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13:21 on June 12 2015

Central Banking Series Event in Madrid

Os recomiendo este artículo de mi compañero Francisco Esteban:



Last May 13-14th I had the opportunity to attend the Central Banking Series Event in Madrid, promoted by the Global Interdependence Center and sponsored by BBVA. It was a great experience and the event lived up to expectations as it allowed for the gathering of opinions from some of the leading minds in the monetary policy arena.

The speaker´s panel included officials from the Fed, ECB, Bank of Poland, Bank of Spain, Bank of Mexico, etc… pand reputable Chief Economists from different financial institutions, corporations and Asset Management firms.

After a series of very thoughtful and thorough presentations, a lot of reflections came to my mind and that´s the reason why I decided to put them together in this document.
As an asset manager I cannot find the words to express my deepest gratitude to the Central Banks for  the Quantitative Easing experiments they are implementing. These have allowed my clients and myself to benefit economically and placed me into a personal transformation process. Now, thanks to QE, I am more selfish, as I don´t care about the effects that this QEs may have on the real economy and the rest of the citizens, my sole concern being how QE will impact the financial markets, which is my  principal source of income. I am now a much greedier person for I now assume greater risk when undertaking my investment decisions for  I know I´ll have the CBs to the rescue in case anything threatens the financial panacea they have created. As a consequence of this personal transformation, the first thing I´ve done in my new era is to make a bonfire with all the text books that I studied at the university. I now know that the major problems in the economy and in finance can be fixed by merely printing more money. It just doesn´t matter about the size of the problem, the country, its currency, its economic cycle nuances, it´s geopolitical circumstances, etc… Quantitative Easing is the new economic "Valhalla".
Of course, I am just kidding…but I´m pretty sure that this describes the growing consensus within the investment community (practitioners) and the Central Banks alike as a means to keep kicking the can further down the road. 
As an economist, I wonder why Central Banks have such an obsessive need to intervene/ manipulate the very nature of economic cycles. Economic cycles go from recovery to expansion and end with a slowdown and subsequent contraction/ recession. Recessions are as important as expansions within an economic cycle, as they act as filters on the inefficient allocation of resources and capital within the system. By killing recessions, we are merely perpetuating inefficiencies thus exacerbating booms and busts during the subsequent cycles.
Central Bankers should know that the amount of risk in a system is roughly constant over time and that any effort to minimize risk or volatility at any point in time will lead to its more forceful re-emergence later on. 
 If you take a look at the shape of both the economic and the stock market cycles in the US during the last 25 years, a period with the highest and most systematic level of intervention from the Fed, you´ll see that it looks like a roller coaster. In just 25 years, the US has experienced the largest bubbles and busts in history  over short time periods. This should lead us to question if the Central Banks are the solution or part of the problem.

The dual mandate of the Fed consists of two goals: full employment and price/financial stability. During the last 25 years the former has encountered problems during the aftermath of the financial crisis (2008-2013), while inflation has never been an issue. Despite this fact, the Fed has been actively manipulating the cost of money since the early 90´s, thus creating false prices in exchange rates. From there, all prices become false and the economy moves ex-growth after a boom built on leverage and marked by a sharp rise in asset prices. What follows is always a bust when the carry traders get killed.
I´ve been managing portfolios for 20 years and I´ve never witnessed such an extended time period  during which the only focus for investors/markets have been on the Central Bank meetings, statements and forward guidance. Macro and micro economics have taken on a secondary role. Here I would argue that Central Banks should never give forward guidance about its future actions. Never. By publicly stating that they will keep interest rates low for a long time, the first thing they are assuring is that they can see long into the future, which is never the case. As a consequence, market participants clamor for more and more of it, on the pretext that if that guarantee where to be withdrawn, the markets would collapse. This policy of forward guidance massively reduces the risk for borrowers over the long run, so reducing risk on the liability side of leveraged positions.
Mr. Massimo Rostagno, from the ECB, said during his presentation in Madrid "one of the benefits of the QE is that it improves the risk adjusted returns of the banks´ loan portfolios…", but he forgot to talk about the monstrous asymmetry that QEs create on the risk adjusted returns for investors (I better call this a dislocation of financial markets). 
As a consequence, the very first lesson that we are learning these days is that QE only benefits those that have a close relationships with the Central Banks, leading to a misallocation of capital.
This leads me to a very simplistic explanation for one of the topics that was addressed during the conferences in Madrid: "Why productivity is slowing down?".

