If you want to know the end, look at the beginning – African Proverb
We’re getting close to the point where the authorities lose control of the markets but I don’t believe we’ll get the downturn until the economy is undeniably in recession. The above quote gives the answer. We started this rally off the financial collapse of 2009 where the authorities had no choice but to take control of the markets.
The combination of federal government spending and the clear manipulation of the equity markets produced an artificial economic recovery. I call it artificial because it represents the extreme exploitation of Keynesianism without the pullback on countercyclical spending favored by Lord Keynes.
If your neighbor borrows a fortune to buy a Porsche and a huge addition on his home, it doesn’t necessarily mean his financial situation has improved. If his income remains constant, his financial situation has deteriorated due to the addition of debt service, a car with high maintenance costs and fast depreciation, and higher taxes for his larger home. That’s the USA in a nutshell.
The market recovery in 2009 started as a short squeeze but quickly turned into an asset value expansion cycle where the Fed added reserves to the banking system to drive down the risk-free rate of return. The result is that investors were herded like cattle into risky assets, both fixed income and equity.
The cycle began with an insolvent banking system evidenced by the loss of Lehman Brothers and Bear Stearns. The Fed’s solution was to make the banking system solvent again by driving up the value of the assets in the system.
What is Risk?
Risk comes from not knowing what you are doing – Warren Buffett
In finance, we equate variance to risk – daily trading variance of a security and then compare the variance of the security to the variance of the index it is included in. I’ve always considered it a ridiculous way to measure risk yet I can’t think of a better way.
If you know the fundamentals of a security – the way it generates its underlying cash flow – then true risk is the probability of a disruption to the underlying cash flow which results in a decline in value of the security. It can be tax revenue, credit card payments, corporate sales or any other revenue that supports a security but there are distribution sets to fit just about everything. Whatever causes a security value to be impaired is the true definition of risk.
Unfortunately, such information can be extremely difficult, even illegal to obtain, so the finance academics settled on the standard deviation of trading data. Trading data is easy to obtain and plentiful but inadequate for determining operating risk for cash flow.
In grad school, we learned the difference between systemic risk and entity-specific risk; I addressed entity-specific risk above. Systemic risk is most closely tied to the economy, interest rates, and geopolitical events. This is the risk where I believe that intervention has skewed our perception and which has allowed for this great reflation following the GFC or great financial crisis.
This is why I chose the opening quote. If we want to know how this ends, we need to know how it began. It began when the Fed implicitly skewed our perception of systemic risk by slashing interest rates to 0% and intervening whenever systematic risk started to turn ugly.
In unfettered markets, does anyone else believe that systemic risk is less than it was 12 years ago? I choose 12 years because 10 years ago, US shale oil hit global oil markets and changed the dynamics of both the dollar trade and the supply of oil. The result was a rise in systemic risk that was blunted by global intervention, particularly in Europe.
Today, we have war in the Middle East, the threat of thermonuclear war in Europe, the potential for war in the South China Sea and growing civil disturbances across Western nations. We are also a couple of years into dramatically higher interest rates with the likelihood of a deep recession growing by the day. In relative terms, risk is the highest it has been in my 58 years yet the markets are priced as if risk is negligible. This is the product of global intervention.
Therefore, in my opinion, the biggest risk in the markets is that the authorities lose control and not the individual factors cited above. The participants in the markets implicitly accept the premise that the financial authorities are both capable and willing to keep risk at bay for a little longer. This is why I watch for evidence that the authorities are losing control as I also watch as the rising elements of risk threaten to overwhelm their containment.
The JuJu Man is sharpening his knife and preparing his magic, knowing that his services will be needed before much longer. It’s his job to collect the payment for the magical services.
Equity and Fixed Income
When you combine ignorance with leverage, you get some pretty interesting results – Warren Buffett
The fixed income market is much bigger than the equity market – and far more important. But given the wide distribution of individual fixed income issues, it’s extremely difficult to influence the value of a bond index through intervention.
Given that debt has priority on the balance sheet in liquidation and given that bondholders get paid interest and principal before dividends can be paid to equity holders, it’s considered less risky. Ipso facto, if equity indexes are maintaining values, then debt must also maintain its value. In this way, financial authorities can kill two birds with one stone. Keep stocks elevated and the bond market will take care of itself.
Junk bonds trade much like equity; we can see this in the chart below. Automated asset allocation programs are rule based, not judgement based. If stocks go up, so too will risky bonds, albeit at a smaller rate of return. If risky bonds go up, higher quality bonds will continue to trade at a premium to the risky bonds. And so on.
Fifteen years of a positive feedback loop combined with advances in computing power have created a pretty solid system that won’t be easy to break. People who think the trading on August 5th is more than just a tremor are going to find themselves disappointed because it’s going to take a substantial hit to the economy to break the markets.
