How to reconcile equities markets punching towards new all-time highs within two short years of the worst financial crisis since the Great Depression? It’s not easy. Intuitively equities should do best when times are good. But they aren’t good are they? That is why we have all this stimulus…
Big Government is back
Global risk markets have become unusually dependent upon government and its egocentric offspring. It’s an outcome of economic stress. Albert Edwards may have maintained the bearish rage throughout, but he did make the point (in December 2009 here) to buy equities when the government is stimulating. It was a good call – the same one that David Tepper was later to make.
Looking ahead, where does all this ‘intervention’ take us? If we assume that times are not good (as the Fed would have us believe), then the first conclusion must be… to more intervention.
Following this line of logic, and admittedly it’s the bear case where the global economic pie gets no bigger for years to come, the task then is to understand how intervention may evolve. Who will be the winners and how will markets respond? Is all intervention good for risk markets?
In the Middle East
While rational expectations theory may deeply flawed, I do believe that we are all driven by a selfish desire for more. Our various systems of government are designed to aggregate this singular ambition to exist. As such, institutional frameworks often embody this same cloying need to continue – let’s call it the ‘status quo’.
So, for example, while Egypt rejoices over the removal of Mubarak (coming in at number 20 on Parade’s worst dictators list here) there is little chance that western style democracy will fill the void. That’s because the void is already full. The institutional structure of the Egyptian economy is constructed around the all pervasive influence of its military. If democracy exists, it exists within the heirarchical structure of that institution. US aid and arms exports (see Fortune’s cover story here) are designed to support that institution. If the hungry masses bang their fists on the gate, then it’ll be important to watch how the military responds. History would suggest that the path of least resistance will be to repress unrest, and the military is well designed for that purpose.
Large tracts of the planet are under the influence of such institutional systems – certainly the Middle East is riddled with them. These regimes ultimately maintain hegemony through force. They rely on a chain of command and the Nuremberg defence. They are not fountains of democracy. If the global economy continues to struggle, and the continued stimulatory response leads to food price inflation, then I think we can expect oil markets to remain sensitive to the changing of the guard in the Middle East.
(While such systems are not inherently evil, their stability seems to gravitate around individuals that are. At the extreme you arrive at Stalin’s earthly paradise where, as Khrushchev notes in his “Cult of Personality” speech, of the 1,966 delegates to the 17th party congress, 1,108 were arrested on charges of antirevolutionary crimes – while 98 of the 139 members of the party’s Contral Committe were shot. ”This very fact shows how absurd, wild and contrary to common sense were the charges of counter-revolutionary crimes made against a majority of participants at the party congress”. And yet it happened.)
And China…
This type of analysis exposes a serious flaw in the commodity super-cycle theory. On the face of it, China operates under a institutional structure that has all the hallmarks of those hierarchical regimes described above. It is most certainly not a democracy even though portions of its population have been enjoying rapidly growing wealth. This makes blind faith in Chinese industrialisation a dangerous choice. China does not have to continue down that path. History has plenty of precedent to suggest otherwise. If threatened from within, the centre is more likely to reassert control via the party hierarchy. The leadership may fear revolution, but the balance of probabilities favors the iron fist rather than glasnost as a way of containing it.
The point here is not that the iron curtain is about to be rehung. It is that there is a real risk that if the system is stressed, then the reaction of the institutional structures are unlikely to be ‘capitalist’ friendly. Now place that risk in the context of commodity prices that are priced for absolute certainty that China will industrialise over the next decade and the conclusion must be that the downside risk baked into industrial commodities prices in the current market is extreme.
Whether China is likely to get stressed, I’m working on the assumption that it is easier to spend money than it is to reign in rampant price increases. So like all ‘swimming naked’ metaphors, we will only learn how command capitalism really works when the tide turns. If it is true that China has a serious case of over-investment, as seems reasonably likely, there is no ultimate escape from that mal-investment. The probability of a tipping point increases as commodity prices trip higher and squeeze the disposable income of the Chinese homemaker.
