Markets Macro Technicals Sven Henrich

Feeding the Monster

cerberusIn Greek mythology there was a monster called Cerberus, the hound of Hades, a monstrous multi-headed dog who guarded the gates of the underworld, preventing the dead from leaving. Today central banks have taken on the role of feeding our own modern version of Cerberus to keep all the troubles away. Ever since the 2008/2009 financial crisis Cerberus has been chained to a wall, but he’s pulling and he’s growling and he’s demanding ever more attention. But in the process of feeding Cerberus with ever lower rates and stimulus central banks keep making him stronger and fiercer and ever more aggressive. But worse, central bankers are running out of food to feed the monster.

This hound of Hades has 3 heads that are named debt, deflation and demographics. Together they make a deadly combination that will result in a massive reset of asset prices. And today I will aim to outline why this will eventually happen.

Most of the town folk have pretended for a long time that Cerberus is contained or denied his existence even as he has grown and is getting stronger. In fact a curious process of denial has begun.

Consider this dramatic shift in narrative:

In 2015 Wall Street analysts had projected the S&P 500 to end the year in the 2,200-2,300 range. Some of the key arguments centered around a narrative that earnings would expand further, that lower oil prices would be good for the consumer (which will spur spending) and that the FOMC would hike rates which would be a positive development as it would show confidence in the recovery and help bank earnings. In short everything was bullish.

None of these narratives came to fruition. GAAP earnings actually started to decline, the fall in oil prices became a disaster as energy stocks started walking on the bring of default and lower oil prices did not translate into increased consumer spending. Finally, after much handwringing and dozens and dozens of Fed speeches, the FOMC finally implemented its first rate hike in 9 years in December of 2015. The immediate result: Bank stocks fell 24%, global markets were in disarray as energy stocks crashed prompting the only response possible: Feed the monster again. China offered stimulus, the BOJ went rate negative, the ECB added QE and cut rates further into negative and the US FOMC took back its offered roadmap of 4 rate hikes for 2016 back to 2 and then, with a highly dovish speech by Janet Yellen, to possibly zero.

In short central banks have simply following the feeding pattern they have followed for years whenever Ceberus get hungry:

DJIA

Yet suddenly in 2016 the narrative has shifted and the irony has not been lost on people as evidenced by the response to this tweet:

This is called playing tennis without the net especially considering we wouldn’t even have this conversation were it not for constant central bank intervention and jaw boning.

Look, humans are great at rationalizing anything. But there are fundamental truths that are very hard to escape from.
One truth is that GAAP earnings have been declining while pro-forma reporting has been able to mask this decline:

gaap

And the recent rally has made the market the most expensive in years in light of this substantial decrease in GAAP earnings:

SPX GAAP

Which brings us back to Cerberus and his 3 heads of debt, deflation and demographics.

A little history first. Ever since the 1980s we have been in a trend of lower highs in GDP growth:

GDP growth

On any sign of trouble central banks have done their part to help: Cut rates. But in doing so their efforts to reflate rates after each downturn has resulted in lower highs and culminated in, well, rock bottom:

Funds

The conclusion: Feeding the monster has diminishing returns and this in spite of feeding the monster ever more.

Consider that these rate declines enabled the ever increasing cycle of debt:

Debt

Not only in absolute terms, but also as part of the economy at large:

debt to GDP

And of course it’s a global issue and has only increased since the publication of this study last year:

debt

The immediate conclusion: Not only is GDP growth shrinking, it is also vastly overstated as it is augmented by deficit spending:

deficits

What central banks have been able to do is permit for all this debt growth to be virtually consequence free. Due to zero rates all debt can be financed at very low rates and so despite massive increases in debt the amount of money needed to pay interest on debt has actually been relatively stable at around $400-450B per year:

interest payments ST

The problem should be obvious: If the FOMC were to normalize rates to say, 3-4%, the incremental increase in interest payments would render the US discretionary budget insolvent as each 1% increase would ultimately cause a $200B increase in payments required. So the notion of rate normalization appears to be entirely unrealistic. Additionally there is zero evidence to suggest that the US government can run deficit free. So it’s a perpetual cycle of ever more debt that requires ever more resources to service it.

Even with the most tax receipts ever the US government is running a massive deficit as shown here for the first 6 months of fiscal 2016:

2016

Government debt is not the only issue. Consumers have been loading up on debt for years:

student loans auto loans mortgage debt consumer credit

All of this also sustainable only due to low rates. In other words: Rate hikes would eventually severely disturb this seemingly serene picture.

household debt payments

Corporations have been joining the party and taking on ever more debt:

debt to equity

debt ebitda

Net Debt EBITDA

and the combination of it all shows a massive disconnect from the underlying productive asset base:

debt loans

The conclusion: Low rates have enabled an unprecedented increase in debt for governments, consumers and businesses.

What has it all produced? What are the results? And how do they pertain to sustainability?

