18 April 2018

A Deal With Kim

External events can swing markets both negatively and positively, and a deal with Kim will certainly be a positive market moving event.

This is one situation that could boost markets, and possibly hold off the eventual end of the bull market. I've attempted to look at factors or situations that could result in a collapse or sharp fall in US and Global equity prices, and lead to a recession or worse; this is one that could/will boost markets. 

The US and North Korea will "do a deal" on Nukes. That deal, like all deals with North Korea over nuclear ambitions, will be praised by those that sign them, lambasted by those not in power at the time of the deal (both in the US and across the Western allies), and will ultimately fail. There is simply too much for North Korea to lose, and not enough to gain, by cutting a deal that would be acceptable to the US.

In the next six months, expect a deal, and expect Trump to tell us what a great deal it is, and how only he could have made that deal, the best deal, the most historic deal. That Trump's talking tough was what brought Kim "Rocket Man" to the table, and that threat will make the deal work.

Being very clear however, Trump and more importantly Mattis, know that no meaningful deal is possible, and that the actual result will be a continued kicking of the can down the road. North Korea has nuclear weapons, and the actual strategy is to contain those Nukes in North Korea and to delay or avoid the further spread of nuclear weapons.

The deal will be hailed as a great victory for Trump. It will fail, but it will appease his base. It will also signal a reduction or removal of war-drums and associated tensions from the Korean peninsula for the next two to three years. That will be good news.

Quick History

Korea has existed as a divided peninsula for the past 65 years, following the cease-fire at the end of the Korean War in 1953. That cease-fire allowed for the entrenching of the Kim dynasty in the North, and a western proxy state in the south. It also created a base from which the United States could continue to exercise influence in the region, beyond Japan and the chain of islands off the Chinese coast. The "victory" of the West also demonstrated that there was a line, albeit not enforced with nuclear weapons, across which China could no longer expand.

Through the decades, North Korea has remained a Chinese client-state, balanced against the Western client-state in the south.

While in the North oppression was the rule, and questioning the Kims was a death sentence, in the South, eventually, democratic institutions and economic success created a wealthy and free society, with a Korean identity, to challenge the dynastic system in the North.

Korea is a society in which ancestor worship is core, and age-based seniority exists throughout society, North and South. In the South, that is reflected in daily life as children enter school, University and eventually the workplace, with each year ahead of them exercising a level of age-based power. In the North, this ancestor worship was used to venerate the elder Kim, and on his death, to anoint the son, and now the grandson. Challenge the Kim, and you challenge the ancestors, who you also worship.

The war, and reunification of the Korean peninsula remained unresolved for decades, and remains unresolved. Both side talk about reunification, but only on their terms. The South will never become a communist country, and the North will never give up the ancestor worship of the Kims, at least not without a fight.

Sitting on the side-lines are the US and China. While China may be the guarantor of North Korean independence, it comes at a price - North Korea must appear to play the game, and must not start a war of reunification. To do so risks a situation that might result in the US and China being at war with each other. China is not ready for that, or for the risk of such a conflict. Likewise, the South is willing to let the North eventually collapse, and to be ready to re-unify under conditions in which they act as the big brother bringing the North back into the Korean family.

Sitting outside is the US, the manufactured threat to the Kims and North Korea. Real or imagined, that threat, or the manufacturing of that threat, ensures internal cohesion and support for the Kims, and worship of the Kim dynasty.

So the North must bluster. And in their eyes, they must be ready to take on the US in Korea, in a fight that they know they cannot win in a drawn-out conventional war, assuming that the US (and its Southern proxy) are willing to suffer as much pain as the North is able to inflict and to absorb in defending the Kim dynasty.

The “Great Assumption”

Here the need for Nukes; the "Great Assumption".

When looking around the world, North Korea (and others) cannot help but notice that countries with Nukes do not get overthrown or invaded by the United States. The Soviet Union survived for decades after World War II, even though they were weaker and still recovering from that war. Yet the United States avoided war with them.

Iraq sought Nukes, and they were invaded first in 1991 (Desert Storm and the eviction of Iraq from Kuwait), and then invaded and their governing party and system overthrown in 2003.

