Stores in Venezuela Resort to Weighing Stacks of Bolivares on Scale Rather than Counting It

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Venezuela: a tragic reminder of the follies of political corruption, unjustified increases in money supply, and heavy handed actions by central planners to cheat basic economics.

The Venezuela hyperinflation saga continues.

The Chavez/Maduro political legacy is on life support. Most unfortunately, life in Venezuela is becoming increasingly unsafe. Protests have turned violent.

Increasing the money supply to pay the tab for unrealistic political promises is a very dangerous game that usually ends in tears. In that respect, it is never “different this time” and thousands of years of monetary history tells us no nation or empire has a free pass to utilize baseless money creation forever without facing dire consequences.

There are many people alive today who were around when Venezuela was the wealthiest nation in South America. Now the currency is approaching worthless and so is the wealth of most of its citizens.

This is how many Venezuelan Bolivares it takes to buy one US dollar on the black market (the official FX rate fixed by the government is not accepted by the market). You will notice the amount is now “off the chart” as the exchange rate rapidly moves above 19,000 BSF/USD. This, during a time when USD has fared poorly against most trading partner currencies, meaning it has nothing to do with USD strength.

This is clearly hyperinflation.

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Perhaps the most important point to convey in this post pertains to stock market performance during periods of hyperinflation.

While above-target inflation is generally bad for equity prices because it implies the central bank might react with tighter monetary policy in the near future to reign in excess liquidity, at a certain point equity prices can melt higher if investors don’t expect a meaningful tightening in financial conditions.

Take a look at the Caracas Stock Market Index below.

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Higher prices mean higher revenues for businesses. This can be falsely appealing initially, and is also part of the reason corporate managers tend to join in on the fashionable “inflation is good” bandwagon amongst elites. However, it is only an illusion of higher wealth and profits due to the diminished spending power of supposed increases in revenues and profits.

Not even the most devout Keynesian print and ease perma-doves will attempt to proclaim that investing in the Caracas stock market is making people rich in real terms, even as the market melts straight up in nominal terms.

Be careful in assuming every financial asset bubble ends in a 2008-style market crash. When debt outstanding becomes unpayable, asset bubbles become increasingly prone to inflationary outcomes rather than the more common market crash outcomes for which everyone these days seems to be on the lookout. That is one reason Alan Greenspan indicated more caution about the bond market than the stock market.

At the very least, future potential economic shocks in the US may result in a more fragmented bond market reaction than the typical risk-off correlations (gov bonds up, high yield down, USD up, EM currencies down, stocks down) witnessed in the past 15+ years.

US stock indices will most certainly fall initially during future economic shocks or downturns, but what you should really be focused on in terms of macroeconomic risk management in the current era is one or two steps ahead of a potential shock — how will activist central planners respond given the remaining options at their disposal during a period of heavily indebtedness and aging demographics?

Dominant Currencies Through History: Why USD is at Risk as a Reserve Currency and What Would Replace It

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As if we needed a friendly reminder, history tells us every dominant global currency shines brightly under the international spotlight… until it doesn’t.

The greenback has maintained its status as global reserve currency since shortly after the Second World War. It has limped through US President Nixon’s termination of gold convertibility in 1971, a historic global financial crisis emanating from the US, several asset bubble busts, and a prolonged 8+ year stretch of zero interest rate policy (ZIRP) paired with accelerated new money supply by the Federal Reserve’s QE programs.

Strategic political alliances with questionable partners at times and tragic international conflicts likely played a role in every empire maintaining dominance of its currency in global trade. This is nothing new, unique, nor surprising if viewed from a historical perspective.

Empires have gone to the greatest lengths possible, by any means necessary, to ensure global trade is conducted with their currency of choice. That is because the wealth of their citizens, businesses, and governments have depended on it.

Global demand for one’s currency ensures superior financing terms to invest in the things that increase living standards and real wealth. It also insures value preservation of a nation’s (or currency union’s) savings. With reserve currency status comes immense privilege and more room for error than enjoyed by those without it.

