The Perils of Inflationism

By Doug Noland

December 13 – Financial Times (Chris Giles and Claire Jones): “When the European Central Bank switches off its money-printing press at the turn of this year and stops buying fresh assets, it will mark the end of a decade-long global experiment in how to stave off economic meltdowns. Quantitative easing, the policy that aims to boost spending and inflation by creating electronic money and pumping it into the economy by buying assets such as government bonds, is on the verge of becoming quantitative tightening. With the Federal Reserve slowly reducing its stocks of Treasuries, central banks are no longer in the buying business. Globally, only the Bank of Japan is left as a leading central bank that has not formally called time on expanding its stock of asset purchases. Arguments over how, or even if, the trillions spent by policymakers helped the global economy recover will rage for years to come. But as central banks step back, the initial view is that the purchases worked — whether through encouraging investors to hold more risky assets, easing constraints on borrowing, providing finance so governments could run larger budget deficits or just showing that central banks still had an answer to weak demand and low inflation.”

At this point, the prevailing view holds that QE “worked.” Moreover, central banks are seen ready and willing to call upon “money printing” operations as need. The great virtue of this policy course, many believe, is that there is essentially no limit to the scope and duration of “QE infinity.” The FT quoted Mario Draghi: “[QE] is permanent and may be usable in contingencies that the governing council will assess in its independence.” Melvyn Krauss, from the Hoover Institution, captured conventional thinking: “No one willingly walks into a room from which there is no exit. Because QE proved temporary, because it worked and because it has ended, it is likely to be used again.”

But what if faith in QE is woefully misguided? What if markets and policymakers alike come to appreciate that QE only masked underlying fragilities and delayed desperately needed structural reform? Worse yet, what if the reality is that QE exacerbated latent financial fragility – through more leverage, speculation, misperceptions and market distortions. And what about social and political instability? Surely, there’s growing recognition that a decade of monetary stimulus and resulting Bubbles have further redistributed wealth and worsened inequality.

It was a downbeat Mario Draghi Thursday discussing the end of the ECB’s QE program. Undoubtedly, he always anticipated concluding an unprecedented $2.6 TN ECB balance sheet expansion with the eurozone in an upbeat environment – with Europe’s markets and economies in a good place. They’re anything but.

December’s aggregate eurozone PMI index declined to 51.4, the lowest reading since February 2016. With chaotic riots, France’s industrial sector is now contracting (PMI below 50). Perhaps more troubling, France’s Services PMI sank five points to 49.6, the low going back to February 2016. Germany’s ZEW economic sentiment index collapsed 13 points in December to 45.3. This is down from 95 early in the year and the lowest reading since January 2015.

Yet Europe’s economy is a pillar of strength when compared to the frail political landscape. Surely QE proponents would have expected the printing of $2.6 TN of new “money” to have, at least for a period, worked to pacify the masses and temper political instability. Detractors of unsound money and Credit are anything but surprised by heightened instability throughout the eurozone, certainly including the heavyweight Italian, French and German economies. The euro is arguably more vulnerable today than back in 2012.

Proponents of central bank stimulus operations take a sanguine view. They note that the ECB joined the global QE party late (2014). Truth be told, the ECB and global central banks are a full decade into their exalted monetary experiment. Let’s not forget Draghi’s “whatever it takes,” along with the ECB’s 2012 “Outright Monetary Transactions” program (OMT). Then there was 2011’s “Long-term Refinancing operations (LTRO),” where the ECB lent $640 billion directly to eurozone banks (liquidity in many instances used to buy government bonds). And back in 2010, the ECB adopted their “Securities Market Program.” All told, the ECB’s balance sheet expanded from a pre-crisis $1.5 TN to almost $4.7 TN.

Proponents proclaim a decade of central bank stimulus has proven a tremendous success. They would point first to stock, bond and asset markets more generally. I view the same markets and see acute instability and fragility. I believe a decade of monetary stimulus has exacerbated financial, economic, social, political and geopolitical instabilities. This will surely be debated for decades to come.

Credit is a financial claim – an IOU. New Credit creates purchasing power. Credit is self-reinforcing. When Credit is expanding, the creation of this new purchasing power works to validate the value of Credit generally. In general, new Credit promotes economic activity, both spending and investment, in the process promoting higher incomes. Credit expansions fuel higher price levels throughout the economy, including incomes, real estate, stocks and bonds. Higher perceived wealth stimulates self-reinforcing borrowing, spending and investment.

Traditionally, bank lending for business investment was a prevailing mechanism for finance to enter into the economic system. There were various mechanisms that worked to contain Credit expansions, including the gold standard and disciplined monetary regimes. As important, there were traditions against deficit spending, running persistent trade deficits and profligacy more generally. Moreover, there were bank reserve and capital requirements that placed constraints on lending and financial excess. In short, there was a limited supply of “money,” with excessive borrowing demands pressuring interest rates higher. There was certainly cyclicality, but systems tended toward adjustment and self-correction.

