If everything is going up…

If everything is going up…

The good news is, financial markets are booming.

The prices of bonds, stocks, gold and everything else you can find quoted on an exchange are rising.

The bad news is, what does that actually mean? If everything is going up, is anything really going up at all?

The brokers and the journalists see rising prices as a sign of prosperity. Rising stocks are an expectation of future profits.

And tumbling bond yields tell us people have faith in government finances.

The thing is, not so long ago, according to the same journalists, those same tumbling bond yields heralded a recession.

And stocks only rose because central banks would pump them up with newly printed money, if needed.

The surging gold price was the giveaway, signalling trouble ahead. A false boom.

So which is it? Boom or gloom?

Is anything really going up at all?

The fact that it’s hard to interpret rising prices is interesting in and of itself. We’re in the twilight zone where prices don’t mean what they used to.

But if it’s central bankers doing the buying of all these assets, then that hardly suggests a true boom is underway. And they’ve certainly been hoovering up gold, stocks and bonds. Or are threatening to.

Last week it was the Americans’ turn. The central bank swapped from anticipating interest rate hikes to interest rate cuts. The markets loved it, ignoring the reason for the coming cuts.

The rising likelihood of a recession, signalled by falling bond yields (the inverted yield curve), just suggests central bankers will soon start buying even more assets to revive the economy. This will make bond prices rise even more, signalling a greater chance of recession.

But who cares if investment prices are rising?

Perhaps money printing really does provide prosperity…to the speculating class.

But maybe not in a meaningful way. This is the thing I’m going to try and explain.

If the price of everything is going up, then perhaps it’s just the value of your money that’s going down.

It’s asset price inflation, not true investment returns.

I’m not talking about consumer price inflation (yet).

We have the price of investments going up, so far. But among those investment classes, you get the same sort of futility as with consumer price inflation.

Getting past misleading information

The property market provides the best explanation of what I’m getting at.

Because property is both a consumption good and an investment.

House owners aren’t getting ahead if their property rises in price because they have to move somewhere to realise those gains. But prices at their new home will also have risen.

Only relative, or comparative, price gains get you anywhere. Which isn’t really what’s happening in financial markets when everything is going up. At least, it’s misleading to consider overall asset price increases as ‘getting ahead’.

Sure, gains across the board sound great. But the meaning is not the same as true investment returns.

Not that rising asset prices don’t have an effect. Inequality is one. Asset owners and the speculative class leave the wage earners behind.

And debt is inflated away. Those who borrow and invest get ahead because what they owe becomes worth less as prices rise. This is what makes property such a great punt — the leverage.

Storm Financial was merely ahead of its time then. In an age of QE, re-mortgaging your house to invest in stocks might’ve worked…

Normally, interest rates rise with inflation and leverage becomes dangerously expensive as asset prices rise. The process is self-correcting. When overleveraged investors get into trouble, this brings prices back down.

But central banks are suppressing interest rates while also pumping in money. There is no self-corrective measure to the boom. That’s why we call it a bubble.

It’s an odd situation. Is this time different? Could the boom go on forever thanks to central bank intervention?

Nope, according to history. But back to that in a moment.

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Zombie firms

The Bank of International Settlements is out warning about the consequences of this policy — suppressing interest rates while pumping in money.

The lack of a free lunch has to cost us somewhere. The BIS set about finding out where.

The BIS warned about the 2008 crisis in advance, too, so pay attention.

First of all, according to the BIS annual report, central banks aren’t capable of generating true economic growth:

What is good for today need not necessarily be good for tomorrow. More fundamentally, monetary policy cannot be the engine of growth.

In other words, inflating asset prices makes people feel richer, but there is something phoney about the boom, as I tried to explain above.

That won’t stop central bankers from trying though.

Especially with non-economists in charge at the ECB and Federal Reserve now. As Quartz put it, ‘the last non-economist Fed chair, William Miller (1979-81), was a disaster, associated with a period of high inflation and unemployment’. I wonder what’ll happen this time.

