Don’t hate the player, hate the game

Central banks are more important than politicians, do you agree?

I had this argument with a very politically interested friend a year or so ago now.

My point was that the true cause of inequality, especially since the financial crisis, was low interest rates and QE which drive a structural widening of the wealth gap, more powerful than any policy, including austerity.

He was apoplectic about my dismissal of politics, and perhaps rightly so. But in his line of work as a journalist and reporter, he sees the direct impact of politics on poor people and is often rightly outraged.

Whereas in my role, I have endeavoured to understand the structural driving forces that central bank policies direct.

The resolution was that perhaps we should both find out a little more about the other’s view – as there was a pretty wide knowledge gap. Anyway, here’s my side of the argument.

Because in recent months I have been gently stewing about the actions of central banks yet again.

Nothing can sum up why better than the below:

Source: Tavi Costa, on Twitter

It charts the growth in Federal Reserve assets (aka how many securities it has bought in order to subsidise government debt support the economy), vs wealth inequality in the US.

If you invert that growth (display it upside down), it tracks directly the decline in the share of assets owned by the bottom half of society in the US.

What this chart shows is that the more the Fed grows its balance sheet, the worse off the already worse off become, relative to the better off.

When central bank balance sheets grow, wealth inequality widens.

Why is this?

The answer ties in with the inflation question. Everyone says we haven’t had inflation. But we have – it’s just that our chosen measure of inflation has just decided not to include it.

The things that have inflated are the values of stocks, bonds, houses and other investment assets. So in 2008, if you were already wealthy and had those things, you’ve had a phenomenal decade.

Because central banks have been injecting liquidity into the financial system, through banks, in order to juice the economy. They have also kept interest rates low.

That has had two key effects – low rates make stocks seem more attractive (because their profits are higher relative to the base rate, when calculating future cash flows).

This is why growth companies (high-growth low-return business) have massively outperformed value companies (which have profits now but low-growth), and so you get charts like this:

Source: Zero Hedge on Twitter (welcome back!)

And this:

Source: Koyfin

That’s a chart which shows that the amazing growth in stockmarkets is actually pretty narrowly focused on technology – classic growth stocks where huge profits are ever promised much further down the line. Sometimes it works out, but not always.

Here’s a similar idea, which shows that again, broadly the indices are not that ahead of themselves – but tech is once again skewing the average in a big way:

Source: Koyfin

Again, this shows that since the middle of 2015, most sectors have performed within a normal distribution – some better, some worse, but nothing extravagant.

The exception being energy (XLE – dark green) doing terribly as oil stocks have underperformed slowly and quickly, and technology (XLK – light green) which has outperformed by more than double its nearest challenger.

So, it’s worth bearing in mind (speaking primarily to myself here) that not everything has gone mad and not everything is at record valuations, but some things are pulling up the averages and making the whole market look historically overvalued. But we’ve seen this before…

Source: Chris Cole, on Twitter

Those are ironic charts, because this whole story could be said to begin at the bursting of the last tech bubble – in 2001.

The US Federal Reserve, unshackled by the historic tether with gold, was learning that it had more power than it knew. Then, as now, it responded to a bout of stockmarket anxiety with a significant monetary stimulus package.

(By the way, I do believe that central banks were compelled to act earlier this year, and did so pretty well, but the problem is not what they do in a crisis – but after one.)

Too often, central banks act as firemen at a burning house – but then don’t turn off the taps, causing a medium-sized fire to turn into a pretty serious flood.

Balance is everything, as I’ve said before, and balance would require central banks to pull back once calm was assured.

But they don’t.

They never do. Like a junkie, just asking for one more hit of liquidity, or maybe some fiscal, the stockmarket demands payment. It’s not stimulus any more, it’s life support.

The first bubble was the tech bubble, which led to the largest bear market in American stocks since WW2 – the dotcom bust.

The second bubble was even bigger – 2008, and drew central banks into record low rates and QE. And now look where we are – more indebted than ever, rates still on the floor, and desperate for even more gargantuan stimulus.

And it’s all because central banks have been all too willing to cut rates and all too hesitant in raising them when times are improving.

GDP since 2008 ranks as the most anemic of any bull market, and inflation has been non-existent. But inflation in asset prices – houses and securities – has been huge. Wealthy people own them, not poor people who live off their wages. And wages have stagnated.

Not only that, but the pay for CEOs and executives has risen far faster and further than for average workers – 940% further since 1978 in fact.

And what does all that coincide with? Deflation and falling rates, as mandated by central banks. Here’s a chart of the Bank of England base rate in the UK:

Source: FRED

Lower rates incentivise taking on more debt (because interest payments are lower) and so growth is bought, rather than made. It’s inorganic.

Inflation paints the same picture, peaking in the late 1970s (chart is for the US):

Source: FRED

Back in 2014, when Jerome Powell was just a person and not the CEO of global finance, he said this: “The federal budget is on an unsustainable path, with high and rising debt. Over time, this outlook could restrain fiscal policymakers’ willingness or ability to support economic activity during a downturn… The debt is growing faster than the economy and that is unsustainable.”

That man is now head of the Fed, and responsible for the most rapid expansion of debt in history. The Fed is charging beyond any other central bank worldwide.

  Source: FRED

The jump at the far right of the chart represents the amount of monetary stimulus the Fed has unleashed in 2020, by buying both government and corporate bonds. It dwarfs the 2008 response.

The big debate is whether the Fed is trying to support the stockmarket, and last week we got some interesting points on this.