If one takes on debt to expand, to produce more, to become more productive, to earn higher rates of return, then debt makes sense as it ultimately gets paid off. But none of these goals are being achieved:

Real household incomes have been decreasing:

real income

Retail sales are not increasing:

retail sales

And how could they? While debt service payments have remained stable, due to low rates, many key budget items for families have gone nowhere but up:

Rents:

rent

Medical:

medical

And we already mentioned student loans:

student loans

Combine some of these things and you get:

College-versus-Medical-Care-or-New-Car

But remember the Fed says there is no inflation. Worse for consumer: The dollars they do earn have ultimately less and less value as purchasing power keeps dwindling:

PP

None of this is sustainable or will result in growth without large increases in wage growth and productivity.

The evidence? Severely lacking.

On the student loan front already over 40% are no longer making payments:

loans

It’s a symptom of larger issues. Folks are stretched and don’t have the income or wage growth to sustain their financial obligations.

The structural reality shows lower highs for wage growth:

hourly wage

Productivity is not increasing:

labor productivity

In fact in this latest recovery, despite the unprecedented increases in debt, productivity is lagging severely:

productivity growth cycle

And it’s a global issue:

UK productivity

Has debt produced investment? The answer is no:

Investment

But it’s producing low rates enabled buybacks of stocks:

Buybacks

So the picture that presents itself is this:

Despite the taking on of record debt with ever more stimulus the returns on investment are decreasing.

The culprit: Structural deflationary forces, the biggest one of which is technology itself. One symptom is the massive value Wall Street places on the very companies that benefit the most from technology: The FANGs of the world. Facebook, Amazon, Netflix, Google and many others that are able to build global monopolies on scalable platforms that require relatively few people. None of these companies produce any real products, but they can reach literally billions of eyeballs with a limited number of employees. Highly effective, highly concentrated, but highly limited for employment expansion. One could even go as far as to say that some of these companies are in essence sapping productivity from the rest of society. All consumer activities associated with them could be counted as nonproductive.

After all who is productive browsing Facebook, YouTube, Google, etc?

social

The answer preciously few.

Speaking of few: The ones actually employed. The Fed tells us we are close to full employment. Yet the number of people not in the labor force has shown one long standing trend:

Not in labor force

As of late there has been a little dip and it is called a major improvement and change in trend.

Perhaps, but it is again the prospect of enhanced technology that suggests further deflationary trends to come, especially for many job categories that may face complete extinction. The driver? AI and robotics. We see incredible developments in driverless cars, chat bots, actual robots capable of taking on basic human tasks. While none of these technologies are ready for mass implementation, one can firmly sense that they are around the corner in the years ahead. The potential victims? The trucking industries, customer care services, warehouse operations, etc. In short: Millions of jobs may disappear and be replaced by what exactly?

Speaking of human replacement: Demographics.

The coming shift in demographics is dramatic:

children-vs-elderly-cotd

And the Fed knows is. The Atlanta Fed after all has this header image on their twitter feed:

demo

They know. And it’s a huge problem as the size of unfunded liabilities is exploding further with each day:

debt clock

Look we can all pretend Cerberus is not there and he won’t come to bite us or let the evils out of Hades. But the math simply doesn’t work.

Central banks can’t change the business cycle. Their game is one of pretend confidence and feeding the monster as best as they can. But they don’t produce jobs, they don’t produce growth, heck they can’t even predict anything:

Here’s the Atlanta Fed in February:

And here they are in April:

Alan Greenspan summarized it best:

greenspan

And so the warning signs are mounting:

deals

guidance

interbank

ipos

And I’m not alone in seeing massive risk building as a result of all these central bank actions.

Here’s Laurence Fink of Blackrock:

“These actions are severely punishing the world’s savers and creating incentives to reach for yield, pushing investors into less liquid asset classes and increased levels of risk, with potentially dangerous financial and economic consequences,” Fink said. That and other forces, including geopolitical instability, are creating “a level of fragility in the global economy that we have not seen since the lead-up to the financial crisis.”

But it’s not only financial risk that is of concern, there is the political risk that appears not priced into markets at all. In June the UK faces a Brexit vote largely driven by discontent over imposing European policies.

Even Germany is feeling the heat and a stretching of its political spectrum.

Germany’s Finance Minister:

Politicians from Chancellor Angela Merkel conservative camp, to which the finance minister belongs, have complained the ECB’s ultra-low rates are creating a “gaping hole” in savers’ finances and pensioners’ retirement plans as returns have dropped.

Schaeuble suggested they risked fuelling the rise of euroscepticism in Germany, where voters flocked to the right-wing Alternative for Germany in state elections last month.

“It is undisputable that the policy of low interest rates is causing extraordinary problems for the banks and the whole financial sector in Germany,” said the 73-year-old. “That also applies for retirement provisions.”

“That is why I always point out that this does not necessarily strengthen citizens’ readiness to trust in European integration,” he added in an interview. 

Markets are currently ignoring all of it.

What does this all mean for stocks for the here and now?

