Despite, or more accurately, because so many markets are at high levels, often on thin trading volumes, many investors are edgy. Even though markets famously climb a wall of worry, I can’t recall a time when there have been so many skeptical long investors.
For instance, even though the famed FAANG keep racing to even loftier levels, a US stock market crash would be unlikely to do a lot of damage. Unlike the 1929 crash, this rally isn’t fueled mainly by money borrowed from banks. And unlike the dot-com bust, speculative stocks are not being used as a form of payment. Recall that companies that should have known better, such as Lucent (this BTW was Carly Fiorina’s doing) and McKinsey were taking equity instead of cash, meaning as consideration for services. Informed insiders say McKinsey had to write off $200 million of stock it took in lieu of fees; the actual number may be higher given that McKinsey could have discounted its fees. That practice was sufficiently widespread to give the dot-com crash a tad more sting than it might otherwise have had. Even so, there was no blowback to the payment system, and the early 2000s recession was not terrible by historical standards.
This is far from a complete list, but investors are worried about ETFs, Deutshe Bank, festering banking problems in Italy, and China’s debts, and a longer than usual list of exogenous risks, including nasty events resulting from increasing hostilities with North Korea, Russia, and Iran, perhaps a nuclear disaster resulting from wild weather, and further down the road, a disorderly Brexit doing more damage to Europe and it not-so-solid banks.
The reason this situation is so striking is that historically, crises that did real damage hurt financial institutions. In the Great Depression, banks all over the world failed, wiping out depositors’ funds, big chunks of the payment system, and the resulting downdraft correctly made the survivors too fearful to lend. In the US, a lot of traditional lending has been displaced by securitization, so investors taking losses or simply getting nervous could damage credit creation.
If one were to step back, and this is hardly a novel thought, the root of investor nervousness is the sustained and extreme intervention by central banks all around the world in financial markets. No one in 2008 would have thought it conceivable that less than a decade later, one quarter of the world economy would have set negative policy interest rates. Even though markets only occasionally pay attention to fundamentals, sustained super low interest rates, by design, have sent asset prices of all kinds into nosebleed territory.
The Fed seemed to be the first to recognize that its monetary experiments had done little for the real economy, save allow for some additional spending via mortgage refis. It had done more to transfer income and wealth to the top 1%, and even more so to the top 0.1%, and enrich banks, all of which are hindrances to long-term growth. Yet Bernanke announced his intention to taper in 2014, and how far has the Fed gotten in getting back to normalcy? The answer is not very. And that’s because central bankers fear that their policies are asymmetrical: they can do more to dampen activity by increasing rates than they can to spur growth by lowering them. As we’ve repeatedly pointed out, businessmen do not go out and expand because money is on sale. They expand when they see commercial opportunity. The exception is in industries where the cost of money is one of the biggest costs of production…such as in financial services and levered speculation.
However, from what I can tell, the Fed’s desire to raise rates is driven by its perception that it need to have short term rates meaningfully higher, as in 2% or higher, so as to have room for cuts if the banking system gets wobbly. That is why it keeps treating a flaccid but less terrible than in the past labor market as robust.
But the potentially more interesting contradiction is in the posture of conservative businessmen. Higher interest rates will hurt their stock portfolios and the value of their homes. It will also hurt fracking, which is very dependent on borrowed money. Yet Republicans are more eager than Democrats to raise interest rates, apparently out of the misguided belief that low interest rates help labor, as opposed to capital (the Fed’s using the state of the labor market as its indicator as to whether to increase interest rates or not no doubt feeds this belief). Similarly, Republicans are far more exercised about the size of the Fed’s balance sheet and want it smaller. Again, there’s no logical reason for this move. The Fed’s assets will liquidate over time. They may not do much additional good sitting there (save the remittance payments back to the Treasury), but they aren’t doing any harm either.
In other words, the varying views about what to do about central bank interest rates and their holdings in many, too many, cases have to do with political aesthetics that often run counter to economic interests. A big reason that conservatives don’t like the Fed’s big balance sheet, even though the Fed is the stalwart friend of banks and investors, is that they still see the Fed as government, and government intervening in the economy offends them, even when it might benefit them. (Mind you, this is not the same as business exploiting government via “public private partnerships” or other approaches where commercial interests have their hand on the steering wheel). (...)
Now you might ask, how does this relate to the original question, that market mavens might be looking for the next crisis in all the wrong places?
The first is that despite widespread worries about a crisis, you don’t need to have a crisis to have a bubble deflate. In the runup to 2008, I expected the unwind of reckless lending spree to look like that of Japan’s. Japan’s joint commercial and residential real estate bubbles were much larger relative to the GDP than those in the US. Yet instead of a dramatic bust, the economy contracted like a car with no wheels banging down a steep slope. A mini-crisis of sorts did occur in 1997, when the authorities made the mistake of thinking the economy was strong enough to take some tightening, which kicked off a series of financial firm failures. So even if it turns out things do end badly, you can have the real economy suffer without having the financial system have a heart attack.
The second is that with some significant exceptions like Deutsche Bank, the authorities have succeeded in moving risk out of the financial system and more and more onto the backs of investors. That means the rich, but it also means pension funds, insurance companies, endowments, foundations, and sovereign wealth funds. Investors have already taken a toll via super low interest rates; economist Ed Kane estimated that in the US alone, that represented a $300 billion per annum subsidy to banks.
So even if we were to have something crisis-like, as in a sudden ratchet down in asset prices that stuck, it isn’t clear that the damage to critical financial plumbing would be significant.
