The market has voted. It’s betting on a Biden victory. The plutocracy is back in town! The major US indices were up big again overnight. Gold surged more than 2%, while the US dollar was down.
Of course, Trump won’t give up without a fight. And if he does go down, expect the Republican-controlled Senate to make life hell for the Democrats.
You reap what you sow…
That is, of course, assuming there are enough Republicans not on the take, or under the threat of blackmail (the dark underbelly of US politics) to represent the voters. After all, the swamp attracts those from both sides of the political aisle.
I’ll leave it to your US correspondent, Dan Denning, to provide his on-the-ground take on the election on Monday.
I’m running with the view that, aside from the theatre, nothing much will change, at least from an economic perspective.
For the past few days, I’ve published excerpts from a recent issue of the Crisis & Opportunity report. In it, I’ve tried to join the dots between monetary and fiscal policy, and the impact on the economy and stock market.
Like most things in markets, it’s not what it seems.
For example, most analysis ignores what’s going on in the ‘shadow banking’ sector. It’s huge, it’s global, and it’s largely invisible. But as I explain below, quantitative easing (QE) is largely a response to the monetary destruction that is occurring in the global shadow banking system.
That is, QE is replacing what is lost, not adding additional firepower. When you grasp this crucial point, everything becomes that much clearer. You’ll understand for example why bonds aren’t responding to ‘all this money printing’.
Why understanding the shadow banking system is the ‘missing link’ in financial markets
If you’re going to have any understanding of the modern financial system, you have to have some idea about the role of the shadow banking system. Because when you do, a lot of this stuff all of a sudden makes sense.
I hope I can make the light bulb go on for you…
Paul McCulley, who was the Managing Director of bond fund manager PIMCO at the time, coined the term ‘Shadow Banking’ back in 2007. There is no easy definition for shadow banks, except to say they are, unlike conventional banks, unregulated.
They operate in the shadows of the financial system. Which is why conventional analysis always ignores shadow banks. It’s hard to see them!
The easiest way to explain the role of shadow banks is to say they monetise previously created loans. Sounds weird, I know. It’s modern financial alchemy, making money on top of money.
A simple example is what’s known as a ‘repo’ agreement. This is where someone who owns a Treasury security (for example) can exchange it for cash for a period of time. The Treasury bond creates new cash and purchasing power. Moreover, the system allows that Treasury bond to be monetised more than once, as it moved through different hands.
Another example is like back in the 2000s, when residential mortgage-backed securities were sliced and diced and monetised a number of times over, eventually being sold to ‘widows and pension funds’ around the world, who thought they were investing in a safe, money-like asset!
I know conceptualising this stuff can be hard. But if you just think of shadow banking as a process that turns longer term, relatively illiquid loans into liquid, money-like securities, you’ll get the gist.
The shadow banking system grew up in the ‘80s and ‘90s (and blew itself up in the 2000s) as a way to get around regulatory constraints and lower the cost of credit for the financial system as a whole.
The ‘shadow money’ created by the system was a way for banks to finance their assets, rather than use more costly funds like customer deposits and long-term loans.
When you think about this from a balance sheet perspective, it means banks used ‘shadow money’ as liabilities to fund the assets on their balance sheets.
That’s what banks do. They use short-term liabilities to fund long-term assets. But in 2007 and 2008, the quality of these liabilities (shadow money) came into question. Everyone all of a sudden realised that this ‘money’ was in fact worthless. It resulted in a ‘run’ on the shadow banking system.
That’s what caused the GFC. Yes it was a boom in real estate prices. But it was the shadow banks’ ability to monetise all the loans made on this real estate, many times over, that turned the boom to bust and nearly brought down the global banking system.
That’s why I say 2008 broke the system. It never recovered. Years of QE and increasing fiscal stimulus merely concealed the problem.
Until COVID hit. The global economic shutdown caused another run on the shadow banking system. Confidence in the usefulness of shadow ‘money’ evaporated. As a result, the money did too.
Combining the 2008 and 2020 crises and the years in between, resulted in a huge amount of destruction of ‘shadow money’. But here’s the thing…you don’t ‘see’ this monetary destruction. It’s in the shadows.
You only see the Fed’s attempt to create ‘money’ (bank reserves) to offset this destruction. Those that only see one side of the equation (the Fed’s activities) think inflation is just around the corner. But when you take the shadow banking system into account, you know inflation (in the real economy) isn’t coming anytime soon.
I know this stuff is hard to understand, especially if you’re new to the banking system and double-entry accounting.
But consider what QE is again. It’s just an asset swap, right? The primary dealer bank sells a treasury to the Fed in return for bank reserves. Easy.
But that’s only half of it. We still have to take into account what happens on the liability side of the balance sheet. (This is where the double-sided accounting comes in. For every asset, there is a liability.)
On the liability side, offsetting the asset that is bank reserves, QE creates ‘checkable deposits’, and checkable deposits show up in the money supply data like M1 and M2.
The money supply is soaring, which is why everyone is freaking out about the coming inflation.
But as I said, you don’t see the monetary destruction that’s happening in the shadows, which is the stuff that doesn’t show up in M1 and M2.
So while US money growth looks like it’s off the charts, it’s only telling you part of the story. As Jeff Snider writes in his excellent deep dive into this issue:
‘The parts that get counted in the M’s [as in M1 and M2] go way up, further reinforcing the inflation/money printing narrative, while the more dynamic and useful pieces that aren’t in any M’s [as in shadow money] got crushed, reinforcing disinflationary monetary reality. People see and hear constantly about the M’s, but the results (disinflation, interest rates, lack of growth) are all dictated instead by what’s going on in the shadows.’
