Friday, October 7, 2016

Brace For a Violent Shift in Markets?

Julie Verhage and Sid Verma of Bloomberg report, Bank of America Says We're Experiencing 'Peak' Everything and a Major Market Change Is Coming:
Some of the hottest trades of the past few years could stage a sharp reversal as global markets face "peaks" in liquidity, free trade, and income inequality.

That's the big-picture call from Bank of America Merrill Lynch, whose analysts argue in a report published Thursday that an apparent fightback against globalization in advanced economies represents a game-changer for global asset-allocation.

"We are convinced that policy is decisively shifting in a direction that is less positive for 'deflation assets' and more positive for 'inflation assets,'" the team, led by Chief Investment Strategist Michael Hartnett, write. This year and next, investors face a reversal of "bullish" trends that have buttressed globalization and liquidity in recent years, they argue.

In sum, Hartnett and team say it's time for investors to consider a new normal for equity and fixed-income markets.

"A reversal of these trends, together with a shift toward fiscal stimulus and higher interest rates strongly argues that the excess returns from stocks and bonds in the past eight years are also likely to reverse," they say.

Explaining their rationale in predicting declining liquidity, the team cites declining enthusiasm among central bankers in Europe and Japan towards negative interest-rate policies. "Central banks are starting to feel political backlash for fueling inequality, and 'Quantitative Failure' (671 rate cuts since Lehman bankruptcy has fostered neither robust economic recovery nor 'animal spirits' as corporations & households continue to hoard cash) means that the era of excess liquidity and QE is now largely behind us."

Anti-immigration and anti-trade sentiment also appears to have increased in the U.S. and U.K. in recent months, while trade tensions are rising. Against this backdrop, BAML reckons trade policies might become more restrictive in the coming years. "Events show nations are becoming less willing to cooperate, more willing to contest," they write, adding that global trade expansion in 2016 is forecast at around 1.7 percent of GDP, below the rate of economic expansion, a development historically associated with recessions.

Inequality might also be reaching a boiling point in a bevy of developed markets, raising the prospect of active fiscal policies, which BAML reckons will help fuel inflation. In this scenario, investors should buy fewer bonds as "a shift toward Keynesian policy is likely to raise growth expectations and interest rates."

Amid signs of a growing backlash against the inequities generated by globalization, analysts at Bank of America last month foresaw a new era with looser fiscal policy in developed countries — combined with trade protectionism and wealth redistribution — that would redraw the global investment map. The report on Thursday adds meat to this call; BAML on Thursday says it is bullish on stocks and commodities and bearish on bonds. The bigger returns are likely to come from 'zero interest rate policy losers,' they conclude.

Nevertheless BAML concedes central banks could remain very accommodative in their policies, and a recession could imperil its calls to snap up inflation-hedges, while the IMF doubts a looser fiscal policy will be unleashed next year.
It's Friday so I want to "shift" my attention to markets and give everyone out there some food for thought. I will circle back to this BAML report below.

First, this morning, the US jobs report came out showing the US economy created a less-than expected 156,000 jobs in September:
Job creation edged lower in September as the labor market showed there still may be room to run.

Nonfarm payrolls increased 156,000 for the month and the unemployment rate ticked up to 5 percent, the Bureau of Labor Statistics reported Friday. Economists surveyed by Reuters had expected 176,000 new jobs and the jobless rate to hold at 4.9 percent. The total was a decline from the upwardly revised 167,000 jobs in August (compared with the original number of 151,000).

"This is within the broad range of expectations," said Mark Hamrick, senior economic analyst at "The main point is, slow and steady does win the race for this recovery, which began in the summer of 2009."

Average hourly wages pushed higher, rising 6 cents to an annualized rate of 2.6 percent. The average work week also inched up one-tenth to 34.4 hours.

A broader measure of unemployment that includes those who have stopped looking for jobs as well as those working part-time for economic reasons was unchanged at 9.7 percent.

