Equity markets have survived the last few years on the mantra that ‘bad news is good news’. Each time GDP slowed, unemployment rose or confidence crumbled, stocks surged.
The reason for this bizarre behaviour is money printing. The worse the news feed looks, the more money will be printed. And the more money, the more stocks levitate.
Just to make the impact obvious, every time the money printers stopped printing, stocks fell. Lately, even a hint that the money printing will be reduced has been enough to send the market tumbling.
The message is clear. If you want the stock market to go up, just print money. All the other stuff like GDP, employment and confidence isn’t really relevant.
But why does the stock market matter more than GDP, employment and confidence in the first place? That is a question economists have an answer for. It’s called the wealth effect. People who own shares that are going up feel richer and spend more. That improves GDP, employment and confidence.
The bit we don’t understand about this wealth effect nonsense is that people need to get their hands on the money to spend it. While their money is piling into the stock market, people can’t spend it and add to GDP. They have to sell their shares first.
So you’d think a falling stock market would boost consumption, because people are pulling their money out and spending it.
But then again, that logic is flawed too, because for every seller, there has to be a buyer. The amount of cash flowing in and out of the market has to be equal. So a levitating stock market can’t help consumption.
Long story short, the wealth affect has it backwards and makes no sense as well. Apart from that, a rising stock market is the result of a healthy economy, not the indicator of one. If you goose stock market prices, you aren’t making the economy improve any more than messing with your speedometer improves your commute time.
Despite its fabulous effects on the stock market, for some reason even the most ardent supporters of money printing reckon it can’t go on forever. So they’re waiting for good news from the economy to begin pulling back their money printing.
For some unknown reason, we’re now at that point. ‘Septaper’ is in the air. In other words, there is a chance the American central bank will reduce (taper) its QE program in September.
This has reversed the ‘bad news is good news’ mantra. Good news is now bad news. An improvement in GDP, employment and confidence signals the end of money printing and thereby the end of stocks surfing a wave of dough.
Rather than relying on money printing, stocks will have to reflect economic reality. That’s going to be a rather rude shock. Especially if the wealth effect does work and people react to the falling stock market by reducing consumption.
Then again, any shock probably won’t last long.
If the Fed tapers, as printing less money is known these days, stocks will drop. If they drop far enough, can you guess what the Federal Reserve will do? Print money in the name of the wealth effect, of course. That’s what it’s done each and every time tapering led to a fall in the stock market over the past few years. Around and around we go.
In other words, even if the Fed does taper, it will be short lived. Economic reality is just too harsh.
The only constraint on this money printing is inflation. And inflation is showing up in the stock market more than anywhere else for now, which is supposedly a good thing. Most economists will tell you that the lack of inflation showing up anywhere except the stock market means the Fed’s policies are working.
But that’s just the problem.
Making economic reality irrelevant to the stock market is just the kind of distortion that makes money printing so dangerous. It completely obfuscates the signals the economy relies on to function. If good news is bad news, is it good or bad? Should you start a business or make an investment when GDP is going up or down? Who knows?
In this kind of environment, the important thing is to look like you know what you’re doing. Nobody really has a clue anyway, so you might as well look the part.
Or you can buy gold. Sticking your head in the sand has never helped anyone, but putting your wealth there is a proven strategy for preserving it.
The one thing you shouldn’t do in an environment with so much uncertainty is go into debt. Sure enough, that’s just what Australia is doing. And at every level too – government, private, and even our all important trading partner China is borrowing like mad.
Why is debt so dangerous? Well, China is slowing down. And debt is very difficult to pay off if your economy is slowing. In fact, debt only really works out well if the money you borrowed is invested in productive assets – the kind that increase your productivity and ability to pay off the debt.
Unfortunately for the Chinese, they invested much of the money in apartments that now stand empty.
Now debt has a binary outcome. You either pay it off, or you default. If Chinese growth slips below the level it needs to manage its debt load, the Chinese slowdown will turn into a death spiral. Economist Irving Fisher called this debt deflation – where defaults trigger a collapse in the money supply, which makes it even harder to pay off debt.
You might think a debt deflation in China would be a disaster for Australia. Well, even if the Chinese don’t experience a crisis, they hardly need more empty cities, do they? So why buy more Australian dirt? The mining industry is in trouble no matter what happens in China.
But it’s not all bad news. If China muddles through, Australia could shift to providing what China will need next – energy. Our natural gas resources could be just what the Chinese start gobbling up now that they’re moving towards a consumption economy.
As the Chinese improve their standard of living, they’ll want to upgrade their bicycles to Volkswagens. ‘There are 9 million Volkswagens in Beijing’ you can hear the city’s car dealers singing to themselves.
If those Volkswagens are powered by LPG, Australia could be in the driver’s seat, economically speaking. A gas boom to replace the mining boom. The lucky country has done it again!
for The Daily Reckoning Australia
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