Clients and investors are increasingly asking the same sensible questions: how do global central banks work? The ECB? The Federal Reserve? The Bank of Japan? The People’s Bank of China? Are they really behind this market bull? Is investing still based on natural indicators and forces? How can we make sense of it all?
Sometimes stories are more fun than just statistics, and to answer these types of heavy questions, I like to tell the following story.
An Easy Story
Imagine a frozen tundra somewhere in the terra incognita beyond the frigid waters of the Bering Straits in a metaphorical land mass somewhere between sub-zero Alaska and Siberian Russia. Think of miles of windswept, barren terrain with blinding snow and howling gusts—a place so cold even the polar bears stay nervously clear.
And there isn’t a soul in sight, not for hundreds of miles in any visible direction. It’s dark 24/7. Now imagine an eerie intersection of ice-covered roads where four separate and lonely lemonade stands tilt against blowing snow drifts and flickering yellow lanterns.
Each stand is run by a highly educated nephew (or niece) of a billionaire residing in one of the following countries: 1) Japan, 2) the US, 3) China and 4) Germany. A flag from each country waives defiantly against gale force winds. And beside each flag sits a freshly waxed (yet snow-covered) Tesla which drives these budding entrepreneurs to a private air strip where G-4’s fly them home daily to lavish estates outside of Tokyo, Beijing, Berlin and DC.
And all of this is paid for exclusively by the record breaking, historically unmatched revenues of these brilliant young beverage millionaires selling lemonade in no-mans land. Meanwhile, their reported growth rates, revenue success and miraculous balance sheets are heralded in nearly every financial periodical and talk show.
Known as “The Four Wunderkinder of the Tundra,” these young, well-dressed prodigies speak often at Davos, Jackson Hole and San Jose coffee shops to wide-eyed audiences who gaze in admiration at their colorful bar graphs, shiny cars and admirably hip loafers. True success! True inspiration! True capitalism at its finest, they are les belles enfants of the infinite potential of free markets at work.
At one of these coffee shop lectures, a nervous barista raises his hand and stutters in awe. “How…how.. how to you do it? How do…do…do… you make billions sell…sell…selling lemonade on an… an… iceberg to non-existent customers?”
The four Wunderkinder confidently set their iPhones aside. Each takes a long sip from a caramel latte and then in one voice answers simply: “Our rich uncles buy all the lemonade.”
The audience lets out a collective gasp of awe. So that’s the secret: rich uncles.
Reality is Stranger than Fiction
My story seems pretty far-fetched. An obvious farce, right? I mean…four hipster millionaires making fortunes selling cold drinks on some snowdrift between Siberia and Alaska? Ridiculous. Impossible. Unthinkable.
Yet this absurd scenario is a sobering metaphor of how our global markets actually operate today. The four great economies of the world are literally buying their own lemonade (or drinking their own Kool-aide) and confusing this artificial demand with success. Let’s just look at the basic numbers behind today’s glorified lemonade stands.
Japan’s Actual Market Story
Japan. In 1989 its Nikkei crashed after a much envied real estate and market bubble (fed by easy credit and irrational herd behavior—aka greed). Solution? Dial up their rich uncle (aka: the Bank of Japan) and shout “save me!”
And boy did this rich Uncle Kuroda step up. Today, Japan has 1 quadrillion (yes, one quadrillion) yen of government debt, standing now at a jaw-dropping 230% of its GDP. The rich uncle has been on a spree, buying every broken asset, bond and lemonade stand in sight, keeping Japan’s economy (its spoiled nephew) temporarily flush with Tesla-like living on broken lemonade stand like productivity.
With that much buying, you don’t need real customers in the market tundra. The uncle has a credit card with no spending limit. JGB’s? Nobody wants em? No problem: Uncle Kuroda will buy em (which might explain why the return on the 40 year JGB rose by 48% in the first half of 2016). The Bank of Japan now owns 426 trillion yen of its bonds—its own “lemonade.”
By the way, most of these bonds have no yield (and 8 trillion of them have negative yield) with no prospect what so ever of being repaid. The BOJ (Japan’s version of the Fed) is just one big fat bid—a perma buyer of what nobody else wants.
And where does the money to buy these lemon bonds come from? The answer is simple: thin air.
That’s right. Thin air. Think of a checking account with 10,000 Yen it. Now imagine having the power to go to a BOJ computer screen (let’s call it the “Magic Computer”) and add a few zeros to your account. Abra cadabra, you are now a multi-millionaire. Seem absurd? Yep. But again: that’s exactly how Japan (and the rest of the central banks) functions today.
The United States’ Actual Market Story
The US has a similar Magic Computer, and thus a similar story of the absurd. Remember 2008, when unemployed agricultural workers and cash-only strippers where taking out six figure liar loans packaged by Wall Street into MBS bonds which the rating agencies defined as investment grade credits that smart Ivy Leaguers from Lehman to Goldman then packaged and sold to the markets as magical beans that were in fact sub-prime manure?
Remember that sub-prime bubble fed by low rates (nod to Uncle Greenspan) and “irrational exuberance”? Remember it popping? And what did the US do in the rubble of its own free-market collapse— its own frozen tundra moment? Well, it speed-dialed its rich uncle.
Yep. Just like that American lemonade stand in Siberia, the post-08 America had a brilliant idea: let’s call Uncle Bernanke and Aunt Yellen, print 4+ trillion dollars out of thin air with our Magical Computer, cram interest rates down to the zero-bound for 110+ months, squeeze the yield down on the 10-year treasury to 1.3% (a low we haven’t seen since 1790) and create the biggest junk bond, credit, equity, and housing bubble in market history and then call that a “recovery” every chance we get. (Sweet lies are often so much more comforting than hard truths).
