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Why S&P500 could fall 35%

The word 'unprecedented' gets thrown around more and more when describing the current global financial environment. Whether its interest rates (5000 year lows), bond yields ($13.5t of which are now negative), debt levels (at all time highs), and now share prices, it is a world of new 'unchartered territory'. When one travels to such places, one normally buys insurance

So let's look at another recent phenomenon. We have written extensively (most recent summary here) about sky high PE valuations and the like as shares hit new highs on investors looking for some kind of yield in this near zero yield world and hang the risk associated with equities. The graph below goes back to 1980 but the 3 instances of the S&P500 yielding higher than a 10 year Treasury bond that you can see on that chart (the GFC, just after the ensuing recession, and now), are the only such instances since 1958!



10 year Treasury yields are pretty much considered the 'risk free rate' in investing. This then raises the matter of the equity risk premium (ERP), or according to Investopedia:

"Equity risk premium, also referred to as simply equity premium, is the excess return that investing in the stock market provides over a risk-free rate, such as the return from government treasury bonds. This excess return compensates investors for taking on the relatively higher risk of equity investing."

So it may come as a 'shock' to you that the equity rally we are witnessing now is pretty well entirely driven by ERP compression. The analysis pictured below by Deutsche Bank shows how fundamentals of earnings growth have completely disappeared and it is all about chasing yield beyond fundamentals and hence risk. This reinforces our message that central banks are the main drivers of this market through suppression of yields through ZIRP and QE. Herein lies their rates dilemma.. Need to raise rates to say everything is find and try and reign in this out of control bubble. Do so by even 0.25% and the bubble could pop immediately.



Zerohedge did the math:

"In turn, this means that every push higher in yield, whether orchestrated by central banks, or due to exogenous events like a "taper tantrum" risks upsetting this precariously compressed ERP "spring", leading to a violent market crash. Because if the ERP is responsible for 92% of the S&P500 move since 2012, or just over 800 points, that would suggest that central bank policies are directly responsible for approximately 40% of the "value" in the market, and any moves to undo this support could result in crash that wipes out said ERP contribution, leaving the S&P500 somewhere in the vicinity of 1,400." That is 1,400 from its current 2,170

 

Gold & Silver "No One's Liability"

Something a little different today.Gold and silver have many unique virtues and one of those is liquidity, and specifically, liquidity in any event. You will be hard pressed to name another asset that does not have counterparty risk, both in its very value and in its liquidity i.e. extracting that value when you need it.

Gold and silver's value is in intrinsic, it is in and of itself by virtue of its rarity. It is often (rightly) said that physical gold (and silver) is no one else's liability. By example comparison, a cash deposit in a bank is the bank's liability (and you are an unsecured creditor) and you are also relying on the bank being 'open' (ask some Greeks and Cypriots about their recent experience); the underlying value of your share certificate depends on the management of that company (what if they go bankrupt, cease trading or have to dilute your shareholding in a capital raising?); a bond is an IOU from the issuer (what if the issuer goes bankrupt or freezes trading?); bitcoin is a digital 'currency' that has already been hacked a number of times with $10's of millions stolen (what could be next?); and finally property, whilst generally another good hard asset like gold and silver, is not quickly liquidated (and can take months in a bad market which is likely when you may most need it) and is one 'thing' not a number of smaller things you can liquidate as few or as many as you need.

Gold and silver have been a medium of immediate exchange for literally thousands of years. That is not about to change. It has 24/7 price discoverability, can be held in small fractions, is fungible, can easily be tested for purity and is understood worldwide. No one can shut its front door, no one can make it go broke, no one can cease it trading, no one can hack it.

 

Half agree, but why are you comparing gold or silver I presume you are implying that we keep at personal home with danger of money kept in the Bank who might go bankrupt or has instructions from the government to confiscate it?

A more accurate comparison Gold and Silver "safe" in your custody with Cash kept "safe" at home?

If you ask Cypriots why they left the money in the bank with months of warning about their bank about to go bankrupt, the only answer can be is because they are stupid.

In the next twenty years, what proof is their that gold will double or even keep its value, because over hundreds of years, it have gone down and up in value, no argument that it it is store of value, simple put GSR have been 14:1 to 80:1 - Im just stating it fluctuates, thatit is not rock solid steady climb.

Say in remote Siberian tundra they find a gold deposit the same size as the famous South Africa gold fields and the world supply and quantiy ever mined will double in ten years. Would it be a good long term investment for the next 5 to 25 year?

But what if however we know that Gold in 30 years today will come out of its doldrums and skyrocket 20x - only marginally good for me, as I will be in my late 60 but fingers crossed I am in good nick and can still enjoy it, as I will have about 5% of my wealth in PM. But what benefit will it be for those that are mid to late 60 now?

