Monday 22 July 2019

Is this a global recovery or The Truman Show revisited?

Jim Carrey in The Truman Show
Jim Carrey in The Truman Show
Fed chief Janet Yellen testifies before the Senate Banking Housing and Urban Affairs Committee on Capitol Hill in Washington

Paul Sommerville

THE Crimean situation is irrelevant. The Ukraine coup does not matter. That is the clear signal from financial markets. While the 24-hour broadcast media have indulged in wall to wall coverage discussing the terrible potential geo-political consequences, the financial markets have exhaled a very large yawn.

The stock markets may have sold off briefly but the major indices quickly regained their poise, the USA indices subsequently trading to new all-time highs.

Recently European markets had struggled a little more, but the cause related to the strong euro and China. Meanwhile, the traditional gauges of geopolitical tension, oil and gold, have not even registered a flicker of alarm.

Indeed, gold is down nearly US$100 from its recent February highs and trades some 30 per cent lower than the highs of 2011. The price of oil never budged materially so definitely no alarm there.

Traders' conclusion from the very start has been that Putin held all the cards, would be a clear winner and the EU and Obama's bluster would be exposed as vacuous.

Sanctions were unlikely to be meaningful as they would hurt EU just as much or even more than Russia. So far they have been 100 per cent correct.

But nothing is what it seems.

Commodity prices in other areas should pique the interest when trying to gauge how the global economy is performing. Copper prices have fallen 12 per cent year to date. Traders often call Copper "Doctor Copper", as it has traditionally been a very good leading gauge of the temperature of the world economy. But why would copper be falling when we are bombarded by news that the world economy is improving?

Nothing is what it seems.

Meanwhile, poor economic numbers released from Germany last Tuesday sent the DAX up 150 points or 1.7 per cent. Then up another 130 points Wednesday. Yes UP. Why? Because the poor numbers started rumours that the ECB would finally embark on printing money – or quantitative easing – so helping all risk markets including European equity markets. The recovery is going so well that the ECB is contemplating what would be the most ambitious and aggressive policy move ever contemplated by them and a complete U-turn!

Even Mr Weidmann, the Bundesbank President and member of the ECB governing council, known normally as chief party pooper of money printing, radically softened his stance and appeared to endorse the move. Bad news is now good news. Traders cannot think of anything better than more bad economic news to spur the ECB into action.

Across the water the new head of Federal Reserve, Janet Yellen, not to be outdone, discarded the forward guidance set out by her predecessor and not only suggested that rates would stay low for longer but clarified that even when rates normalise she expects them to be at much lower levels than a "normal"economy would tolerate.

Her comments and testimony were reported in some media outlets as "a game changer" and more worthy than her predecessor with her more empathic-sounding dulcet tones – utter baloney .

So the foie gras rally continues with central bankers shoving liquidity down investors' throats and the PR machines constantly churning out the message that the world economy is in recovery mode.

But the tectonic plates underpinning these economies are creaking and the central bankers are all too aware. Hence constantly reassuring and escalating easing policies.

The first fissure reveals itself in the price of copper and other precious metals. It is China.

Larry McDonald, the author of the excellent book A Colossal Failure of Common Sense (an epic tale of the collapse of Lehman Brothers), explains it well in a recent article for Forbes.

"Over the last year, many Chinese corporations moved into a meadow of leverage and deception. For some time now speculators have been using commodities as collateral to borrow offshore in dollars.

"Thanks to Ben Bernanke and Janet Yellen, they have been able to get much cheaper financing offshore in US dollars than onshore in Yuan.

"Because of the growing credit bubble, financing is much more expensive in China. Because the Chinese yuan has been pegged to the US dollar, this has been the gravy train of all gravy trains.

"The PBOC, China's Central Bank, knows this and is trying to teach these fine fellows a lesson by expanding the yuan's trading range. Speculators who had dollars falling out of their stuffed pockets, now look like a deer in the headlights."

To put it in simple terms, highly leveraged Chinese corporations feeling the squeeze of a slowing economy are being called for cash.

These margin calls are causing more copper and other precious metals to be released into the market. The fall in copper has everything to do with the deflating Chinese credit bubble.

