David Stockman: Last Week Wasn’t An Error

By David Stockman as originally published on Contra Corner and reprinted here with permission

Last week’s twin 1,000 point plunges on the Dow were not errors. Instead, these close-coupled massacres, which wiped out $4 trillion of global market cap in two days, marked the beginning of a bear market that will be generational, not a temporary cyclical downleg.

What hit the casino wasn’t an air pocket; it was a fundamental change of direction, signaling that the three decade long central bank experiment with Bubble Finance has now run its course.

Moreover, this epochal pivot is not tentative or reversible in any near-term time frame that matters. That’s because the arrogant but clueless Keynesian academics and apparatchiks who run the Fed think they have succeeded splendidly and that the US economy is on the cusp of full-employment.

So they’re now hell-bent on positioning the central bank for the next downturn. That is, they are reloading their recession-fighting “dry powder” thru interest rate normalization and a second giant experiment—-this time in shrinking their balance sheet by huge annual amounts under a regime called quantitative tightening (QT).

Needless to say, both the magnitude and the automaticity of this impending monetary shock are being completely ignored by Wall Street in favor of bromides like “the market knows” QT is coming because the Fed has been transparent in its forward guidance.

So what? Knowing the steamroller is coming doesn’t stop you from getting crushed if you remain in its path. In fact, the $600 billion annualized bond dumping rate incepting in October is a fearsome number; it’s larger than the entire $500 billion Fed balance sheet as recently as the year 2000.

By your way, that had taken 86 years to accumulate through two world wars, the Great Depression and 9 lesser recessions. Yet that monumental change of dimension has faded from the working knowledge of Wall Street punters and commentators alike only be virtue of the insane 9X expansion to $4.5 trillion that occurred over the subsequent 14 years.

Moreover, you can count on the Fed’s impending bond selling spree to get a turbo-charge from the bond pits.

As we insisted on Fox Business this AM, the fast money will soon figure out that the best way to print profits is to pivot with the Fed. That is, just as they were buying what the Fed announced it would be buying in the tens of billions per month during the era of QE, leveraged traders will start selling what the Fed has announced it will be selling during the new ball game of QT.

That will cause the impending bond market yield reset, in turn, to overshoot to the upside. Accordingly, the 10-year yield, which touched another new high at 2.88% early this AM, will be ripping through 3.0% shortly; and then be on its way to 4.0% and beyond.

Indeed, that’s virtually inevitable. With the ECB, BOE, PBOC and BOJ all moving toward tightening in one fashion or another, the US bond market will have to clear $1.8 trillion of supply during FY 2019, but with little prospect of uptake from foreign central banks or their local bond markets.

That’s right. The GOP fiscal geniuses now running the government, who inherited $700 billion of red ink for the upcoming year as a bipartisan legacy of decades past, have promptly layered on another $500 billion. That stems from the unfunded tax cut at $280 billion and from $220 billion more flowing from last week’s spend-a-thon and the associated rise in interest payments.

Indeed, since Congress so dramatically front-loaded the tax-cut, the argument that “growth” will close the gap has been reduced to a bad joke. Even if it boosted GDP growth by a full 1.0 percentage point next year, the gain to GDP would be $200 billion and the associated revenue uptake would be less than $40 billion.

In the context of a $4.6 trillion annual spending level, call that a 0.9% rounding error and be done with it. And don’t expect that the s0-called growth dividend will catch-up a few years down the road, either.

The fact is, FY 2019 will end in month #124 of the current business expansion (incepting in June 2009). That would make it the longest business expansion in recorded history and more than double the average cycle.

As we also argued on Fox this AM, if we even reach that point before the next recession hits, it should be considered a minor miracle. After all, the “yield shock” directly ahead is going to throw everything “priced-in” down there on Wall Street into a cocked-hat—including the likelihood that rising rates will rip $20 per share out of S&P 500 earnings (see below).

But to think you can go another 3-4 years without a recession is surely delusional; and to expect to get all the way through 2027 without a downturn (a putative 219 month expansion), as do both the current Trump budget and CBO baseline, would be downright inconceivable.

In this context, the Fed’s resolve to dump $600 billion per year back into the bond pits should not be underestimated. As our colleague Lee Adler pointed out recently, the Fed has so determinedly adverted to auto-pilot with respect to it bond selling campaign that it not only announced it would refrain from commenting about it in its meeting minutes, but has now even stopped publishing the monthly runoff schedule.