Even the statement -> is fungible, can easily be tested for purity and is understood worldwide -> is debatable the many threads about people buying fakes, tells us so.

 

Record Monetisation v Growth & Inequality

When the US was in full flight of Quantitative Easing (QE or money printing) it was the hot topic. When they ended that a couple of years ago expectations turned to tightening monetary policy. The graph below highlights how very wrong that assumption was and the unprecedented scale of quantitative easing since its inception after the GFC undertaken to re-kick start the global economy.



The US stopped QE because everything was fixed. As you can see below GDP has been in decline ever since. As we reported in today's Weekly Wrap, Q2 GDP has just been finalised at just 1.1%. This may well be why the market expectations for further stimulus in the US has not been so high in many years; ironically at a time of rate rise jawboning by the Fed.



We've shown you before that earnings are on a similar trajectory and yet you are well aware of the chart for US shares which is the opposite of the above. Combined, it reinforces financial markets based on cheap money (to those who can get it) and central bank direct share investment inflating assets rather than real growth and prosperity for the masses hence Trump's popularity.

A recent survey found that the entirety of U.S. household net worth growth over the past 30 years has been concentrated in the hands of just the top 10%. This is not a socially nor economically sustainable situation, and the correction could be huge.

 

NFP fails Bad News is Good News (For Now)

On Friday night the US NFP employment figures were released and were well below expectations on a number of measures. Against the backdrop of a 3 month average of 232,000 new jobs and market expectations of 180,000, the August print was just 151,000. Whilst that was bad it was joined by very disappointing earnings data as well. Hourly earnings growth came out half of that expected, a third of July's number, and barely above zero at 0.1% and weekly earnings actually fell from August and now sees the annual growth rate at its lowest in over 2 years.

The data also showed the continuing trend of the dominance of lower paying hospitality jobs, and of course (in our 'stimulated' Wall St World) financial service jobs, but a decline or stagnation in jobs that actually produce things.

This was a data print the world was hanging on to gauge whether the US Fed will raise rates sooner than later (or at all!). The disappointing numbers saw those odds fall dramatically and up shot everything except the USD as the free money game looks set to continue. Bad news is good news prevails. Gold and silver jumped too as negative real rates remain and it is now becoming blatantly obvious this will continue until financial markets crash.

Should this outcome really be a surprise though? A September rate rise just before the most contentious US election in living memory was always destined to be thwarted somehow (and as the latest Reuters poll has Trump ahead). It was also in the week we saw Q2 GDP growth in the US finalised at a woeful 1.1% despite that easy money. What would it be with tighter monetary policy with higher rates??? If you want a picture of this there is no better than the following. The situation is not hugely different in Australia as we've written before. The simple fact is we are borrowing at a far greater rate than economic growth. Regular listeners to the Weekly Wrap know that whether its GDP growth, company earnings, manufacturing and service business indices, or the aforementioned employment figures - they are all below expectations but the debt burden just keeps growing. Until it can't. Soon bad news will be bad news.

 

Farewell Glenn Stevens & The 'Cost' of QE

Today RBA governor Glenn Stevens gives his final interest rate decision before handing over the reigns. Since he started in 2008 he has cut rates from 7.25% to the current record low of 1.5% as the world came, and still comes to terms with the GFC, what started it and how the central banks' response threatens another of a much bigger scale.

Whilst the RBA has not gone down the quantitative easing (QE) path of other nations, desperately printing money to spur on growth and inflation, we are getting periously close to the line in the sand where they have said they would do so, as we reported here. Few, however, think he will lower rates today, taking us just 0.25% from that magic 1%. Greg Canavan of The Daily Reckoning summed it up nicely:

"It would be folly to fire another interest rate shot in a war we simply cannot win. The RBA would be much better off conserving what little ammo they have, using it when they really need it.

As I've pointed out many times before, our dollar is strong because Chinese stimulus at the start of the year put a rocket under the iron ore price, which has a big bearing on Australia's finances. While the perception of the Chinese economy remains strong, there will be a strong bid for the Aussie dollar.

Cutting rates by another 25 basis points will do little to dissuade foreigners from buying the dollar, especially when the options are to hold euros or yen (and having to pay fees to do so).

But another rate cut will impact bank margins, punish savers and knock confidence in an already fragile economy."

That said, the market still expects more cuts soon, just not today. As for Australia joining the QE game before we get to that 1%, the following graph by Citi bank should send shivers up your spine if you are 'all in' in financial markets. It shows the balance sheets of the 6 major central banks in the world. If you recall, QE is when the central bank buys assets with freshly printed money (those assets sit on their balance sheet). The US led the way buying only US Treasuries. More recently the likes of Japan, the ECB and the Swiss have been buying nearly anything they can get. We've reported previously how the BoJ is now a top 10 shareholder in over 200 of the Nikkei's 225 companies. So look at the following graph in the context of 'what if' these central banks can no longer prop up markets anymore. What happens when purchases (much of that debt in the form of bonds) to the tune of 40% of global GDP either stop or stop working. The description 'Ponzi scheme' is often used in describing this unprecedented economic set up, and it's hard to argue.