Forward guidance is leading to an increase of leverage in the system and to inflation in asset prices. Since assets are held by wealthier people, the rich get richer. But the rich tend to buy existing assets, not build new assets (which by definition have uncertain cash flow), so the national stock of capital does not rise. As a result, productivity falls, the structural growth rate of the economy declines, and the poor get poorer.
In fact, there´s no question that one of the very real consequences of the QEs on the US economy has been in the form of growing inequality. Today the top 1% of American tax payers pays 40% of the tax bill and the top 10% of tax payers account for 90% of the total tax income. That means that only 11,7 million workers are supporting 108 million other people through the government, while food stamp recipients total 46.2 million. Statistics that are closer to those of a banana republic than those of a First World country and the leading economic power in the world.
History tells us that whenever the stock market performance exceeds economic growth, economic inequality follows and consequently social unrest (is Ferguson just the canary in the coal mine?).
During the Madrid Events, the Fed officials put on the table the evolution of some economic figures from the US economy during the last few years (GDP, capital spending, employment etc…), as a means to highlight the benefits of QE on the real economy. But on the other hand, in a further presentation they showed a slide where we could see the evolution of capital spending and investments on energy infrastructure (which has been impressive during the last 10 years), and the Oil & Gas industry employment (which has been growing much faster than total private sector employment since 2007). Though they argue that Energy remains a relatively small share of GDP, as it totals less that 1%, I would say that this 1% is equivalent to  at least one  third (if not half) of the real GDP growth in the US, thus a very real contributor to growth rather than QEs. 
In fact, this evolution from an oil consumer country to al oil producer one, will be one of the reasons that explain the lack of transmission from the oil prices slump into an increase in net income and consumption during the last months, and a cause for concern in the structural/ transitory nature debate of the weak spate of economic data that has been released during the first quarter of 2015.    
Central bankers continue to search for clues on why despite these "long for longer" monetary stimulus, saving rates keep growing (instead of falling) and consumer spending does not take off (as should be the case). Maybe they should simply revisit the "Animal Spritis" term used by Keynes in his 1936 book "The General Theory of Employment, Interest and Money". A term that he used to describe how human emotion drives consumer confidence.

