not. My guess is the physicist and Nobel laureate would tell policymakers that their strenuous efforts to propel the economy simply don’t fit the equation he so famously wrote about in 1905. For those of you who’ve forgotten your high school physics (I’m right there with you; thank heavens we now have Google), Einstein is most revered for his theory of special relativity, conveyed by the deceptively simple equation, E=mc². The nutshell version, care of Britannica.com, goes like this: “the increased relativistic mass (m) of a body comes from the energy (E) of the motion of a body – its kinetic energy – divided by the speed of light squared (c²).”

Leave it to the New York Museum of Natural History to translate the equation into something children can comprehend. For starters, energy and mass are one in the same as long as you convert them by the speed of light multiplied by itself. If you could convert a penny by 90 billion kilometers squared per second, also squared, you would generate enough energy to power the New York City metropolitan area for over two years. Energy independence, here we come! Except for one little detail. Did I mention “could”? The vexing thing is accomplishing such a feat requires temperatures and pressures much greater than those found inside the sun. So a nix on the pragmatic and back to square one, or at least smaller feats such as using neutrons to split a uranium atom many times over to generate nuclear power.

Do central bankers the world over believe they’ve split their own atom, creating sufficient motion in the economy by unharnessing infinite buying power? Isn’t that, after all, what all of this unending quantitative easing (QE) is as the global tab pushes the $13 trillion mark? Not to mix equations, but the challenge to accomplishing this economic coup is that it’s not a zero sum game. Consider that at the extreme, buyers of Swiss long bonds can expect a yield of 0.55 percent over the course of the next 30 years. Step in off that spectrum one notch, and Italian two-year bonds are now trading at negative yields.

What has gotten us to such a surreal place? In the end, only history will satisfactorily close the door on this profligate era but it just might be that individual central bankers are deluding themselves into believing that they can win the currency war. Take the latest ongoing battle raging among global central bankers. Just when it looked as if there was a tentative truce at hand, the Fed launched a fresh attack with the September release of its FOMC statement, which mentioned the dollar by name, something once considered taboo, a strict preserve of Treasury officials. With that, the dollar began to weaken.

Then came the September employment report along with its unusual downward August revisions. Two consecutive months of sub-150,000 payroll growth. With a gasp and rumblings of QE4 unsettling the calm surface, much of the European Central Bank’s (ECB) own QE began to come undone as the euro strengthened against the dollar.

Market watchers could almost hear ECB head Signore Draghi’s saber rattling across the Atlantic. If the element of surprise was what was required, well then, he too could deploy such weaponry, which is exactly what he did at the conclusion of the ECB’s October meeting. Draghi’s premature pronouncement promising more QE to come surprised the stock market into a short-covering rally. Those poor souls betting markets would be taking a breather after the Fed-induced rally were caught off guard, forced to cover their positions propelling equities skywards. And instant, presto. The euro weakened.

Did you know that you can say ‘no’ in Mandarin five ways? All five were on audible display within hours of the ECB’s move with China’s announcement that it would lower rates for a sixth time. Do we think anyone has ever told Will Farrell how to say “More Cowbell!” in Mandarin? With that, the dollar is perched near its loftiest levels of the current cycle.

So the Fed met this week with weak oil prices that were supposed to have had a “transitory” effect on inflation and a strong dollar, which the script said would only impinge U.S. corporate earnings on a temporary basis. Uh-huh. Maybe it’s a good thing the fair Chair didn’t have to face the gauntlet of reporters this go round. We’ll have to leave it to what promises to be airway-choking Fedspeak in the six weeks leading up to their December deliberations to explain the substantive changes made in the October statement.

For now, we can only wonder at the mystery of the changes to the statement. Those international developments that caused them such angst at the September Federal Open Market Committee (FOMC) meeting — vanished into thin air. Inserted in its place “next meeting” – the most explicit a reference if there ever was one to a temporal rate hike target. Of course, the dollar strengthened anew conveying a sense of another truce at hand. As long as we agree to be on the losing end of the global stick, other central bankers can carry out their own expansive QE programs in relative peace.

Could it possibly be that simple? It’s hard to believe that today, October 29th, marks the one-year anniversary of the final open market purchases by the Fed to grow its balance sheet. With complete acknowledgement that correlation is not causation, the nearby graph certainly makes for a charming depiction of coincidence. The representation is as old as QE illustrating how the S&P 500 rose in lockstep with the growth of the Fed’s balance sheet. Could a pedestrian picture provide plentiful evidence to policymakers to elicit pause about the prospect of shrinking the balance sheet? Maybe more investors should be asking this question.

 (Graph courtesy of Paradigm Advisors)

BTIG’s eagle-eyed Oliver Wiener raised this very issue pointing to a recent Bloomberg article that suggested reinvestment is really where the action is at when the Fed meets. Consider that $215 billion in Treasurys are set to mature in 2016, vanishing off the Fed’s balance sheet. Another $800 billion are due to roll off through 2018. Will the powers that be attempt to communicate that shrinkage is not tightening, just as they attempted to do so at the onset of the reduction in the pace at which they were expanding the size of the balance sheet?

It’s plain to see that while tapering might not have been tightening (open debate material), it did a whole lot of nothing for the stock market. It doesn’t take a PhD in physics to determine that a steady state is not one and the same with reverse motion. In fact, when it comes to the balance sheet, achieving a steady state requires heavy lifting. Chew on this one – net Treasury issuance this year is projected to be $400 billion thanks in large part to the barely discernible interest expenses Uncle Sam has to pay the nation’s creditors. Even so, the Fed’s $175 billion in purchases to prevent balance sheet shrinkage will command a remarkable 44 percent of net issuance.

Our communicative central bankers have emphasized in the past that rate hikes would be step one in a progressive tightening process and that shrinking the size of the balance sheet could notproceed a first hike. The trick will be convincing investors to not run for the hills. As it is, sustaining stock prices has required record levels of both mergers and share buybacks this year.

