Category Archives: Monetary Easing

image

Where The Risks Are: It’s Not Where You Might Think…


  • Car sales are in a downtrend and PMI is falling, which ties the FED’s hands.
  • Japan has just entered into direct economic stimulus with $273 billion.
  • The Bank of England behaves like the economy is in a depression, cutting rates and printing money.

Introduction

Yesterday we discussed how China isn’t as big of a risk as many would like to make it out to be. Today, we are going to go through the latest data from the U.S., Japan and Europe in order to assess their riskiness.

The U.S. 

We already discussed on Tuesday how the GDP has grown at a slower rate than expected and the actual growth is fueled by increased consumer debt, which isn’t a sustainable long term situation. Going into more detail will enable us to better forecast what will happen in the short to midterm.

One area of consumer spending that is currently essential for U.S. GDP is car sales. In the first 7 months of 2016 car sales have hit a plateau, which means there is more downside than upside. Car sales peaked in October 2015 and it looks like a downtrend is forming. The peak reached in sales is especially worrisome as car loan rates have hit historical lows and are currently around an average of 4%.

figure 1 car sales and rate
Figure 1: U.S. Total vehicle sales and car loan interest rates. Source: FRED.

This explains why the FED’s hands are tied when it comes to interest rate increases. Increased rates would increase the costs for consumer debt and therefore immediately lower consumption, sending the U.S. into a recession.

If you are overweight car stocks, be careful and watch what is going on because the low valuations are there for a reason and any kind of economic turmoil might be very negative on stock prices.

Continuing on the state of the U.S. economy, the Institute for Supply Management’s (ISM) Purchasing Managers Index (PMI), which measures factory activity, came in positive but below expectations on Wednesday. The PMI declined from 53.2 in June to 52.6. Any reading above 50 signals activity is expanding which is a good sign, but a downward trend isn’t ideal to see as most indicators were slower than in the previous month.

figure 2 manufacturing
Figure 2: U.S. manufacturing. Source: ISM.

Apart from the decline in activity, it is also important to note how the PMI reacted to the FED increasing interest rates in December 2015. The expectation of an interest rate increase alone decreased the PMI, and only with the later change in the FED’s rhetoric did the PMI return back into positive territory.

figure 3 the fed and PMI
Figure 3: PMI index in the last 12 months. Source: ISM.

This is yet another indication of how difficult it will be for the FED to increase rates as businesses and people have gotten used to low rates and any increase would immediately lower economic activity, pushing the FED to step backwards.

Japan’s Easing

On Tuesday Japan’s prime minister, Shinzo Abe, approved a $274 billion stimulus package aimed to help the Japanese economy and to help ensure his political survival. The package includes $173 billion of fiscal measures, $73 billion of government spending and $59 billion in low cost loans.

As this is a step beyond monetary easing, we will see what the impact will be on the Japanese economy. Analysts expect added economic growth of 0.4%.

The conclusion is that, if everybody is easing, it doesn’t make much of a difference and forces other central banks to do the same. This is the third reason in this article that makes it difficult for the FED to increase rates.

UK

The situation isn’t better in the UK.

While the major economic impact of BREXIT won’t be seen for two to four years, the first signs of a slowdown can be seen from the weaker sentiment. The UK Manufacturing PMI came in at its lowest level since 2013, which was a recession year in Europe. What is also important is the sharp decline, the PMI index fell to 48.2 in July from 52.4 in June which confirms BREXIT related uncertainty.

figure 4 uk pmi index
Figure 4: UK manufacturing PMI index. Source: Markit Economics.

On top of the negative PMI, the Bank of England has slashed its growth forecast to 0.8% from 2.3% for 2017, lowered interest rates to a record low, and announced increased lending of 100 billion pounds to banks. It will also increase bond purchases by 60 billion pounds. The Bank’s actions portend an outright depression in the UK rather than a possible future economic slowdown, but this is what central banks do these days.

