We published our macro narrative Monitors last week (attached here), and something really jumped out at me.
Media attention to an inflation narrative turned dramatically in December, and I will tell you that I see signs of it continuing to accelerate to the upside here in January, particularly in sell-side analysis and reports (which are typically NOT picked up in our Monitor analysis, which pulls from publicly available media).
Does this mean that real-world inflation is off and running?
No idea. I mean … my personal opinion is that real-world inflation is much more
prevalent and entrenched than we are led to believe by the mandarins, but
that’s just my personal opinion. I do not have a professional opinion on
real-world inflation. I DO have a professional opinion on narrative-world
inflation, however, and that is YES, this a classic “Emerging Narrative”
set-up. We are a couple of CNBC missionary statements away from everyone
knowing that everyone knows that inflation is off and running. We are one “hot”
employment report from everyone knowing that everyone knows that inflation is
off and running.
And that’s going to be a very squirrely day for markets.
Why? Because it’s going to bring the politicization of the
Fed into sharper focus than any amount of overnight and short-term repo
financing will ever achieve.
The Fed is playing a weak hand. If we get an inflation narrative now, just as the “global recession is nigh” narrative kicks the bucket, then the chatter immediately becomes whether or not the Fed has to HIKE. Not “stand pat”. Hike.
There is zero market anticipation for this, which makes this a dinner bell for the trader types reading this note, and a warning bell for the buy-and-hold types. Political risk starts to get real after the Iowa caucuses in a few weeks. Put that together with an incipient inflation narrative and you’ve got the makings of a volatility party. Be careful out there.
Every year, I try to put together a series of notes that captures where I think we are, from both a political and investment perspective. This year, that series is The Long Now. I’ve compiled the four notes in that series into a single PDF, attached here.
The kicker here is that I think both parties have embraced a
profoundly destructive meaning to the fiscal powers of the State – to tax and
to spend. When the tether between taxes and spending is severed – and make no
mistake, both the Republicans and the Democrats have been working to this end
for 20+ years – then taxes become a pure mechanism for the exercise of
government power. They don’t exist to pay for government programs. They exist
to satisfy the ruling regime’s conception of justice, equity and retribution
for prior wrongs done by the other side. Again, this isn’t a partisan thing.
This is a power thing. This is a Management thing.
Regardless of who wins the 2020 election, I believe we are
going to be buffeted by punitive fiscal policies in the years to come …
punitive on the tax side in the usual sense, where the rich and the old will be
pitted against the non-rich and the non-old, back and forth … punitive on the
spend side in the inflationary sense, where we will all feel the bite of a
monster we haven’t seen in 40+ years.
You know, there was an article in the Wall Street Journal today, titled “China is Taking No Chances with Stagflation”. As if this were something that could be banished by fiat … as if soaring pork prices and declining growth would cease to exist if Chinese citizens were just TOLD that they didn’t exist.
As with every “outlook” or “analysis” article in the WSJ
that talk about China, I took this as a crystal ball for what’s coming down the
pike in the US in 6-12 months. Seriously. It’s uncanny how that works. (and the
subject for another note another time)
So yes, that’s what I think is going to be the Big Story for
the next several years … disappointing growth + alarming inflation + a
government that tries harder and harder to TELL us that everything is
wonderful. A United States that becomes more like China *politically* as
well as economically. Smiley-face totalitarian flirtations on the political
front, and old-fashioned stagflation on the economic front, all bearded by a
stock market that has been transformed into a propped-up-at-all-costs political
The thing is that – depending on where you stand in the
pecking order – it won’t feel that BAD as the world is undone by inflation and
the politics that comes with it. As the country song goes, “Funny how fallin’
feels like flyin’ … for a little while”. But this IS what undoes us.
We need to get together and talk about all this. Maybe I’m
wrong about The Long Now. Maybe I’m exaggerating the issues here. Wouldn’t be
the first time. But right or wrong I think we’d all be well served to connect
in person and share our ideas and observations. Stay tuned for details on timing
and location … probably early fall before the election. Let me know if you’d
like to help.
One of our original macro narrative Monitors attempted to analyze the US credit cycle, but we rarely got enough media articles in a given month to generate robust results, so we placed it on hiatus. Recently, however, we (and once again this is the royal we … it’s actually all Rusty) hit upon a clever way to recast our search queries so that we think we are now able to capture a decent narrative signal on debt and credit markets. Here’s the narrative map for Debt and Credit in November, first colored by cluster topics and then colored by sentiment (you can see the high resolution graphics in the Monitors document):
We’ve got three takeaways from these maps and the prior 12
months of narrative analysis with the new query formulation:
After a mid-year bout of complacency in credit markets, the past few months have seen a rapid acceleration in cohesion (focused and connected narrative topics) mostly around a negative sentiment narrative of concern regarding leveraged loans, CLOs, and the liquidity of CCC loans.
This is taking place as the proportion of articles we measure as Fiat News (highly opinionated/editorial articles) has risen consistently. Missionaries are increasingly promoting the idea of a ‘coming collapse’.
At the same time, however, there is also an almost equally positive sentiment narrative building around technology-based lending solutions in consumer credit.
We’re going to do more with credit narratives in 2020, as we
know that a lot of our Professional subscribers work in FI and credit markets.
If you have questions regarding our Debt and Credit Monitor, please give us a
That brings our total of ET Pro Monitors to six, covering:
Trade and Tariffs
US Fiscal Policy
Debt and Credit
Of the six, Trade and Tariffs remains the most dominant in
terms of narrative attention. It’s also relatively coherent, as it remains
dominated by US-China vocabulary. But I want to highlight two really striking
(to me, at least) narrative phenomena happening here:
As described in the last several emails I’ve written you (“Silly Season” and “The Sillier Season”), coherence continues to collapse across almost all macro narrative categories. What does this mean? It means this is a market waiting for a Big Narrative from a Big Missionary. Could be a positive narrative and it could be a negative narrative. But the will-they-or-won’t-they-sign-a-deal narrative regarding the US and China, what I’ve described at length as a game of Chicken where no odds are assignable, is no longer enough to move markets up or down with any sort of narrative half-life. I think that if nothing else, we’ll get a Big Narrative of some sort coming out of the Iowa caucuses in early February. Maybe that will be a market-positive narrative. Maybe that will be a market-negative narrative. Maybe we’ll get something else before then. But right now there is nothing to serve as a narrative engine – risk-on or risk-off – for this market. God help us, but fundamentals and stock-picking might actually matter for a while. I’d be long dispersion while this continues.
The other really striking finding is in regards to the inflation narrative. Attention has collapsed, as has cohesion. This is the most complacent narrative structure around inflation that I’ve ever seen. If you’re looking for an asymmetric trade, where a little narrative shock could go a loooong way, this is where you need to spend some time.
And that leads to a final thought. It’s been a fantastic
year of growth here at Epsilon Theory, and we truly couldn’t have achieved that
without your support. We are more committed than ever to being an independent
voice for original research and original thinking, and the Professional
subscriber base is our most important resource for ensuring that. THANK YOU!
Happy holidays (and yours in service to the Pack),
Every day we run the Narrative Machine on the past 24 hours
of financial media to generate a list of the most linguistically-connected and
narrative-central individual stories. We call this the “Zeitgeist” and we use
it for inspiration or insight into short-form notes that we publish a couple of
times a week to the website. It’s usually pretty obvious why the articles rise
to the top of our natural language processing (NLP) metrics, as they tend to be
about specific companies or specific market events … topics where you see the
headline and think “oh yeah, I understand why this article is appearing in
Until recently, that is.