Howard Silverblatt, Standard & Poor’s spreadsheet-armed market veteran of veterans, reports that during the current third-quarter earnings season, roughly one-in-four S&P 500 companies have bought back enough shares to boost earnings by four percent or more. Helping finance the gorging is a $1.2 trillion debtfest; U.S. investment grade and high yield corporate bond issuance in the first nine months of this year has smashed all prior years’ records.

With about half of company results in, Silverblatt shared some revealing details: “Companies continued to reduce their share count resulting in 24 percent of them (S&P components) adding at least four percent of tail winds to their third quarter 2015 earnings per share over the same quarter last year. At this point, this should be the seventh consecutive quarter in which at least 20 percent of the index adds tailwind of at least four percent. While it’s always nice to have the wind at your back (as compared to the currency headwinds), old-fashioned growth would be nice—which, as measured by the 2.1 percent decline in year-over-year sales (which are not impacted by buybacks), does not have a strong presence in the market.  Of note, if I exclude energy’s 30.4 percent year-year-over sales decline, the index sales are up 1.5 percent—better, but not the growth we’re looking for.”

Ain’t financial engineering grand? In what could be the quote of this young century, a market watcher who goes by the clever name of Macroman made the following observation: “Buybacks come and go but debt lasts forever (or until it’s paid back).”

In that same spirit, but a bit more elegantly worded, Michael Spence and former Fed governor Kevin Warsh wrote a must-read in Monday’s Wall Street Journal titled, “The Fed Has Hurt Business Investment,” which presciently preceded yet another terrible report on capital investment. The article’s most notable tidbit, from yours truly’s perspective, is that half of earnings in the QE era can be attributed to share buybacks rather than investment in the future.

What a sad legacy for the next generation to inherit, especially considering America’s proud traditions of innovation and hard work. Were it only the case that the neutrons the Fed has been firing into the economy yielded sustainable energy instead of frenetic speculation. Einstein gifted the world with the revelation that energy and mass are different forms of the same thing. If only monetary policymakers could understand that the very nature of financial repression holds that QE and the paper gains it produces for a time are not one in the same with regenerative prosperity.

And yet investors are clearly looking past the statement that accompanied the October FOMC all but guaranteeing a rate hike will arrive in holiday gift wrap. It’s no coincidence that recent speeches by some of the most influential and influenced members of the FOMC have moved the payroll and inflation goal posts using the subtle weapon of verbal suasion. The question is why? The business cycle has not been slayed removing forever the prospect of recession. And if it’s sooner rather than later that the economy succumbs, more QE is likely to follow. What if the real plan is to raise rates and maintain the size of the balance sheet? What if indeed.

My wise friend, The Lindsey Group’s Peter Boockvar, has an exceedingly simple theory to explain the root of investor fascination with QE, one that Einstein himself would probably applaud. “Quantitative easing is simply psychological.” Investors want it to be something that it is not. Perhaps the pennies investors perceive to be falling from heaven are simply that, pennies.

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Whistling Past the Junkyard

To this day, I still count by the flash of lightning and the thunderclap to guesstimate a storm’s distance. To this day, I make sure all trees are trimmed to be absolutely positive they’re clear of any window in my home. Such is the impression Poltergeist left on yours truly’s psyche back in 1982. For those of you who need reminding, Robbie, the name of the character who played the son in Poltergeist, would count the seconds between the lightning and the crashes of thunder for comfort knowing that the longer the pause, the more distant the storm. In the end, as the unsettled spirits rose through the floorboards beneath which they were buried, the time spans grew frighteningly shorter, culminating in Robbie’s being snared right out of his bedroom by a possessed tree. Though Robbie was rescued from the storm’s grasp, his fictional sister Carole Anne was not so lucky. The demons in the TV grabbed her very body and soul and didn’t let go until her determined mother went into the netherworld to get her back.

For the credit markets, the storm sounds as if it’s closing in. In a genuinely spooky “They’re here” moment, just last week, Zerohedge broadcast the news that the UBS Managed High Yield Plus Fund had announced it would be nailing the doors shut and liquidating their holdings. Slowly. The doomsday blog warned that the illiquidity Minsky moment was finally knocking on hell’s door; big banks’ bond inventories have been decimated and funds’ ability to liquidate in an orderly fashion would be stress-tested and fail. Forget for a moment that UBS is also the name associated with the first stressor to emanate from the burgeoning subprime crisis. This fund, which opened to investors in 1998, had survived both the dotcom bubble bursting and the credit collapse that accompanied the subprime crisis.

There’s no doubt the time should be nigh. Credit spreads, a measure of the extra compensation over Treasurys investors command for the risk of taking on corporate credit risk, for both high grade and junk bonds have gapped out in recent months. Investors are now demanding seven percentage points above comparable maturity Treasurys to hold the riskiest credits, the most in three years. Though nowhere near their post-crisis highs that exceeded double-digits, spreads are nonetheless flashing red. They’re cautioning investors that the distress emanating from commodity-dependent global economies and signs of a slowing U.S. economy could create enough turbulence to derail one of the most glorious credit cycles in the history of mankind.

Aside from macroeconomic indicators, what exactly are spreads tuning into? A recent report by Deutsche Bank’s Oleg Melentyev, whom I’ve known long enough to spell his last name by heart, suggest that the stage is set for the next default cycle. For starters, the current credit cycle is pushing historical boundaries. Going back to the 1980s, high-yield debt creation waves have lasted between four to five and a half years resulting in 53-68 percent debt accumulation from the baseline starting point. Where are we in the current cycle? Over the past four and a half years, junk credits have tacked on 55 percent growth when you take into account the combination of bonds and leveraged loans on bank balance sheets, putting the cycle, “comfortably inside the range of previous cycles,” according to Melentyev.

But that’s just one omen. Issuance aggressiveness is another way to test the credit cycle winds. Cumulative credit cycle issuance volumes of companies rated CCC and below, the junkiest of the junk, half of which can be expected to default over the next five years, casts a light on investors’ true pain thresholds. The mid-1990s and the mid-to-late 2000s saw highly toxic issuance swell by 20- and 18-percent, compared to the current cycle’s 17 percent.