Europe

A positive note comes from Europe which saw its PMI grow in July to 53.2.

figure 5 gdp pmi europe
Figure 5: Europe PMI. Source: Business Insider.

But the negative news is that GDP growth in Europe is expected to only be 0.3% in Q3 2016, further emphasizing the already bad decline to the 1.2% annualized growth rate in Q2 2016. All eyes are on the ECB which has stated many times that it will do whatever it takes to keep things stable and growing, thus, more stimulus.

Conclusion

The main question is: how long will central banks be able to keep things stable and markets high, and when will monetary and fiscal stimulus become inefficient and spur inflation? All factors indicate that the markets are overvalued, the economies are stretched and monetary stimulus is reaching its limits. As soon as signs of a normal economic cyclical downturn emerge, central banks step on the gas and print more money.

On one hand, investing logic would indicate that investors stay in cash as a bear market is imminent, but the fact that central banks keep printing money and saving markets, or not even allowing markets to decline, indicates that stocks and bonds will be artificially propelled even higher and investors might want to stay long these markets for the time being rather than fight the trend.  However, having well thought out stop loss orders in place is a must, and raising some cash would be prudent too because at some point things will turn.

It is important to keep an eye on inflation because low or no inflation is what is enabling central banks to continue with easing. As soon as inflation increases, central banks will have to start tightening.  Consumer price inflation is still at only 1%.

figure 6 inflation rate
Figure 6: U.S. inflation annual inflation rate per month. Source: Trading Economics.

As we discussed yesterday, China is growing at 6.7% per year, has low debt when compared to developed countries yet and is considered a risk. While developed countries use desperate measures to keep things as they are, fight deflation and spur some economic growth. Logic suggests that the risks lie in the developed world and China is a much safer bet.

 

image

“Helicopter Money” Contagion & A Weimar Germany Type Hyperinflation?


  • Japan is flirting with new and more aggressive monetary easing.
  • Inflation in the U.S. might already be higher than officially reported.
  • Further monetary easing could be beneficial if, and only if, it stays under control.

Introduction

We live in very interesting financial times. With low inflation, central banks are able to inject lots of money into the economy through asset swaps, and still keep interest rates low.

figure 1 balance sheet and sandp
Figure 1: FED balance sheet and S&P 500. Source: FRED.

In theory, more money should mean more growth. Since there has been no inflationary consequence thus far, why shouldn’t central banks just keep injecting the economy with more money?

Figure 1 shows how the increase in available liquidity has influenced asset prices by lowering risk aversion, as the S&P 500 has moved in lockstep with increasing liquidity.

Since there has been no visible inflation, a rumor that central banks might inject even more money into global economies by using so called “helicopter money” is now circulating among certain financial circles.

This article is going to introduce you to what “helicopter money” is, what the real risks of it happening are, what the impact will be on your portfolio, and discuss some investment ideas if it really happens.

What is Helicopter Money?

“Helicopter money” is an idea made popular in 1969 by the great American monetary economist Milton Friedman in his paper “The Optimum Quantity of Money” where he shares the following:

“Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated.”

The idea is that if you receive more money, you will spend more and thus bring inflation to the target rate. As printing money is done at a minimal marginal cost, there are no constraints on central banks, however, they have not yet resorted to such a measure. The latest rumor of using “helicopter money” was started after Former Federal Reserve Chief Ben Bernanke visited Japan and discussed more creative and extreme monetary policies. The first consequence of more monetary easing is currency devaluation. And last week, just the rumor of more easing saw the Japanese Yen depreciate by 5%.

figure 2 yes usd
Figure 2: JPY per 1 USD in the last 7 days. Source: XE.

No monetary policy seems to work in Japan and its central bank has reached its limit of “asset purchases.” There may be no other option for Japan than to get creative with “helicopter money.” If Japan pulls the trigger, other global economies will follow in order to stay competitive.