Citi quite rightly ask the question of whether the cost of all this QE is outweighing the benefits and produced the neat graphic below that clearly answers the question. Let's hope the RBA never follow this 'folly'.

 

ECB to go QE3? To Infinite & Beyond!

Gold and silver had a cracker of a night last night, silver in particular up 2%. Whether it was the poor economic and employment data released last night (which as usual we will report in the Weekly Wrap on Friday), news of Trump hitting the lead in a number of polls, or the heightening tensions over the South China Sea, it's hard to know.

What is not hard to know is that this insane world of central bank stimulus artificially inflating assets must end badly and its feeling soon. History is littered with examples of economic collapse occuring when debt reaches levels beyond what can be repaid.

So it beggars belief that, when you look at the graph below of the ECB's balance sheet (and we looked at a few yesterday) and the resulting real growth, that they are now expected to increase it at their meeting this week. The ECB are now well into their current QE program of buying $1.9 trillion of assets using freshly created money. That program is due to finish in March 2017. In a Bloomberg article over the weekend they reported that 80% of surveyed economists expect this to be extended at the ECB meeting this week.



As we've reported previously, so rampant is their program that they maxed out on sovereign bonds to buy and are now buying corporate bonds as well. A similar proportion of economists also see them 'relaxing the rules' to allow them to broaden their purchasing scope i.e. increase the risk profile.

The comparison has been made to QE3 in the US when the then Fed chief Bernanke, introduced the 3rd round of QE but that time made it open ended for 'as long as necessary'. Given the results to date of the ECB QE have seen little success with inflation in the EU running at just 0.2% in August & July (per the graph below), the IHS Markit economic growth index at a 19 month low, and GDP (as can be seen above) heading down not up, that could be for quite a while before they maybe learn that it just doesn't work (take a look at Japan and US) and racks up enormous amounts of debt.



So again the missing piece in all of these exercises is what happens to that debt and how much money can you print before people lose faith in it?

 

GDP Via Debt & Trump Effect

GDP (Gross Domestic Output) growth continues to be the metric by which a country's economy is judged. We have on numerous occasions pointed out what seems to be lost in the mainstream, that you can 'buy' GDP with debt. On Monday we showed the US added $645b in debt in Q1 to 'buy' just $65b in GDP growth, a ratio of 10:1. Back in April we reported Australia's 3% GDP growth came at a cost of 6.6% more private sector debt PLUS the public sector racking it up as well. At some stage the debt overwhelms and it all collapses.

This may well be playing out now in the US as GDP struggles around the 1% mark despite all the stimulus. Indeed right now not only is it continuing a downward trend, it is now in territory that in every instance in the last 60 years has lead to a recession. Check out the graphs below:



The other key measure that again you never seem to see is the GDP growth per head of population. Per the graph below that is now at its lowest in the last half century. This reinforces too the inequality issue we most recently reported on Friday and why Trump is now ahead in the polls as we've discussed here and here.



This is a dangerous cocktail indeed with US shares at record highs on central bank stimulus but with the above chart as a 'reality backdrop' and the groundswell of Jo Public discontent seeing the likes of Trump assume power. Many analysts are uniquivecal in their view the market will crash if he is elected. Only time will tell.

 

Euro Money Printing Gone Mad

As we reported in today's Weekly Wrap and further to Wednesday's article on the topic, the ECB last night surprised the market by not announcing any extension of their already $90b/month QE program nor lowering of their -0.4% deposit rate. Even though they lowered their inflation forecast well below their target and to an almost stagnant 0.2% from 1.1% just a year ago (when they thought all this stimulus would actually work), they appeared reluctant to move at this stage, most likely waiting to see what the US Fed will do in the September meeting on the 21st.

As we touched on in Wednesday's news, their issue is they have current rules around what they can and cannot buy. These include purchasing bonds with maturities ranging from 2-30 years but more critically in this world with $13.5 trillion of negative yielding bonds, they must purchase bonds with a yield above their deposit rate of -0.4%. When you look at the graph below from Bloomberg you can see how man that excludes




These restrictions eliminate around $1.5 trillion of otherwise eligible Government bonds. To make it harder they can't buy more than a third of any EU member country's bonds, all equating to only around $2 trillion being available. Purchases are then further restricted as they are supposed to be proportionate to the size of those country's economies meaning the more attractive propositions like Germany are likely to be the ones they exhaust first. All terribly inconvenient when you just want to print with reckless abandon to achieve. just 0.2% inflation!?