Melentyev hedges the two metrics’ signals with the caveat that he’s using 2011 as a starting point despite clear evidence that the markets were expanding by the latter half of 2010. Erring on the conservative side, in other words, leads him to the ominous conclusion that, “the pre-requisites for the next default cycle are now in place.” Pre-requisites, though, do not make for certain outcomes though other fundamental benchmarks validate Melentyev’s premise.

At the most basic level, companies reassure bond investors by demonstrating they can cover the coupon they’ve promised can be clipped. The higher a company’s credit rating, the greater the probability the firm can make good on its commitment. The question is, what does it say when the presumptive pristine credits that populate the investment grade universe, the ones who disdainfully look down their noses at their lowly junk-rated brethren, begin to emit signs of balance sheet stress? The ratio of debt-to-earnings before interest, taxes, depreciation, amortization and whatever else is left in the kitchen sink for this superior cohort rang in at 2.29 times in this year’s second quarter. That tops the 1.91 clocked in June 2007 before the onset of the financial crisis. So a less cushioned starting point – that is, if this is the starting point and the storm really is fast approaching.

There are plenty of guideposts that indicate we haven’t yet arrived at the beginning of the end. Topping the list is the furious merger and acquisition (M&A) activity dominating the news flow. At $3.2 trillion globally, 2015 was already on track to take out the 2007 record of $4.3 trillion in M&A volume. And then the big guns came out. Michael Dell’s ambitions as a private market tech mogul became crystal clear with the announcement that Dell, partnered with Silver Lake, would take out EMC in a $63 billion transaction that requires at least $40 billion in debt to finance. The kicker is that $15 billion would be junk bonds – the biggest of its kind in history.

To not be outdone, Anheuser-Busch InBev muscled in to buy SAB Miller with a sweetened $106 billion offer giving new meaning to “This Bid’s for You!” As for the financing to consummate this tie-up? A cool $70 billion in debt financing, a figure that tops Verizon’s one-for-the-history-books $49 billion in bonds that helped pay for its acquisition of Vodafone.

In the event these figures have induced a bit of debt indigestion or indignation, rest assured, Standard & Poor’s (S&P), that other mighty credit rating agency, is on the case. In the first nine months of the year, S&P downgraded companies 297 times, the highest pace since that dark year 2009, with liquidity in the bond market one-tenth what it was, caveat clearly emptor.

And yet…there’s that sticky issue of the dumb money that’s on the prowl. This is not some reference to a pile of mutual fund “money on the sidelines,” which history has proven can be as ephemeral as a poltergeist you wrongly conclude has been exorcised. Nope – we’re talking about brand-new allocations to the credit markets.

Brian Reynolds of New Albion Partners, whose name has graced these pages in the past, helpfully keeps a real time score of the number of public pensions allocating fresh funds to the credit markets since August 2012. His most recent reckoning: 782 votes amounting to $169 billion in new monies being put to work in credit funds. Assuming a conservative five times leverage (which beats the 10-50 leverage multiples deployed in pre-crisis days), some $1.2 trillion in new credit flows have goosed the debt markets since late 2012.

What, pray tell, do stock market gyrations the likes of which we’ve seen since August do to pensions’ collective pain thresholds? In a nutshell, it strengthens their resolve to diversify, diversify, diversify away from their stock market exposure. August, September and the first half of October have set a three-month record for new pension allocations. Taking the cake in the “you-just-can’t-make-this-stuff-up” category, the Louisiana Firefighters’ pension is putting $50 million to work in an unconstrained fixed income fund; the funding will be sourced from an equity fund liquidation. On second thought, maybe it’s a good thing they’ve got access to plenty of firehoses.

Looking ahead, Moody’s high yield soothsayer Tiina Siilaberg, (I can spell her name from memory as well), sees clear evidence that refunding risk is building in the pipeline. Tiina’s barometer is the credit rating agency’s proprietary index that gauges the future ability of companies to roll over their maturing debt in three years’ time. The last time this indicator was at its current level was in the depth of the 2009-2010 credit crunch. “A significant contributor to the decline in the index is the increase in upcoming maturities. We currently expect $109 billion of speculative-grade bonds maturing over the next three years vs. $88 billion at the beginning of this year.” Indeed, refinancing volumes are down by some 37 percent over the last year.

Eric Rosenthal, at Fitch, which rounds out the Big Three credit rating agencies, foresees some messiness in the statistics to come thanks to the degradation of issuer balance sheets coupled with the less-than-friendly refinancing landscape. Rosenthal, whose last name practically spells itself, now expects the corporate bond market default rate will end the year around 3.5 percent and keep moving up in 2016. This rate, he cautions, is materially higher than the 2.1-percent average rate that coincides with non-recessionary times. In an conscious nod to $45 oil, nearly half the energy and metals & mining issues are trading below 80-cents on the dollar (par is 100-cents) compared to seven percent for the whole of the high yield universe. Still, the beat goes on, Rosenthal concedes – which is good news for Michael Dell. Issuance may be down 35 percent over last year for the aforementioned beleaguered commodities space but it’s up three percent for the rest of the junk market.

Are the conditions for a meltdown in the bond market firmly in place? Are investors deluding themselves, whistling past the junkyard? Absolutely. But that shouldn’t necessarily keep you up at night, counting the seconds in between lightning flashes and thunderclaps. Or, as Deutsche Bank’s Melentyev’s quips, “A stack of hay is not a fire hazard in and of itself; someone being careless with matches nearby makes it so.” By that same token, Poltergeist’s greedy real estate developer could have ponied up the extra moola to move the coffins of the dead and buried under the subdivision he so profitably erected. Instead, he rolled the demonic dice and simply removed the headstones, whistling past the houses until the unsettled corpses rose through the floorboards, shattering the illusion of suburban serenity.