For example, Rusty wrote a brief note today (“Our Dumb World”) about one of the highest scoring financial media articles, “Amazon Removes Auschwitz Christmas Ornaments, Bottle Openers After Outrage”. This is as horrible as it gets, but we’ve been having lots of weird or off-narrative articles scoring high for narrative relevance recently. The same weird article never stays in the Top Ten from day to day, but it’s another weird flash-in-the-pan article day after day.
I think it’s related to the observation I sent you a few
weeks ago (“Silly Season”) where I mentioned the low attention and coherence
scores we were seeing across all of our macro narrative Monitors. It led me to
ask a Big Question, one that I didn’t have an answer for:
At what point, if ever, do political narratives
about Inflation and Fiscal Policy become market narratives about
Inflation and Fiscal Policy?
We won’t have this month’s macro Monitor analysis completed
for another few days, but I’ll tell you what it feels like to me. It feels like
the lack of coherence around our “standard” macro narratives like Inflation or
Central Banks or Recession has expanded into a lack of coherence around ANY
market narrative, standard or not, macro or not. It’s like anything goes in
financial media over the past few months, where not only is the ground unsteady
beneath our feet in the real-world of market or company fundamentals, but it’s
ALSO unsteady in narrative-world.
It feels like literally anything could happen in
narrative-world. I honestly can’t imagine anything that would surprise me, or
anything that would make for an investable move in markets, up OR down. It’s
like the narrative-world heart is just quivering without a stable rhythm or
beat of any sort.
We need a defibrillator.
Can you believe that the Iowa caucus isn’t until February? I
think that’s going to be the defibrillator, the first real-world electoral
result that begins to focus the political competition that’s going to dominate
2020 markets. That’s when I think political narratives start to become coherent
Until then … the silly season is going to get even sillier.
I was invited by the Financial Times to write a guest post on my recent windmill-tilting exercise of calling attention to how corporate management is using increasingly large stock buybacks to mask increasingly large stock-based comp packages issued to themselves. That post should appear in the Market Insights column online next Monday and on the back page of the paper next Tuesday (possibly this Friday), but I thought I would give you all a sneak preview today!
I think (hope) that it’s the sort of article that can create a bit of a stir on its own, so I’ve toned down some of my more incendiary language on stock buybacks that I might use on Twitter. At the bottom of the piece, I’ve also appended my notes to the FT editor so that you can see the math behind the “Lycroloft” example. MSFT 10-K available for download here.
If you’ve missed any of the notes I’ve written to date on
the topic, here are the links:
OK, Boomer (FedEx … not directly on this topic, but of somewhat related interest)
As always, I’m keen to get your take on this. And if you
happen to run through your favorite company’s 10-K and find something
interesting to relate, I’m all ears! – Ben
In poker, the rake is the cut that the casino dealer takes out of every pot. It’s usually a couple of dollars per hand … barely noticeable, certainly not to a donkey poker player like me.
But what if the dealer started taking 10% out of every pot? Would you notice then? How about 20%? How about 70%?
That’s what many large public
companies are doing today, taking a rake of anywhere between 10% and 70% from
the “pot” of stock buybacks – the hundreds of billions of dollars that these
corporations make as a “return of shareholder capital” every year.
And no one
This is the
agency problem, a classic conundrum of economics, where shareholders’ agents –
corporate management – find ways to enrich themselves at the expense of
shareholders by gaming the system.
this latest incarnation of the agency problem work? Through massive stock
issuance programs, masked and sterilized by even more massive stock buyback
company issues new shares to employees with one hand (at a low price) and buys
back those shares on the open market with the other hand (at a higher price),
that price difference multiplied by the number of wash-traded shares equals
value that never reaches shareholders at all, but is entirely captured by the
recipients of the new shares. Please note that this value is lost to
shareholders and captured by the employees whether or not their new shares are
sold back to the company in the open market buyback operation. It’s an
accounting identity. As the “Yay, stock buybacks!” crew likes to say, it’s just
let’s say a company whose name rhymes with Lycroloft trumpets a big stock
buyback program in their year-end earnings call, where they “returned capital
to shareholders” in the prior 12 months by spending $16.8 billion to buy back
150 million shares of common stock on the open market. Sounds great, right?
Very shareholder friendly!
also say that same company issued 116 million brand new shares to employees
over those same 12 months as a result of employees exercising their stock
options or vesting their previously restricted stock units (RSUs). The company
receives some cash from their employees as these options are exercised and RSUs
are vested (about $1.1 billion in this case), but obviously these new shares
are being issued to employees at a dramatically lower average price than the
average price of the same year’s open market buyback activity.
As a result,
more than 60% of the total buyback “pot” that we donkey investors thought was
coming to us as shareholders, close to $12 billion for this one company in this
one year, is actually being raked by management to distribute among themselves.
Is this rake
widely distributed among corporate employees? There’s no clean data on this, as
– quelle surprise! – companies provide next to zero detail on the recipients of
new stock issuance in their 10-Ks. What’s clear, however, from even a cursory
review of the stock holdings of “insiders” at any big public company (Form 4 in
SEC-speak), is that senior managers have done particularly well in this new
regime of more stock issuance sterilized by more stock buybacks.
only CEO billionaires like Jamie Dimon, who owns more than 7 million shares of
JP Morgan stock, or near billionaires like Tim Cook, who sold $114 million of
freshly granted Apple stock just this August. It’s not only independent
directors like Al Gore, who was issued 80,000 shares of Apple stock over the
past two years, worth $21 million, after selling $38 million worth of stock in
2017. It’s the centimillionaire COOs and CFOs. It’s the legion of
decamillionaire vice presidents and business line managers.
I think it’s
a historic wealth transfer from shareholders to the managerial class. Not to
founders or entrepreneurs or risk-takers. To managers.
What’s to be
done? Here are three suggestions to start changing the incentives of
Separate the CEO and Chair positions of publicly traded companies. When the Chair of JP Morgan, Jamie Dimon, says in his 60 Minutes interview that the board independently sets the salary of the CEO of JP Morgan, also Jamie Dimon, we may be forgiven our incredulity. Let’s remove this obvious vehicle for the agency problem.
No stock-based compensation for independent directors. Cash only. Let’s not give guardians of the shareholder hen-house any fox-like incentives.
No exercise of stock-based compensation by ANY directors, independent or not, while they serve on the board. Again, hen-house. Again, fox-like incentives.
We’re never going to eliminate the agency problem, and the dealer deserves a proper rake. But we better start making this casino fairer to shareholders and less of a wealth transfer engine to the managerial 1%. Or someone is going to burn the casino down.
Notes to FT editor …
On Microsoft … see page 72 of 157 in the PDF (pg 44 of the original doc) for the FY 2019 open-market share repurchase of 150 million shares for $16.8 billion. Note that some sources like Bloomberg show total share repurchases for FY 19 were $19.5 billion, but that includes $2.7 billion that MSFT used to repurchase stock directly from management for tax withholding purposes, NOT open-market buyback operations. The note on the $2.7 billion (as well as more info on the open-market buyback) is on page 132 of 157 in the PDF.
Also on Microsoft … see page 131 of 157 in the PDF (pg 85 of the original doc) for the FY 2019 new share issuance of 116 million shares. The $1.1 billion in funds received for that issuance is on page 85 of 157 in the PDF.
The math on Microsoft is as follows … $16.8 billion spent on open-market buybacks divided by 150 million shares is an average price paid of $112.00 … $1.1 billion received on 116 million shares in an average price received of $9.48 … the difference in price per share paid and price per share received ($102.52), multiplied by the number of wash-traded shares (116 million), is the value received by employees ($11.9 billion). The total buyback “pot” is $19.5 billion ($16.8 b in open-market purchases + $2.7 b in direct-to-mgmt purchases), and $11.9 billion is 61% of that.