But the most fascinating thing of all, is that CBs not only try to manipulate the nature of economic cycles but also try to manipulate (in fact they do), stock market prices and, emulating market strategists, make statements on their views on equity markets expectations and valuations. Recent Janet Yellen´s remarks citing that "overall measures of equity valuations are on the high side", remind us of the famous "irrational exuberance" by Alan Greenspan back in 1996. In fact, markets reaction have been basically the same, as at the end of the day investors chose to ignore what Yellen said and stay invested. In my view the reason for this is that the market has already formed a mind of its own and is not in a mood to listen, as the lure of free money and easy returns clouds our vision. The bartender wants his customers to sober up but they want more alcohol/ party. Maybe her warnings, like those of Greenspan in the past, just come a little late.
But in fact those warnings DO exist. Here are some signals of concern:
   - Margin debt has recently hit an all-time high at roughly $470 Bn. This shouldn´t be a problem by itself, as it is highly correlated to the stock market performance, thus fuelling more upside. But the problem is that when it reaches such extreme levels in times of market overvaluation and overbought condition, any sharp correction could fuel forced selling to meet margin requirements. If the market declines further, the problem becomes quickly exacerbated creating panic selling.
   - Both Market Cap to GDP (the so called "Buffet Valuation Indicator") and Shiller P/E actual readings imply long term flat or even negative stock market returns going forward. The first indicator is flashing red at a 126,8% market cap over GDP. Just to put things in context, this indicator was at 107% during the 2007 financial bubble, 136,5% at the peak of the dotcom bubble, and at roughly 82% before de 1929 crash. At a 126,8% over GDP it stands more than 2 std deviations above its long term average of 60-65%.
As for the second indicator, Cape Shiller stands at 27,3x, which is 64,5% higher that its historical mean of 16,6x, and is consistent with a future market return of -0,4% a year over the next 8 years.
   - 71% of the total debt issued in the US during the last 2 years is "B" rated or less. This compares to the 28% level back in 2006-2007 (just at the peak of the financial bubble). So not only they have issued a lot more debt, they´ve been doing so at much lower standards.
   - Again, back in 2006-2007, less than 20% of the total debt was issued covenant light. Now the number is 60%.
   - Last year corporations in America earned 2,5 Trn in operating cash flow. They spent 1,7 Trn on business capital equipment and another 700 Bn on dividends. So virtually all of their operating cash flow has gone to business spending and dividends, which is ok. But then they increase their debt in 600Bn what makes no sense if they don´t have negative cash flow. They basically went out and bought 567 Bn worth of stock back by issuing debt. Their book value stays virtually the same but their debt is skyrocketing.
- 80% of the IPO´s are unprofitable when they come. The only other time we´ve seen those levels or higher was in 1999.
   - In 1987, when Alan Greenspan took over from Volcker, the US economy went from 150% Total Debt to GDP (Private + Public Debt), to 390% as they had these easy money policies moving people more and more out of the risk curve. During the deleveraging after the financial crisis, that ratio went down from 390 to 365%, but now because of government behavior, corporate behavior, etc…that ratio is starting to go back up again.
   - 18% of the total high yield debt issued last year was concentrated in the energy sector. The slump in crude oil prices and the contraction taking place in the industry, poses a growing threat in terms of credit risk.
   - Aging population has become one of the biggest structural problems, not only for the US but for the majority of the western economies. In the US, aging population is one of the reasons behind the slump in the labor force participation rate (now roughly 62%). Although this rate has been declining during the last 20 years, the rate of decline has been specially steep since the beginning of the financial crisis and subsequent QEs implemented by the Fed. If we take a look at the evolution of the rate by age tranches we  see that since the financial repression started, the participation of people above 55 years has skyrocketed, while teenagers participation have been falling dramatically. In my view, there´s no wonder why this has happened. Apart from the obvious explanation coming from "aging", people now need to work longer and save more if they want to get the same retirement income they expected to get before both the crisis and the financial repression started.
With an aging population (which means more people living on pensions and public money, increasing social security spending, etc…), a labor force base highly dependent on those above 55 (so closer to retirement), and the youngest falling apart…, I wonder how, when and who is going to pay for those record and increasing Debt to GDP ratios.
   - Looking to the Euro Zone and its common monetary policy, I would argue that the different countries have (and have always had), completely different "natural rates", so they should have completely different "actual rates". A common interest rate would be too high for some countries and too low for others. So the system will be diverging until it finally explodes. No amount of QE will ever work.
My feeling after hearing officials from both the ECB and the Fed talk in these Madrid Events, is that they have implemented all these new age Quantitative measures simply because previously they entered a vicious circle of systematic intervention in both the economic cycles and the markets, things have spiraled  out of  their hands, volatility is mounting with an unprecedented sequence of booms and busts, and they found a huge asymmetry when they had to decide between a "do nothing" response to the financial crisis (taking the risk of letting the system explode), and an "unprecedented active" response (taking the risk of navigating unchartered waters and ultimately "perhaps" being wrong).
I think that we are simply in the last scenario, thus navigating unchartered waters with no conviction on the final outcome of the measures they have implemented, the forward guidance given time after time, and all simply based on trial and error. 
The most worrying aspect of all this is that as rates remain stuck at zero and CBs run out of ammunition after the implementation of these immense QE programs, they have no margin for error, which leaves the system highly vulnerable to any economic or external shock.
At the end of the day markets will find evidence that there´s no infallible thorough model, no math, no science… but simply hope and time buying behind CBs policies. It´s like the emperor without any clothes but nobody will tell him. That´s why I think the next very big crisis won´t be a financial crisis, but a crisis of confidence.
These days we´ve been hearing about many forms of "exits" in the markets (Brexit, Grexit, etc..), but I think that the very important exit that we should be talking about is the "FEDXIT", and I don’t mean tapering, but the real fall apart of the Fed (and CBs in general) from the economic cycles and the markets.

Francisco Esteban, Portfolio Manager at Alpha Plus Gestora SGIIC

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