Old Roach Motel

By Doug Noland

One hundred and six months. The current expansion, having emerged in the aftermath of the collapse of the mortgage finance Bubble, is now the second-longest on record (lagging only the 120-month 1990’s Bubble period). The unemployment rate dropped to 3.9% last month, the lowest level since the 3.8% print in April 2000. Corporate earnings are at unprecedented levels and stock prices only somewhat below records. Home prices in most markets are at all-time highs. U.S. GDP is forecast to expand 2.8% this year, just below 2015’s (2.9%) 12-year high.

We should be leery of prolonged expansions. The longer a boom, the greater the opportunity for deep-rooted structural impairment. Back in 2013, I proposed the concept of “Government Finance Quasi-Capitalism.” This was updating previously updated Hyman Minsky analysis. Minsky’s “Stages of Development of Capitalist Finance” seems especially relevant these days:

Minsky: “In both Keynes and Schumpeter the in-place financial structure is a central determinant of the behaviour of a capitalist economy. But among the players in financial markets are entrepreneurial profit-seekers who innovate. As a result these markets evolve in response to profit opportunities which emerge as the productive apparatus changes. The evolutionary properties of market economies are evident in the changing structure of financial institutions as well as in the productive structure… To understand the short-term dynamics of business cycles and the longer-term evolution of economies it is necessary to understand the financing relations that rule, and how the profit-seeking activities of businessmen, bankers and portfolio managers lead to the evolution of financial structures.”

Minsky saw the evolution of capitalist finance as having developed in four stages: Commercial Capitalism, Finance Capitalism, Managerial Capitalism and Money Manager Capitalism. “These stages are related to what is financed and who does the proximate financing – the structure of relations among businesses, households, the government and finance.” (CBB 12/28/2001 “Financial Arbitrage Capitalism”)

Late in his life, Minsky was increasingly concerned with the transmutation of Money Manager Capitalism: “The emergence of return and capital-gains-oriented block of managed money resulted in financial markets once again being a major influence in determining the performance of the economy… Unlike the earlier epoch of finance capitalism, the emphasis was not upon the capital development of the economy but rather upon the quick turn of the speculator, upon trading profits… A peculiar regime emerged in which the main business in the financial markets became far removed from the financing of the capital development of the country. Furthermore, the main purpose of those who controlled corporations was no longer making profits from production and trade but rather to assure that the liabilities of the corporations were fully priced in the financial market…”

Proffering “Financial Arbitrage Capitalism,” I first updated Minsky’s analysis back in 2001. Noting Minsky’s “financial structure is a central determinant of the behavior of a capitalist economy,” I had become convinced that a fundamentally new power center had evolved within the financial system.

With the activist Greenspan Federal Reserve pegging short-rates and guaranteeing market liquidity, a new regime of enterprising financial speculation was unleashed. At the same time, Washington’s GSE’s had become powerful market operators with the capacity to issue seemingly endless quantities of “AAA” securities, while providing central bank-like (“buyers of first and last resort”) market liquidity backstops.

“Wall Street Alchemy” was transforming risky loans into money-like marketable securities (“Moneyness of Credit”). These securities provided the fuel for aggressive leveraging by the hedge fund community and Wall Street proprietary trading desks. This sophisticated Financial Structure profoundly bolstered Credit Availability and growth, while also fueling pernicious asset inflation, stoking over-consumption and, over time, fundamentally altering the nature of investment, resource allocation and Economic Structure.

Financial Arbitrage Capitalism proved a powerful if relatively transitory Stage of Capitalistic Development. The mortgage finance Bubble collapse ushered in the latest phase of government and central bank control over Financial Structure and Capitalistic Development.

It’s now been almost a decade of unprecedented monetary and fiscal stimulus – ten years of central bank command over the financial markets. Over time, markets became progressively less attentive to risk, including business cycle cyclicality, financial excess and instability. Bear markets and recessions had been prohibited. Basically, no amount of excess was concerning. And, importantly, the magical concoction of extremely low rates and extremely big deficit spending would ensure a corporate profits bonanza as far as the eye can see.

May 2 – Bloomberg (Shannon D. Harrington and Erik Schatzker): “Greg Lippmann, who helped design the trade against subprime mortgages that became known as the Big Short, says the next financial tremors will come from corporate debt. The former Deutsche Bank AG trader who now oversees about $3 billion at his LibreMax Capital LLC said… that corporate debt and equities will face the biggest pain when the next downturn comes. Investments linked to consumer debt, unlike the last crisis, will be relatively safe because companies have been the ones gorging the most on the ultra cheap interest rates during the past decade. ‘If the first quarter’s volatility is a harbinger of something bigger, I think that you’re going to see a lot more trouble in the corporate market and the equity market than the structured products market,’ Lippmann said on the sidelines of the Milken Institute Global Conference… ‘The consumer is in much better shape than corporates. Consumers are less levered than they were pre-crisis. Corporates are more levered than they were pre-crisis, and I think structured products are not going to be the epicenter.'”