There’s something weird happening in narrative-world, and I’ve
been trying to figure out what it means since we published our monthly
Narrative Monitors update last week (attached to this email). I still can’t
figure it out, but instead of continuing to wrestle in silence, I’m going to
tell you what I find odd and ask what you think it means … if anything.
It’s entirely possible that I’m just too much in my head on this.
First I’ll report on what we saw in the Monitors from
October’s financial media.
Inflation – “Inflation
narratives faded in both cohesion and attention in October. Any inflation
narrative exists almost wholly within political worldas opposed to
Central Bank Omnipotence –
“the level of attention on central bank narratives has faded rapidly: common
knowledge has emerged that other investors are more focused on trade, IPO
market/growth issues and election politics.”
Trade and Tariffs – “the
attention on Trade War narratives has ticked down from our maximum level for
the first time in months.”
US Recession – “US
recession commentary drifted downward in both cohesion and attention in
US Fiscal Policy – “there
is no Fiscal Policy, Deficit or Austerity narrative, at least as it concerns
Individually, none of these Monitor reports is that odd.
Taken together, though … well, that’s the weird part. Our measures of attention
(drumbeating on an issue in financial media relative to all other issues) fell
in October for ALL of these market-impacting macro narratives. Yes, Trade &
Tariffs is still garnering a lot of attention, clearly the most of any of these
standing issues. But even there we saw a noticeable decline in both the number
of articles published in financial media on the topic and – much more
importantly for our research – the centrality or “gravity” of those articles
relative to other topics.
What took the place of these core macro factors? Well, we
saw a ton of articles about politics … both impeachment and “how a Warren
Presidency would destroy markets as we know them” articles. We also saw a lot
of “OMG, WeWork” articles. I doubt that the spate of WeWork articles persists,
although the Street really needs a good IPO to take the stench out … so
we’ll probably get just that.
But I think we’re just getting started on the dominance
of political narratives in financial media.
In fact, if you look at the Monitor narratives in terms of
political-world rather than market-world, both Inflation and US Fiscal Policy
are pretty darn robust in their attention scores. That is, “people are talking”
about prices and taxes and spending as it impacts politics. People are
not talking AT ALL about prices and taxes and spending as it impacts markets.
Or market prices.
Which leads me to the big question I have … and it’s the big
question I don’t have an answer for:
At what point, if ever, do political narratives
about Inflation and Fiscal Policy become market narratives about
Inflation and Fiscal Policy?
Because right now they’re not, so we gravitate to new market
high after new market high. And it is entirely conceivable to me that they
never do – become market narratives, that is – and we continue to live in this,
the best of all possible worlds. But I’m trying to figure out what might make
that transition happen. Is it just time and getting closer to the election? Is
it something else? That’s the weirdness that I’m wrestling with. As always, I’d
love to hear your thoughts.
You know, I was a big fan of stock buybacks back when I was running a fund. And I’ve thought (and written) that so much of the anti-buyback fervor we’ve heard over the past year or so, particularly from political candidates, was mostly silly on the merits, even though it was pretty effective as a narrative. I think that’s why it’s been so shocking to me when a few hours work on Texas Instruments in response to a stray tweet turned into a research project that’s threatening to take over my life!
The difference in my views now is that I’m looking at stock
buybacks from a micro perspective, not a macro or overall market perspective.
And from that perspective, there is no doubt in my mind that stock buybacks
have been totally hijacked by corporate management and boards over the past few
years to sterilize exercised options and restricted stock units. As a result,
this narrative of “returning capital to shareholders” is pretty much a sham, as
anywhere from 10% (McDonalds) to 40% (Texas Instruments) to 60% (Microsoft) of the
money spent on buybacks never reached shareholders at all, but simply carried
out a wash trade where one corporate hand issued new stock on the cheap and the
other corporate hand bought it back at a much higher price. Note that the full
monetary value of this wash trade goes to the recipients of the newly issued
stock whether or not they sell it then and there at the repurchase price. There
is ZERO EPS leverage accomplished through these wash sales. There is ZERO
benefit to non-management shareholders.
For example, over the past 3 fiscal years Microsoft bought
back 419 million shares at an average price of $85 per share, but they also
issued 254 million NEW shares to management at an average price of $11.50. So
out of the $35 billion that Microsoft supposedly “returned to shareholders”
with their buyback program, less than half of that actually went to the benefit
of shareholders. More than $18 billion in value went directly to the Microsoft
employees and directors who exercised these options and restricted stock units.
In addition, Microsoft spent more than $6 billion over the past 3 fiscal
years to buy back stock to satisfy the tax withholding requirements of
management option grants. That’s more than 20% of Microsoft’s cash flow from
operations over that span.
But at least, you say, Microsoft stock outperformed all of
its benchmarks over the past 3 years. Fair enough. But that’s one hell of a vig
that the casino withheld on your winning bet!
Last Friday we
published a note – “Yeah, It’s Still
Water” – about a company that has
decidedly NOT outperformed all of its benchmarks, but has comped management and
directors with billions regardless. That company is Texas Instruments (note
From 2014 – 2018, 40% of TXN’s stock buybacks went to
sterilize the options and restricted stock grants given to senior management
and the board, for a direct value transfer of $3.6 billion from shareholders.
There’s an additional $2.6 billion in stock-based comp already issued but yet
to be exercised. That’s above and beyond a billion or two in cash comp.
For what? Over
the same five year period, 2014 – 2018, TXN stock performance matched the
Philly Semiconductor Index ETF zig-for-zag. That’s an ETF with a 47 basis point
all-in expense ratio, by the way.
we’ll get as angry at index-hugging corporate managers who get paid BILLIONS as
we do at index-hugging fund managers who get paid a few basis points.
we’ll see the Zeitgeist of the Obama/Trump years for what it is: an
unparalleled wealth transfer to the managerial class.
What is financialization? THIS.
It’s not illegal or incompetent.
this is why our world is burning.
Do I like companies that return unproductive cash to
shareholders? YES. So use a special dividend. That’s why they exist. There,
fixed it for you.
And one last point. IMO, the most culpable parties in this entire charade are the independent directors of these public company boards. I think they’re bought off by options and RSUs of their own, and I think they’re almost always ex-management or current management of other companies, with all the incestuous baggage that brings.
Okay, I’m off the soapbox. For now. But I am going to keep working through these 10-Ks and compiling my list of the naughty and the nice. That second list is the null set so far.
I’m not THAT into dominoes, but I am into figuring out what’s next for changes in the Fed narrative and how that impacts markets.
To recap, three weeks ago I published a note called The Old Man and the Sea, where I set out my belief that the narrative connection between monetary policy and any actual impact on the real economy had been diminished to the point of non-existence. Common Knowledge (what everyone thinks that everyone thinks) still made for a powerful connection between monetary policy and market impact, but it seemed to me that Common Knowledge on real world impact had disappeared.
And then last week I wrote in Coal Mine, Meet Canary that I thought the recent dislocations in overnight repo were a sign that the Fed had lost its credibility as a non-political actor, that these emergency actions showed a loss of market faith in the stated price of money. My question was where this mistrust in the stated price of money would show up next, and my guess was HY credit.
Here are two quick updates on both notes …
First, here’s the overall Central Bank narrative map for
September. What’s useful here is to look at the individual clusters or topics
within this overall map of all the talk around Central Banks. What you’ll see
is that there are really only two clusters that are focused on the US real
economy (both on the lower left of the map) and they are on the periphery of
the overall map rather than being central clusters. That’s the crucial
attribute for interpreting an NLP network … centrality and size of the clusters
… and the large, central clusters are about the market economy rather than the
Beyond looking at the clusters and sub-narratives within the
larger Central Bank narrative map, we can also highlight articles that are
relevant to specific search queries regardless of which cluster they fall
within. We call this “attention”, and it shows us how much drum-beating is
happening on a topic within a larger narrative. It’s like using a dye or a
marker chemical in a microscope slide or a radiological study, so that it
highlights the cells or tissues of interest. In this case, we set up queries to
highlight the “cells” that are talking about real economy stuff (business
investment, mortgages, consumption) within the Central Bank map, as well as a
queries to highlight the “cells” that are talking about market economy stuff
(equity and bond returns).