As Citi bank said in an interview this week:

"There are various estimates of when the ECB will hit a wall because it does not provide exact breakdowns of the bonds it already owns but everyone agrees that it is close to reaching its limit.And the bank cannot slow the pace of bond purchases without sending out a signal to the markets that something is wrong."

The obvious question is. When you have a negative interest rate, when there are $13.5 trillion of bonds where you PAY for the privelege of holding someones debt (not them paying you interest for your risk), and when your central bank is buying basically all available debt issuance above your said negative interest rate with freshly printed money to the tune of $90b per month, and your inflation and GDP are both not responding why would increasing that indicate "something is wrong".

 

Is This The Turning Point? Time to Get "Real Assets"?

Friday night saw a bloodbath on Wall St with everything dropping as the market got spooked that a US rate rise was back on the table for September. US shares saw their worst week in 7 months and the biggest single drop since June. Gold and silver weren't spared though gold was down only 1% compared to shares falling around 2.5% and bond yields surging globally as bonds too were dumped. The USD shot up, putting the AUD down and buffering us from some of the losses.

In a dramatic end to one of the longest spells of non volatility the VIX (volatility index) went from a 45 year low to its highest since Brexit. This is classic market behaviour.

So what happened? Well firstly it was a market already wary of bond price movements after the ECB surprised by not easing further, and the Bank of Japan speculated to be reconsidering its easy money as well. The dovish Fed member Rosengren then appeared hawkish (talking up a rate rise) and that really spooked everyone. There was also a press release that fellow dovish member Brainard would talk tonight our time. It has all the appearances of another Rosengren moment which continued the bond sell-off along with shares and PMs. Tonight should definitely be interesting one way or another.

It's incredible how quickly a market can turn. On the poor NFP numbers the September hike was off the table and the usual stimulus talk abounded. Now (intriguingly just after the G20) central banks appear to be changing their tune. It almost looks like they have agreed all this monetary stimulus - zero and negative interest rates combined with QE money printing - just isn't working. That then leads to possibly fiscal stimulus (big government spending on infrastructure etc) being tried to kick start the still relatively stalled global economy post GFC. That then gets people talking about this being the bottom of interest rates and possibly inflationary forces coming to bear. The Fed may well raise rates in September to show that it can and is serious. The theory may be that moving stimulus from Wall St to Main St will be more effective in generating inflation and the Fed has hinted recently they are likely to accept higher inflation than previously targeted.

That latter point is why more are seeing this dip as the time to buy gold. Gold LOVES inflation, especially when rates are likely to stay low for some considerable time. That gives you negative real rates and that is an environment where gold thrives. Even the sceptics are changing their tune. Vocal anti gold bug and ex chief investment strategist for Merrill Lynch, Richard Bernstein, explained why he is now a buyer of gold:

"You buy real assets when inflation expectations are starting to go up"

 

Jawboning & Volatility Settle in

The much anticipated speech from US Fed member Brainard last night delivered yet another surprise when she came out dovish when, after Rosengren Friday night, many were expecting a change to the hawkish side and more hints at a September rate hike. The reaction was therefore predictable in that it was almost the reverse of the Friday night rout. The S&P500 regained 1.5% of the 2.4% it lost Friday night, bond yields dropped, gold and silver rose, and the USD fell. Yesterday saw $35b wiped off our ASX in the biggest one day fall since Brexit, and leaving it back to zero gains for the year. If our market follows the US then we could see some of that reversed today. For now

Brainard's speech called for "prudence" in removing monetary accommodation and said the case for tightening was "less compelling" given the lack of inflation and a less than convincing economic recovery. In a warning for Australia as much as the US she said "China is undergoing a challenging transition from a growth model to one driven by consumption".

And so welcome back to the jawboning we saw in the protracted lead up to the end of QE3 and then the first US rate hike last December. The Fed knows a rate hike will cause chaos, but they also know it is necessary as this credit cycle appears out of control. So they need to get the market as conditioned with words as possible. The odds for a September rate hike, after spiking Friday night, are now back down to just 11%.

However one would be foolhardy to think it's back to easy-money-situation-new-normal for good. Last week and Friday night may still mark a change in tact by the world's central banks as we discussed yesterday. Friday night showed how sensitive easy money addicted markets are to such a change, even if just mooted. So such volatility and jawboning by central banks may be around for a while as they try to transition. Now more than ever, a balanced mix of assets in your portfolio is critical. Some theorise this is the 'death throws' at the end of this epic credit cycle that started in the early 70's.

