December is meant to be the season to be jolly.
Markets obviously didn’t get the memo.
In early November the Dow Jones Index was within a whisker of the record high it set in May 2015.
The wobbles of August and September were becoming but a distant memory.
There was great hope the Christmas spirit would lift markets higher…perhaps even a new high to finish the year off.
The forces of the Great Credit Contraction do not operate on a seasonal basis. They just keep crushing in — 24 hours a day, seven days a week, 52 weeks of a year. The force is relentless and gaining in intensity.
The Great Credit Contraction is glacial in speed and in intent. Slowly but surely it is taking the heat out of the global economy.
To avert the economic ice age, central banks backed up the fuel tankers and flame throwers.
The only thing they managed to ignite were asset prices. The economy is still cooling.
We have this fire and ice theme at play in the global financial system. Markets are hot and the economy is cooling.
Markets no longer focus on discounted cashflows to determine value. It is all about how much more fuel will be added to fire up asset prices. The theory goes something like this — if we heat up the market, hopefully it’ll thaw the economic freeze.
Mario Draghi’s recent efforts — taking the deposit rate further into negative territory and extending the existing asset purchase program — clearly weren’t enough to keep the heat in the market.
Markets dived. Without ever increasing amounts of central banker fuel, the markets run out of steam.
What’s actually happening is the reverse of the central bank theory. It’s the cooling economy that’s taking the heat out of the markets..
The last thing Wall Street and central bankers want is for the market flame to be extinguished by an economic frost.
The economy is cooling for a variety of well known reasons. Debt servicing costs and capital repayments take money away from consumer spending. Boomers are either in or close to retirement. Technology and competition are driving costs down. The world has far more capacity to make things than there is demand for things.
Thirty years of debt accumulation — way beyond any level ever witnessed in history — created an economic model that is unsustainable. Expectations are divorced from reality.
Negative interest rates are proof of this. Penalising banks for holding cash is madness. Central banks are trying to force banks to lend…irrespective of a borrower’s creditworthiness.
Does subprime ring any bells to these people?
However the banks aren’t responding to the stick and borrowers aren’t buying the carrot.
Central banks are desperately fanning and fuelling the cooling embers of consumerism to re-ignite the economy’s glory days.
It is an exercise in futility.
Adair Turner is the former Chairman of the UK Financial Services Authority and Senior Fellow at the Institute for New Economic Thinking.
Turner’s recent book Between Debt & The Devil carried a rather frank admission from a bureaucrat :
‘There is so much debt we cannot earn our way out of it without a sustained period of inflation or more debt write-offs.
‘There is more debt in the system than can be serviced out of cashflow and surpluses.
‘Our addiction to private debt is to blame.’
We did not know when enough was enough. The debt binge was of epic proportions. Definitely one for the history books.
Every time the cost of debt was lowered by central bankers, we responded with Pavlovian conditioning.
Borrow more to buy more things. This was our addiction. The spending high. The instant gratification. The need to keep up with or even surpass the Jones’s. Look at me, look at me.
Debt collided with demographics in 2008/09. Ageing consumers, with debt burdens that needed to be cleared prior to retirement, no longer responded to the temptation of cheap and abundant money.
The response from households has been at best, lukewarm. Boomer consumers have other priorities.
The Great Credit Contraction is a result of millions of households changing their attitude towards money. Do we pay down debt? Do we need to save more for our retirement? Do we really need that? Can we afford that? I’d rather spend the money on travel.
Society’s collective re-assessment on what to do with their money is a force the central bankers have tried to counter for seven years. The fact their unprecedented stimulus efforts have gone on for this long and are likely to continue for the foreseeable future, tells us they are fighting a formidable foe…deflation.
Deflation is the cooling influence working its way through the global economy.
Goldman Sachs’ recent declaration that Brazil — the world’s seventh largest country — is in depression is another sign of how powerful the cooling forces are (emphasis is mine):
‘What started as a recession driven by the adjustment needs of an economy that accumulated large macro imbalances is now mutating into an outright economic depression given the deep contraction of domestic demand.’
Alberto Ramos, chief Latin America economist at Goldman Sachs Group Inc
15,569 kilometres separates Australia from Brazil. However, interconnected financial markets can travel that distance in a millisecond.
The ramifications of credit defaults ricochet around markets quicker than you can drink a cold beer on a hot summer’s day.
There are already some tell-tale signs that investors are sensing the chilly economic conditions may turn decidedly nasty.
The Bank of America Merrill Lynch High Yield spread measures the risk premium between higher risk corporate bonds and (perceived) risk-free US government bonds. How much extra do investors want to be paid to lend to borrowers with lower credit ratings?
In mid-2014, investors were prepared to accept an extra 3.5%. Not today.
Now investors want close to 7% above the (perceived) risk free return — a doubling in the risk premium over the past 18-months.
Concerns are elevated and with good cause.
After seven years the world is getting worse not better.
Debt levels are much higher. Budget deficits are getting larger. Markets are expensive. Retiree numbers are increasing. Welfare dependency is increasing. High earning jobs (mining) are being replaced with low earning ones (making coffee). China is slowing. Commodities have fallen off the cliff, forcing mining companies into asset sales to clear debt.
The threat of terrorism is much higher — who knew of ISIL in 2008? Interest rates are falling further into the negative. The private sector is trying to deleverage. Investors have taken on more risk than they realise in their search for yield.
The US dollar has strengthened significantly, forcing those foreigners with US dollar denominated debt to dig deeper into their pockets to meet their debt obligations.
All these forces are relentlessly crushing in on the global economy.
Debt. Demographics. Deficits. Deflation. Depression. These are the cooling forces the central bankers are trying to keep at bay with a hot asset market.
The colder the economy becomes, the more the central bankers will turn up the heat — more QE, peoples QE, further reductions in interest rates, direct asset price manipulation.
All this heat will generate a bonfire…a bonfire of the vanities.
These conceited, know-it-all bankers who refuse to heed history’s many lessons, will have their reputations burnt at the stake.
History will judge them poorly.
But that’ll be cold comfort for those who believed these charlatans had the power to make the world not too hot and not too cold.