Here’s the attention visualization of real economy topics
within the overall Central Bank narrative. Detached, sparse and barely
On the other hand, here is the attention map within central
bank narratives for equity and bond returns. Strong and central to the
The takeaway, then, is that narrative drum-beating for Central Bank impact on the markets is still VERY strong, while there’s next to ZERO narrative attention being paid to Central Bank impact on the real economy. That disjuncture is (IMO) the critical aspect of how media coverage of the Fed is going to play out in markets over the next 12 months.
And then here’s the update on where this dislocation in Fed credibility is bubbling up. A friend on the sell-side sent me this chart yesterday, and I thought it was worth passing along to you. This is a slow-motion train wreck in the levered loan market.
Jay Powell announced today that the Fed would expand their balance sheet “organically”, meaning that the “temporary” expansion of overnight repo operations is about to become not-so-temporary. Rather than continue to treat the recent spike in demand for cash as an anomaly, the Fed will satisfy that demand going forward as an ongoing, more-or-less permanent adjustment to the Fed’s balance sheet.
“It’s a feature, not a bug.” That’s what Powell said
Powell went to great lengths to explain that, in his mind at
least, this balance sheet expansion was NOT Quantitative Easing, because the
intention here was NOT to provide stimulus for the real economy or any impact
on longer-term interest rates, but rather to “maintain a firm grip” over
short-term rates. In Powell’s mind, balance sheet expansion is a rectangle and
QE is a square … all QE is balance sheet expansion, but not all balance sheet
expansion is QE. Whatever.
I say whatever because I don’t think the question I hear
people asking – is this QE or isn’t this QE? – is particularly helpful. Why
not? Because the engine that makes QE “work” (and by work I mean its impact in
pumping up financial asset prices, not any supposed impact on the real economy)
is not so much the mechanistic effect of balance sheet expansion per se, but is
the narrative of monetary policy support in the form of
associated forward guidance. And that narrative ain’t happening here.
So yes, this is balance sheet expansion. It’s more than just
a “reverse-twist”, where the average duration of the Fed’s holdings are
shortened but the size of those holdings remain the same. And if your
definition of QE is balance sheet expansion, then you’re right in saying this
is QE. What I’m saying, though, is that a mechanistic, balance sheet approach
to the meaningof QE for markets is weak sauce. The WHY of
balance sheet expansion matters a lot more for market impact than the FACT of
balance sheet expansion.
But that doesn’t mean that Powell’s announcement yesterday
is no big deal. It’s a huge deal. I think it’s a dead canary in the coal mine
of monetary policy.
I think these emergency actions in the repo market – and to
be sure, these ARE emergency actions – and now the expansion of the balance
sheet to get more cash into the system, are the clearest indications yet that
the Fed has lost its fundamental credibility with Mr. Market.
What do I mean by fundamental credibility? I mean the belief
that the Fed sets the price of money on the basis of its legal mandate – full
employment and price stability. Not to weaken the dollar. Not to juice the
market. Not to influence the 2020 election. Not as a negotiating chip in a
China “trade war”. Not as an overtly political entity.
It’s not possible to see recent Fed easing actions as
anything but a non-mandated political reaction to external pressures.
It’s not possible because They’re. Not. Even. Pretending.
Anymore. It’s not possible because Jay Powell TOLD US this is why they are
easing. It’s not possible because Jay Powell TOLD US that the Fed is concerned
about “maintaining a firm grip” on short-term interest rates.
THE FED IS CONCERNED ABOUT “MAINTAINING A FIRM GRIP” ON ITS
CONTROL OVER THE PRICE OF MONEY.
As they say in the twitterverse, let that sink in.
Are these emergency actions in the repo market a problem for the market? No, not at all. The Fed can literally paper over this doubt in the overnight repo market by shoveling limitless money at the doubters. And they will. (see The Right Price of Money for more thoughts on this) But this is a disturbance in the Force. This is a dead canary.
What I’m trying to figure out is where this failure of
credibility – this mistrust in the stated price of money – will bubble
I think it shows up next in HY corporate credit. Unlike the
overnight repo market, this will be a slow-motion train wreck. But I do think
it will be a train wreck. And I don’t see how this gets papered over so easily.
As always, I’d love to hear your thoughts on all this. Still trying to figure it out. But I think I’m on the right track.
I wrote a brief note today about the narratives surrounding emerging market investing, particularly what I call EM Investing™ – the business of EM as an asset class. The skinny of that note is that I believe there are two necessary narratives for EM Investing™ to work: EM Growth! and EM Property Rights!. Unfortunately, the former has been under siege for close to a decade, and the latter has suffered what I think is a mortal blow from the Argentina/IMF debacle. Can investment in idiosyncratic or even country-specific emerging market opportunities work in the absence of a supportive narrative structure? Absolutely. Will institutional flows into the asset class of EM work under these conditions? I don’t see how.
As you’ll see from the text of the EM note (reprinted
below), I’m not unsympathetic to Argentina’s populist political movement (now
with a healthy lead in the polls) seeking to defeat Macri and undo the IMF
accords that provided loans of $57 billion in exchange for the usual IMF
“structural reforms” enshrining the primacy of global capital. But regardless
of what you or I may think about the merits of all this, I don’t think there’s
any disputing that property rights (in this case those of foreign investors)
are under assault in Argentina, and that it’s an intrinsic plank of that
country’s populist movement.
“Assault” is probably too strong of a word. Let’s call it a
subordination of property rights … a political reconfiguration of the meaning
and primacy of property rights in relation to other political rights.
But if you’re a foreign holder of Argentine sovereign debt, it probably feels
like a physical assault.
My larger point is this: the subordination of property
rights to other political initiatives and good things isn’t limited to
Argentina. It’s everywhere a populist political movement exists,
including the United States. I think the way it will present itself in the US
is through massive changes in tax policy following the 2020 election,
regardless of who wins. I think that no one is talking about this, much less
preparing for this. I think that I’m not sure how to prepare for this.
As always, I’d be keen to hear your thoughts.
Yes, Deadwood is the greatest HBO series ever. Don’t @ me. I’m not having it. David Milch is MY President.
And while Al Swearengen is the greatest character of that greatest show, the fact is that it’s another character – George Hearst – who drives the narrative arc for the entire series (and movie). Distant oligarch George wants the gold. He wants the timber. He wants the land. He goes to great lengths and great expense over a period of several years to acquire those assets, and then, by God, he is prepared to go to even greater lengths and greater expense to keep those assets. Because once acquired, by hook or by crook, those assets are HIS.
You see, Deadwood is a show about property rights.
The International Monetary Fund refused to say Thursday when it will disburse the last $5.4 billion of a massive loan to Argentina that was originally planned for mid-September.
IMF spokesperson Gerry Rice said at a news conference that he didn’t “have specific information on timing.”
Reporters had asked him whether the organization will wait for the winner of the October presidential elections to take office on December 10 before releasing the funds.
Over the years, I’ve written a lot about Emerging Markets (EM) and the narrative here in the US and other developed markets about EM Investing ™. Here’s the note from six years ago that started this thread, “It Was Barzini All Along“.
Six years later, and I wouldn’t change a word. What is the core narrative for thinking of emerging markets as an asset class? What is the line you hear over and over and over again?
“EM is where the growth is.”