Two Thursdays ago, indices plunged – some by around 7%, the worst day since March.

Within a week, Powell has announced that the Fed would also be buying individual corporate bonds – not just corporate bonds ETFs (which by the way, he has huge personal holdings in).

This gave relief to the stockmarket, which quickly halted its slide.

But outside of markets – no turmoil was present? Fears of a second wave were rising, but while they were always there, markets were essentially functioning normally.

When asked at a Fed meeting if he was worried about the Fed’s impact on a developing bubble in stockmarkets, Powell dodged.

“We’re supposed to be pursuing maximum employment and stable prices, and that’s what we’re pursuing.” His actions suggest that he has very much u-turned now that he’s on the inside, being pressured by the president via Twitter.

Speaking of people changing their views once they’re on the inside, how about Donald Trump in 2016: “They’re keeping the rates down so that everything else doesn’t go down. We have a very false economy, at some point the rates are going to have to change. The only thing that is strong is the artificial stock market.”

Given my strongly held belief that extended QE has damaged the economy by increasing debt, limiting creativity and putting a ceiling on wages and productivity, you can imagine that Powell’s comments bugged me.

But let’s get on to the final bubble. The cause of the current bubble, and the most dangerous idea in investment.

The idea has been growing for some time that you can invest according to what the Fed is doing.

That if the Fed is buying so should you.

That a “Fed Put” exists – where you can bank on the Fed coming in to save us if the stockmarket falls.

This is not a new idea.

It was common to see the Fed’s input after a crisis as a potential reason for optimism after a bear market. This goes back as far as 1929-33, and 1921.

This idea has been growing lately, until now it seems to be reaching almost a “peak consensus” moment, where its response to Thursday’s crash a couple of weeks ago was so immediate and so unwarranted that it seems to many that it must be true.

But remember, the market is designed to exact the maximum amount of pain on the maximum number of participants.

Just at the moment when it becomes folly to bet against the Fed, then that idea will have reached its limit.

It has never been more dangerous to believe in the Fed, in my opinion, simply because so many people already do.

Goodhart’s law states that when a measure becomes a target, it ceases to be an effective measure.

People started to notice that Fed action came near the end of bear markets. So those smart people started investing when they saw this. The Fed then noticed that this happened, and now we have the situation we’re in now where weeks into a market crash (it took two years after 1929), the Fed has gone bigger than ever, and markets have rallied immediately.

The Fed’s support cannot get quicker, and it cannot get bigger forever.

Russell Napier points out in his book The Anatomy of the Bear that if you had bought stocks on the first injection of liquidity in 1931, you would still have suffered a 69% decline before markets bottom.

Likewise, after a brutal two-year bear market, if you’d seen the central bank action in 1932 as a sign to buy, you’d still have lost over 30% before markets bottomed the following year.

Fed watching is not new, and it doesn’t always work.

We are nearing the point of maximum gullibility in the idea, and so we must be extra cautious, because the damage if it fails will be severe.

Making and preserving wealth does not require you to squeeze an extra 10% or 20% out of stocks in 2020.

It requires you to never lose 40% or 70%. If your portfolio falls by half, it must double in order to regain its position.

At average stockmarket return rates, this could take anywhere between eight and 15 years. Even just eight years of zero growth would be crippling, especially if inflation does return.

To conclude, growth and tech are driving a bubble during the fastest and deepest recession since the Great Depression of 1929.

That bubble is itself driven by a bubble – not in stocks, but in an idea, the idea of central bank support being forever a positive thing.

But that positive thing has caused worse inequality than almost any wicked or average politician has manage, especially since 2008.

At times like these, when all others are losing their heads, we must keep ours because wealth in not built in a month or a year, but in 20, or 40.

The number one protection against the excesses is gold, other precious metals, and even miners if you can handle the volatility in a broader market crash.

That’s why so many of us here at Southbank Investment Research keep talking about it.

It will hedge against the bubble in faith in central banks.

So please, keep an eye out for our gold investing service in the coming days – it looks like gold may just be breaking out of its little range from the last few weeks. It’s consolidated, and could be set to break out. This chart dates from late last year to today:

Source: Tracy Alloway, on Twitter

One of my colleagues has been working hard to bring you the best research and investment recommendations in the gold and precious metals space, and it’ll be coming your way soon, so an eye out for it.

Sorry for the long note by the way – but to be honest, you could write a book about this stuff. I hope you found it a worthwhile read despite the length.

All the best for now,

Kit Winder
Editor, UK Uncensored

PS Don’t just listen to me – here’s David Stockman, who was director of the Office of Management and Budget in the Reagan administration (emphasis added):

It’s quite simple. The Fed has unleashed the greatest torrent of liquidity ever, and it’s finding its way into a relentless, massive bid for risk assets.

Since the eve of the Lockdown Nation disaster on March 11, the Fed’s balance sheet has erupted from $4.3 trillion to nearly $7.2 trillion. That’s $32 billion per day—including weekends, Easter, and nationwide riot days.

Worse still, at their June meeting, the mad money printers domiciled in the Eccles Building promised to keep printing $120 billion per month to buy US Treasuries and other assets for an indefinite period. That should get us to a $10 trillion balance in less than two years’ time.

What this means, of course, is that honest price discovery in the canyons of Wall Street is deader than a doornail. We now have a putative capitalist economy in which the most important prices in all of capitalism—the prices of financial assets—are pegged, rigged, and manipulated by the central banking agents of the state.

The result, of course, is speculation and malinvestment on a biblical scale.

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