So far, central bank intervention has featured some interesting side effects the BIS has picked up on:

For quite some time, credit standards have been deteriorating, supported by buoyant demand as investors have searched for yield. Structured products such as collateralised loan obligations (CLOs) have surged – reminiscent of the steep rise in collateralised debt obligations that amplified the subprime crisis.

Debt is booming. Investors have become lenders. And companies with iffy credit ratings have borrowed the most:

The share of bonds with the lowest investment grade rating in investment grade corporate bond mutual fund portfolios has risen, from 22% in Europe and 25% in the United States in 2010 to around 45% in each region.

There are now more than a dozen corporate junk bonds with negative yields in Europe alone. Companies with low credit ratings that can borrow for less than 0% interest…

The vast growth in zombie corporations — companies that can’t afford their debts — is another long-term BIS topic. Remember, these companies are already struggling during the lowest ever interest rates…  

In Europe, the percentage of zombie firms is surging:

Source: Global Economic Trend Analysis

And the BIS is worried about another side effect the zombies are having:

They sap economy-wide productivity growth not only by being less productive themselves, but also because they crowd out resources available to more productive firms. Evidence suggests that their increase over time has had an economically significant macroeconomic impact.

This isn’t the only unproductive use of debt.

A lot of the borrowing is being used to buy back stocks, especially in America.

This shrinks the equity share of companies’ balance sheets, making them more profitable and valuable per share, but not overall. And buybacks do not contribute to the economy at all because they refinance, not grow, companies. But stock prices go up, so it looks like a good idea.

Banks were a major focus of the BIS report. Especially in Europe, banks haven’t recovered alongside financial market prices. This is largely thanks to non-performing loans and central bank policies.

This is a problem because central bank policies operate via the banking system. That’s primarily how they influence the economy. Central bankers call it the banking channel. But if the banks are broken, then monetary policy isn’t effective.

My worry is that central bankers are stuffing money down a clogged banking system. If the drain ever unclogs, it’ll turn into a water cannon aimed at the value of our currencies. But that’s another story.

None of the BIS’s warnings are new, by the way. But what makes them interesting is the size of the list of warnings. At this point, the ‘everything bubble’ is pointing to an ‘everything crisis’ in the works.

This makes sense. If you keep bailing out but not solving whatever crisis comes your way, then eventually you’ll end up with an everything crisis.

Take you cue from those in the know

What you might not know is just how often we’ve been here before. Government attempts to suppress bond yields in order to deal with excessive sovereign debt consistently trigger the same series of events.

That is, a stock market boom and crash, followed by the sort of inflation that is less popular. This happens the moment people realise it’s their money that was devalued instead of their assets going up in value.

That’s why gold is rising — the tell-tale sign those in the know are looking for to opt out of the financial system. The tell-tale sign that the boom leading up to the 2008 financial crisis was shifty was the gold bull market back then, too.

The history books don’t describe the run up to the tech bubble, South Sea Bubble, Mississippi Bubble, sub-prime bubble, European sovereign debt crisis or anything else in this way. In fact, any respectable bubble historian, employed by a government-funded university, is careful to start the story with the speculative mania, not the government financial policy that kicked it off.

But the money to inflate bubbles must come from somewhere. And someone has to be desperate and stupid enough to try the policy that has always failed before — QE. Excessive government debt is usually the problem that makes it worth trying.

Where does Australia sit?

We’re joining the rest of the developed world with incredibly low interest rates. Will we get stuck there too?

The good news is, as a commodity-producing nation, Australia has a bright future. Real stuff becomes disproportionately important when financial promises break down.

The bad news is, Australia’s financial industry is also a huge chunk of the economy. That will take a hit as the consequences of QE around the world play out.

Until next time,

Nick Hubble Signature

Nick Hubble,
For The Daily Reckoning Australia