The number of workers considered not in the labor force fell by 207,000 to 94.2 million, the number in the labor population surged by 444,000 and the level of the employed jumped by 354,000, according to the household survey. The employment-to-population ratio rose to 59.8 percent, a half-percentage point gain from a year ago.

Professional and job services led the way with 67,000 new jobs while health care added 33,000 and restaurants and bars contributed 30,000.

The report comes at a critical time for the Federal Reserve as the U.S. central bank looks to resume getting rates back to normal. The Fed last hiked rates in December, the first such move in more than nine years. However, it has held off since then amid a variety of global and domestic concern.

Traders expect the Fed to hike again in December.

"This is a solid number," Cleveland Fed President Loretta Mester told CNBC. "This is very consistent with what we expected to see, certainly with my forecast."

Traders pushed chances for a December rate hike higher, from 63.9 percent prior to the payrolls report to 70.2 percent afterward.
Cleveland Federal Reserve President Loretta Mester told CNBC on Friday the government's weaker-than-expected employment report for September was still strong enough to keep her thinking central bankers should increase interest rates:
"It's a solid labor market report," Mester said on "Squawk Box." She's a voting member this year on the Fed's policy panel, the Federal Open Market Committee. "This is very consistent with what we expected to see."

"The economy has been very resilient," she said, citing bounce backs from the stock market plunge early in the year and the June vote by Britain to leave the European Union.

On Friday morning, the Labor Department said 156,000 nonfarm jobs were added in September. The unemployment rate rose slightly to 5 percent. "The unemployment rate is about at what my estimate of full employment is, natural rate of unemployment," Mester said.

Economists polled by Reuters had predicted the U.S. economy would create about 175,000 nonfarm payrolls last month, with an unchanged jobless rate of 4.9 percent.

"Remember 75,000 to 120,000 [jobs added] per month is about what you need to keep unemployment stable," Mester said, citing stronger labor market numbers this year, with the three month average of about 192,000.

Average hourly earnings matched expectations with an increase of 0.2 percent in September and an annualized rate of 2.6 percent. The average work week also inched up one-tenth to 34.4 hours.

"I see inflation measures moving up," in addition to stronger jobs, Mester said. "We have to be forward-looking. So in terms of our two goals ... it makes sense to move up the [fed funds] rate another 25 basis points."

The Fed's next two-day meeting concludes on Nov. 2, just six days before the presidential election. But Mester said "all meetings are on the table" for a possible rate increase, and that politics do not have any bearing on policy setting decisions.

The Fed also meets in December, one year after the Fed hiked rates for the first time in more than nine years.

"I don't think we're behind the curve yet. I don't see that we need to bring rates up very quickly," Mester said. "I'd like to be on this gradual path that we've been communicating."
Interestingly, this morning I saw a BBC interview with Charles Dumas, chief economist at Lombard Street Research, claiming "the Fed is behind the curve, ignoring inflation pressures that are building up."

Really? Am I missing something here? When I click on Lombard Street Research, the first thing I see is a story on how it's too soon to cheer the end of deflation in China (click on image):

But right under that is a report on how central banks would like to overshoot their inflation targets as ‘insurance’ against the next recession but with inflation set to move higher, bond markets don’t believe they can achieve this and investors could be set for a nasty surprise.

Those of you who read my blog regularly know that I'm obsessed with one and only one big macro theme: the titanic battle versus deflation.

It has been my contention all along that central banks are doing everything in their power to fight a deflation tsunami that is headed our way but they can only buy time. Whether you are prepared for it or not, the deflation tsunami is coming and even a massive, coordinated fiscal intervention won't save the global economy from entering a prolonged period of debt deflation.

How sure am I on this long-term call? I'm pretty sure and I'll share exactly why I think the inflationistas are out to lunch, just like Morgan Stanley was when it said the US dollar was set to tumble at the beginning of August (look at the DXY over last three months, they blew that call).

Look, all these people claiming deflation is dead are not looking at the bigger picture properly. Importantly, China, Japan and Europe remain very much mired in deflation and the risks remain that deflation will eventually reach America.