Some 2 years ago we quoted Joseph Baratta, Global Head of Private Equity at the Blackstone Group, the biggest fund manager in the world. Back then he said:

"We are in the middle of an epic credit bubble, in my opinion, the likes of which I haven't seen in my career in private equity."

Yesterday the CEO of one of the world's biggest banks, J P Morgan, said the Fed should just get on and raise rates. Of course higher rates are more profitable for banks, so he would Interestingly though, on the same day one of his senior execs said:

"the current credit cycle is unlike any the bank has seen".

Sound familiar? That, from 2 of the world's largest financial institutions.

There is no easy way out of a credit cycle. Central banks have inflated what many think are now an out of control asset bubbles through monetary stimulus gone too far. Should, as many now believe, governments now move to unleash unprecedented fiscal stimulus instead, that still requires more debt and/or printed money to do so. It is not a solution, it is a final throw of the dice. Get used to the jawboning and volatility until it ends.

 

2 Wise Men Warn What's Coming

As we warned yesterday last night lived up to expectations dishing out another volatile night in all markets. The S&P500 sold off again, down 1.5% to its lowest since July (down 1.8% at one point), bonds around the world fell yet again (with yields surging to their highest in 3 months), gold fell $9 and silver down 25c. Off the back of a plunge in the oil price, the USD surged to the extent that the Aussie dollar lost almost a full cent and nicely buffered most of those USD gold and silver losses for us.

So what happened this time? A lot of it could be attributed to two Wall Street heavyweights chiming in with some fairly dire warnings for investors. Firstly, Ray Dalio, head of the world's largest hedge fund, Bridgewater, said:

"there's only so much you can squeeze out of a debt cycle... we are there... you can't lower interest rates materially, and you are also at the limit on QE (because spreads are limited)."

"Globally, those forces that were behind us are no longer there... we are at the end of a debt cycle... and everybody will have a lower growth rate than we are used to."

"We are to various degrees close to pushing on a string"

We then heard from multi-billionaire hedge fund manager Paul Singer (who gave this warning in June). After his prior warnings on the dangers generated by the US Fed (and similarly other central banks around the world) through near or below zero interest rates and monetary expansion, which he described as unprecedented in the "5,000 years-ish" history of finance, he warned again:

"What they have done is created a tremendous increase in hidden risk, risk that investors don't exactly know or have faced about their holdingsI think it's a very dangerous time in the global economy and global financial markets."

"the ultimate breakdown (or series of breakdowns) from this environment is likely to be surprising, sudden, intense, and large."

As a reminder, on gold, last year Ray Dalio famously had this to say:

"If you don't own gold there is no sensible reason other than you don't know history or you don't know the economics of it"

And Paul Singer had this to say:

"We're very bullish on gold, which is the antipaper money,."

 

Risk-Parity - The New Market Danger

Shares and bonds tend to be uncorrelated with one generally down when the other is up. It is to some extent the same for gold, though 2016 has seen a broader trend of both US shares and gold rising together apart from the crash in shares and surge in gold at the beginning of the year. We have surmised this is investors taking an uneasy punt on the Fed continuing to prop up US Shares (the 'don't fight the Fed bet') but having their hedge in place with gold. Moreover though, share prices have been driven not by 'investors' but rather company share buy backs.

Rarely do you see what we've witnessed recently, and especially to extent of the last few days, where both shares and bonds fall and rise in unison to the extent depicted in the chart below (remembering falling bond price means higher yield).



There are a relatively new breed of fund that promise gains on using the traditional lack of correlation between shares and bonds and extensive use of leverage. These are called risk parity funds. From The Wall Street Journal:

"So-called risk-parity funds seek to produce above-market gains with lower risk by using futures or other derivatives to increase their returns on safer assets such as bonds. This leverage has at times resulted in strong performance by the funds, which analysts estimate control tens of billions of dollars of assets. But it also leaves them vulnerable when stock and bond prices fall suddenly, as happened both on Friday and Tuesday.

Broadly speaking, risk-parity funds try to equalize the potential volatility in a portfolio of stocks, bonds and assets like commodities by applying leverage to lower-risk, lower-returning investments such as government bonds.

During a period of damped volatility, risk-parity funds are able to push up their equity holdings and still maintain a low-volatility profile. The danger, some analysts say, is if bonds and stocks both fall for a prolonged period, the funds can be forced to deleverage by selling investments, amplifying an already negative market environment."

This forced dumping into an already falling market when "tens of billions of dollars of assets" are held is one of the many elephants in the room at the moment. The AQR Risk Parity Fund Index is one of the larger such funds and the chart below shows an unsettling similarity to the crash last August.