More room for error does not mean infinite room for error. Unfortunately, squandering wealth and credibility are much easier and faster to execute than building them. Human nature is highly cyclical and dynamic. Once an empire goes through the exhausting process of winning the hard way, it wants to enjoy the fruits of its labor the easy way.

Complacency sets in. Greed, impatience, and hubris replace the blood, sweat, and tears on which the empire was built. Short cuts become misinterpreted by common wisdom as “the new way to work smarter, not harder.” Mal-investment on unproductive activities are implemented to improve short term optics at the expense of long term real gains. Power breeds corruption. Corruption deteriorates trust in the social contract gluing a society together. The political power cycle peaks and begins to reverse.

The basis of Keynesian economics and “stimulating demand” now by stealing it from the future is inherently a product of short-cut thinking exhibited by an empire’s coddled intellectuals with no skin in the game. Why ever make difficult political decisions to prioritize finite resources or tighten one’s own belt when you can simply goose the economy for awhile longer with borrowed funds or freshly printed money?

Like the academics of previous eras, the academics of the current one have decided they have a short-cut with groundbreaking, new ideas: create new money from thin air and buy most of the bonds responsible for setting interest rates to keep rates low. Ah ha! Why hasn’t anybody else been so clever?

Of course, there is nothing groundbreaking whatsoever about demand-driven Keynesian economics. Different tactics, same tricks. There are no free lunches in economics over the long run. Eventually the long run becomes today.

Today’s central bankers and politicians have decided they are intelligent enough to increasingly control market economies better than all of those who have failed before them trying to do the same, and certainly better than a large number of diverse market participants with skin in the game from various perspectives competing for the best deals (aka, “markets”). The more things change, the more they stay the same.

Too much market intervention by central planners has some of the nastiest long term side effects imaginable, even with relatively good intentions in the short run. Unexpected losses in purchasing power, real wealth, and real wages have silently been responsible for contributing to wars and other bloody conflicts (ie. hyperinflation in Germany in the 1920s, 2011’s Arab Spring, today’s Venezuela) with fewer mentions than deserved. Nothing evaporates complacency and fuels anger like losing everything almost overnight.

When a debt situation deteriorates past the point of no return to a level of de facto insolvency, governments choose creating money from thin air to pay the bills 99% of the time rather than not paying them when presented with one or the other as the unfortunate final options on the table. This eventually, if not immediately, causes said money to lose its value.

In fact, even though the dollar is still the most widely held global reserve currency, it has lost approximately 95% of its purchasing power since the Federal Reserve was created in 1913 to manage the nation’s money supply. Throughout most of this time, the deterioration in value has been manageable because interest rates were high enough to compensate savers.

Now we have a policy of financial repression where savers are forced to lose real purchasing power on their savings without being compensated by adequate interest earnings. This has been a direct transfer of wealth from savers to debtors and government entities. That fact is yet to be fully appreciated by the public, broadly speaking.

When a currency rapidly loses purchasing power, faith and trust in its future value begin to erode even faster. Lenders of debt in said currency demand higher interest rates to compensate for the risk and expectations of additional losses in value.

High interest rates make it more costly for individuals to make large purchases or maintain their living standards in a cyclical economic downturn. High rates make it more difficult for new businesses to form and for existing businesses to expand. Most importantly, high rates make it terribly difficult for indebted governments to continue spending more than they collect in taxes, or even to pay back previous debts.

Yet, sometimes higher interest rates are exactly what is needed in order to ensure a moderately painful period of belt tightening rather than a full blown crisis or economic collapse down the road. This in return helps attract investment capital seeking higher rates of return to a struggling nation (or region) in need of it, thus creating demand for the beleaguered currency once again and completing the cycle.

This, anyways, is how it is supposed to work in a market-based economic system: self-correcting periods of relative economic strength and weakness with a bias toward long term wealth creation. This holds true even in hybrid economic systems where governments intervene to nudge economies in the direction of desired political outcomes without excessive force or explicit price controls.

But that is not the modus operandi in the current Keynesian global central banking regime. We have seen one experimental intervention policy after another enacted essentially in coordination by advanced economy central banks in order to keep the economic flame flickering and avoid another global recession. Economic nature has not been allowed to run its course with natural corrections in recent years, with few exceptions.