The way to look at QE then is that it is a reaction to what’s going on in the shadows, rather than a proactive policy response to an economic crisis. That’s another reason why QE is not inflationary. It’s merely offsetting monetary destruction in the shadow banking system.
I hope that makes sense. If you’re like me, you’ll probably have to read through it a few times for it to make sense. But when the light bulb does go on, as I said, EVERYTHING becomes clearer.
But we still haven’t addressed the elephant in the room in all this, which is the ongoing bull market in stocks in the US. Let’s turn to that now…
Why disinflation is good for stocks (and bonds), and why inflation will be a disaster for asset prices in general (except one)
If the system is so broken, and shadow banks are shrinking, why does the stock market continue to go up?
It’s a good question.
There are two factors at play, both equally important:
Falling bond yields, which inflate asset prices via a lower ‘discount rate’.
Ongoing credit market expansion via massive fiscal stimulus. This keeps incomes and company earnings elevated.
The first point is pretty straightforward. A broken system produces an economy in structural decline, which in turn results in falling inflation, which is known as disinflation. This results in falling bond yields.
Falling bond yields are beneficial for rising asset prices via the effect on the ‘discount rate’. Let me explain…
The discount rate is an interest rate used to value stocks. It does so by ‘discounting’ future earnings back to a present value. The basis of any discount rate is the 10-year bond yield plus a risk premium.
With US 10-year bond yields at around 0.77% (and if I’m right, headed lower over time), the discount rate to value stocks has never been lower. Here’s how falling rates impact asset prices…
Using a simple valuation model, a company with $1 million in earnings, using a discount rate of 10%, has a value of $10 million.
At a 5% discount rate, the valuation in the above example increases to $20 million.
At a 2.5% discount rate, the valuation doubles again to $40 million.
You get the point.
Perversely then, a structurally-weak economy that results in lower and lower interest rates provides a bullish tailwind for stock prices via a lower discount rate.
This feeds into sentiment. The promise of low interest rates (especially when people think it’s because of central bank control, rather than secular decline) creates a bullish mood and a willingness to speculate. When the mood is bullish, valuations can go from expensive (but justifiable based on interest rates and earnings) to outright crazy.
But companies need the prospect of earnings (either now or in the future) to derive their value. That can only occur if the economy is growing enough to generate these earnings.
In a credit-based financial system, the only thing that keeps the wheels spinning in the economy is debt growth. And thanks to a 22% growth in federal debt outstanding in the year to 30 June (latest figures available), total non-financial debt growth for the year was a robust 10.6%. That compares to 4.7% growth in 2019.
A large proportion of this strong growth came in the three months to 30 June, in response to the shutdown.
That 10.6% roughly equates to an additional US$6 trillion in credit injected into a US$19.4 trillion economy. That’s not quite as massive as it sounds (30% of GDP), as it doesn’t take into account the credit destruction that you don’t see from an economic recession/depression.
But still, it included $4.1 trillion of new federal borrowing going into the economy, which no doubt helped to boost spending, which flowed through to companies’ revenues and earnings. It’s a big part of the reason why the US market quickly made new highs.
So disinflation and lots of fiscal stimulus — which keeps credit growing and gives the appearance of a ‘recovering economy’ — fuels the bull market psychology and keeps stocks well supported.
While this ‘weak but not too weak’ growth environment continues, I think the stock market should continue to do OK…with one major caveat…
In my view, the tech part of the market, and anything associated with it, has gotten completely out of control in terms of valuation. The bull market psychology is at an extreme. There is a lot of risk in this part of the market right now, especially in the US.
But in markets like Australia, it’s nowhere near as bad (although there are pockets of stupidity in tech and at the microcap end of the market). I’ll discuss this in more detail in the next issue.
Why inflation will be disastrous for asset prices
The one thing that would derail my sanguine view of markets is if inflation (as in consumer price inflation) returns. While such a scenario appears unlikely, if central bankers start to monetise assets directly and allow bank reserves to become legal tender, inflation could take off in a big way.
And if that happened, it would be a disaster for asset markets: stocks, bonds, cash, property…
At this point, commodities and gold would be the place to be, and quality companies with pricing power.
We’re not at this point yet. And it might be years before we get there.
But it’s important that you’re prepared for these scenarios and have a plan of how to position your portfolio when things change.
It’s also time to start thinking about the role cryptocurrencies could play as this monetary dysfunction continues in the years to come.
But for now, the key takeaways are:
- The monetary system is irretrievably broken.
- QE is a response to the destruction of ‘shadow money’. It is only inflationary for stock prices in a limited way.
- The major global economies are in secular decline. That’s why bond yields are at record lows and/or in negative territory.
- You’re going to see more government involvement in the economy and your life as it seeks to ‘fix’ the system. There will be growth spurts here and there based on these stimulus measures, but they won’t be self-sustaining.
This requires nuanced and contrarian thinking about stocks and portfolio management.
If you’re interested in getting access to the upcoming Crisis & Opportunity issue, click here.
Editor, The Rum Rebellion
PS: In a brand new report, market expert Vern Gowdie warns of the dangers waiting in a post-COVID-19 world. Plus, he outlines the steps you should take now to protect your wealth. Learn more.