It’s not only the decade-long experiment with QE (with ultralow rates) that makes contemporary finance unique in history. As the key source of additional system “money” and Credit, banks and business investment were some time ago supplanted by market-based finance and leveraged securities/asset purchases. Contemporary (“digitalized”) finance expands virtually without constraint.

Meanwhile, finance entering the system to speculate on higher asset prices creates a very different dynamic than back when bank loans were financing capital investment. Excessive borrowing and investment placed downward pressure on profits, in the process reducing the incentive to borrow, invest and lend. In contrast, a system of unfettered “money” and Credit financing asset prices is acutely unstable. Expanding finance leads to higher asset prices and only greater impetus to borrow and speculate.

Going on a decade now, I’ve been chronicling the “global government finance Bubble.” It has not been ten years of systemic smooth sailing. History’s greatest Bubble stumbled in 2011 on fears of the Fed’s “exit strategy.” The Fed quickly backed off – and then proceeded to double its balance sheet again by 2014. Europe tottered badly in 2011 and 2012, inciting “whatever it takes” and a reckless ECB balance sheet gambit. Fed, ECB and global central bank liquidity stoked a historic boom throughout the emerging markets. China’s epic Bubble, pushed into overdrive with aggressive global crisis-period stimulus, inflated uncontrollably. All of it almost came crashing down in late-‘15/early-’16. But the Chinese adopted more stimulus, the ECB and BOJ boosted QE, and the Fed postponed “normalization.”

I believe the world over the past two years experienced a momentous speculative blow-off – in stocks, bonds, corporate Credit, real estate, M&A, art, collectibles, and so on. I would further argue that speculative melt-ups are quite problematic for contemporary finance. Surging asset prices spur rapid increases in speculative Credit, unleashing new self-reinforcing liquidity/purchasing power upon markets, financial systems and economies around the globe. The problem is it doesn’t work in reverse. The greater the price spikes, the more vulnerable markets become to destabilizing reversals. De-risking/deleveraging dynamics then see a contraction of speculative Credit, leading to problematic self-reinforcing destruction of marketplace liquidity.

As inflationism has demonstrated throughout history, QE was always going to be a most slippery slope. The notion of inflating risk asset markets with central bank liquidity has to be the most dangerous policy prescription in the sordid history of central banking. And, importantly, the longer central bankers held to this policy course the deeper were market structural distortions. Rather than attempting to rectify crucial flaws in contemporary finance, central bankers chose inflationism and market backstops as stabilization expedients. This was a monumental mistake.

The expansion of central bank balance sheets ensured a parallel expansion in global speculative leverage. Over time, there was an increasing multiplier effect on each new dollar/yen/euro/etc. of central bank “money.” The original Fed QE “money” program basically accommodated speculative deleveraging. In contrast, the past few years (in particular) incited an aggressive expansion of speculative leverage throughout global securities and asset markets.

In addition, the parabolic increase in central bank liquidity over recent years was instrumental in the parabolic ballooning of ETF assets and passive investment funds more generally. While not “leverage” in the conventional sense, the enormous growth in ETF/passive funds and associated risk misperceptions have amounted to a historic market distortion. Trillions flowed into risky stocks, bonds, corporate Credit, EM assets and derivative structures believing that these fund shares were a liquid store of (nominal) value. The phenomenon of perceived money-like ETF shares was integral to the global risk market speculative blow-off.

The problem with speculative blow-offs is that they inevitably reverse. Upon the reversal, the seriousness of the problem is proportional to the amount of underlying leverage, the degree of market misperceptions and the scope of associated market and economic structural maladjustment. The world now confronts one hell of a problem.

The unfolding de-risking/deleveraging dynamic is extraordinarily problematic from a liquidity standpoint. A powerful “risk off” dynamic – having unfolded following a global speculative blow-off instigated by massive central bank liquidity injections – leaves global “system” liquidity acutely vulnerable. Faltering global liquidity will now expose the misperception of “moneyness” for ETF and passive index products. As such, global markets are now at high risk to global de-risking/deleveraging fomenting a transformative change in risk perceptions. Past risk reassessments (that seem minor compared to what is now unfolding) have led to panic and dislocation.

Flawed central bank policies are directly responsible for both a decade-long global Bubble and the more recent speculative blow-off. Markets, meanwhile, cling to the belief that central bankers remain fully committed to doing “whatever it takes” to hold bear markets, recessions and crises at bay. There’s a disconnect. The harsh reality is that “whatever it takes” has failed. It was built on fallacious notions of inflationism, markets and finance, more generally. Most regrettably, a tremendous amount of market hopes, dreams and capitalization have been built on little more than fallacy.

Total global Credit growth has slowed dramatically. I would argue speculative (securities and derivative-related) Credit, having evolved into a key marginal source of total global Credit, is now in significant self-reinforcing contraction. This portends liquidity issues for markets, faltering asset values and trouble for economies. In the markets, Fear is supplanting greed. Risk aversion and waning liquidity now spawn powerful Contagion across markets.