Equity volatility is at all-time lows. As in, forever. The Bank of Japan is buying stock ETFs at multi-year high prices, is forcing a negative interest rate at the short end of the debt curve, and is even manipulating the shape of the curve deeper out by instilling an unlimited bond buying program to keep 10 year JGB rates at precisely zero while there is no apparent recession to fight. The European Central bank is printing 60 billion euros per month and spending some of the money on bonds that have negative yields.

One would naturally wonder why central bankers have spent so much precious monetary ammo and political capital fighting the natural business cycle during a period of time in which the economic indicators are looking quite strong overall? They have explicitly pledged to do “whatever it takes” on a number of occasions to prop up the banking system and keep interest rates ultra low long past a time of actual crisis.

The answer is frightening: there is way too much global debt without the growth to support it and another major recession in several advanced economies could expose an insolvent global monetary system. What would happen if in a recession the US returned to $1-2 trillion dollar deficits with no end in sight and debt-to-GDP already stretched near maximum sustainable levels? If the deficit already looks increasingly bloated during a time of quasi full employment, and political dysfunction is preventing anything sensible from correcting course on the ship before it is too late, what does “too late” look like?

The Keynesian groundwork has been laid in the public discourse already. There will almost certainly be so-called “helicopter money” policies enacted by emergency decree during the next recession–direct coordination between the government and the Fed to monetize debt with no questions whatsoever about what is going on.

The Fed will create money to purchase not only financial assets, but will back the US Treasury with newly created money so it can cover its bills without technically “defaulting.” Financial repression will be relentlessly pursued to stop people from getting their money out of the banking system because private savings will be used to bail out unsustainable public debt one way or another. Either you spend it quickly to “stimulate demand” or watch it’s value diminish before your eyes.

If ever used, helicopter money will end USD’s reserve currency dominance reign.  It would no longer be trusted as a store of value, to the extent it even is now. The only way to effectively enact such heavy handed policies is through financial repression, limiting the use of cash, and quasi currency controls because otherwise there would be a massive run on the financial system. Everybody would try to get rid of their fiat currency deposits at the same time to instead acquire other assets that are superior stores of value.

Competing non-fiat assets would then be under the spotlight and removed as an option similar to how FDR made it illegal for private citizens to own gold in 1933 by executive order. People literally went to jail for owning gold. That type of policy would surely spark a much harsher public backlash this time around, resulting in at least a partial departure from the current USD dominated post-Bretton Woods monetary system.

The only way to prevent this from happening is for the US to ignite sustained GDP growth above 3% while gradually reducing debt-to-GDP over time.  Or, the government chambers could join together to enact unpopular budget cuts on things like entitlements and military spending, without diminishing tax revenues. Seeming how the same legislators have already made a mockery of the supposed hard cap budget sequestration enacted in 2013 by largely ignoring it, as well as publicly declaring that it will let its own healthcare system fail due to current political dysfunction,  the hill to climb seems steep for the greenback to remain the dominant reserve currency.

Contrary to the graphic at the top of this post, the Chinese yuan is not necessarily going to be a better alternative to the dollar. China’s debt problem might even be worse than the US’s. Traditional “paper” fiat currencies in general are highly subject to central bank oversupply and deteriorating faith in traditional institutions globally.

Digital blockchain assets such as bitcoin could be a viable alternative or complement to traditional fiat, at least eventually, but related businesses such as cryptocurrency exchanges could be targeted heavily in an intensified financial repression regime. It is still very easy to imagine demand for digital assets surging exponentially higher than supply with or without a helicopter money scenario taking place in the future.

The next official reserve currency is likely to be plural. SDRs, or Special Drawing Rights, are currency units composed of several major currencies that the International Monetary Fund (IMF) is increasingly highlighting as a better solution than USD for bank reserves. The problem with SDRs is that they are still based entirely on fiat currencies and are also centrally controlled, leaving them politically vulnerable and prone to perpetual devaluation.

The monetary system will become increasingly decentralized as a natural response to too much centralized planning reliance and risk concentration. SDR’s and even government sanctioned crypto assets will include USD in the global financial system, albeit with a diminished role from its current dominance in energy commerce and bank reserves.