Yet next door, Iran is able to thumb its nose at the US, is able to support uprisings in Iraq and support the government in Syria, without realistic threat of invasion or attack from the US. The difference? Nukes. The US was not able to stop the acquisition of enough enriched uranium and associated technology to ensure that Iran does not have the bomb, and this ambiguity has inoculated Iran from American regime change.

As far back as 2013 Israel was suggesting that Iran already had nuclear weapons“It’s too late for Israel [to prevent an Iranian bomb]. Iran has crossed all the borders and all the constraints, and it has a first nuclear bomb in its possession, and maybe more than that,” Yerushalmi writes, basing himself on what he says is the assessment he heard this week from state security sources. “We are facing a historic change in the strategic balance of forces in the region.”

Likewise Pakistan, a country that has funded terrorism, gave refuge (not officially we are told) to Osama Bin Laden, Taliban leadership and a host of others, and served as a base for terrorist attacks in India including the Mumbia attacks. Pakistan should be in the cross-hairs for regime change, yet as a country continues to receive billions of dollars in "aid" each year. Pakistan has the bomb, and therefore is untouchable, even though it has unofficially sold of allowed the sale of nuclear capability.

Syria, working under the same Great Assumption, had a program to develop a bomb or capability. That was bombed by the Israelis in 2007, flew fighter-bombers over Lebanon and destroyed the Syrian reactor before it could become operational. There is nothing quite like a cute name for a bombing mission. Something like "Outside the box". 

Fast forward to 2011 and the Arab Spring, and soon Syria was in the cross-hairs of Western leaders and calls for regime change and the removal of Assad. Years later Syria is a destroyed country, one that formerly was a shining start of secular economic moderation. Certainly a multi-year drought in the Middle East has not helped, but external support has funded the destruction of that country.

Even Libya was rumoured to have nuclear ambitions, and publically disavowed those in 2003. While there is no direct linkage to the Arab Spring and Western involvement in the overthrow of Gaddafi, the lack of a viable nuclear program certainly cleared the way for aggressive support for rebels.

And so the Great Assumption - if you have a nuclear bomb, you are safe from attack by the West, at least any attack that is designed to overthrow your government.

The Need for a Deal

The deal will happen, because all the key players need a deal, if for no other reason than to allow all to get back to what they were doing before the flair-up. The five countries directly involved each have reasons to want a deal, but those reasons are not the same as needing a deal that actually results in the denuclearisation of the Korean peninsula.

All parties know that nukes are now a part of the Korean political and national landscape. The only remaining question is what the US will offer to South Korea to stop them from developing their own atomic weapons, if they have not already done so.

South Korea:

Certainly South Korea wants a nuclear free Korean peninsula, but it is not going to get it, and it knows that. The next best thing will be an agreement that defacto limits the number of Nukes in the North to a relative handful, and that buys the South enough time to develop and produce their own nukes and refine their knowledge of exactly where and how to hit the North if it comes to that.

South Korea wants closer ties with the North, and economic ties. Not for reunification, as that will actually, following the West German / East German reunification, be a tremendous cost to the South Korean economy for a decade or more. Over twenty years, German reunification cost approximately €1.3 trillion (or almost $2 trillion)

South Korea wants quiet, and peace, and trade. All of those are threatened by the current noise.

Japan:

Like South Korea, Japan wants quiet, and no missiles landing in their waters, or flying over their islands. They would love to see a nuclear-free peninsula, but they know that will not happen, at least not without a war, and they most especially do not want a war with nukes involved. They want a deal that brings quiet.

China:

The last thing China wants is a reunified Korea, under either the North or the South. Therefore China needs a deal that ensures a "protected" North and constrained. China would be very happy to see the North dismantle its program, and decommission the bombs.

While China would like to see, and build, a sphere of influence in Asia that is not threatened by the US or American allies, it also knows that economic power is what will grow China and create an intergenerational strong China. Control of resources and economic power can be soft, and China will build a soft empire; is already building a hard empire in the South China Sea.

The inner ring of islands, Taiwan, Japan, and in a logical sense, Korea, will not be going away. Certainly there remains the intention of reunification of Taiwan into a single China ruled from the Communist Party, and this may one day become a reality, preferably by negotiation. But that ring of islands will not go away, so the best option is to exercise leverage over each.