Consequences of Helicopter Money

The main consequence of such bold moves would be even more uncertainty. We already have negative interest rates and ballooned balance sheets, for which we have no historical precedent, the same holds for “helicopter money.” With no hard evidence all we can do is guess how such an experiment will end.

The first signs of increasing uncertainty will show up in the currency markets. Figure 2 above showed that even the mention of new monetary measures in Japan sent the Yen 5% lower against the dollar.

“Helicopter money” is always a bad idea with negative long-term consequences, even though in the short run it may provide a “boost” to the economy. Let’s not forget, the same argument was used for the current easing monetary policies, which have yet to “boost” the economy. When easing didn’t work, central banks and politicians opened the easing spigot even more. The same temptation would exist with “helicopter money” and could get completely out of control.

If central banks choose to deploy “helicopter money,” their only focus should be to reach the 2% inflation target for Japan, Europe or the U.S., which according to the FED has not yet been reached.

But increasing the money supplies can become a “monetary addiction,” since it makes it easier for any government to repay its debts and go deeper into deficit spending, which always helps to get reelected. With the coffers full of new money, much less thought is given to the need to repay debt.

figure 3 U.s. inflation
Figure 3: U.S. Inflation rate. Source: U.S. Inflation Calculator.

Even though the Fed says the 2% inflation target has not yet been met, other sources state that the inflation rate is much higher than what is officially reported. The common consumer price index (CPI) is a questionable measure of inflation as it tracks consumer spending and not the real supply of money. The current money supply has been constantly growing which means money is worth less. What’s misleading is the fact that the constant increase in money supply has not translated into higher prices in the last few years.

figure 4 money supply
Figure 4: M2 money supply vs. CPI. Source: FRED.

As the CPI measuring method constantly changes, it’s a good idea to take a look at inflation that doesn’t take into account measuring method changes since 1980. The shadow stats rate of inflation is much higher than official, and in line with the above increases in money supply.

figure 5 shadow inflation
Figure 5: Constant CPI method inflation. Source: ShadowStats.

The true definition of inflation is an increase in the money supply, which always makes it worth less, regardless of what current economic indicators tell you. Rising prices are just a symptom of inflation, and more money put into the system might spur hyperinflation, should central banks decide “helicopter money” is the road to take.

How Will Investments Behave?

With more money flooding the system, the current asset inflation would just continue.  However, there will be sectors that outperform.

As governments start “dropping” money from helicopters, infrastructure companies should be some of the biggest beneficiaries. As more infrastructure gets built, it requires more materials. Since there is a limited supply of commodity resources, it’s inevitable that with more money in circulation, prices rise. Therefore, materials can protect and hedge against inflation.

Conclusion

We don’t know when and if central banks are going to pull the trigger on more monetary easing, but it is a good idea to consider such a scenario and how it could affect the global economy and various investments.

If Japan starts with “helicopter money,” investments there might increase as the Yen devaluates since the revenue of many of Japan’s corporations is derived abroad. A weaker yen also promotes their exports. If “helicopter money” appeared to be working in Japan, Europe would quickly follow since the other forms of monetary easing haven’t achieved the desired result in either country.

In the short run, any additional monetary easing efforts should benefit all equities, which has been the case over the last 7 years. But in the long run, if the easing is not done “properly” (can we expect politicians and bankers to behave properly?) it is almost certain to bring long lasting economic troubles, similar to those Japan has experienced over the last 20 years. One has to wonder why they think more of what hasn’t worked is the best solution.

Historically, all money printing experiments end badly. One of the worst resulted in a World War as Germany was looking for a way to exit its hyper-inflationary crisis. The 1924 100 billion Deutsche marks banknote is an indication of how monetary easing can easily get out of hand.

figure 6 billion mark
Figure 6: German 1924 100-billion-mark note. Source: Solingen.

We can hope that monetary easing doesn’t get any more out of control than it already is.  And that it only continues to inflate asset prices and increase investment returns, as it has done for the last 7 years. But don’t bank on it.