On an individual level, diversification into prime real estate, land, precious metals, and crypto assets should perform well in real terms during a future recession. As mentioned in several earlier posts, Assist FX does not expect an imminent near term recession. Nonetheless, it would be a good idea to do some planning and perhaps gradually accumulate assets on a regular interval able to outperform traditional fiat currency bank deposits should you see the same risks that we do longer term. We are closer to an economic peak than a trough at this stage of the credit cycle.

Odds of a recession occurring in the next 1-3 years are likely about 50-55%. Beyond 3 years the odds increase dramatically as it becomes apparent full monetary normalization is no longer possible absent an unexpected renaissance of productivity and growth in an aging demographics world.

We are past the point of no return yet not quite to a dead end. That leaves us with an ideal opportunity to assess risks realistically now and plan for an uncertain future where USD could lose its dominant reserve currency role in the world and instead become part of a diversified currency basket mainly featuring SDR’s.

French Support of Eurozone Reaches Multi-Year Highs: Euro Currency Demand to Remain Firm

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The sentiment tide has turned favorable for the euro.

The types of existential threats which hampered the euro currency during the European debt crisis have largely receded for the time being.  EU citizens do not seem particularly interested in following the UK down the path of currency devaluation, inflation, and political turmoil by leaving the eurozone.

Demand for the single market currency will remain firm as the European economy continues its stable trajectory and the initial consequences of Brexit serve as a deterrent to others.

Longer term, we do expect to see perceptions improve regarding the decision by the UK to leave the European Union as the UK economy re-balances and the worst fears are not realized. Life will go on for Britons. There will eventually be appreciation for the modest claw back of British sovereignty, though the UK and EU will remain close economic allies out of geographic proximity and necessity.

Caution on China Exposure As Credit Is Starting to Dry Up

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When the RBA decided earlier this week to hold fire on gunning for a gradual rise in interest rate expectations, surely it was considering this: China credit impulse with a 9 month lead is taking a dive.

In other words, very recent mothers-to-be shall be giving birth to their children in a notably worse Chinese economy than when said children were conceived. How much worse? Perhaps four PMI points worse, which implies GDP growth falling by about 1-1.2% from the current annual growth rate of 6.9%. This doesn’t imply a market crash but it does imply that fewer Australian businesses need to boost investment.

We like leading indicators at Assist FX — both quantitative and qualitative. While the future is always uncertain, analyzing it as accurately as possible is best accomplished with forward looking indicators and models. What we are seeing on the horizon in China is a controlled, modest deleveraging with a minor tail risk of accelerated bankruptcies. As the facts change, so will our models. For now, we remain cautious on China-sensitive financial instruments such as the Australian dollar.

Soft RBA Tone and Quiet China Liquidity Drain to Constrain AUD

The Reserve Bank of Australia expressed more caution than market participants expected in its monetary policy statement this morning.

The nuanced hawkish rhetoric shift by other advanced economy central banks recently, particularly from the RBA’s key commodity producer counterpart in the west, the Bank of Canada, was not imitated by RBA Governor Lowe. It was a highly balanced statement with several risk factors included, rather than including just a few boilerplate risks as could have been the case with less accommodative intentions.

Here are the policy statement highlights courtesy of Reuters (bolding is mine):

  • Indicators of labour demand remain mixed
  • Employment growth has been stronger over recent months
  • Some signs housing market starting to cool
  • Housing debt has outpaced slow growth in incomes
  • House prices rising briskly in some markets
  • Supervisory measures should help address debt risks
  • Various forward-looking indicators point to employment growth going forward
  • Rising A$ would complicate economic adjustment
  • Economic outlook supported by low rates
  • Wage growth remains low, likely to continue for a while yet
  • Inflation expected to increase gradually as the economy strengthens
  • Slow growth in real wages is restraining growth in household consumption
  • Business conditions, investment have picked up
  • Economic growth expected to strengthen gradually
  • Broad-based pick-up in global economy continuing

Why the caution? I believe the RBA is factoring in reduced Chinese liquidity into its forward looking models as China looks to reduce some froth out of its shadow banking sector. The PBOC has refrained from injecting liquidity via open market operations for eight consecutive days. This is already negatively impacting equity prices in Shanghai and will dampen near term demand for Australian exports as Chinese financing dries up.