And the US…
So to the land of the free, in the absence of a commensurate revival of fortunes, the fat fingered hand of government is going to be handing out the food coupons for a while yet. The question is ‘for whose benefit’?
While the administration has been busying itself with support for all and sundry, the institution that has really been driving the redistribution of wealth effort has been the Fed. Its QE programs, designed to lift asset prices ‘higher than they would otherwise be’, have sent equity markets skyward and with them the prices of real assets – principally the commodities that we all consume. The owners of at least these assets have benefited. But, remembering that the economic pie isn’t any bigger, at the expense of those that live a more cashflow oriented life. Bernanke would have it that higher commodity prices aren’t a problem – that disposable incomes in the US aren’t sensitive to the price of corn, meat and wheat. This is the clearest indication yet of where the Fed as an institution sits – and that is outside the political system. It may not be sensitive to higher food prices, but the Congress sure is.
This points to the conflict that is brewing between the political process and the institutional structure that has built up around the Fed. Ultimately, the Fed reports to Congress - and while QE’s non-inflationary magic may cloud the looking glass for a while, the more that capital benefits at the expense of wage earners, the more the pressure for change will grow.
In short.
1) For the Federal Reserve, QE once started will be near impossible to get off. QE will never deliver real economic growth in a deleveraging economy – wages and home prices will be the last to benefit from the unconventional easing. So the Fed will keep running up the credit card until…
2) The political process stays stop.
Conclusion
To draw this random walk to close…
1) We are still running by the playbook that simply says – ‘risk-on’ when governments are stimulating, ‘risk-off’ when markets are left to their own devices. With valuations stretched to extremes from our assessment of fair-value, and liquidity now being tightened in China, and the end of QE2 on the near(ing) horizon, it’s time to de-risk the portfolio once again.
2) Political meddling in all its varied guises is going to be a feature of the world economy for years to come. We retain a core position in energy and a preference for the long side of precious metals and agricultural assets – as capital continues to run to real assets. We’re out of industrial commodities – the risk/reward skew strongly favours the downside if you like to play that side of the fence.
Big Government is back
Global risk markets have become unusually dependent upon government and its egocentric offspring. It’s an outcome of economic stress. Albert Edwards may have maintained the bearish rage throughout, but he did make the point (in December 2009 here) to buy equities when the government is stimulating. It was a good call – the same one that David Tepper was later to make.
Looking ahead, where does all this ‘intervention’ take us? If we assume that times are not good (as the Fed would have us believe), then the first conclusion must be… to more intervention.
Following this line of logic, and admittedly it’s the bear case where the global economic pie gets no bigger for years to come, the task then is to understand how intervention may evolve. Who will be the winners and how will markets respond? Is all intervention good for risk markets?
In the Middle East
While rational expectations theory may deeply flawed, I do believe that we are all driven by a selfish desire for more. Our various systems of government are designed to aggregate this singular ambition to exist. As such, institutional frameworks often embody this same cloying need to continue – let’s call it the ‘status quo’.
So, for example, while Egypt rejoices over the removal of Mubarak (coming in at number 20 on Parade’s worst dictators list here) there is little chance that western style democracy will fill the void. That’s because the void is already full. The institutional structure of the Egyptian economy is constructed around the all pervasive influence of its military. If democracy exists, it exists within the heirarchical structure of that institution. US aid and arms exports (see Fortune’s cover story here) are designed to support that institution. If the hungry masses bang their fists on the gate, then it’ll be important to watch how the military responds. History would suggest that the path of least resistance will be to repress unrest, and the military is well designed for that purpose.
Large tracts of the planet are under the influence of such institutional systems – certainly the Middle East is riddled with them. These regimes ultimately maintain hegemony through force. They rely on a chain of command and the Nuremberg defence. They are not fountains of democracy. If the global economy continues to struggle, and the continued stimulatory response leads to food price inflation, then I think we can expect oil markets to remain sensitive to the changing of the guard in the Middle East.