I also doubt that structured products will be at the epicenter of the next crisis. Subprime, mortgage Credit, and Wall Street Alchemy were the nexus for Financial Arbitrage Capitalism period excess. Government Finance Quasi Capitalism fundamentally altered the prevailing Financial Structure financing what is now one of the U.S. history’s longest expansions.

Financial Arbitrage Capitalism altered perceptions, market behavior and Financial Structure in one (critical) segment of the marketplace. In particular, it incentivized leveraged speculation by the hedge fund community and Wall Street trading desks. This had profound ramifications for consumer Credit availability and borrowing. The overall surge in system Credit growth imparted structural effects throughout the financial markets and economy. Latent fragilities emerged with the collapse of mortgage Credit growth.

Notably, though with some obvious exceptions, corporate balance sheets were not in terrible shape when crisis hit. After all, years of historic mortgage Credit growth had funneled cash to corporate America, as well as to the U.S. Treasury. Washington was well-positioned in 2008 for a robust crisis response.

Fannie and Freddie were nationalized, with zero impact on the perceived creditworthiness of Treasury obligations. The Fed immediately slashed rates to zero. This incited a refinancing boom, significantly reducing household debt service costs. Large quantities of previously higher risk mortgages were refinanced into top-rated GSE securities, many surely making their way onto the Fed’s ballooning balance sheet. Especially with the failure of Lehman and AIG, structured finance was generally in disarray. But the limited number of operators in this space made the situation manageable for the Federal Reserve and Treasury. There were only limited issues with money market funds, and for the most part the U.S. mutual fund complex was outside the worst of the fray.

I would argue that the current Government Finance Quasi Capitalism stage has created much deeper and problematic financial and economic structural maladjustment. As has been said, “Capitalism without failure is like heaven without hell.” A decade of aggressive policy activism worked its magic.

The old notion of one-decision stocks morphed into One-Decision Markets: Just buy and hold – your favorite equities or Credit index. Analysis Not Required. Central bankers will ensure the trajectory of stock prices remains up. The Fed’s commitment to liquid and continuous markets has never been as rock solid. There will be no panic selling of stocks, and no destabilizing spike in market yields. And with rates at or near zero, there has never been such powerful incentives to buy risk assets (stocks, corporate Credit, EM, etc.). The perception of liquidity and safety (“Moneyness of Risk Assets”) ensured a wall of liquidity would inundate funds holding equities, corporate bonds and EM securities. Amazingly, ETF assets grew almost 10-fold since 2008, in one of history’s most spectacular speculative financial flow episodes.

May 3 – Financial Times (Joe Rennison and Ben McLannahan): “An important shift in how companies finance themselves has reached a milestone. The leveraged loan market has officially become a $1tn asset class and is catching up fast with US high yield or junk bonds. Since 2010, the leveraged loan market has doubled in size from $500bn while US high yield has expanded $250bn to $1.1tn, according to Bank of America Merrill Lynch. The growth in loans reflects a post-financial crisis shift away from being a ‘private bank-loan model to a thriving syndicated market with hundreds of participants’ that has coincided with retail money flowing into the market, says the bank. Money has continued to pour into loan funds, where interest rates are floating and adjust higher as the Federal Reserve tightens policy. That kind of demand has helped fund and drive a record era for merger and acquisitions. ‘A higher proportion of capital raised today goes towards LBOs [leveraged buyouts] and acquisitions than was the case in 2010,’ says BofA, noting how half of money raised since 2016 has reflected M&A, up from a level of 30 to 40% at the beginning of the cycle.”

Indicative of the altered Financial Structure, Government Finance Quasi Capitalism ensured a more than doubling of the leveraged loan market (since 2010) to $1.1 TN. “Retail money flowing into the market.” Indeed, the proliferation of ETF products has ensured the flow of retail money in abundance to all corners of the risk markets – corporate Credit and equities in particular. Indirectly perhaps, but retail flows are these days helping fuel record M&A. And let’s not forget the “short vol” funds and other complex derivatives strategies. And especially during periods of dollar weakness, performance chasing flows have deluged EM. It’s been heavenly, or at least financial nirvana. And the massive “retail” flows into global risk assets remain oblivious to now rapidly mounting risks.

Going back centuries, the “money market” has traditionally been at the financial crisis epicenter. From traditional bank runs to the 2008 run on Lehman’s repurchase agreements, it’s the panic liquidation of previously perceived safe and liquid instruments that can instantly spark illiquidity and crisis. Money has special attributes to be coveted and safeguarded. To purposely bestow the perception of moneyness upon risk assets – across asset classes on a global basis – is one of the great transgressions in the history of central bank monetary management.

I would add that the proliferation of tantalizing new technologies makes this cycle all the more perilous. Massive prolonged speculative financial flows throughout a period of alluring technological innovation ensures malinvestment and deep structural impairment. Historical revisionism paints the 1920’s as the “golden age of Capitalism,” brought to a catastrophic conclusion by the Fed’s negligent post-crash failure to inflate the money supply. In reality, it was a historic period of misperceptions – misperceptions as to the capabilities of Federal Reserve, Wall Street, financial innovation and technological advancement. It all came home to roost.