 

The Global VIXen

As explained in today's Weekly Wrap, last night saw US shares rally 1% on the back of a number of awful economic data prints leading punters to the view the September rate hike is now off again and indeed the chances of any rate rise in 2016 dropped to just 50%. Surprise surprise bad news is good news

The volatility in markets is in stark contrast to the 'everything is awesome' record low VIX we saw just a couple of weeks ago as we discussed here and here.

Indeed this week saw a new record break where the VIX ETF (yep, there is pretty much an ETF / derivative for anything nowadays), VXX, see a higher volume of trade on Tuesday than even the most traded stock on the S&P500, as the VIX spiked after Friday night's turmoil. As we reported Monday, the VIX went from its lowest in 45 years to the highest since Brexit



This volatility is in the week before that of both the US and Japanese central banks meeting on 20/21st. After last night one would think the US Fed raising rates next week is off the cards, but the last week showed how wildly that view can change. The BoJ have put many a mixed signal out this week and could have just as much effect on the market as the US Fed.

These are the 1st and 3rd biggest economies in the world. Their actions affect world markets. We are certainly not immune as we've seen this week, in terms of our sharemarket, bond market and currency. Last night's economic data saw most economists slashing the GDP forecast for the US as their shares rallied. What many forget is they are not alone. The graph below is self explanatory. This is a global issue, not a US and Japan issue.

 

GLD/SPX Flags Gold Rise Ahead?

2016 has been an interesting year to say the least. We had the sharemarket crash in January and February on a mix of China devaluing the Yuan and a delayed reaction to the US rate hike in December. The feeling has been one of growing scepticism on whether the central banks have 'got this'.

Gold and silver surged to high 20's% and mid 40's% driven in large part by rampant buying of GLD and SLV ETF shares and hence huge demand from the ETF's. This demand was driven by Wall St looking for a safe home.

Things have cooled off since as shares rallied, fuelled by continuing central bank stimulus, company buy-backs and more debt. There was probably even an element of 'if we can survive Brexit we are bullet proof'. It certainly wasn't on fundamentals, with earnings for companies in the S&P 500 having fallen for five straight quarters, the longest such run since the GFC. And yet the S&P500 is up 6.3% for the year.

In Australia where we (at the moment) have slightly higher rates, no other monetary accommodation, and feeling the China slowdown more than most, our ASX200 is almost unchanged from 1 January.

Gold and silver on the other hand are still up 20% and 33% respectively for the year despite our higher AUD (they are up 24% and 36% in USD spot).

And hence we have such market nervousness around the next Fed rate hike. We find out this week the outcome of the much anticipated September Fed meeting (and, nearly as important for us, the Bank of Japan too) as we discussed in Friday's Weekly Wrap.

There are a couple of things to keep in mind though. Firstly September is the 'crash month'. Many think it is October but the graph below shows September's average is worse:



Importantly for gold, it is a reminder that despite those healthy year-to-date gains, when considered against a US sharemarket at record highs based on nothing but central bank stimulus and starving a market of 'safe' yield in deposits, the ratio of GLD/S&P500 (see graph below) is still relatively low. You will see the little rest it has had of late, but when, not if, the US shares take a dive you could well see a repeat of January and February, and more. The blue line is the amount of gold held in GLD, and you can see the big amounts bought early this year. The red line is the ratio of GLD value to the total market cap of the S&P500 and you can see how far it has moved away from the blue line despite that gold price increase. Just look at what happened in the GFC Combing these 2 charts and a couple of critical central bank meetings in that month and it is certainly an interesting set up. Whether you are nervous or relaxed may well come down to how much gold you hold versus shares.

Don't discount however the very real prospect of dovish central bank meetings pushing both US shares and gold strongly higher this week and up into late this year when the December rate hike jawboning starts again. Both rising will just make the graph below become even more tantalising.

 

China Banking Crisis Near

While the world is pre-occupied with whether the Fed will raise rates tomorrow or BoJ holds or capitulates with more stimulus, the world's central banks' central bank the Bank of International Settlements (BIS) has delivered a serious warning from another part of the world China. The world's top financial watchdog warned that China faces a full blown banking crisis as its credit-to-GDP gap, a key measure of economic vulnerability, is now 3 times the generally accepted 'danger level' of 10. Per the graph below you can see China has been above 10 for most of the period since the GFC, but never in all of history has it been as high as it is now at 30.1, and nowhere else in the world is it this high. This from the world's second biggest economy.

So what does it mean? The famed economist Hyman Minsky (of Minsky Moment fame) found that over 60 years of analysis of banking crises, there was no better indicator than the credit to GDP gap, and that 10 was the magic number above which careful monitoring was required. 30 screams a bust is close.

China's total official credit at the end of last year reached $28 trillion or 255% of GDP, nearly doubling since the GFC, still rising fast, and considered dangerously high for a developing economy. What is particularly concerning is that 171% of that 255% debt to GDP is corporate debt. How much, if any, of China's infamous and massive shadow banking sector debt is captured is unknown.