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PEAK 2 PEAK

As long as you don’t look down, it really is a lovely ride. But then, that is the stated goal of British Columbia’s PEAK 2 PEAK Gondola ride, the longest and highest lift in the world connecting Whistler and Blackcomb Mountains. Make no mistake, there’s no hype on that ‘world record’ claim. At nearly two miles, the ride crosses the longest unsupported (which one definitely senses) span that also boasts being the highest, some 1,427 feet above the valley floor. For suspended suspense of a different kind, I highly recommend taking this 11-minute journey in June. That way, you can see two seasons in one – elegant, be-downed skiers at the very top of the mountains and, if you dare peer below towards terra firma, mountain bikers in summer garb bounding down the mountain. Luckily, 56-millimeter-thick cables allowed me to live to tell the tale of the surreal sight of witnessing live performances of both winter and summer Olympic sports in tandem.

The occasion for my trip to the pristine northwest was a Vancouver speaking engagement hosted by an international group of foresters. Their one query, back in 2012:  when would American homebuilders recapture the 2005 glory year pace of annual construction of over two million new homes? (Spoiler alert: they’re still waiting) In fact, there’s a solid chance the mill owners and loggers will be forced to play the waiting game for another generation. Such is the case when demand is pulled forward causing an unnatural rise in prices culminating in a burst bubble, which has to then be unwound in painstakingly slow order. Of course, I refer to home prices rising at an unsustainable rate due, in part, to loose monetary policy facilitating bad behavior, basically all around.

Today, policymakers find themselves staring down the barrel of another bubble that’s burst. This year’s International Monetary Fund’s annual meeting concluded with the world’s greatest minds in policy and economics agreeing that there will be no easy solutions to the problems facing emerging markets in coming years thanks to the bursting of the commodities bubble, which has also pulled forward demand on a global scale.

In an October 11 speech at the IMF confab, Fed Vice Chair and Reining Godfather of Central Bankers, Stanley Fischer, nodded to the dilemma facing U.S. monetary authorities. It is unwise to devise policy in a domestic vacuum given the, “increasing influence of foreign economic developments on the United States economy, both through imports and exports, and through capital account developments.” Beyond the slowdown in U.S. job growth, “the possibility that shifting expectations concerning U.S. interest rates could lead to more volatility in financial markets and the value of the dollar, intensifying spillovers to other economies, including the emerging markets.” At a mere word count of four, Fischer’s speech was relatively judicious in citing the ‘dollar’ by name as a concern. Contrast that to the September Fed meeting minutes wherein references to the strength of the ‘dollar’ made a record 19 appearances.

The bursting of the housing bubble, which to this day remains a thorn in the lumber industry’s side, and today’s commodities bubble, currently plaguing the global economy, are two bubbles bound by a troubling ‘flation’ paradox. The reaction to the PEAKing in home price inflation led to the PEAKing in commodities inflation. Meanwhile, boom/bust cycles, which stretch back in history as far as black tulip mania and characterize the current era of policymaking will inevitably usher in deflation scares that emanate from bursting bubbles. The debt Band-Aids applied provide an easier path than the restructuring of economies that would make them more productive over the long haul. The absence of such structural reforms leaves countries reliant on re-igniting their sputtering export engines. The only catch is, not everyone can play the same game at once.

Where in today’s boom/bust cycle does the U.S. find itself? According to the latest WSJ headlines, “Worry Over Low Inflation Kept Fed at Bay.” And yet, eight days earlier, another headline, this one from the Dallas Morning News angsted over, “Area Apartment Rents Rising at a Record Rate.” Well, which is it? According to two of the brightest minds in investing, Van Hoisington and Jim Grant, the answer is BOTH.

At a recent conference, fixed income investing legend Van Hoisington explained why the Fed cannot technically “print” money, at least when gauged by true M2, which is cash, checking and savings deposits and money market mutual funds. Recall that at its simplest, inflation is too much money chasing too few goods. Buying up all manner of debt with the hopes of inducing inflation only works if what the Fed spends circulates back into the economy in the form of M2 chasing goods. But that hasn’t happened. Rather, Fed purchases have been deposited right back at the Fed where they now sit fallow generating a pittance of income that sadly beats the negative rates they’d get otherwise. In Hoisington’s words, these reserves are simply not ‘transactable.” Hence the conundrum: M2 was growing at about six percent in 2008 where the rate remains today despite $2.5 trillion in Fed purchases. When money growth stagnates, the economy won’t slip into gear, which is just what we’ve seen for over six years now. (True money printing involves depositing money directly into checking accounts and happens to be illegal for those of you wondering.)

Jim Grant of Interest Rate Observer fame concedes that while we have seen little in the way of inflation of goods in recent years, we remain real time witnesses to the effect of the extraordinary amount of credit chasing asset prices from stocks, bonds and commercial real estate to the mountain PEAKs and beyond. Rising asset prices have no place in traditional inflation metrics as they are viewed as misleading economic growth signals. Or, as Grant  “The distortion of prices puts us in a Hall of Mirrors.” It is thus an illusion of prosperity via the prism of asset bubbles that deludes us into believing anything of economic value has been produced.

But back to those paradoxical inflation/deflation headlines. The two gentlemen above, along with some acknowledged defects within the Fed’s preferred inflation measure, help solve the riddle. The creation of debt in debt-laden economies accomplishes a whole lot of economic nothing, hence incomes grow at no faster pace than the rest of the economy. That’s what happens when debt levels cross a line in the sand of the whole of a given country’s economic output. (Look no further than Japan’s debt to GDP of 670 percent to understand why that country is flirting with recession yet again.)

At the same time, credit has been chasing high-end apartment construction and prices to what is hoped are PEAK levels. Dallas, with its influx of jobs, may be the economic exception given the ease with which companies can actually conduct business there, but seven percent over the past few years will quickly extinguish a defining attraction of the area – that of reasonable housing costs. At a national level, apartment data miners find that rents are rising at something more along the lines of a five-plus percent pace. The core consumer price index (CPI), which excludes food and energy, meanwhile, reports a more subdued 3.6-percent pace in rental inflation.