The “Roaring Twenties” episode was a confluence of colossal financial flows and historic technological development that ensured epic structural maladjustment and attendant latent fragilities. Unappreciated, especially late in the cycle, was the harsh reality that the finance fueling the boom was increasingly unsound, unstable and unsustainable. When speculative flows inevitably reversed, everything came tumbling down – everywhere.

Few companies have benefitted from Government Finance Quasi Capitalism as much as Amazon.com. For years, markets afforded Amazon virtually free money. The company would readily borrow billions, invest aggressively and not worry a lick about profitability. With current market capitalization of $767 billion, things have worked out fantastically for the company, their employees and shareholders. It’s worked out pretty well for consumers as well, but at the expense of traditional retailers across the country.

My issue is not with Amazon.com, but with today’s thousands of wannabes. Just raise “capital” and spend as aggressively as possible. Profitability and cash-flows are a concern for some day out in the future. What matters is a clever idea, growth, market share and dominance the quicker the better. It’s a financial, market and business backdrop that has fostered an Arm’s Race Mentality – online retail and services, the cloud, AI and quantum computing, blockchain, 5G, cybersecurity, Internet of Things, electric automobiles, battery technologies and alternative energy, autonomous vehicles, biotech and pharmaceuticals, automation and robotics, nanotechnology, and on and on.

It’s somewhat reminiscent of 1999, but on such a grander scale that the two periods are hardly comparable. The late-twenties is more pertinent: the proliferation of exciting technologies and innovation; lavishly over-liquefied securities markets; faith in policymakers and a general disregard for risk. In 1929, there was essentially no recognition of downside risk. A long boom had convinced about everyone that financial and economic underpinnings were sound. Similar to today, little attention was paid to the soundness of the finance underpinning the boom.

During the mortgage finance Bubble period, there was some recognition of how the system was “privatizing profits and socializing losses.” And that’s exactly how it played out during the crisis, with expensive bailouts, massive deficit spending and crazy central bank monetization. I would expect the next crisis to have disparate and more problematic dynamics.

At this point, an abrupt reversal of “retail” flows from the risk markets will pose a potentially greater systemic challenge than the previous crisis of confidence in structured finance. Not only have retail flows come to play a major financing role throughout corporate America, I would expect the sophisticated leveraged speculating community to move quickly to get ahead of (“front-run”) outflows as they begin to materialize. Moreover, there are these gargantuan derivatives markets that are expected to function as an insurance marketplace. Rather quickly, liquidity will become a serious systemic issue across the securities and derivatives markets. Financial conditions might tighten dramatically almost overnight, abruptly interrupting plans for tens of thousands of negative cash-flow enterprises across the country – big and small. That’s when Financial and Economic Structure will matter mightily.

A decade of Government Finance Quasi Capitalism has deeply engrained the view that enlightened central bankers and spendthrift governments have together tamed the business cycle. Bear markets and recessions were conveniently removed from the calculus. It’s accepted as gospel that myriad risks have been fundamentally downgraded. In reality, the socialism of finance has annulled the capacity of markets to self-adjust and correct. Pressure just keeps building.

The upshot has been highly unstable Bubble flows – into the securities markets, intermediated through perceived safe and liquid investment vehicles into business enterprises on increasingly fragile footing – on an unprecedented scale. On a global basis (again with parallels to the 1920’s), Bubble dynamics have ensured that financial and real resources have for years been poorly allocated, with maladjustment and imbalances now greatly in excess of those prior to the 2008 crisis.

I have posited that the February blowup of “short vol” marked a critical juncture for the global Bubble – the initial round of market instability that would set in motion de-risking and de-leveraging dynamics and waning global liquidity. I’ll suggest that global markets have commenced round two. The dollar index jumped another 1.1% this week, as stress intensifies in the emerging markets. The Argentine peso sank 6.1% this week, as Argentina’s central bank hiked rates 675 bps (to 40%) to support its collapsing currency. The Turkish lira dropped 4.5% to a record low, as 10-year yields surged to almost 14%. The Mexican peso dropped 3.4%, the Polish zloty 2.4% and the Brazilian real 2.0%. Stocks were down 4.7% in Argentina, 4.7% in Turkey, 3.8% in Brazil and 2.7% in Mexico.

EM stress somewhat supported Treasuries and safe haven sovereign debt more generally this week. Weak EM likely spurred some unwind of global “carry trade” leverage, with negative ramifications for EM currencies, equities and bonds – and global liquidity more generally. There also appeared to be an unwind of long EM/short “developed” trading dynamic, which might help explain this week’s rally in European equities (that spilled over into U.S. equities Friday). If nothing else, EM is illuminating how abruptly speculative flows tend to reverse course – and the newfound proclivity for Crowded Trades to Morph into Liquidity Traps. The Old Roach Motel.

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Gary

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