Or in the Epsilon Theory lingo, “Yay, EM growth!“
Except it’s not working. Or at least it’s not the emerging market-ness of a country that has driven its economic growth (or lack thereof) over the past decade, but rather that country’s sensitivity and vulnerability to DM monetary policy in general and US monetary policy in particular.
Is there a meaningful secular growth reality in emerging markets? Of course there is. But that and $2.75 will get you a subway token. It’s not that the secular growth story in emerging markets is a lie or doesn’t exist. It’s that it hasn’t mattered. In the same way that value and quality and smarts and careful fundamental analysis haven’t mattered. For a decade now. You know … Three-Body Problem and all that.
But the growth narrative for EM as an asset class is just the public core narrative for EM Investing ™. There’s a non-public core narrative, too. A much more foundational narrative.
“Your property rights as a foreign investor will be preserved.”
Or in the Epsilon Theory lingo, “Yay, EM property rights!“
This is why the IMF exists. This is what the IMF does. This is what the IMF means.
To protect the property rights of foreign investors in emerging markets.
Now don’t get me wrong. I believe that the property rights of foreign investors SHOULD be protected. I believe that everyone – but most of all the citizens of emerging markets – benefit from the free flow of global capital, and global capital ain’t gonna flow freely to you if there’s a risk it gets stolen.
But I also believe that the local returns on global capital access are almost always hijacked by the local oligarchs, and even if they’re not hijacked completely, it is entirely appropriate for local governments to negotiate and renegotiate those returns on capital. I also believe that there’s nothing sacred about foreign investor property rights, as those rights are not at all the same as the rights of citizens. I also believe that a nation should be free to burn itself on the hot stove of nationalizing assets or defaulting on debt or otherwise choosing an antagonistic stance towards global capital.
And to be sure, it’s not like the IMF rides into town like George Hearst rides into Deadwood, surrounded by Pinkertons and committed to preserving his “rights” through the barrel of a gun.
But it’s not that different, either.
I know, I know … here I go getting all political again.
Look, you don’t have to agree with me about whether the subordination of foreign investor property rights is a good thing or a bad thing to agree with me that this subordination IS … that foreign investor property rights are, in fact, under a withering political assault in Argentina today, and that this isn’t just an idiosyncratic Argentina thing.
Why am I so down on investing in emerging markets AS AN ASSET CLASS?
Because I think you need two functioning narratives for EM Investing ™ to work.
Yay, EM growth!
Yay, EM property rights!
Today those narratives are broken. And until they’re somehow patched together again, I don’t think it’s possible to have the systemic narrative support required for institutional capital flows into emerging markets as an asset class.
It’s not just the Argentina narrative that’s broken. It’s not just the IMF narrative that’s broken.
It’s the entire EM Zeitgeist that’s broken.
What’s a Zeitgeist? It’s the water in which we swim.
Can idiosyncratic investments in emerging market opportunities work while the EM Zeitgeist is broken? Sure!
But can the business of EM Investing ™ work while the EM Zeitgeist is broken? I don’t think so.
I’m late with this note because I was in Paris for a BAML conference. I wanted to see what European allocators thought about Draghi and the most recent ECB monetary policy “stimulus”. I wanted to see if their narrative was the same as the narrative I’m hearing in the US about the Fed. It is.
The line between the anchor and the ship has been cut. The line between the fisherman and the fish has been cut.
Monetary policy – at its core the setting of the price of
money – is no longer connected to the real economy. I mean, of course interest
rates are connected to the real economy. But the setting of those rates,
by both the Fed and the ECB, is no longer connected. The setting of those rates
is now a disembodied symbol of governmental will, all-important to the market
economy and utterly … utterly! … ignored and immaterial to the real economy.
My catch phrase these days is They’re. Not. Even.
Pretending. Anymore. and that’s still totally in play. Draghi and Powell and
the rest of the mandarin crew hardly even give lip service to the idea that
cutting rates or expanding the balance sheet do anything helpful in the real
economy. It’s really quite remarkable. There’s more talk about “fixing” the
yield curve – as if the yield curve were a real thing – than about fixing
corporate investment in property, plant and equipment.
But what I didn’t realize until this week is that it’s not
just the central bankers who have cut the cord here. It’s everyone else, too.
No one on either side of the Atlantic believes that central bank actions have
ANY efficacy or connection to real economic outcomes. Worse, everyone knows
that everyone knows that central bank actions have no connection to real
economic outcomes. THIS is the new common knowledge, and I don’t know how or
where or when, but I think it changes everything.
For example, I think this cutting of the line between
interest rate-setting and interest rate-using is the underlying
reason for the bizarro-world we are experiencing in overnight repo, where $75
billion is not enough to satisfy the demands of the financial “system” for
cold, hard cash, but maybe $100 billion is. Maybe.
Overnight repo is a rope between anchor and ship. It is
where the interest rates that central banks SET meet the interest rates that
real economic actors USE. What we are seeing with this huge spike in demand for
overnight financing is, I believe, a direct result of real economic actors
trying to figure out what it MEANS when the interest rates are a symbolic
communication to markets rather than a clearing price of money in the real
I know what it would mean to me. It would mean that I want
the cash, not the securities, and I’d be willing to pay up to have that cash.
Because if the price of that real-world cash isn’t connected to monetary
policy, then it can trade … anywhere.
I think there are a lot of these dislocations happening
today, and I don’t think it’s an accident that they are happening in places
where the real world meets the symbolic world. The WeWorks IPO would be another
I have no idea where this ends, and I’d be keen to get your
thoughts on all this. But where I have a very clear idea is that the common
knowledge around central banks has shifted dramatically. Everyone now knows
that everyone now knows that central banks are powerless to impact the real
economy (but are still the only thing that matters in the market economy).
We’re adrift in a way that we haven’t been before.
There are a couple of tectonic plates moving in
narrative-world of late, just like there have been a couple of tectonic plates
moving in market-world. The market-world tectonic plates are factors like
momentum and value, and lots of people are talking about them. The
narrative-world tectonic plates are inflation and central banks, and that’s
what I’m going to talk about.
Our most impactful structural attribute of narrative is
Attention – the level of “drum-beating” for a certain narrative relative to all
of the OTHER narratives taking place. It’s not just an increase or decrease in
the number of articles that drives an increase or decrease in narrative
Attention … it’s much more an increase or decrease in the centrality and
the connectivity of the articles.
These measures of centrality and connectivity within a giant
multi-dimensional data matrix don’t lend themselves to two-dimensional
visualizations very well, at least not nearly as well as other attributes like
Cohesion and Sentiment, so I won’t be showing those visualizations here
(although you can see them in the attached data packet). But just to reiterate
… I believe Attention is the most important measurement we take in the
So I think it matters that the Inflation narrative is close
to all-time lows in its Attention score coming into September, while
both the Central Bank narrative AND the Trade & Tariff narrative are at
all-time highs in their Attention scores coming into September.
Our rule of thumb regarding Attention (and this is true
whether you’re talking about single stocks or sectors or macro issues) is
pretty simple: fade high Attention and accumulate low Attention.
More specifically, I’ve got the following takes from these
narrative Attention scores:
There is enormous market complacency around inflation. Just enormous.
Markets are far more likely to be disappointed by Central Banks today than encouraged.
The all-China-all-the-time news cycle is at a peak.
How does this play out? I dunno. If there were any signs of the US Recession narrative actually taking root in domestic US issues, then I’d say that it’s time to study up on the stagflation playbook. But as I described in last week’s letter, there’s nothing about the US in the US Recession narrative … it’s all non-US issues. Still, even if it’s not an all-out stagflationary world, we’re going to have some whiffs of that stagflationary odor. Gold? I don’t think you get hurt with all this complacency on inflation, but it’s hard for gold to work so long as Central Banks are front and center. Keep in mind that I think markets are likely to be disappointed in Central Bank action, not that they’ve lost faith in the ability of Central Banks to control market outcomes.