Since 2008, the stock market, just like that lemonade stand entrepreneur in Siberia has literally been drinking its own lemon juice on money handed to it from the Fed to the tune of $7T in stock buy-backs, money which goes to the C-suite (i.e. management) not back into company re-investment.
In other words, the lemonade stands have no straws, no lemons and no cups—just the G-4. Today, the US credit market/bubble is over $40T in size but its daily trading volume is less than 1.5%. In short: there’ll be no liquidity (i.e. escape) when you need it. When someone eventually wises up and yells “fire” in our bond market, the exit door will be the size of a pin-prick. But again, you won’t hear this on Bloomberg, NPR or the Barron’s cheerleading squads.
Europe’s Actual Market Story
Europe’s Magic Computer in Brussels, like its Uncle Draghi, has been equally busy supporting its Alaskan lemonade project. Its 10-year Bund returned a negative 20 bps because Uncle Draghi spent 90 billion euros per month buying its own bonds—i.e. the lemons no one else on that frozen tundra is willing to purchase.
The net result is an equally absurd faith that such a sovereign business model is sustainable—that soon sales in the tundra (i.e. productivity) will justify subsidizing that spoiled nephew out there with his Siberian juice stand. But as anyone who deals with spoiled kids—as well as investors—knows: handouts create bad rather than efficient behavior. (See: Reality Check & Spoiled Investors)
This kind of rich uncle support (“do whatever it takes, spend as much as you want”) is making honest yield impossible to find, which is why the return on European junk bonds had fallen from 11.5% two years ago to 3.5%. Add in taxes and inflation, and European investors are literally getting zero yield for incalculable risk. This is crazy.
China’s Actual Market Story
Ahhh… but certainly China, that great engine (40%) of global growth, that epicenter of brilliant fiscal and monetary stimulus has a smarter uncle than the rest of the world, right? Not even close.
In fact China is the biggest (and most dangerous) rich uncle of them all—caught in a bi-polarity between Keynesian free market thinking and a Stalinist control-complex. There’s nothing honest or free about Chinese markets, IP laws, media-spin, growth reports, bond regulations or productivity projections.
Instead, China represents the greatest, most inefficient, opaque and reckless rich uncle of the entire sample. Uncle Deng and his Magical Computer at the Peoples Bank of China takes the whole cake as the poster child for the truly unbelievable. Sitting on the greatest debt pile of all four uncles, China has been playing out the greatest credit spree in the history of the world. In the last two decades, its uncle’s balance sheet has expanded 100X from $40B to $4T.
(BTW: since the dot.com lemonade stand, the total global public and private debt level has risen 6 fold from $40T to $225T. That kind of world-wide debt and magical money, of course, buys a lot of lemons.)
So what does the Chinese lemonade stand have to show for it? Well, just outside of Shanghai, a developer recently completed a full, to-scale copy of the Pentagon (imagine that, the Chinese copying things?) and designated it as a shopping mall. Only one problem: there isn’t a single store or shopper in the mall. (See: Shanghai Empty Mall)
This is no outlier example of the absurd. Such “Siberian lemonade stands” dot the entire landscape of the so-called China miracle. With over 1.4 billion tons of steel over capacity alongside massive overspending in ghost infrastructure and real estate projects (Chinese cement consumption in the last three years is the equivalent to 160 Hoover dams in each of our 50 states) we can plainly see why China’s 65 million empty apartment units will not make for good collateral in further debt-roll-overs.
This is just crazy. But the truth is often stranger than fiction. Instead of a Chinese miracle lemonade stand, we have a Chinese bubble machine and ticking time bomb—one which fully explains recent bubbles of crude oil (who else but China’s Ponzi scheme demand could explain $100 barrel oil?), copper, iron ore, aluminum and nickel.
The Chinese State-Owned Enterprises (SOE’s) carry a debt that surpasses 180% of Chinese GDP—a figure so absurd it makes the lemonade stand in Siberia seem like a safer bet. By the way, once China has its visibly inevitable “08 Moment”—the rest of the world goes with it. That’s what happens when the “engine of global growth” stalls: the passengers stall too.
Hard to Believe, No?
So we close with the rich uncles. Hard to believe they could be so crazy to support such lemons, but today’s BOJ, FED, PBOC and ECB are literally doing nothing more than put their respective economies (spoiled nephews) on a VISA Card paid for by the Magic Computer which just adds zeros to sovereign balance sheets literally out of thin air.
But we all know what happens to spoiled nephews and rich uncles. Eventually there has to be consequences to one too many handouts. As for that Magical Computer in Beijing, Brussels, DC and Tokyo, at some point it creates a monster.
Diluted Currencies Trading on Faith Not Value
Currencies created on screen get circulated into the real economy one way or another. (in other words: the velocity of money does its inflationary thing. (But more on the inflation/deflation duel in a separate blog.) And if you add too much alkaline to an acid—you dilute its base, just like adding gallons of water to a glass of lemonade dilutes the flavor.
The same is true with currencies. All over the world, these rich uncles and their reckless monetary policies are diluting their fiat currencies and inflating asset bubbles while not generating any more real income/productivity than those metaphorical lemonade stands out there in that fictional tundra.
This may seem like a gross over-simplification. Unfortunately, it’s not. Things really are this crazy. At some point, however, the reality of our non-fictional absurdity has to play out, despite the Teslas, the waving flags, the cheerleading and the caramel lattes we distract ourselves with.
At some point our rich uncle runs out of effective money, and when he does, those lemonade stands on the four corners of fantasy economics go bust.
At some point, the bond managers, funds and markets look at their negative to flat yields (all the direct result of that Magic Computer) and start to yell “sell!” and there won’t be enough rich uncles left to buy those falling lemons. Or if they do, the money itself will be inflated beyond much value, diluted—like bad lemonade.
July 17 2017