What about the recent cracks in the bond market? What about Donald Trump, protectionism, or Hilary Clinton and fiscal spending on infrastructure? (Note: Both candidates want to spend on infrastructure)

What about it? I've already exposed bond bubble clowns and as far as fiscal policy, even if the dysfunctional Congress manages to agree on a massive infrastructure package (a big if), it's a day late and a dollar short.

Even Federal Reserve Vice Chairman Stanley Fischer, a well-known hawk, has finally admitted that near-zero rates, QE may be the future:
Evidence that the so-called natural rate of interest has fallen to low levels could mean the economy is stuck in a low-growth rut that could prove hard to escape, Federal Reserve Vice Chair Stanley Fischer said on Wednesday.

Speaking to a central banking seminar in New York, the Fed's second-in-command said he was concerned that the changes in world savings and investment patterns that may have driven down the natural rate could "prove to be quite persistent...We could be stuck in a new longer-run equilibrium characterized by sluggish growth."

As a result, he said, central bankers may face a future where the short-term interest rates set by policymakers never get far above zero, and the unconventional tools used during the financial crisis become a "recurrent" fact of life.

"Ultralow interest rates may reflect more than just cyclical forces," Fischer said, but "be yet another indication that the economy's growth potential may have dimmed considerably."

Fischer's remarks did not address current Fed policy or interest rate plans.
I'll repeat what I've said plenty of times, ultra low rates and the new negative normal are here to stay, which effectively means the pension Titanic will keep sinking.

And by the way, it has nothing to do with this savings and investment imbalance Fisher alludes to. Alan Greenspan continuously alludes to this too and is on record stating that entitlement spending run amok spells doom for developed and developing economies (conveniently ignoring how a rising inequality is impacting aggregate demand).

But the real structural problems behind these ultra low rates and low growth are demographic shifts, high and unsustainable debt, rising inequality (the retirement crisis exacerbates this), long-term structural unemployment and underemployment, and disruptive shifts in technology.

Interestingly, on Wednesday, Ray Dalio, the founder of $160 billion hedge-fund behemoth Bridgewater Associates, warned of a coming “big squeeze” in a speech delivered at the Federal Reserve Bank of New York’s 40th Annual Central Banking Seminar:
Dalio, 67, says that the long-term debt cycle, which typically lasts 50 to 75 years, is approaching its limits. This is also the “most important” force at play in the economy.

“The biggest issue is that there is only so much one can squeeze out of a debt cycle and most countries are approaching those limits,” Dalio said.

Since the financial crisis, central banks around the world loosened monetary policy aggressively, keeping interest rates low and encouraging more lending activity. But the incremental benefits of all of this has been diminishing. This is troubling when balance sheets are becoming increasingly debt-laden and vulnerable.

“In other words, they are simultaneously approaching both their debt limits and central banks’ ‘pushing on a string’ limits,” he said. “Central banks are approaching their ‘pushing on a string’ limits both because interest rates are approaching their maximum lows, and because the effectiveness of [quantitative easing] is approaching its limits as the risk premiums and spreads are compressing. Also, the wealth gap and numerous other factors make lending to spenders more challenging.”

Critically, this is not an isolated problem.

“This is a global problem,” he said. “Japan is closest to its limits, Europe is a step behind it, the US is a step or two behind Europe, and China is a few steps behind the United States.”

The coming squeeze will happen as the baby boomer generation leaves the workforce and begins collecting retirement and healthcare benefits like Social Security and Medicare. According to Dalio, many of these promises can’t be kept. The problem is the expected low returns on assets won’t be enough to fund those government liabilities.

For now, any sense of financial security among individuals can be characterized as a false sense of security.

“Holders of debt believe that they are holding an asset that they can sell for money to use to buy things, so they believe that they will have that spending power without having to work,” he said. “Similarly, retirees expect that they will get the retirement and health care benefits that they were promised without working. So, all of these people expect to get a huge amount of spending power without producing anything. At the same time, workers expect to get spending power that is equal in value to what they are giving. They all can’t be satisfied.”