But that still isn’t the number that poisons the ‘flation’ worry well. The Fed’s “preferred measure,” the core personal consumption expenditures (PCE) gauge, most recently crawled in at a worrisomely low 1.3-percent rate, a level sufficiently shy of the Fed’s formal 2 percent target. When numbers are this low, four-tenths of a percent is material. That’s exactly the size of the difference between core PCE and CPI, the latter of which last clocked in at 1.7 percent. The main difference between the two comes down to their shelter weightings. In the CPI, shelter has a 31-percent weight, which reflects an ideal but modern-day unrealistically low proportion of a household budget. The PCE’s 15-percent weighting insults households struggling to keep a roof over their family’s heads.

Tellingly, the core PCE also came under scrutiny during the PEAK years of the housing boom because it failed then, as it fails today, to capture the immense drag housing puts on household budgets. Harvard’s Joint Center for Housing Studies most recent data find that almost half of all renters spend more than 30 percent of their income on rent; they call this cohort ‘burdened’ and I’d have to agree. More than a quarter of all renters are ‘severely cost burdened,’ and spend more than half their income, half, on rent. The Harvard data reveal that lower income individuals are even more disproportionately burdened, which distressingly stands to reason.

In a recent report titled, “The Burden of Shelter,” Michelle Meyer, Bank of America economist and renowned housing expert, nodded to policymaker’s dilemma: “If renters have to allocate more of their disposable income on shelter, there is less money to spend elsewhere, contributing to the disinflationary pressure for consumer goods.”

And that’s just what we’ve seen. The Liscio Report’s latest survey of sales tax receipts picked up a distress signal being emitted from household budgets crimped by the factors discussed here and others: Only 30 percent of states met their forecasted sales tax collections in September, down from 68 percent in August.

Impeding policymakers’ future efforts are further downward pressures building in the pricing pipeline for goods. Though exporters to the U.S. don’t see it this way; the silver lining of a strong dollar is that it makes the goods we import cheaper. Indeed, import prices overall are down 10.7 percent over the last year, which largely reflects the bloodletting in the energy complex. Zero in on nonpetroleum import prices, though, and they have slid 3.3 percent from year ago levels. Even the supposedly Teflon services sector has failed to generate the level of inflation associated with economic recoveries. At last glance, services inflation was running at a 2.6-percent rate, far shy of the pre-crisis highs that exceeded 3.5 percent.

As for the prospects for truly normalizing interest rates one day, demographic trends only promise to increase the ranks of severely cost burdened renters in the coming years. Harvard’s data project that due to the rise in minorities and elderly as Baby Boomers age, those who spend more than half on rent will increase by 11 percent over the next decade and that’s IF rental inflation slows to that of income growth.

Of course, the opposite scenario unfolding would be ideal – that income growth begins to outpace that of rent inflation. Such an economic miracle, though, will only be possible with a radical change of thinking among policymakers. Policymakers are either blind, or worse, willfully blind to the financial asset price inflation that flashes red today, just as it did during the dotcom and housing bubble eras. If that is the case, the bust to come will be followed by yet another boom in asset prices, one that will require firehoses to douse the flames of impending deflation.

At the core of policymakers’ Catch 22 is the fact that there is no easy way out. To borrow from Hoisington’s philosophy – developed countries such as the U.S. are simply too large to devalue their way out of debt by using a depreciating currency to reduce debt loads. That leaves belt tightening which generations of central bankers have been trying to avoid at all costs.

Can the same brands of debilitating debt loads that leveled the global economy during the Great Depression be sustained indefinitely? That’s surely the hope as the frequent application of additional debt-creation bandages over the open wounds of high debt levels seem to be the only solution politicians find palatable. Perhaps the privileged skiers atop the world’s financial markets will be nimble enough to avoid sliding on the ice as one season of asset bubble glides into the next creating the illusion of a powdery permanent winter wonderland for a chosen few. Perhaps they can be magically transported from PEAK to PEAK with little in the way of collateral damage.

But what of the hard landing on the fully-thawed bare earth at the bottom of the mountain that must be endured by the millions of workers who cannot choose a more accommodating trail to escape their budgetary shackles? Will central bankers always be seemingly divinely endowed with soothing words to calm and assure the masses?  After all, inflation in the wise words of central bankers, is only an illusion and does not exist. Except it does exist in a very real way for the masses far below the rarified air of the lofty PEAKS.

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Fear Factor

I sure hoped that instruction manual was in the same Spanish I was trying to perfect. My life had already flashed before my eyes as the propeller plane was violently tossed to and fro in the furious thunderstorm on that thankfully fate-less flight to Isla Margarita from Caracas. It was 1995 and I was taking a weekend away from my summer internship with some Caraquenos, as I learned to call them. The teeny south Caribbean island, 25 miles from the Venezuelan mainland, was supposed to be a quick hop across the sky. Instead, the storm was so intense, it had knocked the pilot senseless. Back before cockpits were sealed tight, one could simply peer down the aisle straight into the cockpit. Doing just that for some reassurance, I was instead horrified to see our obviously less-than-capable captain reach under his seat for what appeared to be an instruction manual. Let’s just say there was no comfort knowing I was in the hands of someone who just happened to be reaching for Flying for Dummies. The moment rendered new meaning to the term, Fear Factor, or Factor Miedo for those of you Spanish speaking readers.

According to the jubilant stock market, the September jobs report packed just enough fear factor of its own to paralyze the Fed into further inaction. As Morgan Stanley’s Ted Wieseman sagely wrote, “The market more decisively priced out a December rate hike and started to ponder if asking when the Fed is going to raise rates is even the right question anymore.” I couldn’t have said it any better if I had tried. And that’s the problem.

My Caracan summer internship at Sivensa, a steel conglomerate, and the events unfolding in America’s labor force are actually linked at the hip. Back in 1995, the current commodities supercycle hadn’t even been born, at least according to the history books which peg the advent year at 2001. But Sivensa was already in the global hunt. In 1993, the pre-Chavez-era government privatized SIDOR, the then-state-controlled steel company. Sivensa was all too happy to play a leading role. Into this happy marriage, this summer intern stepped, tasked with comparing Sivensa’s business model, using my accounting skills (which were about to get severely stress tested) to that of a potential benchmarking partner in the U.S. steel industry. In three months.