(While such systems are not inherently evil, their stability seems to gravitate around individuals that are. At the extreme you arrive at Stalin’s earthly paradise where, as Khrushchev notes in his “Cult of Personality” speech, of the 1,966 delegates to the 17th party congress, 1,108 were arrested on charges of antirevolutionary crimes – while 98 of the 139 members of the party’s Contral Committe were shot. ”This very fact shows how absurd, wild and contrary to common sense were the charges of counter-revolutionary crimes made against a majority of participants at the party congress”. And yet it happened.)
And China…
This type of analysis exposes a serious flaw in the commodity super-cycle theory. On the face of it, China operates under a institutional structure that has all the hallmarks of those hierarchical regimes described above. It is most certainly not a democracy even though portions of its population have been enjoying rapidly growing wealth. This makes blind faith in Chinese industrialisation a dangerous choice. China does not have to continue down that path. History has plenty of precedent to suggest otherwise. If threatened from within, the centre is more likely to reassert control via the party hierarchy. The leadership may fear revolution, but the balance of probabilities favors the iron fist rather than glasnost as a way of containing it.
The point here is not that the iron curtain is about to be rehung. It is that there is a real risk that if the system is stressed, then the reaction of the institutional structures are unlikely to be ‘capitalist’ friendly. Now place that risk in the context of commodity prices that are priced for absolute certainty that China will industrialise over the next decade and the conclusion must be that the downside risk baked into industrial commodities prices in the current market is extreme.
Whether China is likely to get stressed, I’m working on the assumption that it is easier to spend money than it is to reign in rampant price increases. So like all ‘swimming naked’ metaphors, we will only learn how command capitalism really works when the tide turns. If it is true that China has a serious case of over-investment, as seems reasonably likely, there is no ultimate escape from that mal-investment. The probability of a tipping point increases as commodity prices trip higher and squeeze the disposable income of the Chinese homemaker.
And the US…
So to the land of the free, in the absence of a commensurate revival of fortunes, the fat fingered hand of government is going to be handing out the food coupons for a while yet. The question is ‘for whose benefit’?
While the administration has been busying itself with support for all and sundry, the institution that has really been driving the redistribution of wealth effort has been the Fed. Its QE programs, designed to lift asset prices ‘higher than they would otherwise be’, have sent equity markets skyward and with them the prices of real assets – principally the commodities that we all consume. The owners of at least these assets have benefited. But, remembering that the economic pie isn’t any bigger, at the expense of those that live a more cashflow oriented life. Bernanke would have it that higher commodity prices aren’t a problem – that disposable incomes in the US aren’t sensitive to the price of corn, meat and wheat. This is the clearest indication yet of where the Fed as an institution sits – and that is outside the political system. It may not be sensitive to higher food prices, but the Congress sure is.
This points to the conflict that is brewing between the political process and the institutional structure that has built up around the Fed. Ultimately, the Fed reports to Congress - and while QE’s non-inflationary magic may cloud the looking glass for a while, the more that capital benefits at the expense of wage earners, the more the pressure for change will grow.
In short.
1) For the Federal Reserve, QE once started will be near impossible to get off. QE will never deliver real economic growth in a deleveraging economy – wages and home prices will be the last to benefit from the unconventional easing. So the Fed will keep running up the credit card until…
2) The political process stays stop.
Conclusion
To draw this random walk to close…
1) We are still running by the playbook that simply says – ‘risk-on’ when governments are stimulating, ‘risk-off’ when markets are left to their own devices. With valuations stretched to extremes from our assessment of fair-value, and liquidity now being tightened in China, and the end of QE2 on the near(ing) horizon, it’s time to de-risk the portfolio once again.
2) Political meddling in all its varied guises is going to be a feature of the world economy for years to come. We retain a core position in energy and a preference for the long side of precious metals and agricultural assets – as capital continues to run to real assets. We’re out of industrial commodities – the risk/reward skew strongly favours the downside if you like to play that side of the fence.
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