It’s an all-around gloomy situation that could force policymakers into desperate positions before the whole thing ends in tears.

“As a result of this confluence of conditions, we are now seeing most central bankers pushing interest rates down to make them extremely unattractive for savers and we are seeing them monetizing debt and buying riskier assets to make debt and other liabilities less burdensome and to stimulate their economies,” he said. “Rarely do we investors get a market that we know is over-valued and that approaches such clearly defined limits as the bond market now.”

These low or negative interest rates translate to low or negative returns on bonds. This incentivizes investors and savers to avoid bonds and put their money into 1) safe-haven stores of wealth like gold, or 2) riskier assets like stocks that promise higher returns. Dalio argues that these alternatives are not necessarily cheap relative to their risks, but they certainly look cheap relative to bonds.

“[H]olding non-financial storeholds of wealth like gold could become more attractive than holding long duration fiat currency flows with negative yields (which is what bonds are), especially if currency volatility picks up.”
Dalio isn't the only one recommending gold these days. You'll recall bond king Jeffrey Gundlach came out at the beginning of August warning investors to sell everything except gold (another bad call as gold prices have declined over the past two months).

Another well-known bearish hedge fund manager, Crispin Odey, is so convinced a "violent unwind" of the QE bubble is just ahead, that he's taking a massive gold position which could make or break his fund (my bet is he's toast if this is true).

Look, I'm weary of all these delivering alpha types making big proclamations. I don't think it's the twilight of central bankers but I'm not convinced there is much they or politicians can do to stop this prolonged period of debt deflation headed our way.

This doesn't mean there won't be opportunities to make money in these markets but I think you need to be nimble and trade which isn't easy to do, especially if you're a mammoth fund.

But take all these dire warnings of a "violent unwind of the QE bubble" or even the "end of the debt supercycle" with a grain of salt.

My thinking has not changed much, I still think we're headed for a long period of debt deflation but there are always going to be tradeable opportunities in these markets if you know where to plunge (and which sectors to steer clear of).

This brings me to the BAML report at the top of this comment. I remain highly skeptical of a global economic recovery and would take profits or even short emerging market (EEM), Chinese (FXI),  Metal & Mining (XME) and Energy (XLE) shares on any strength. And despite huge volatility, I remain long biotech shares (IBB and equally weighted XBI) and keep finding gems in this sector by examining closely the holdings of top biotech funds.

And in a deflationary, ZIRP & NIRP world, I still maintain nominal bonds (TLT), not gold, will remain the ultimate diversifier and Financials (XLF) will struggle for a long time if a debt deflation cycle hits the world (ultra low or negative rates for years aren't good for financials).

As far as Ultilities (XLU), REITs (IYR), Consumer Staples (XLP), and other dividend plays (DVY), they have gotten hit lately partly because of a backup in yields but mostly because they ran up too much as everyone chased yield (be careful, high dividend doesn't mean less risk!). Interestingly, however, high yield credit (HYG) continues to make new highs which bodes well for risk assets.

Below, Cleveland Federal Reserve President Loretta Mester told CNBC on Friday the government's weaker-than-expected employment report for September was still strong enough to keep her thinking central bankers should increase interest rates.

I don't agree with her rosy assessment of the US labor market and neither does Warren Mosler, which is another reason why I still maintain the Fed shouldn't raise rates now. If it does, it could unleash a massive deflationary hurricane which will clobber financial markets and the entire world economy.

That is the only violent shift in markets that terrifies me, a major policy blunder by the Federal Reserve (so far, they have been keenly aware of global deflationary risks).

Also, Yanis Varoufakis, former Greek finance minister, believes the disintegration of the European Union will "breed monsters." I disagree with him on what Greece needs but he's right, the disintegration of the EU will unleash a huge global deflationary crisis (in his own words,"Europe exports deflation, it exports crisis").

On that cheery note, enjoy the long Thanksgiving weekend in Canada. Please remember to kindly donate or subscribe to this blog via PayPal on the right-hand side under my picture (you can't see it on your cell phone, only on your tablet or desktop). Have a great weekend!

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