It was clear overnight fluency was in the cards following a naïve attempt to get Microsoft Excel, the English version, that is. Instead I was forced to learn that “FILE” is “ARCHIVO” and got to work. The high point of my internship (in a good way, as opposed to that heart-stopping flight) was an excursion to Puerto Ordaz to see how the sausage was made, or in this case, how the hot steel was rolled. Sivensa was kind enough to put me up at the Hotel Intercontinental replete with air conditioning and cable TV. I spent the better part of that summer in a current affairs vacuum looking like I had smallpox as I was no match for the mosquitos that swarmed my Caracas boarding house room. Imagine my dismay at 24-hour OJ trial coverage the minute I found CNN.

Puerto Ordaz, founded in 1952 as an iron ore port and one of Venezuela’s fastest growing cities, is spectacularly situated at the intersection of the Caroni and Orinoco Rivers, the former the color of the darkest of night and the latter a light brown – who knew sediment could be so influential?

Though the hard-hatted plant tours were fascinating – Sivensa was on the cutting edge of producing hot briquetted steel, a premium form of direct reduced iron — the real marvel was the port itself, bustling with Asian tankers. That image, it turns out, is one for the ages. Back then, the developing world didn’t even contribute one-quarter of the world’s economic output; today it accounts for 40 percent of global gross domestic product. Narrow the focus to the now infamous BRICS – Brazil, Russia, India, China and South Africa; these resource-driven five countries at the forefront of the commodity supercycle accounted for 56 percent of developing countries’ GDP in 2014 and 22 percent of global GDP.

The recent reversal of fortunes for the BRICS was the main reason for trepidation on the Fed’s part when it last met. Now they have something much closer to home to ponder. As has been widely broadcast, September’s job creation was punk. But the real news was the downward revisions of the prior two months’ payrolls data. We still have another revision for August, and both revisions for September, so maybe the long-term trend of upward revisions to those two months will save the day.

A deeper delve into the recent trend in revisions proves more worrisome. Though it can’t be proved on a month by month basis, economists tend to associate a trend of upward revisions with an economy that’s gaining steam. As things currently stand on the payroll front, a string of positive revisions at the turn of the year has switched to a string of negatives. My Liscio partner, Philippa Dunne, long an expert in gleaning hidden nuances in labor market data, has never been one to be satisfied with superficial analysis. She notes that the final word on payrolls, the annual benchmark revision, although within the long-term average, took out jobs through March 2015, meaning the BLS’s models were too positive on the contribution of new business formation to the monthly job churn. And since young businesses are the engines of job growth, that’s not a good thing going forward.

To make matters worse are the less-than-lucrative types of jobs being churned out. The Liscio Report’s tallies find that the eat, drink and get sick sectors – health care, bars and restaurants – accounted for 47 percent of private job creation in September, two-and-a-half times their share of private employment. Mining and logging, which captures energy and the recent re-downdraft in oil prices, lost 12,000 positions (to think that last year at this time, the sector had been adding an average of 4,000 a month over the prior 12-month period). Meanwhile, manufacturing’s rolls fell by 9,000, the flipside of factory’s average gain of 9,000 over the last year.

Extrapolate this trend to encompass the rest of the world and you can imagine the bar at the Intercontinental in Puerto Ordaz just ain’t moving and shaking like it used to. For starters, the Chavez government did a number on the Puerto Ordaz private sector when he re-nationalized SIDOR, among others. (Actually, the hotel has been expropriated by the Venezuelan government as well. A recent visitor commented on Trip Advisor that though the food and beverages were reasonably priced, the waiters were much too serious.)

Perhaps the waiters used to be employed in a factory and have taken a seriously painful pay cut. The good but sad fact is they still have a job, albeit one increasingly at risk if jobs that rely on resource industries are being cut at a rate similar to that of the U.S. market At this time last year, jobs that support our own mining industry were seeing gains averaging 2,000 a month over the prior year. Flash forward to today and support positions have been pared by 81,000 in the last 12 months.

The question is, will the contagion spread beyond the network that supports the mining industry? The non-manufacturing ISM report, which captures the economically dominant service sector, reported four sectors had contracted outright in September – mining, arts and entertainment, retail trade and miscellaneous services. Granted, 11 of the 18 sectors surveyed still report expanding new orders, but the pace of gains has slowed to the lowest level of the year.  A sister report that captures global services activity also fell to its lowest level of the year.

Corroborating the weakening trend is a fairly new measure of labor market conditions the Fed has devised which captures 19 indicators harvested from hard data on job creation and wages to survey results and job opening postings. Like the nonfarm payroll report, this diffusion index – it denotes expansion when positive and contraction when negative — is also subject to revisions. The latest September read was a goose-egg, as in zero, balancing on a high wire between an expanding and contracting labor market. Incorporating downward revisions to June, July and August, the average for the year is 1.1 compared to an average of 5.4 in 2014, 4.0 in 2013, 3.8 in 2012 and 5.9 in 2011.

Why the death by numbers? I won’t say “hindsight” in my next sentence. During my tenure at the Fed advising Richard Fisher, I argued against launching successive iterations of quantitative easing, what some refer to as money printing (OK, QE1 was DEFCON 1 and I was on board with that). But back in 2011 and 2012, the economy was not perfect, however the need to begin tightening nevertheless outweighed the emerging financial market imbalances. And I battled mightily to taper swiftly and raise rates in 2013 and 2014. It was real time and it was never going to be an easy decision but the time to remove the punch bowl was at hand. Instead, policymakers appear to have waited for so long that it’s too late. Cycle missed.