For instance, even though the famed FAANG keep racing to even loftier levels, a US stock market crash would be unlikely to do a lot of damage. Unlike the 1929 crash, this rally isn’t fueled mainly by money borrowed from banks. And unlike the dot-com bust, speculative stocks are not being used as a form of payment. Recall that companies that should have known better, such as Lucent (this BTW was Carly Fiorina’s doing) and McKinsey were taking equity instead of cash, meaning as consideration for services. Informed insiders say McKinsey had to write off $200 million of stock it took in lieu of fees; the actual number may be higher given that McKinsey could have discounted its fees. That practice was sufficiently widespread to give the dot-com crash a tad more sting than it might otherwise have had. Even so, there was no blowback to the payment system, and the early 2000s recession was not terrible by historical standards.
This is far from a complete list, but investors are worried about ETFs, Deutshe Bank, festering banking problems in Italy, and China’s debts, and a longer than usual list of exogenous risks, including nasty events resulting from increasing hostilities with North Korea, Russia, and Iran, perhaps a nuclear disaster resulting from wild weather, and further down the road, a disorderly Brexit doing more damage to Europe and it not-so-solid banks.The reason this situation is so striking is that historically, crises that did real damage hurt financial institutions. In the Great Depression, banks all over the world failed, wiping out depositors’ funds, big chunks of the payment system, and the resulting downdraft correctly made the survivors too fearful to lend. In the US, a lot of traditional lending has been displaced by securitization, so investors taking losses or simply getting nervous could damage credit creation.
If one were to step back, and this is hardly a novel thought, the root of investor nervousness is the sustained and extreme intervention by central banks all around the world in financial markets. No one in 2008 would have thought it conceivable that less than a decade later, one quarter of the world economy would have set negative policy interest rates. Even though markets only occasionally pay attention to fundamentals, sustained super low interest rates, by design, have sent asset prices of all kinds into nosebleed territory.
The Fed seemed to be the first to recognize that its monetary experiments had done little for the real economy, save allow for some additional spending via mortgage refis. It had done more to transfer income and wealth to the top 1%, and even more so to the top 0.1%, and enrich banks, all of which are hindrances to long-term growth. Yet Bernanke announced his intention to taper in 2014, and how far has the Fed gotten in getting back to normalcy? The answer is not very. And that’s because central bankers fear that their policies are asymmetrical: they can do more to dampen activity by increasing rates than they can to spur growth by lowering them. As we’ve repeatedly pointed out, businessmen do not go out and expand because money is on sale. They expand when they see commercial opportunity. The exception is in industries where the cost of money is one of the biggest costs of production…such as in financial services and levered speculation.
However, from what I can tell, the Fed’s desire to raise rates is driven by its perception that it need to have short term rates meaningfully higher, as in 2% or higher, so as to have room for cuts if the banking system gets wobbly. That is why it keeps treating a flaccid but less terrible than in the past labor market as robust.
But the potentially more interesting contradiction is in the posture of conservative businessmen. Higher interest rates will hurt their stock portfolios and the value of their homes. It will also hurt fracking, which is very dependent on borrowed money. Yet Republicans are more eager than Democrats to raise interest rates, apparently out of the misguided belief that low interest rates help labor, as opposed to capital (the Fed’s using the state of the labor market as its indicator as to whether to increase interest rates or not no doubt feeds this belief). Similarly, Republicans are far more exercised about the size of the Fed’s balance sheet and want it smaller. Again, there’s no logical reason for this move. The Fed’s assets will liquidate over time. They may not do much additional good sitting there (save the remittance payments back to the Treasury), but they aren’t doing any harm either.
In other words, the varying views about what to do about central bank interest rates and their holdings in many, too many, cases have to do with political aesthetics that often run counter to economic interests. A big reason that conservatives don’t like the Fed’s big balance sheet, even though the Fed is the stalwart friend of banks and investors, is that they still see the Fed as government, and government intervening in the economy offends them, even when it might benefit them. (Mind you, this is not the same as business exploiting government via “public private partnerships” or other approaches where commercial interests have their hand on the steering wheel). (...)
Now you might ask, how does this relate to the original question, that market mavens might be looking for the next crisis in all the wrong places?
The first is that despite widespread worries about a crisis, you don’t need to have a crisis to have a bubble deflate. In the runup to 2008, I expected the unwind of reckless lending spree to look like that of Japan’s. Japan’s joint commercial and residential real estate bubbles were much larger relative to the GDP than those in the US. Yet instead of a dramatic bust, the economy contracted like a car with no wheels banging down a steep slope. A mini-crisis of sorts did occur in 1997, when the authorities made the mistake of thinking the economy was strong enough to take some tightening, which kicked off a series of financial firm failures. So even if it turns out things do end badly, you can have the real economy suffer without having the financial system have a heart attack.
The second is that with some significant exceptions like Deutsche Bank, the authorities have succeeded in moving risk out of the financial system and more and more onto the backs of investors. That means the rich, but it also means pension funds, insurance companies, endowments, foundations, and sovereign wealth funds. Investors have already taken a toll via super low interest rates; economist Ed Kane estimated that in the US alone, that represented a $300 billion per annum subsidy to banks.
So even if we were to have something crisis-like, as in a sudden ratchet down in asset prices that stuck, it isn’t clear that the damage to critical financial plumbing would be significant.
by Yves Smith, Naked Capitalism | Read more:
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