 

That get’s us to the market’s misplaced confidence that after a moderate-sized hissy fit on Wall Street, the Fed and other fellow-traveling central banks will back-off from normalization and QT. The fact that the head of the New York Fed and Goldman plenipotentiary at the central bank, Bill Dudley, pointedly referred to last week’s two-day $4 trillion stock plunge as “small potatoes” is perhaps a hint of things to come.

In that vein, the next chairman of the ECB in waiting, also left little to the imagination.

German Bundesbank President Jens Weidmann called on the European Central Bank Thursday to wind down its giant bond-buying program after September, urging officials not to be distracted by a stronger euro currency or volatility in global financial markets.

Here’s the thing, however. Wall Street’s complacent belief that the auto-pilot shift toward QT will be turned-off and reversed in the event of a recession is badly misplaced. That’s because the era of Bubble Finance has turned business cycle causation upside-down.

Collapsing bubbles on Wall Street, not credit excesses on main street, are now the trigger for recessions. Accordingly, the Fed and other central banks are now strictly in the mop-up business, as the 2008 crisis so dramatically documented.

During the 16 months between the stock market peak in November 2007 and the March 2009 bottom, global market cap plunged from $62 trillion to $26 trillion. The Fed and other central banks were powerless to stop the $37 trillion bloodbath because it was not really triggered until September 2008 after the Lehman collapse; it was then that the C-suites began to jettison excess inventories and labor with nearly reckless abandon.

For example, the goods producing sector—-mining, energy, manufacturing and construction—is far more cyclically sensitive than the US economy as a whole, where large swath of employment such as government (22 million jobs) and health and education (33 million jobs) are nearly immune to downturns. Thus, when fear ripped through the C-suites in September 2008 owing to collapsing stock prices and stock options, the  goods sector dumped inventories and workers like there was no tomorrow.

During the 10 months from September 2008 through the following June, more than 2.8 million workers were sacked, which represented 13% of employment at the December pre-recession peak and upwards of 70% of all jobs lost in the good-producing sectors during the entire Great Recession. In January 2009 alone, the sector lost 433,000 jobs or 2% of its payroll.

Stated differently, the corporate C-suites of America have been turned into financial engineering joints by 30 years of Bubble Finance. They are driven by short-term stock prices and the massive stock option packages attached to them.

Accordingly, when financial bubbles inevitably burst the resulting collapse of stock option values triggers full-on panic. At that point, anything which can possibly pacify the angry gods of the casino gets teed-up for desperate action, thereby giving rise to sweeping “restructuring” plans and drastic liquidation of fixed assets and inventories.

In the case of manufacturing, for example, inventories kept building during the first nine months of the statistically declared recession. But after the stock collapse in September 2008, inventories were dumped with malice aforethought. During the next 10 months more than 15% of manufacturers inventories were pitch overboard, causing ricocheting impacts among upstream suppliers and workers.

So the question is not whether a weakening economy will cause the Fed to take QT off auto-pilot. Instead, the issue is what might catalyze a continuation and acceleration of last week’s stock plunge, thereby triggering the next bout of recessionary mayhem in the corporate C-suites?

We think the answer to that question is lurking in plain sight. To wit, the unfolding rise of bond yields in no way will resemble the comforting Wall Street myth that it’s already “priced-in”. In the case of the S&P 500, for example, the interest expense margin on sales averaged about 3.75% during the 1994-2008 period, and could be taken as the pre-QE and pre-ZIRP baseline.

Notwithstanding a veritable tsunami of corporate debt issuance during the past nine years, however, the interest margin in 2016 was only 2.00%. And that was after the amount of corporate debt outstanding had ballooned by more than one-third.

Accordingly, the bottom-of-the barrel net interest margin was not due to deleveraging, but, instead, was a function of drastic financial repression by the Fed and other central banks. The latter had become so extreme by 2016, in fact, that upwards of $14 trillion of sovereign debt traded with negative yields and the fundamental benchmark for corporate bonds—the 10-year UST—-hit an all-time low of 1.35% in July.