If nothing else, the mighty dollar has come off its high boil; that will hopefully provide relief to that stoic Venezuelan mesero (Spanish for waiter) given inflation at upwards of 60 percent (some reports say 200 percent) puts the price of an iPhone 6 at $47,700 in local currency terms. A weaker dollar could hold the key to forestalling the global recession many seem convinced is in the cards. A recent International Monetary Fund (IMF) report is making the media rounds with a clear message to the Fed: Stay on hold, or else. The IMF, which convenes in Lima this week for its annual meeting, cites the quadrupling of non-financial emerging market corporate debt in the past decade to $18 trillion as an accident waiting to happen that would be catalyzed by a Fed interest rate hike. Tack on the fickleness of today’s ample bond market liquidity at times of market stress and the formula for igniting systemic risk is squarely in place, the IMF warns.

The Economist’s latest cover, Dominant and Dangerous, referring to the globalized greenback, takes an even deeper (recommended reading) dive into the vulnerabilities the dollar’s expanding empire presents. The bottom line is the entire offshore dollar system is twice its 2007 size; by the 2020s it could rival America’s banking system. During the heat of the financial crisis, the Fed opened the spigot to the tune of $1 trillion in emergency credit facilities to foreign and central banks. The magazine rightly asks if the political wherewithal will still be in place in the event the swollen dollar-denominated global financial system needs rescuing again.

One thing is for certain. With its questionable allies, rampant corruption and most recently, waging of war on its own people, it’s highly unlikely the U.S. will proffer aid in any form to our hobbled western hemisphere neighbor to the south. December 6th’s parliamentary elections appear to be the best hope for the country to begin to heal its economy. In what can only be deemed a small world coincidence, Maria Corina Machado is one of the main voices of the opposition. Her father is the Chairman of the Board at Sivensa and Maria, who is my age, started her own career in the hot and dusty steel mills.

Though I learned many things that summer about commodities and cockpits, the trickiest lessons were on the dance floor. The two-step was as complicated as things got on Saturday nights for this South Texas girl. Salsa, though, is a dance that engages couples on a cerebral level. Let’s just say that missteps were frequent until midsummer when my brain and feet finally connected. The Fed would do well to take some salsa lessons of its own, especially in light of some “truths” it still holds dear.

All dance moves aside, in a Wall Street Journal op-ed by Ben Bernanke shared some memorable nuggets of wisdom about the challenges of executing crisis-era monetary policy. There was this one line, though: “By mitigating recessions, monetary policy can try to ensure that the economy makes full use of its resources, especially the workforce.” Only history can judge the sanctity at the core of the Fed’s intractable operating assumptions. As is the case with perfecting salsa’s intricacies, dancing against the beat starts at the beginning of the song, not the end.

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Tiny Bubbles

A recent trip to Piero’s, an old-school Rat Pack-era Las Vegas institution, a place with high-backed banquette seating, white-glove waiters and even today, a real-life Pia Zadora entertaining in the restaurant lounge, brought back memories of my very first trip to Sin City. I was not even 21 and had traveled there with my best friend’s family, who I later came to appreciate with having had a long history of operating casinos. There on the Strip, at the Flamingo, I wore a bonafide, albeit borrowed, evening gown for the first time, as opposed to something better suited to prom night. My friend’s mother, bedecked and bejeweled, with her hair piled high, had insisted we adhere to, for the times, the city’s strict evening dress code. Surrounded by men in black tie and bevies of glamorous women, we took in the pomp and circumstance required to hit the blackjack table or spin the roulette wheel.

These days, Vegas is conspicuous in its absence of any dress code. And one wonders if the next stop for slot machine installers will be bathroom stalls. In truth, as football season rages on, any mobile phone will serve as an adequate conduit for those inclined to throw the cyber-dice. For that matter, a land line and a quick call to your friendly bookie or stockbroker, as the case may be, will work in a pinch. Such is the backdrop of today’s global financial markets, which increasingly resemble casinos. The stakes are rising for investors cum gamblers as markets are increasingly fizzing with tiny ticklish bubbles rising up to their surface and threatening to pop.

Evidence of any bubbles forming in the financial markets are criticized as inflammatory in nature and roundly dismissed. After all, are we seeing a repeat of the dotcom era wherein profit-bereft firms are given VIP access to an IPO private reception…en masse? Well no. Are average-income-earning Americans financing exceptional mansions using fraudulently-underwritten, nefariously-negative-amortization mortgages? Well, not exactly. Have investment bankers the world wide wrapped $23 trillion in high-yielding contracts around a fraction of notionally physically deliverable commodities? Without question – absolutely not.

To be precise, not one glaring market is jockeying to be crowned the singular bubbly culprit of the current era of ultra-loose monetary policy. Therein lies the challenge for policymakers and investors alike. The latest bout of market upheaval certainly has all parties on high alert. But no one, including yours truly, can lay credible claim to soothsaying what’s to come.

That’s not to say there aren’t plenty of suspicious bit players, hence those Vegasesque lyrics of Don Ho’s from way back when. High-end housing, high yield bonds, marquee market office buildings, emerging market debt, luxury apartments and hotels, for that matter, go-go momentum stocks, fine art, private market tech financing, student debt and runaway commercial lending and commercial real estate are just a few that jump out.

Valuation is a subjective endeavor, even at history’s most blatant evidentiary junctures. Think of the insistence of market cheerleaders in early 2000. Forget tech IPOs. At the time, when I was still on Wall Street, I couldn’t even get a straight answer as to why our firm’s energy analysts wouldn’t budge on their Enron price target. Or even more egregiously, the circa 2006 reader hate mail I received during my stint as a columnist. These allegations called into question my allegiance to my country simply because I had the audacity to disagree with the Maestro himself on home prices, which, after all, had never, and never would decline on a national level. (See the many Liscio Reports that focused on this misunderstanding back in the day.)

Today’s criticism is more nuanced, though no less pointed. The U.S. banking system is purportedly clean as a whistle. Regulators have made sure of that. I’ll agree that most of the pre-crisis toxic rot has been jettisoned, but serious imbalances have emerged on bank loan books. Never before have banks held such a small proportion of residential mortgages and hence had such concentrated exposure to commercial and industrial (C&I) loans on their books. Regulators have begun to sound warning bells about some industry-specific risks, such as energy loans.