In the Koreas this means ensuring no reunification in the foreseeable future, but also no war, especially no atomic war so close to home.

China will support a deal, even if it only pushes the problem into the future.

USA:

Trump and the US need a deal to save face. The US cannot go to war with North Korea, therefore a deal, almost any deal, is needed to avoid further erosion of its position in Asia, and with that a continued shifting of authority to Beijing. Without a deal, at home the Trump administration will appear weak on foreign policy and unable, with all the bombs and ships, to bring a tiny adversary to heel.

North Korea is, without the cast, music or comedy, the Mouse that Roared, and unless the US can do a deal, the world will perceive that the US lost. And losing is not something that Super Powers do, as this undermines their position as protectors of their surrogates, and leaves openings for alternative powers to displace them.

At risk for the US is not just South Korea or Japan. Without a US willing to stand up to North Korea, let alone China, Taiwan will look for a deal with Beijing leading to the closure of any US bases and the reunification of Taiwan into China. The Philippines already is experimenting with just how far it can move toward China.

This will continue around Asia.

The US needs a deal, and Trump needs a deal; more than North Korea needs a deal.

North Korea:

But North Korea does need a deal, just not as badly as the US. Economic sanctions can be suffered through, and the Chinese and Russians certainly will cheat when the US is not looking too closely. People will starve, but that is an acceptable price to pay to keep the Kims in power and preserve worship of the Kim dynasty.

But North Korea does need to trade, especially with China, and that will lead to a deal. China's influence should not be either over- or under-estimated. And China needs North Korea to do a deal.

So North Korea is reaching out to make a deal. After all, they have inoculated themselves against regime change by the US, and therefore it is now time to reap some of the benefits of that investment, through more open trade to avert famine and economic collapse at home.

The stage is set.

What would a Deal look like?

We should expect extended talks, interrupted by Tweet-storms suggesting failure then success (repeat) and an eventual "deal". The entire purpose will be to buy enough time to make it appear that everyone is getting something.

North Korea will agree to international inspectors.
The US will reduce sanctions once inspections have begun.
International trade with North Korea will recommence.
North Korea will promise to dismantle its existing nuclear weapons and program.

We do not know what the behind the scenes agreements will be, the secret concessions that the US will make; the sweeteners for South Korea, the promises to Japan and China, or the "we'll pretend not to look too closely for the next few years" promise that the US will make to Kim, as long as he is not lobbing missiles over Japan, or anywhere else for that matter.

How it will be sold

China, Japan and South Korea will look at any deal for what it is, a ploy by two dictators to attempt to look like they won, and the other guy capitulated. No one in those three countries will gain any comfort from the deal, other than the comfort of knowing that things will go back to being quiet again, so they can get on with their lives and businesses.

In the US, Trump may even hold his victory parade, complete with marching soldiers, tanks and jet fighters. He will not, I desperately hope, get off Air Force One and hold up his "Peace in Our Times" meaningless piece of paper, though he probably will sign a proclamation of victory in the White House. 

North Korea of course will hold a victory parade, and the people will be told that the US has been defeated. The Kims have brought peace to the peninsula, and reunification will happen, eventually, once South Korea understands the might of the North, and that they have been abandoned by the US. This will be sold as, and will be, a great victory over the forces of the West that have worked for decades to destroy the Korean people; They failed.

Kim's Peace in Our Time will be real, as he has proved the Great Assumption correct, and all he will now need to do is to carry on with the same game that North Korea has played for decades; agree and cheat.

Because in the end, all that the US wants is for the appearance of victory, while everything North Korea wants is victory and protection of the state that the Kims created.

04 April 2018

Will the US become the new Greece?

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This continues my series of closer looks at the seven areas I think can bring the 103 (now 105?) month economic expansion in the US to an end. The previous articles are here (overview)here (interest rates), and here (Inflation).
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When considering "Budget Deficits" we are naturally looking at Government deficits, and not the overall global debt load, a load that in and of itself should scare almost anyone. In addition, government deficits are not a US-only problem, at least not US government debt alone. Governments around the world have spent the past decade amassing an ever growing pile of national debt. This has been an easy way to stimulate economies, placate masses, and generally take advantage of the ability to make new, cheap money, or to access pools of "cheap" money.