China's recent landmark Chaori bond default event confirmed Beijing's policy change to allow defaults to take place where they believe regional or systemic risks will not be triggered.

With China's corporate debt having doubled over the past five years to more than US$12 trillion, we can expect many more defaults.

Now we can see why Mr Weidmann is suddenly changing his tune.

China is now a major concern.

The second fissure is creaking right underneath the Federal Reserve but it has yet to be exposed. It goes to the very core of the current financial system. Credibility.

The US debt burden is colossal. By some measures total USA interest payments for 2013 were a huge 17 per cent of total tax revenue. Meanwhile, one arm of the US government buys debt off the other in the shell game that is now the norm.

The Federal Reserve now actually owns 34 per cent of all 10-year equivalents of their own US bonds. This situation continues much unnoticed because of the high regard or "god-like" status with which the Fed is held.

The Fed is credible so long as its story regarding the recovery holds up. But what if the recovery bought by trillions of borrowers' dollars is actually coming to an end rather than just beginning? It would not take long for the Fed's credibility to crumble.

Hence Mrs Yellen's comments regarding eventually putting up interest rates. She must say that for her story to remain credible.

She says she might be "forced" to put up interest rates because the recovery may be stronger than expected. It's all just smoke and mirrors – her real worry is a stalling USA economy, hence she extenuates the other possible outcome.

The Fed has created a market that has been aptly described as The Truman Show. In the movie of that name, the central character lives a seemingly charmed world, nestled comfortably into an American suburbia of white picket fences and crisply cut lawns. But gradually Truman starts to notice something is not quite right. He is actually trapped inside a film set controlled by hidden directors, and discovers that he is the unknowing star of the world's most popular reality TV show.

In a similar way, central banks' ultra-loose monetary policy has manufactured a fake reality. The exit from these policies is going to be extraordinarily difficult to handle.

All the Trumans – the fund managers, the traders, the market pundits, the economists – know at some level that the environment in which they operate is not what it seems on the surface. But they are guests at the biggest and most extravagant free party on earth, drunk with the euphoria and numb to reality.

Nobody wants it to end. It is not 2007 all over again – it is worse.

There is no risk in the marketplace or, more succinctly, the price of risk is dead. When that occurs it can only lead to one thing – reckless behaviour followed by volatility and systematic shocks.

This is why the markets did not move on the Crimea news. It is impossible to assess a fair price in any market where there is no risk.

The perception is that, whatever happens, central banks will step in.

No matter what market you look at – be it junk bonds, sovereign debt or the stock markets – traders are all betting on one premise: the central banks of the world will protect them. Over-optimism and euphoria abound.

You are now living in The Truman Show. Investors should be ready for increased volatility when reality hits.

So how does this affect Ireland?

The loose monetary policy of world central banks has helped Ireland enormously. The NTMA has done an excellent job in both the timing and execution of navigating Ireland back into the bond markets.

It was criticised in some quarters for over-borrowing in the run-up to bailout exit, but I could never understand this criticism. It didn't know what headwinds would face us. so had to be prepared for every eventuality.

It was also criticised for not taking a precautionary credit line.

Again, I did not agree with that criticism as it was then clear we could proceed on our own and it sent a much more powerful PR message that we are able to stand on our own two feet. The UK's strong QE programme has also helped sustain our very important export market there.

But the overriding effect of our plunging bond yields has had negative consequences. Our politicians use it as a badge of honour and do nothing else, as if their actions somehow affected the price of our debt. They did not.

Would you lend that bunch large amounts of money at 3.5 per cent without a safety net? The falling yields have actually slowed down the necessary structural changes needed to take place. They have lessened the urgency for reform. We have fallen back into our parochial gombeem politics. At the very time when real and radical reform should be taking place its urgency has evaporated.

The world central banks have given us an opportunity to change and restructure while the waters are calm, but it looks like we will squander the opportunity – as so many times before .

The world is living in The Truman Show – while we continue to live in Hall's Pictorial Weekly.

Paul Sommervile is CEO of Sommerville Advisory Markets

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