December 14 – Bloomberg (Lisa Lee): “Funds exiting the U.S. leveraged loan market at a record pace are clobbering sentiment as they go. History suggests that the record $2.5 billion yanked from funds in the past week could mean more short-term loan price pain. Earlier this year, investors flocked to leveraged loan funds in pursuit of floating-rate assets as the Fed sounded hawkish… The loan market has only suffered two bouts of such outflows exceeding $2 billion… Both times, loan prices sank and took months to recover. In August 2011, when the loan market was roughly half its current $1.3 trillion size, loan funds saw $2.1 billion of outflows… In December 2015, they lost $2.04 billion.”

QE previously bailed out the leveraged loan market twice, along the way solidifying the perception of “moneyness” for leveraged loan fund shares. What was not to like about owning assets with above-market yields that would reset higher as the Fed raised rates? And as “money” flooded into leveraged lending, liquidity and recession risks were about the furthest things from investors’/speculators’ minds.

The Bubble has burst – the greater global Bubble, the Bubble in leveraged lending, and Bubbles across asset classes around the globe. In the case of leveraged loans, I don’t expect another bout of QE to resuscitate Bubble Dynamics. Excess within this market, similar to so many, went to parabolic extremes. Risk misperceptions went to extremes; lending terms to extremes; and speculation to extremes. Now the downside.

December 14 – CNBC (Angelica LaVito): “Johnson & Johnson knew for decades that its baby powder contained asbestos, Reuters said in a new report that drove the company’s shares down more than 10% Friday. Reuters based its report on a review of documents and deposition and trial testimony. It said the review showed that from 1971 to the early 2000s, J&J executives, mine managers, doctors and lawyers were aware the company’s raw talc and finished powders sometimes tested positive for small amounts of asbestos. Those involved discussed the problem but they did not disclose it to regulators or the public, Reuters’ examination found. The company released a statement Friday calling the Reuters article ‘one-sided, false and inflammatory.’”

Company denials and positive analyst comments didn’t stop a double-digit Friday drubbing in Johnson & Johnson’s stock. It’s worth noting that the Healthcare SPDR (XLV) sank 3.4% in Friday trading. Prior to Friday’s drop, the XLV had enjoyed a y-t-d return of 12.6%, trading near all-time highs just seven sessions earlier. The index was up over 53% from 2016 lows (J&J up almost 60%).

It was a timely reminder of how deeply Bubble Dynamics have permeated the marketplace. I would argue that some of the greatest excesses have unfolded in perceived low-risk sectors and strategies, certainly including the “defensive” healthcare space. Perceived low risk became a risky Crowded Trade. In the unfolding bear market, there will likely be few places to hide.

What only weeks ago appeared a rather straightforward meeting is now a pivotal juncture for the Federal Open Market Committee. With low unemployment and relatively robust household and business expenditures, the Fed has been widely expected to raise rates next Wednesday. It may now be a close call. But, then again, the Fed may not yet appreciate the seriousness of what is unfolding in the markets. They’re in a real predicament, along with central bankers around the world. They all waited way too long to begin normalizing monetary policy. Today, normalization has barely even commenced, and yet the Bubble they nurtured has already begun to deflate.

December 11 – Reuters (Stella Qiu and Kevin Yao): “China’s banks extended more new loans than expected in November after a sharp drop the previous month… Chinese banks extended 1.25 trillion yuan ($182bn) in net new yuan loans in November, slightly more than analysts had expected and up from the previous month… Total social financing (TSF), a broad measure of liquidity and credit in the economy, jumped to 1.52 trillion yuan in November from 728.8 billion yuan in October, also beating expectations. But growth of outstanding TSF slowed to a new all-time low of 9.9% from 10.2% in October, as regulators continued to crack down on riskier types of financing…”

We’ll continue to closely monitor Chinese Credit data. Credit growth bounced back strongly in November. Total Social Financing (TSF) rose from a weak October’s $84 billion (weakest since October ’15) to $198 billion. This was still 15% below growth from November ’17. This puts y-t-d TSF expansion at $2.129 TN, down 20% from comparable 2017. This slowdown is explained by contractions in key categories of “shadow” lending.

As noted above, Chinese Bank Loans expanded strongly in November. At $182 billion, new loans were 12% above November ’17. Bank Loans have expanded $2.186 TN y-t-d, running 17% above comparable 2017. At $95 billion, Consumer Loans were 6% above November ’17. Indicative of a booming year of mortgage lending, y-t-d growth in Consumer Loans is running 18% above last year. In numbers that illuminate the scope of China’s mortgage finance Bubble, Consumer Loans increased 44% in two years, 78% in three years and 141% in five years.

I don’t want to imply that resurgent Chinese Credit growth and/or even a more dovish Fed wouldn’t matter. I just believe at this point the bursting global Bubble is increasingly beyond resuscitation. A bold statement, I fully appreciate. But Fear is rapidly supplanting greed in “Core” U.S. securities markets. The “Core” has seen de-risking/deleveraging dynamics attain important momentum. Latent “Core” fragilities are being exposed. And the further the global Bubble deflates, the greater the scope of monetary stimulus required to re-energize broad-based securities market inflation. I fully expect more QE. But it will come in a crisis backdrop. I’ll presume the first few Trillion or so will, at best, accommodate deleveraging.

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