What happens when the markets' perception turns, and easy government money is viewed as a liability that will push down economic growth? The answer is Greece, where crushing debt, and without its own flexible, sovereign currency, coupled with no external forgiveness resulted in the destruction of the economy, in a self-reinforcing cycle of negative government policies and economic collapse.

How long can budget deficits continue to grow before the markets decide that US sovereign debt is no longer "risk free", or that there are other options for making a return greater (and at equal or lower risk) than government debt? When will there be a tipping point of belief that deficits and national debt payments actually do matter, with the expectation of a drag on economic growth by allocation of national budgets to interest payments, greater probability of a recession, ultimately resulting is loss of market confidence (and reduced resilience should a recession occur)?

Couple the growth of visible budget deficits with the fiscal gap of promised future expenditure, and the outlook is even worse (though perhaps a subject for a future article).

There is a fine balance between Sovereign debt as a safe-haven, and the returns on sovereign debt being strong enough to shift money from other markets - especially if such strength is due to an increase return (the occasional spikes in Spanish and other European debt as a good example), and therefore the future drain on government coffers to pay the interest. Once those interest payments are perceived as being high enough to impact the economic viability of the rest of the economy, we could see a general loss of faith and an associated flight to any "safe" none-market assets.

It is fairly easy to see the reason for concern. Currently 6% of the Federal budget is required to make payments on the interest on the national debt. This is interest only, at an average rate of 2.32% for January 2018, which on a national (Federal) debt of $21 Trillion. This should represent an annualised total debt servings cost of $481 Billion, with no associated reductions in the outstanding debt. In fact, US Federal debt will continue to grow, and with that growth, an even growing servicing cost.

Currently the Fed 10-Year treasury rate is hovering around 2.8%. This is a .5% increase over the past six months effectively matching the increase in the Fed discount rate.

So what happens if the Fed does deliver 3 rate hikes in 2018 (2 more)? If they increase at the .25% rate, we should see a Fed rate in the 2.75% range from the current 2.25% rate.

All things being equal, we should then see the actual rate of interest paid by the US Government rise by .75% to around 3.1%. This excludes any sovereign debt risk premium should China and Japan stop purchasing US sovereign debt, or if there is another downgrade of US debt.

So if we then look at the total that would be payable on the $20.7 Trillion debt, (but for simplicity staying at the current level even though this debt will rise to closer to 21.5 Trillion by the end of the year). The increase to 3.1% across the $20.7 Trillion debt would result in an annualised cost of $642 Billion, an increase of almost $160 Billion.

Markets will look at that increase, and see a combination of increased government spending to fund that debt, and a compounding level of debt expenditure. If the current debt load on the US budget is at 6%, every increase squeezes the amount of government spending available for non-debt servicing expenditure.

This at a time when economists are predicting that the US will begin running almost perpetual $1 trillion deficits. The interest component of the Federal budget is going to rise quickly. The tipping point will come not when the debt can no longer be serviced, as that realistically is too far in the future to be meaningful in terms of market reactions (years, not months). But it will be the tipping point of lost confidence that such deficits can deliver economic growth. And that point is either very soon, or may already have passed.

In their 2009 book “This Time Is Different” Reinhart and Rogoff state that national debt above 90% of GDP results in falling GDP growth. This number certainly caught the headlines, and for a while was presented as a Great Truth. Of course, there were then numbers of papers downplaying that Truth, and highlighting potential errors in their calculations.

Yet their premise stood up to critics, in as much as the 90% threshold does seem to signal a future decline in GDP growth due to debt servicing headwinds at the national level.

The United States is now well past that level, with the current (Federal) debt load of $21 trillion, and State and Local debt loads adding another $3 trillion, for a combined government debt load of $24 trillion. This against a GDP of approximately $19.5 trillion, the US is already running at well over 105% at the Federal debt level, with an additional 15% debt at the State and Local level.

This entire discussion ignores, though it should not, the fiscal gap, and therefore excludes the future bow wave of additional, already promised expenditure. It was this bow wave of pensions expenditure and social support expenditure that ensured Greece would only dig deeper into debt, regardless of bail-outs. 