When you consider too that $28 trillion is more than the entire bank loan books of both the US and Japan combined you soon understand BIS's concerns.

BIS determined too that just a 250 basis point rise in interest rates sees it fail. This warning was authored before last week's global sell off of bonds with the corresponding increase in yields.

This too will be weighing on the Fed's mind as the consequences of raising rates could be catastrophic for emerging markets carrying enormous amounts of USD debt. China is leading the way of dumping US Treasuries, now down to their lowest level since 2012, but still at an incredible $1.22 trillion worth. Good luck Janet no pressure.

 

One Chart Why The Fed Is Stuck

The world is on tenterhooks on the eve of the US Fed announcing whether or not they will raise US interest rates by a measly 0.25%. There are many reasons why such a small increase could cause market carnage but in its very simplest form the following graph speaks volumes:



We discussed this most recently last week, but more fundamentally in August on the 45th anniversary of this epic credit cycle, and you can see oh so clearly where things go (beyond) parabolic from 1971 in the graph above. GDP will continue to be the 'benchmark' for prosperity, but as we continue to point out, you can 'buy' GDP with debt. The problem, as it is at the end of each credit cycle, is when that debt overwhelms.

There is no easy way out of this, it just comes down to when 'they' are prepared to take the medicine. The odds are low on a rate rise tonight but some big names warned yesterday that you should not be surprised if the Fed do indeed take that medicine tonight. We continue to think they won't do it before the election and you could see both shares and gold soar tonight. If they do you can expect to see gold and shares take a very big hit. The problem, as the chart above highlights, is that the system will struggle with higher rates and it could be the 'prick of the bubble' that sees the whole thing unwind. The GFC may have been a minor preview shares halved and gold rebounded after that initial dip to go on to double.

 

Fed & BoJ Last Night Explained

Yesterday and last night saw both the Bank of Japan and the US Fed announce their latest monetary policies. Both saw good gains in gold and silver prices ensue.

BoJ, whilst holding their negative 0.1% rate and Y80 trillion ($1trillion) per year bond buying program (plus another $75b ETF's), flagged changing the way in which they buy their bonds (JGB) to try and steepen their yield curve, get the 10 year bonds to at least zero and keep their banks happier. Enter the new term "QQE with yield curve control" (quantitative and qualitative easing). You gotta hand it to them, they are not giving up on their quest for inflation and will keep mixing it up

For those new to this (and we suspect you are going to hear a lot more about yield curves going forward) the yield curve is a plot of yields (interest rate a bond 'pays') on the vertical axis versus the maturity date on the horizontal axis. A 'normal' curve (depicted below) rises from short term (say 3 month) out to, say, the 30 year long term bond (as we discussed in last week's Weekly Wrap, Australia has only just introduced 30 years).



Banks make their money borrowing cheap and lending dear, effectively playing that curve. Of late, given fears about the future economy and rampant bond buying by central banks (of shorter maturity bonds hence depressing the price and raising the yield), the yield curve has been relatively flat not ideal. Throw in negative yields (i.e. the bank PAYING to hold the bonds) and it gets a bit nasty for them. If banks hurt, the "1%" hurt, and that's just not on. The problem is too that BoJ have been SO rampant in their JGB buying that they now own over a third of all outstanding Japanese sovereign debt! This change in tack is seen then too as an admission they have pretty much exhausted their purchases. To date they have only be allowed to buy 7 to 12 year bonds and this new policy will give them more flexibility to vary that to manipulate the curve.

The funny thing is that they are still part of a global market and whilst the US Treasury (UST) yield curve (the global benchmark) did indeed steepen on the BoJ announcement, it got thoroughly smashed on the Fed announcement last night nice segue

Yes, surprise surprise, the US Fed kicked the can a little further last night and held rates unchanged at 0.5%. The speech was not unlike all the others with the theme of 'nearly there' continuing and the usual contradictions like "economic activity appears to have picked up" but then revising down their 2016 GDP forecast to 1.7-1.9% from 1.9-2.0% just a few months ago, but reassuringly said "Our decision not to raise rates does not reflect our lack of confidence in the economy". oh brother.

Of course one of the core reasons they actually need to raise rates is they are continuing to inflate fundamental-less asset bubbles setting us up for an even bigger bust when it comes, or in her words "we don't want the economy to overheat". When asked specifically about this Yellen 'reassuringly' said "we routinely monitor asset valuations... nobody can know for sure what valuation represents a bubble". History shows they have an absolutely shocking record of getting that wrong.

And so, right on cue, shares, bonds, gold and (the star of the night) silver all surged. But here's a clue as to what is likely to come 2 of that list of 4 assets are already over inflated and 2 are just coming off cyclic lows.