On a GAAP basis earnings are back to where they were at the peak of the 2007 earnings cycle:

SPX GAAP

Structurally the S&P 500 has been following a familiar pattern: It rises on increased earnings, it breaks trend once earnings stall, has a correction and bounces back to reconnect with major moving averages before falling further. Markets have just bounced back and strongly so primarily driven by short covering and massive central bank intervention and jaw boning. But now we find ourselves at a key juncture: Repeat the pattern or diverge from it. My supposition has been that without a sudden positive turn in earnings this rally will be hard to sustain:

WLSH

XVG

So the question that presents itself is not one of destination. The destination is clear. It’s a massive re-alignment of asset prices down the road. It’s widely acknowledged that most asset prices are vastly overvalued. Here’s VC Peter Thiel:

“Startup tech stocks may be overvalued, but so are public equities, so are houses, so are government bonds”

While Janet Yellen denies the existence of bubbles she is amongst the chief architects of fueling overvaluation of asset prices globally.

The math shows clearly that the FOMC can’t really raise rates in any substantial manner at all. So it’s an elaborate PR dance that is on display on a monthly basis with dozens of Fed speeches full of sound and fury signifying nothing.

The real question then is one of the exact path to perdition. The charts above indicate that markets are at a key juncture. Either they will break lower this summer or, if central banks succeed one more time, can create the one element this bull market has been lacking: A proper blow-off top.

Just know a blow-off top will make markets not cheaper, but much more expensive:

SPX GAAP

In either case: Cerberus will continue to demand to be fed. And the math says he is getting hungrier every day. And looking around the world it appears he wants a change in diet as more and more stimulus is not only producing diminishing return, but is breeding more political discontent.

BOJ

DAXM

What this means for me from a trading perspective is simply this: I want to observe this earnings season for clarity. Without a sudden positive shift in earnings prospects this market remains at very high risk of following the previous historic structures, hence I remain defensive/tactical here.  Should earnings improve subtantially then basic fib retraces of this rally may be buyable. If not, then Cerberus will break his leash sooner rather than later.

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Categorised in: Daily Market Brief, Market Analysis

10 Responses »

  1. Outstanding stuff as usual Northy. Thanx for taking the time to produce all this.

  2. Great great read. the earning season will either break the camels back or we are destined to start another bull run

  3. Many thanks for sharing “Feeding The Monster.” Your well thought out narrative is convincing and leads me to think, “Wow, Northy has nailed the present situation.” However, one important fact set missing from Feeding…is dividends. For the S&P 500, dividends are still growing, yoy and qoq. What happens to dividends and payout ratios in ’16, will also impact future market direction.

  4. Thank you Northy!! Awesome read for big picture perspective of where the markets are in time and space. You have a true gift for assembling the far flung parts into a coherent whole. Thank you again.

  5. Tour de force! The irrationality continues unabated.

  6. Thank you for taking all the puzzle pieces and assembling a coherent, large scale view of where the economy is presently and where its likely to go in the not too distant future.
    This is an outstanding compilation of facts. Will be forwarding.

  7. All of this is very helpful.

    The thesis, however, that the economy will break rather than bend may be incorrect.

    As long as the Fed suppresses interest rates and provides cheap credit to the sovereign, government can expand its expenditures while the capital base is depleted by inflation exceeding real interest rates. This simply means that savers will become poorer, buy less and slide into poverty.

    Government will remain robust with its free credit for expansion.

    Thus the private sector will contract, government employment will expand and the society will contract economically. It has happened before many times. The Romans kept this contraction going literally for many generations. It was not that they were overwhelmed by the barbarians, but they lost the capacity to resist as the State consumed more and more of the society’s wealth while destroying the producers.

    As someone pointed out, one third of agricultural lands were allowed to go fallow by 470, and at the edges of the realm citizens began to join the other societies across the boarder where they would be free of Roman taxes and free to pursue their farming or other employment. Thus the empire “collapsed” slowly and quietly.

    That is the secret of the Fed’s success. It feeds the government and its associates while it impoverishes the disenfranchised citizens. The capital base is transferred into consumption by the government and its non productive beneficiaries.

  8. Bloody awesome stuff!
    However, one thought has been bugging me for quite some time now – is this a new reality altogether where the cost of energy for humanity is going to grind to virtually zero due to technological innovations in (primarily) solar sector? Couple it with (as stated in the article) breakthroughs in AI and robotics and you have Skynet in the making. Plus the markets are already dominated by non-human agents as never before, with the algos re-writing their own codes without human participation any more.
    Doesn’t pricing in zero rates ad infinitum lead to an expansion of P/Es ever higher, away from the ‘human norm’?
    Say what you will, but the advent of the AI has already changed the market rules forever, where the evolutionary human logic simply no longer applies. It’s only going to diverge further and further from what we perceive as ‘normal’ to the point where our control of the processes will dwindle to virtually zero.

  9. Rare quality stuff here. Thanks for posting.

  10. I believe traditional monetary policy is not working anymore because investments in intangible assets (software mostly) often decrease GDP initially, unlike tangible assets.

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