My best take at putting all this together? The back-up we’ve seen in rates over the past two weeks has the narrative legs to back up more. Maybe a lot more. And that’s not going to make anyone happy. Especially the guy in the White House.
Before I get into the planned subject for this week’s note, I thought I would take a minute to describe what we’re seeing from a narrative perspective in the under-the-market-surface dislocations that have occurred over the past few days. As you’re probably aware, Value stocks (financials and energy listings, for the most part) have outperformed Growth stocks (tech listings, for the most part) to a degree that we haven’t seen in years.
None of this shows up in the specific financial sector,
energy sector, and tech sector narrative data. On the contrary, the specific
sector narratives are wrong-footed for these sharp shifts. This isn’t a
financials story per se, or an energy story per se, or a tech story per se.
I think it’s a Value narrative in general that is playing
out here (for how long is anyone’s guess), and a yield curve / negative
interest rates story in particular. The “negative interest rates are inexorably
coming to the US” story got a lot of play last month, as did “the ECB is going
to go crazy with new policy” … both of which were terrible narratives for
financials and the yield curve and value stocks in general. We’ll see what the
ECB actually does on Thursday, but the narrative of the last week or two has
been “well maybe we were being overly optimistic about ECB boldness” and you’ve
seen the yield curve on both Bunds and USTs steepen a lot, with a commensurate
move in financials and value stocks in general. The last few days have been a
magnified version of that, playing out across everything that touches the
On a personal note – and I certainly don’t have any
narrative analysis to back this up – the past few days (and the past six weeks,
really) have felt like long periods of 2008 and 2009, where the only thing that
mattered for markets was risk-on/risk-off, and that “factor” swamped whatever
else you were doing in your investment process. This isn’t as all-pervasive as
risk-on/risk-off, but whatever it is (rates-on/rates-off?), it’s as impactful
in the value/growth context.
And now our regularly scheduled note.
We’re pleased to announce a sixth standing narrative Monitor
– US Recession – to join our roster of Central Bank Omnipotence, Inflation,
Trade & Tariffs, Credit Cycle, and US Fiscal Policy. We’ve produced
historical values for the Recession Monitor through January of this year, and
we can speak to the 2018 narrative patterns here.
You can see the full write-up for all six narrative Monitors here, but thought I’d speak directly to the Recession findings today.
Here’s a copy of the Recession narrative map for August.
The first thing you’ll notice is how many narrative
sub-clusters there are for non-US issues … in a US Recession narrative map!
Yes, most of these non-US clusters are outside of the narrative center of this
map, but not all … German stimulus and ECB stimulus are at the heart of this
map, and Chinese economic data is not far out from the center.
I’ve never seen a US-oriented macro query that yielded more
non-US narrative clusters!
Moreover, the largest (and most central) narrative cluster
has nothing to do with the real economy in the US, but is focused on the
inverted yield curve and its “signal” of recession. Again, nothing to do with
an actual recession in the US real economy.
Finally, as Rusty notes in the attached commentary, the
cohesion of this August Recession narrative map is quite low, meaning that the
sub-clusters tend to be spread apart and relatively unconnected with a common
Put it all together and here’s my conclusion: there is
quite a lot of narrative attention being paid to the concept of a US recession
… everyone is falling over themselves looking for a US recession. But it
doesn’t exist. At least it doesn’t exist in the US real economy.
Peter King (the sportswriter, not the Congressman) writes a
football column where he makes a distinction between the things he thinks and
the things he thinks he thinks. The latter being less certain in his own mind,
I guess. It always struck me as a strange conceit to use as the framework for a
regular column that dates back … decades … but I’m adopting it in this note to
make a slightly different distinction.
I think I think that there have been two tectonic shifts in
major narrative patterns over the past few weeks. I put it this way because I
don’t have any strong evidence from our Narrative Machine measurements that
this is the case. Not yet, anyway … these are both recent developments.
If I did, then I’d say that I think these things. As it stands,
I’m telling you that my views are based on my subjective and personal narrative
antennae for this stuff. I’m less certain than if I had Narrative Machine data
to back it up. But I think I think this is true nonetheless.
The first tectonic shift concerns the market narrative
around central banks in general and the Fed in particular. For the past decade,
the “cover story” for market-supporting or financial asset-supporting monetary
policy has been that it helps the real economy, too. That cover story has
evaporated. More and more, I am seeing and hearing prominent media Missionaries
(in the game theoretic sense of the word) question the idea that cutting
interest rates from these low levels does anything for the real economy,
particularly for corporate investment in productive economic activities.
To be clear, no one is saying that more and more
accommodative monetary policy would be unhelpful for *markets*, so I do
NOT think I think that this shift in the central bank narrative foreshadows
some big down move in financial asset prices. No, no … when the Fed cuts (not
if but when) two or three or four or five more times, financial asset prices
will react as they always react. Oooh, that feels good! More drugs, please! But
losing the cover story of accommodative monetary policy helping the real
economy and the little guy has an enormous impact, I think I think, on *politics*.
Hold that thought.
The second tectonic shift that I am seeing and hearing is
only a few days old. I think I think that the market narrative around Donald
Trump changed dramatically last Friday, between “hereby ordered” and “enemy
Powell” and those tariff numbers thrown around like confetti. I think I think
that Donald Trump lost the Wall Street Journal and CNBC on Friday with his
conduct of the China Trade War, in exactly the same way that Lyndon Johnson
lost Walter Cronkite with his conduct of the Vietnam War, and with ultimately
the same *political* effect.
I think I think that the financial media has been the
strongest media force for the normalization of Trump, as the near-universal
subtext (if not overt text) of financial media Missionaries has been “I don’t
like his style, but he’s done some good things.” Like a stock market that’s
gone up, up, up since his election. Like tax cuts. That normalization narrative
stopped on a dime last Friday, and has been replaced by a narrative that Donald
Trump IS “macro risk”.
Putting these two tectonic narrative shifts together, I
think I think we are rapidly approaching a moment of political nihilism, where
NOTHING is believed on its merits and ALL of our pleasant fictions that support
cooperative gameplay in our domestic political institutions are dashed.
Again, I do NOT think I think that all this puts us on the
cusp of some market breakdown, as the narrative of “the Fed has got the
market’s back” is still going strong. But I DO think I think that the widening
gyre of American politics is now poised to “take another leg down”, as we’d say
in a market context. How that manifests itself … I don’t know. But I think I
think it’s coming.
I learned the distinction between excuses and reasons when I
was 12 years old and had failed to do some sort of chore at home. As my father
told me before grounding me, “Ben, you have lots of good excuses, but no good
So I’m late with this week’s ET Pro email, and my excuse is
that I was up in the wilds of Maine from last Thursday through Monday for a
Team Elite fishing camp experience that David Kotok graciously hosts every
year. Internet connectivity was pretty non-existent, the fish were biting …
yada, yada, yada.
But I also have a *reason* for being late with the
email this week. The news about Jeffrey Epstein’s death on Saturday hit me
hard, as did the escalation in the Hong Kong protests over the weekend, as did
the collapse in Argentina’s currency and stock market on Monday. As the kids
would say, I was shook. And I’m still trying to figure out what I think about
all this, both as a citizen and as an investor.
Of the three events, I’m most settled in my views on
Epstein. I think it’s possible to be outraged (beyond outraged, really) at his
death without succumbing to any conspiracy theory at all, much less the way
out-there theories, and that’s what I’ve tried to capture in “I’m a
Superstitious Man”, published yesterday on the website and attached as
a PDF here. It’s a feeling that I haven’t experienced since October 2008, when
the US Treasury put the full faith and credit of the United States behind the
unsecured debt of Goldman Sachs, Morgan Stanley, JP Morgan and Bank of America
… a feeling that the pleasant skin of American democracy has been peeled away
to reveal the naked sinews of power, wealth and violence beneath. Does anything
about the Epstein case impact markets and investing? Nah. Not so far as I can
see, anyway. But this was the event that shook me the most.