AUDUSD is likely to see continued weakness into .7525 support. Rather than jumping on the AUDUSD selling bandwagon it is preferable to sell rallies against CAD and NZD.

What the Market Overlooked in the Personal Consumption Expenditures Report

  • Most market analysts are pointing to the slight miss in May’s headline year-over-year PCE deflator reading of 1.4% vs. 1.5% expected and 1.7% previous.
  • What has been overlooked by most are the strong back-to-back personal income figures of 0.4% m/m in May and 0.3% m/m (revised from 0.4%) in April. While April was revised a tick lower, May’s rebound capped off an impressive two month gain of 0.7% in personal incomes.
  • This runs counter to the prevailing sentiment that the Phillips Curve is broken and wages are not picking up or at least holding their own.
  • The Fed has shifted focus recently, as they often do on a discretionary basis, to focus on financial stability after the epic run up in mega cap tech names, equity  valuations, and market complacency suggested market psychology was fostering an unhealthy rise in market bubble dynamics.
  • The core Fed FOMC members are now willing to overlook taming inflation for the time being as a 15% fall in the energy complex drags down PCE and CPI for the next few months. They still believe continued labor market tightening toward what is deemed to be “full employment” will eventually boost wages and keep inflation expectations on a steady projectory. Other central banks are following suit.
  • Assist FX sees the recent central bank turn toward slightly less dovish rhetoric as supportive of a more sustainable recovery. While asset valuations are still stretched and in bubble territory on a longer term basis as regularly discussed on this site, letting some pressure out of the “everything bubble” is actually productive overall.
  • Letting asset valuations and house price-to-income ratios skyrocket unchecked by a tightening reaction function in monetary policy would be one major catalyst capable of changing our S&P500 bias to negative as prices become increasingly stretched like pulling a thinning rubber band.
  • Assist FX sees moderate Fed action to trim asset purchase reinvestments in September with another 25 bp Fed Funds target increase in December.
  • Our equity, fixed income, and USD bias remains neutral.

Retail Industry Credit Risks Are in Dangerous Territory As “Taper 2.0” Approaches

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  • 95% of banks view retail industry credit risks as “significantly greater” or “moderately greater” than in previous cycles (Moody’s Investor Service).
  • 2017 retail store closings are somewhat quietly on pace to surpass levels seen during both 2008 and 2009 when we were experiencing an historic financial crisis.
  • Stalwart retailer Bed Bath & Beyond shares were down 12% today on a worsening sales outlook. Consumers are choosing to buy fewer “things” on net and more of what they do purchase is from a decreasing number of mega cap online providers.
  • Online purchases due to technology advancements can explain part, but not all, of the ongoing retail “fall from grace.”
  • Consumers are stretched from elevated real estate, healthcare, and education costs. The Fed’s bloated balance sheet promoted the same stretched asset prices that are now harming consumers and posing correction risk.
  • Overcapacity fears in the retail and energy sectors are beginning to seep into investor sentiment and inflation expectations.
  • Assist FX sees the Fed keeping interest rates on hold through at least September in order to provide a large enough window to begin trimming its balance sheet.
  • The Fed will initiate a gradual, mild, balance sheet reduction in 2H2017 as outlined in the June FOMC policy decision. This could begin as early as September. Even doves such as Evans and Bullard are nearly ready to begin tapering asset purchase reinvestment.

Bottom Line:

Previous calls from Assist FX of a low volatility grind higher in US stock indices were accurate. It is now time to increase caution modestly and move to a more neutral stance in US equity indices, long duration Treasuries, and USD. Bond market volatility should increase headed into the Fed’s asset purchase reinvestment trimming, which we are calling “Taper 2.0.” A cyclical increase in volatility will incur within the context of the secular decline previously discussed by Assist FX. This means volatility will not always be low; it will however be lower than it would have otherwise been in a previous era.