But as banking expert and good friend Joshua Rosner recently pointed out, the harm to the system has already been done. Since 2011, C&I loan volumes have expanded by more than 60 percent while the loans’ average yields have declined to under three percent from five percent. Meanwhile, the terms of these loans have shortened meaningfully. If these were your grandfather’s conservative credit borrowers, these statistics wouldn’t be so worrisome. But once again, lower for longer has allowed sickly companies to stay alive purely because credit has been cheap for long enough to sustain them. The quick resetting of so many of these loans presents a massive challenge to the Fed in lifting interest rates.

As for student debt, the emerging consensus is that new laws ensure it cannot be a bubble. As long as the cottage industry, designed to help students expunge rather than pay off their debts, continues to grow and thrive, student loans are simply a future taxpayer headache. Furthermore, student loans outstanding are nowhere near the size of the mortgage market when it blew, so no harm, no foul. (A trillion here, a trillion there. Moral Hazard, anyone?)

Unicorns are rainbow-hued and mythical creatures, especially for the deep-walleted investors who have ventured as far out West as the eye can see on the risk spectrum. Don’t be anxious, we’re assured, these sophisticates who have poured money into the current stable of 133 unicorn startups, valued at $1 billion or more, know exactly what they’re doing. If they should, for example, lose money by eventually valuing such a unicorn darling as Uber at a higher valuation than that of all Nasdaq stocks combined. That’s their contained problem. Except that niggling issue of mutual funds that invest in unicorns, some of which are distressingly on offer to unsuspecting, less sophisticated 401k plan participants in companies all across America.

At least, as we are constantly comforted, the publicly traded stock market is soundly valued. While some froth has certainly come off the top since the August 24th Chinese yuan devaluation, it’s still nearly impossible to make heads or tails of stock valuation. For one thing, low interest rates have flattered profits while reducing the pressure on corporate captains to grow the bottom line the old-fashioned way. But that’s not where the real juice is. To get to that Shangri La of financial engineering, you have to actually reduce share count via debt-financed buybacks, regardless of whether you’re referring to companies buying back their own stock or buying other companies outright.

While the usual effervescent suspect in bond land is today’s high yield debt market, I worry about yesterday’s and tomorrow’s junk bonds. Looking back in time, it’s difficult to gauge the ramifications of the stunting of the last credit meltdown’s default rate cycle. We know certain companies should have gone into full blown bankruptcy but have avoided that fate thanks to the Fed’s rolling out of unconventional monetary policy. And our public’s inattention to the whole affair. Less appreciated is the potential for a good number of today’s poshest-credit companies losing their investment grade status. And yet, the potential for a dramatic fall from grace is on full display in the case of mining giant and commodity trader Glencore as it battles to dispel rumors that its $30 billion debt load could cause the company to implode. Shares of the company have lost about two-thirds of their value and analysts say another five percent fall in commodity prices will suffice to strip the company of its precious investment grade credit rating.

Further afield, emerging market (EM) debt, of both the sovereign and corporate sort, is a black box. The asset class could prove to be a safe haven. But the preponderance in EM debt of commodity issuers and the lenders that banked the resource-dependent industry does give pause. If you harbor any doubts, just ask Bill Gates about his views on Petrobras, the Brazilian oil behemoth that’s buried itself alive in a corruption scandal for the history books. The Gates Foundation is suing both the company and its auditor for failing to flag signs of bad corporate behavior. Petrobras’ stock has lost more than 90 percent of its value and has been downgraded to junk by the credit rating agencies.

Meanwhile, back in Manhattan, commercial real estate (CRE) continues to trade at bespoke levels. Prices in midtown have long since surpassed their 2007 highs. And showing they can’t be left out of the party, banks’ loan-to-value ratio on their CRE loans nationwide is perched at 118 percent; they’re just as far out on an underwriting limb as they were in the heady months leading up to the 2008 crisis. You could just as easily substitute in similarly bubblicious valuation stats for penthouses in top tier markets, presidential suites anywhere a luxury hotel stands, high-end speculative home construction, fine art, classic cars, wine and partridges in pear trees of the sweetest red D’Anjou variety (OK, I made that last one up).

Perhaps, in hindsight, it’s the very preponderance of prickly little bubbles that market historians will chastise the masses for having dismissed. For now, the lack of an individual, identifiable bubble perpetrator gives the bully pulpit free reign to calm any hint of anxiety. No need to debunk red herring books salaciously titled, “Dow 36,000,” circa November, 2000 or its successor, “Are You Missing the Real Estate Boom?” published in February 2005.

There’s no book I can point to so I’ll stick with Robert Shiller’s take on the current euphoric era. (Sorry, Mr. Icahn – I find it troubling that less than a year ago you were pounding the table for Apple to buy back its shares and now you’re vilifying CEOs who do just that.) In any event, in Shiller’s estimation, we’re in a “fear” bubble, much like that which preceded WWI, a time where people rushed out to secure gold for fear of what was to come. Today’s equivalents are mutual funds and exchange traded funds which promise investors immediate liquid convertibility despite underlying holdings that could prove to be as liquid as dried mud.

Over the years, the Nobel Laureate has defined bubbles in many ways (oddly, he’s had plenty of material to work with since 1987). The one that most aptly captures the mood of the day is as follows: “People are motivated by envy of others who made money….regret in not having participated and gambler’s excitement.”

Do tiny bubbles make you happy? That’s the funny thing about bubbles, especially when they’re so numerous as to delude the beholder into perceiving innocuity. They never play out according to script. So we’ll have to settle for some lyrics to tide us over in the interim, in honor of the dearly departed Don Ho who oft delighted the adoring crowds of blue-haired denizens on that Flamingo stage all those years ago. If not for our subject matter du jour, you’re almost tempted to raise a glass when you hear these two lovely lines in your mind: “So here’s to the golden moon. And here’s to the silver sea.” If only we could know our greedy illusion won’t pop when the sun rises on our collective party. Even in Vegas, night eventually succumbs to day.

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