Both the US and the UK face such a systemic problem - over promise of future expenditure that is not already considered in existing budget and deficit projections. In addition, these future promised expenditures are not limited to the Federal government budgets, and we already are seeing pressure on state and local level pension and entitlement programs.

At some stage there will be a loss of confidence that the combined debt load is manageable, and that the predicted negative impact on growth either has begun or will be felt in the near term.

When that happens, the “US will be the new Greece”. That will not be a pretty picture.

10 March 2018

Inflation Expectations can kill the recovery - soon

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This continues my series of closer looks at the seven areas I think can bring the 103 (now 104?) month economic expansion in the US to an end. The previous articles are here (overview) and here (interest rates).
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Since the onset of QE (Quantitative Easing), also known as the printing of money, by the US, the UK, ECB, BoJ and others in the wake of the Global Financial Crisis, there have been dire warnings that this "new" money would create out-of-control inflation. We have yet to see that, but we will. TARP poured $700 billion into failing banks to prop up the economy, with too much of it ending up as bonuses in the pockets of the very bankers who almost killed their banks, and the economy with them. The FED then created $3.7 trillion more in QE . In Europe, the BoE created £375 billion more, and the ECB has bought €1.1 trillion in assets through the course of their Quantitative Easing (QE) programme.

Much of that money sent to major banks or corporations. The banks were able to take advantage of "cheap money" to rebuild their balance sheets and solvency margins, by passing on only a limited amount of the reduced borrowing costs of Fed (or ECB or BoE) money. In his Bank Performance Outlook for 2018, Chris Whalen points out the "Fed is still effectively transferring $80 billion per quarter from depositors to banks."

Additional stimulus has flowed into global economies in the form of budget deficits piling on debt to record levels. Yet still there is no meaningful inflation, and central banks continue to lament their failure to reach the vaunted 2% level.

Where is the inflation, and will there be an inflation shock? Spoiler alert, yes, but from wages and probably not from the cost of goods and services, although the recent announcement of tariffs may push inflation expectations in other areas.

First, we need to remember what inflation is, and why it occurs. Inflation is the general increase in the cost of goods and services across an economy, or the devaluation of a currency and the associated resetting of the costs of goods and services in that currency. We are told that inflation is caused by an increase in money supply over the increase in the supply of desired goods or services. Where there are too few mangoes (for example) and a high demand for mangoes, the price of mangoes will go up - inflation and good old fashion "supply and demand".

We cannot doubt that there has been significant increase in the supply of money over the past decade. M2 in the US, has almost doubled in the past 10 years, from under $8000 (billions) to just under$14000 (billions). As a reminder, "M2 is a measure of the money supply that includes all elements of M1 as well as "near money." M1 includes cash and checking deposits, while near money refers to savings deposits, money market securities, mutual funds and other time deposits.". Strangely that almost doubling of the money supply has not resulted in inflation in the average cost of goods and services.


Looking at the BLS (Bureau of Labor Statistics) there appears to have been embarrassingly low inflation over the past 20 years. One inflation calculator puts total inflation between 2008 and 2018 at 13.7%, or in dollars, it will cost $113.70 today to purchase what would have cost $100.00 in 2008.


The same money supply and inflation sites tells us that UK money supply, UK M2, has increased by 50% in the past decade, while we are told that inflation has been a "brisk" 29.4% over that decade. So while the money supply has grown from £1600 (billions) to £2400 (billions), it "only" costs £129.40 to purchase today what would have cost £100.00 in 2008.

Certainly the housing market in the UK has been on a multi-year boom, at least in and around London, and in the almost continually expanding London commuter belt. Property price inflation outside of the London catchment has been muted at best, and has artificially moderated the national average inflation.


So if inflation is the result of money supply growing faster than the supply of good and services, then where is the money going, and what does that tell us about what might happen?

We then need to consider a key attribute of inflation; not all goods, service or assets increase in price equally. The first set of US inflation data that I shared above seem to tell us that inflation is under control, or in fact not under control at all, if there is a target of 2% inflation. But over at the American Enterprise Institute, they have a chart that shows inflation broken out quite differently, and they should a roughly 55% inflation over the past twenty years. John Mauldin uses this table in his recent "thoughts from the Frontlines" on 3 March 2018.