 

Why the Fed's Trapped & Crash Inevitable

We came across an excellent article this morning outlining just how trapped the US Fed (and by inevitable flow-on.. the world) is with it's easy money policy gone too far. We will endeavour to get it up on our site shortly but if there are 2 graphs and accompanying quotes to take away its these.

"A 'Liquidity Trap' is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.

The problem for the Federal Reserve is that getting caught in a liquidity trap was not an unforeseen outcome of monetary policy, but rather an inevitable conclusion. As shown in the chart below the more active the Fed has become with monetary policy, the lower the eventual rates of GDP, inflation, and interest rates has become. As stated, the current low levels of inflation, interest rates, and economic growth are the result of more than 30-years of misguided monetary policies that have led to a continued misallocation of capital."



They quote the Wall Street Journal article we discussed in last week's Weekly Wrap regarding the Bank for International Settlement view:

"The BIS has for years warned that the global economy is too dependent on its central banks, whose money-printing power allows for a rapid response to crises. The result is that central bank money boosts asset prices even if underlying economic conditions haven't changed."

Enter exhibit B



"Of course, this was ALWAYS the intention of these monetary interventions. As Ben Bernanke suggested in 2010 as he launched the second round of Quantitative Easing, the goal of the program was to lift asset prices to spur consumer confidence thereby lifting economic growth. The problem was the lifting of asset prices acted as a massive wealth transfer from the middle class to the top-10% providing little catalyst for a broad-based economic recovery. [and fuelling the social discontent playing out in the likes of Brexit, Trump and our very own Senate]

Unwittingly, the Fed has now become co-dependent on the markets. If they move to tighten monetary policy, the market sells-off impacting consumer confidence and pushes economic growth rates lower. With economic growth already running below 2%, there is very little leeway for the Fed to make a policy error at this juncture.

Therefore, the Fed remains trapped between keeping the financial markets happy and trying to resolve their monetary dilemma. The problem is that eventually something has to give and it will likely not be the outcome the Fed continues to hope for."

"In fact, there have been absolutely ZERO times in history that the Federal Reserve has begun an interest-rate hiking campaign that has not eventually led to a negative outcome."

"While raising rates would likely accelerate a potential recession, and a significant market correction, from the Fed's perspective it might be the "lesser of two evils.""

"For Janet Yellen, the "window" to lift interest rates appears to have closed which could potentially be a policy nightmare for the Fed, the economy and you."

Keep an eye out for the full article as it gives an easy to understand, graphically well presented account of why this is going to end very badly for financial markets and why you want your "insurance" in place

 

UN's Warning on Globalisation 3rd Leg of GFC


'Globalisation', once the great go forward phase (or phrase) of world prosperity is becoming decidedly 'on the nose' as the human side of it starts taking it's toll and the economic dangers, whilst not new, start getting mainstream attention.

Last week the Unitied Nations' annual report on the UN Conference on Trade Development (UNCTAD) did not mince words on where this is heading, saying it is leading us to the third phase of the financial crisis:

"There remains a risk of deflationary spirals in which capital flight, currency devaluations and collapsing asset prices would stymie growth and shrink government revenues. As capital begins to flow out, there is now a real danger of entering a third phase of the financial crisis which began in the US housing market in late 2007 before spreading to the European bond market,"

The underlying issue is the sheer amount of debt (often US denominated) taken on by emerging economies on the back of all the money printing through QE. The stats are nothing less than breathtaking. Corporate debt in these emerging markets has nearly doubled from 57% to 104% of GDP since the end of 2008 to the staggering amount of $25 trillion. For context the GFC was triggered by 'just' $2 trillion in sub prime loans. From the report:

"If the global economy were to slow down more sharply, a significant share of developing-country debt incurred since 2008 could become unpayable and exert considerable pressure on the financial system,"

Part of the core issue too is that companies are not reinvesting in their businesses, something we have highlighted time and again. They are instead buying their own shares and other short term measures to prop up their price using cheap debt.

The UN is inherently left wing but their solution is in stark contrast to the 'globalisation' script and some would argue even radical. They are calling for a shift from private to public policy, leaving behind the neo liberal approach and looking to protectionism, prescriptive or tax incentivised reinvestment controls, capital controls, and government stimulus. These ideas have been getting traction of late with central banks even looking to more fiscal than monetary expansion. Today's AFR even runs a story where IFM Investors chief economist advocates helicopter money for Australia with that printed money going purely into infrastructure spending. Where does this stop?
It's a scary prospect and as the UN says:

"If policymakers fail to mitigate the negative impacts of unchecked global market forces, then a turn to protectionism could trigger a vicious downward spiral for everyone,"