Japanese Carry Trade
We shall not grow wiser before we learn that much that we have done was very foolish – Friedrich von Hayek
I attribute the decline in the markets on August 5th to the movement in the Japanese yen following monetary tightening by the Bank of Japan. Furthermore, I attribute the tightening by the BOJ to pressure from the US Treasury Department to put a floor under the value of the yen. As such, I think Janet Yellen made a mistake that will partially attribute to a market decline later this year.
I consider the Japanese yen carry trade to be a form of financial repression that is at the core of keeping global financial markets elevated. Traders borrow in yen at rates just above 0%, convert to dollars or euros, buy risk assets, and pay the Japanese savers back in discounted yen – discounted to the dollar.
We can see this from the chart below of the yen versus the dollar. It’s been a highly lucrative trade for years.
But now that Janet Yellen is pressing the BOJ to put a floor under the yen for trade reasons, she risks tipping over the apple cart with her obtuse view of the currency markets. The sharp jump in the value of the yen created a margin call on borrowing in yen, which created the sell-off in the risk markets.
The Chinese yuan has been highly correlated to the Japanese yen over the past couple of years and I suspect that the Treasury Department wants to minimize incentives for manufacturing to return to China. A decline in the value of the yuan makes Chinese manufacturing more competitive in global markets. But this should be a secondary consideration for the US Treasury because the global financial markets are very jittery at the moment and unable to handle the loss of an extremely valuable funding source in Japan.
The BOJ has responded by adding liquidity to the system to calm the global markets and it has worked. In my opinion, Monday’s trading is a tremor for what is going to following later this year – but yet.
Ms. Yellen doesn’t need to fear China’s resurgence because Xi is doing everything in his power to destroy the Chinese economy.
China
Totalitarianism is feudalism in the twelfth century sense of the word – Barbara Amiel
Most people are unaware that China is a combination of Communism and Feudalism. The aristocracy of China is made up of the offspring of the men who formed Mao’s upper echelon during the revolution. These families are collectively known as the “Princelings” and they hold most of the power, prestige, and wealth in China. It’s not a stretch to say that China is run for the benefit of these families, including the Xi family.
In his quest for dictatorial power, Xi has angered most of these families and over the past year, Xi has been rebuked by them in private. The “Princelings” have grown fond of the riches offered by capitalism and are not keen on moving back to the policies and austerity of the Mao era.
The CCP just concluded their 3rd Plenum of their 20th Central Committee meeting in mid-July and Xi has been strangely quiet since. He hasn’t been deposed but I think it’s safe to say that he’s on notice.
Beijing is out of cash. Traditionally, the rulers in Beijing bribe the regional bureaucracies to enact changes but Xi’s ridiculous handling of Covid has emptied the coffers at the regional level and the national level. Before his death, Li Keqiang famously admitted this lack of cash in meetings across the country.
The CCP is in deep trouble and in their desperation, they are attempting to claw back 30 years of profits from private companies across the country. I’ve been expecting this move for over a decade even though it’s just about the dumbest move imaginable.
The CCP is going to find that the profits that weren’t shipped abroad are either locked up in struggling companies, in real estate, or deposits at banks. You could say that the funds that are deposited at banks are liquid but I don’t think so. Most banks are in such bad shape and so illiquid that large withdrawals need to be approved by both regulators and local police officials. The CCP can put a claim on the cash but they’ll destroy their own banks by taking it out.
If banks are forced to sell assets to raise the funds, the result will be fire-sale prices and deflation. If the CCP attempts to liquidate real estate investments, the result will be fire-sale prices and deflation. Clearly, the geniuses in the CCP haven’t thought this through enough because every step leads to a deflationary loop.
The takeaway is that China is out of cash and the princelings are sharpening their knives for Xi. This is the very definition of risk! China is in play and we need to remember that the People’s Liberation Army is not as centralized as Beijing wants us to believe; it’s regional and those regions have their own agendas.
The Chinese economy is in its death-throes and they are going to create an initial deflationary vacuum followed by higher global prices when Chinese manufactured goods drop from the market. It’s happening quickly and it will likely blow a hole in the global economy by 4Q24.
Conclusion
We can’t solve problems by using the same kind of thinking we used when we created them – Albert Einstein
The financial authorities pulled off the seemingly impossible in 2009 when they miraculously lifted us out of the Great Financial Crisis. It always struck me as akin to “juju magic” which is why I’ve been watching for signs of the “juju man” coming to settle the contract – what the system owes him for pulling off the impossible. The title of this piece just seems fitting to me.
A similar metaphor could be Robert Johnson meeting the devil at the “crossroads.” We’re going to pay for the last 30 years of asset inflation but I don’t think the markets are quite ready for the break lower.
It’s going to take more than a bureaucratic miss-step. That said, the markets revealed just how close we are to a sustained move to the downside on Monday. When it comes, it is going to be far worse thanks to 15 years of employing juju magic.
The solution has always been to trust the markets much like when Andrew Mellon wanted to purge the “rottenness” from the system in 1930 but that would require the financial authorities to cede power. Nobody cedes power willingly. They are going to use every trick and artifice left to make it through November. It has worked for 15 years so why not a few more months?