And that’s where the skunk is hiding in the woodpile. Should the 10-year bond rise to even 3.5%during the year ahead (reflecting a 75% increase from the 2.0% average of 2016), the interest margin on the S&P 500 would revert to at least its 3.75% pre-2008 baseline average.

Needless to say, the serious adverse implications for earnings are nowhere baked into the current Wall Street hockey sticks.

Thus, during 2016, the pre-tax interest margin on the S&P 500 according to the guru of corporate earnings, Ed Yardeni, amounted to $22.30 per share; and, at an effective tax rate of 26.5%, the after-tax cost was $16.40 per share.

By contrast, at a 3.75% interest margin, the pre-tax cost would be $42.50 per S&P 500 share, while at the new lower effective tax rate of about 16%, the after-tax cost would rise to more nearly $36per S&P 500 share.

In a word, that potential $20 per share cost of rising yields is nowhere “priced-in”. For that matter, not even a fraction of that amount is embedded in the Wall Street hockey sticks–if any at all.

As we said, knowing that the steamroller is coming, does not mitigate the bodily mayhem of remaining in its path.

And most especially, not when the steam-roller is being operated by central bankers who are oblivious to the epic bubbles and wild-west speculation that has been fostered throughout the warp-and-woof of the financial system after nine years of massive money printing and decades of central bank “puts”.

In that context, it is fair to say that everybody has been picking up nickels in front of the steamroller—-the legendary pros and homegamers alike. For instance, Ray Dalio, who is the godfather of the risk parity trade, which is among the most sophisticated short vol trades, was celebrated by the media on January 23 for saying at Davos that,

“If you’re holding cash, you’re going to feel pretty stupid.”

What a difference 10 days can make. Undoubtedly, even some of his investors are wondering exactly what part of the anatomy he is holding now—-given that during February to-date, the risk parity trade is down by 5%.

“About 10 days ago, that’s where I thought we were. However, recent spurts in stimulations, growth, and wage numbers signaled that the cycle is a bit ahead of where I thought it was.”

This is just another way of saying that Bubble Finance has sown the seeds of its own destruction by causing foolish action on both ends of the Acela Corridor. With the budget now on automatic pilot and borrowing accelerating at unprecedented rates for the tail-end of a business expansion, it is only a matter of time before the bond market “yield shock” triggers carnage in the risk trades.

Last week’s ETF/ETN explosion on the vol trade was only the tip of the iceberg. The real size in vol shorts was lodged in the much bigger positions represented by hundreds of billions invested in risk parity, vol control, naked puts, and CTA trend following strategies.

As one astute hedge fund trader, Eric Peters, observed over the weekend:

 Relative to the aggregate of all other forms of volatility selling, they’re (ETFs) not big, just really painful. They make for good headlines too. So the question now is whether the pain/spark of their blowup is enough to ignite bigger structural volatility shorts?”

(A) “This is the equivalent of the June 2007 Bear Sterns moment. In this scenario, market participants see the VIX ETF/ETN complex implosion as an isolated event sparked by poorly constructed products. Once investors really understand how they were constructed, they gain comfort in the ‘superiority’ of the strategies that they currently use to sell volatility (uncapped variance, risk parity, vol control, put selling, etc). They feel smart. And continue selling. Until a more widespread volatility unwind inevitably unfolds – probably tied a bit more closely to the economy and QE exits by the ECB/BOJ.”

(B) “This VIX ETF/ETN spark ignites other structural volatility shorts over the coming days/weeks, driven by a critical mass of risk managers across the financial industry not wanting to be the last to de-risk. Selling of risk assets increases volatility and this sparks more selling of risk assets in a reflexive way. In this scenario, visions of the ETF/ETN blowup makes value investors more patient in buying the dip. And with a new Fed governor, you don’t get a swift response. It’s bombs away for risk asset prices.”

Either way, the day traders will be the last to get the word—especially since more than half of today’s fund mangers have been in the business less than nine years (i.e. the got their long pants after the 2008 meltdown).

As one 29-year old certified millennial and London fund manager, Ben Kumar, told Bloomberg,

After $3 trillion was erased from global stocks in a week, he’s weighing whether to buy on the dip now–or wait a bit longer. “I don’t even think that this move is a wake-up call,” he said on Tuesday…..“I haven’t worked in a different era to this one, but who says we’re going back to the old era?

We’d bet most surely we are.