I’m still not settled on my views on Hong Kong, but Rusty
made a big contribution in helping me frame those views with a wonderful note
he published yesterday, “Does It Make a
Sound?”. The answer to that question – what is the Hong Kong Resistance
narrative in the US mainstream media? – is pretty resounding: it does not
exist. Rusty presents the empirical evidence from the Narrative Machine. As
we like to say (cribbing the old George Soros line), we’re observing, not
predicting. What I’m wrestling with now is the WHY … why is the HK Resistance
narrative so muted in American media? Is it a conscious effort by status quo
elites to downplay what’s happening? Is it a structural element of a domestic
widening gyre? I’m still wrestling.
If any HK-resident ET Pro subscribers (of which there are
several) are able to share their thoughts, I’d be grateful to hear them. Your
privacy and anonymity are my greatest concern, and unless you explicitly tell
me otherwise, NOTHING you email will be shared with ANYONE.
I’m also not settled on my views on Argentina specifically
and EM more generally, other than what I’ve been saying for a while now … with
the exception of China and its insulated domestic currency, EM monetary
policy is just a shadow of DM monetary policy.
Macri embraced that shadowy semi-sovereign existence, as it
allowed the IMF support package of all IMF support packages. Foreign investors
(and local oligarchs) rejoiced, of course, as the cornerstone of any IMF
support package is preserving the property rights of those foreign investors.
Now Fernandez and Kirchner want to break that shadow existence and chart a
(much) more independent monetary policy path, which means that the IMF support
package and its associated property right protections for foreign investors
will evaporate like a winter rain on the pampas. Good times.
Is Argentina an idiosyncratic outcome for EM investors, or
is Argentina indicative of a structural risk for EM investors? Yes. Not trying
to be flippant with that answer, but in truth that is the answer. If you’re
thinking about EM as a thing – as a discrete asset class – then this is
absolutely indicative of a structural risk. It’s a manifestation of what I
think is the category error you’ve made in thinking about EM as a thing. If
you’re not thinking about EM as a thing, then this is absolutely an
idiosyncratic outcome. But it’s also an idiosyncratic outcome that can easily
be duplicated in a lot of countries … so maybe not so idiosyncratic after all.
Either way, I don’t think there is any more difficult job in finance today than
being an EM investor. And it’s not going to get easier.
Two last points to call your attention to before closing
this belated email.
First, if you haven’t reviewed the ET Pro Monitors, they
were updated earlier this month and I’ve attached that PDF here. Frankly, no
big breaks or changes in the macro narrative structures we measure, but we’re
watching the Central Bank Omnipotence narrative carefully for any signs of it
being replaced by a coherent “central banks are impotent” counter-narrative.
Second, we recently put out an In Focus piece for ET Pro
subscribers with our analysis of “Big
Tech Anti-Trust Narratives: Deteriorating but Disconnected”. The skinny
here is that while we think this could be a powerful thematic short, you’re
VERY early from a narrative perspective if you’re acting on this now.
Last October I wrote “Things
Fall Apart (Part 3) – Markets”, focused on the three big deflationary
shocks that could hit markets, and the one big inflationary shock that would
ride in on a pale horse after the deflationary shocks had their way with us.
The Three Horsemen of the Investing Semi-Apocalypse
The Fed keeps on raising interest rates and shrinking its balance sheet, ultimately causing a nasty recession in the US and an outright depression in emerging markets.
China drops a trade war atom bomb by letting the yuan devalue sharply, sparking a global credit freeze that makes the 1997 Asian crisis look like a mild autumn day.
Italy and its populist government play hardball with Germany and the ECB in a way that Greece could not, leading to a Euro crisis that dwarfs the 2012 crisis.
Markets suffered through the deflationary shock of the First
Horseman in Q4 of last year, but then recovered nicely after Jay Powell’s
monetary policy independence was taken out into the street and shot in the head
on Christmas Eve.
Markets are now suffering through the Second Horseman
riding into town, as China “surprised” markets with a sharp devaluation of the
yuan last night in response to higher/broader tariffs that Trump threatened to
impose last week.
Here are the questions Rusty and I are asking now, along
with our answers …
Could the tit-for-tat of a trade war escalation into a
currency war and a global credit freeze result in as painful a market decline
as Q4 last year?
Will the Second Horseman ultimately be vanquished like
the First Horseman?
I very much think so.I can’t tell you which
equilibrium in a game of Chicken will prevail, but there will be an
equilibrium reached, probably one where both China and the US declare victory
When will the Second Horseman be vanquished?
No idea. It’s a core ET precept, taking from an old
George Soros line … we’re observing, not predicting.
How will we know if we’re wrong, and the Second Horseman
is here to stay?
Two ways: a) if the Trump administration turns the
trade/currency narrative into a full-blown national security narrative (i.e.,
this is a new “Cold War” against a new “Evil Empire”), or b) if common
knowledge around the Central Bank Omnipotence narrative weakens dramatically
(i.e., the Fed and ECB are “powerless” to do anything about the ongoing
So that’s what we’re going to be watching closely – any
shift in the Trade & Tariff narrative towards a national security
narrative, and any shift in the Central Bank Omnipotence narrative towards an impotence
narrative – and that’s what we’ll be reporting back to you.
In real-world, as opposed to narrative-world, I think you
should be looking for signs of a credit freeze in trade finance to get a sense
of how bad this trade/currency war can get.
As in 1997 (and to a lesser extent 2015), this is a credit
freeze that will start in Asia and then spread globally. It will be levered to
trade finance, but will hit ANY sector or subsector where the narrative is
based on trade and growth. In other words, EM currencies and markets get
absolutely gob-smacked, DM rates continue to plumb uncharted depths in the negative-rates
abyss, and financials have no support.
It’s that last piece – shorting non-obvious financials that
have secondary exposure to trade finance woes, at least in narrative-world –
where I think there’s a trade that hasn’t already been priced in after the last
few days. For me, that go-to trade is buying CDS protection on the iTraxx
Senior European Financial index, a trade I’ve written about before for ET
Professional subscribers, as recently as this May (“In the Flow –
Here’s the one year chart for the SNRFIN, wider by 5 bps
today but only in the low 70s …
And the five year chart …
If the yuan devaluation sparks a credit freeze in global
trade finance, which I think is more likely than not, then we could see
these spreads widen to 120 bps in very short order, which would be … something.
The next ECB policy meeting isn’t until Sept 12, so unless Mario and Christine
start jawboning pretty hard and pretty fast from wherever they are vacationing,
I don’t see how the blisteringly negative narrative around European financials
changes course for the next four weeks.
Like I say, this is a trade and not an investment, and a CDS
contract is a chef’s knife – they’re sharp and you need to know what you’re
doing. But these are exchange-traded instruments and can be an effective tool
in any professional investor’s kitchen.
The dog that didn’t bark is the punchline to a famous
Sherlock Holmes story, Silver Blaze, where our man Sherl deduces that
the killer was a familiar presence at the murder scene because of the absence
of a clue – the watchdog who barked not at all as the murderer came and went.
It’s the same thing with US fiscal policy … it’s the
absence of a clue that tells me the market is extremely complacent about what
is coming down the pike here.
That clue is, of course, the market narrative, and when I
say that a market narrative is absent from US Fiscal Policy, I mean that there
is no connection between the occasional financial media article about
budget votes or fiscal policy and ANYTHING written about markets per se. This
was the point of an ET Zeitgeist note I published last Friday, titled We’re All MMT’ers Now.
It’s a quick read and worth your time.
In this email, I want to show you the Narrative Monitor we
maintain on US Fiscal Policy so that you can understand why we think this is a
As in prior months, there is very little attention being paid to fiscal policy/budgetary topics, and practically no linguistic connection between them and financial markets narratives.
Cohesion and Fiat News, too, remain at floor levels.
We counsel some awareness of the scale of policy proposals, especially those being promoted by leading Democratic candidates. The market is paying zero attention with zero cohesion, which we observe as a complacent structure.
A sufficiently credible candidate with a GND/MMT-style approach could be a significant surprise to a market that could not care less about debt ceiling negotiations, government shutdowns, debt levels or budget deficits.
And here’s the narrative map itself:
What Rusty is focused on is the peripheral position of
market-related narrative clusters (what’s moving the US market, why are China
stocks rallying/falling, etc.) all found at the top of the narrative
map, and the distance and empty space between these clusters and the center
of the narrative – the record US budget deficit – as well as the distance and
empty space between these clusters and the bottom of the narrative map –
the fiscal policies proposed by Democratic candidates.
Up/down/left/right means nothing in these narrative maps.
You can turn them 90 degrees or upside-down and nothing changes in their
meaning. What is meaningful is centrality and distance and the connective
links between clusters.
When Rusty and I see a narrative map like this, we immediately
look at the narrative core of anything written about US fiscal policy – the
record deficit shown as a bright red cluster – and how linguistically divorced
those articles are from ALL other articles that show up when you do a search on
“fiscal policy”. None of these peripheral articles are really about
fiscal policy. They use that phrase in the article, but the article is about
We also see that the articles about markets are as far apart
from articles on Democratic candidate policies, like student debt forgiveness,
as it is possible to be on this map. In other words, even though all of these
articles share the phrase “fiscal policy” somewhere in their text, there is
ZERO linguistic connection between an article about markets and an article
about what a Democratic president would do about student debt. THAT is what we
mean by a complacent narrative structure.
Will the market go up or down as it becomes less complacent
over fiscal policies over time? Yes. And I’m not trying to be cute with that
I don’t know what the market reaction will be as (or if)
fiscal policies and proposals become biting (or pleasing) realities. All I know
is that the market is unprepared for this. All I know is that fiscal policy is
NOT in the price of financial assets today.
Yesterday I published a brief note called “I’m Not a Raccoon! I’m the Lone Ranger!” about the hucksters and the con men in the crypto space. The point was that the obvious frauds reveal themselves pretty easily, but there are less obvious – yet no less fraudulent –narratives for Bitcoin being made by prominent people who live at the intersection of Wall Street and Bitcoin. These are people who should (and I think do) know better, but promote these false narratives anyway because it makes them money.
The false narrative I was referring to specifically in that
note was the idea that ‘network effects’ or Metcalfe’s Law or some other
description of transaction volumes was a source of intrinsic value in
Bitcoin. This is nonsense. There are no ‘network effects’ for a
non-cash-flowing, non-productive thing. There is no ‘tipping-point’ in the
transactional network around a non-cash-flowing, non-productive thing beyond
which it becomes ‘too big to fail’ or becomes ‘an accepted store of value’.
Are there non-fraudulent arguments for buying-and-holding
Bitcoin? Sure! There’s an inflation hedge / fiat debasement argument. There’s a
security / privacy argument. There’s a fashion / expression of identity
argument. But my raccoon-radar starts beeping like crazy whenever I hear
someone make a network effects argument for buying-and-holding anything,
much less a non-cash-flowing, non-productive thing.
“Lowering the cost of equity would stimulate growth through organic channels of investment, including research and development, which can provide durable economic gains.”
I mean … I like to think of myself as something of a
connoisseur of trickle-down economic arguments. I get the joke. But this is
INSANE. The ECB is going to spur growth in the real economy because publicly
traded corporations are going to spend more on R&D if their stock price
goes up? WHAT?
I’ve met Rieder and Fink a couple of times, but I don’t know
them. At all. Maybe they’re decent guys. Maybe they really believe in their
heart of hearts that this is wise public policy. I truly don’t know.
But if it talks like a raccoon and walks like a raccoon …
As long as the music is playing, you’ve got to get up and dance. We’re still dancing.
Chuck Prince made his infamous
get-up-and-dance quote to the FT in reference to Citi’s levered loans business,
although it was later taken to refer to subprime lending. No matter, it’s the
perfect quote for any age and any asset class where institutions intentionally
take risks they know are foolish, but risks they believe are manageable
because there’s a greater fool looking to get on the dance floor after them.
The greater fool theory is
the driving force behind the bid for negative-yielding debt, whether it’s
European government bonds or European investment grade corporate debt.
Sure, it would seem that I’m
the fool for paying the German government 25 bps per year for the privilege of
giving them my capital for ten years, but if there’s someone down the road
willing to pay me a nice premium over what I paid for this Bund because the
10-year rate is now -35 bps … well, take my money now, Ms. Merkel!
The rationale for buying
negative-yielding debt securities is capital appreciation and gain-on-sale, not
(obviously enough) the expected return of the coupon as the security is held to
maturity. In other words, the get-up-and-dance game is always a return ON
capital game, not a return OF capital game.
But playing for capital
appreciation in a (supposedly) risk-free rates portfolio or an IG debt portfolio
is a VERY different game than playing for capital appreciation in an equity portfolio
or a distressed debt portfolio.
Who is managing these
negative-yielding IG and rates portfolios? The same portfolio manager who has
made a career out of honing a hold-to-maturity mentality? Or did they parachute
a distressed guy into this world of macro carry trades and monetary policy
analysis? Either way, it’s a prescription for massive error. Either way, it’s
the management of the now $13+ trillion in negative-yielding debt securities
that I think is the catalyst for a blow-up here.
Let’s leave aside the distressed
guy parachuting in to manage this portfolio. Because that’s not what’s going
on. What’s going on is that there are a lot of hold-to-maturity IG and rates guys
who now fancy themselves as momo traders. I mean … that’s not really how they
think of themselves. They think of themselves exactly as Chuck Prince
thought of himself – the true heir to Sandy Weill, master of the deal and the pivot,
a man who knew how to hoof it – when really he was just another lawyer who
couldn’t dance to save his life.
Bull markets make everyone
think they’re a freakin’ genius. While bear markets doth make cowards of us
all. And that last part is the problem.
In my experience, hold-to-maturity
guys – and here I’m talking about both hold-to-maturity bond guys and their
equivalent in equity-world, the put-it-in-a-drawer-and-never-sell-a-share guys –
always get two things wrong when they decide to play the get-up-and-dance game.
vastly overestimate the liquidity in their market, and they are paralyzed by
the absence of bids when the shit hits the fan.
sell-discipline muscles have atrophied (if they ever existed), so they hang on waaay
too long before making the first sale, and then they panic and puke out the
rest into an illiquid market.
This is why I think the
negative-yielding bond bubble ends in tears.
Not because bond managers are wrong about the intentions of central bankers and the direction of monetary policy for the foreseeable future. But because they overestimate their ability to trade this portfolio and they underestimate the mad rush off the dance floor when nobody sees a greater fool waiting in the wings.
I’ll discuss in more detail over next few weeks, but here’s
the skinny: Yes, we’re still in a zeitgeist of Central Bank Omnipotence, where
deflationary shocks simply can’t take the market down for much or for long.
That said, the Cohesion measure of both Trade & Tariffs and Central Bank
Omnipotence is really breaking down, meaning that there is enormous narrative
confusion over how the rate cut trajectory plays out … far more confusion than
the 100% implied market odds of a cut would imply.