What is so interesting about this chart is that the elements that link to a higher standard of living and higher potential income are the elements that are rising the fastest. While it also shows that wages have increased at a rate faster than inflation, there is ample evidence that such wage growth has been skewed to the higher income earners.

It shows healthcare and education growing at well over 100%, and far outpacing most other goods and services. These are the two key areas where potential impact on future standard of living are felt the strongest. Education directly contributes to an individual’s ability to find and retain higher paying work, and without that higher paying work, healthcare becomes less and less affordable. Without good healthcare, and the economic capacity to purchase quality healthcare, the ability to continue to earn at any level of income is impaired.

Which leads back to the original question; will an inflation shock kill the markets?

Not the inflation we have been seeing. The markets do not, and will not care about inflation in costs of goods and services that upper income earners consume. The increases, while nose-bleed levels for some goods and services, the incomes of consumers of those goods and services have risen at pace. This is not where the shock will come from. 

Inflation in almost all other categories has been constant, but as the BLS numbers show in the earlier graph, there has been little inflation in most goods and services. Fundamentally this is because there has been no shortages in those areas, and therefore no supply and demand need for costs to inflate.

However, the market "correction in February has already shown us what inflation can do, when that inflation is in the form of increased wages, when that increase is in lower and middle income wages, not those at the top. We can expect more.

If inflation is too much money chasing too little of a given resource, then the low unemployment rates in the US today, if you believe the 4.1% number reported by the BLS for January 2018, is that "too little" resource. Wages will need to increase to attract that resource, reducing future expected incomes for employers.

The name of the business function has said it all for the past few decades: Human Resources. Resources just like copper and wood, cash, electricity and fuel. Humans are now a commodity, and have been for decades, and that commodity price is about to rise. Inflation in the cost of this now theoretically scare "resource" will push up prices across the board.

Fourth Quarter 2017 (US) numbers should give us any comfort, with Productivity growth at 0%, yet Labor Unit Costs and Hourly Wages both being revised upward. This is not sustainable without real wage inflation, and inflation moving beyond the human commodity and into the wider economy. These number tells us that we should expect lower corporate profitability, lower free cash, and lower expected returns in appreciation of already overpriced shares.


So watch the monthly unemployment rate (with ADP projecting a 235,000 increase in payrolls for February 2018) and an announced 313,000 BLS-reported increase for February, and watch the wage data from the BLS.

These two provide an indicator of future inflation in the one major commodity area where the only way to "mine" new resources is to pay a higher price. The mangoes in case are humans, and there are not enough to go around. This means the mangoes (humans) will cost more - the classic definition of inflation, and the warning of problems to come across the economy.



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Next week I aim to tackle another of the seven areas that could kill this recovery.
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02 March 2018

Will Interest Rates kill the recovery?


In my "103 Months" post last week, I specifically mention seven areas that could bring about the end of the Bear market, and result in the end of this business cycle. First on the list was Interest Rates. I also specifically stated that none of the seven areas could take sole credit for a fall in the markets (and flow on negativity and economic contraction), and that each may be impacted by others, and impact others. Which will come first, an Interest Rate hike generated collapse in house sales, or a collapse in house sales spreading uncertainty resulting in an interest rate spike?

Markets exist to facilitate the effective application of capital. As such, capital will flow to the markets in which capital can be expected to deliver the greatest return to the owners of the capital. Capital will flow to assets with the greatest probability or generating the highest risk-weighted return. And while markets do not get this right all the time, generally markets sense where returns will be achieved, high or low, and move capital to those asset classes. The result has been capital allocation distortions. (It was interesting to write that first sentence, then to google the exact words - first place returned was the SEC

The mythical Rational Market Hypothesis tells us that open access to information ensures that capital will flow efficiently. This or course does not and cannot happen, as there is not free and open access to all information relevant to investment decision making. Different players have and always will have access to market moving information that is not available to all investors. In addition, a range of human and even algorithmic factors will ensure a different weighting of information by different market participants, ensuring a less than efficient market.

What does this have to do with interest rates?

Each time the Fed or the BoE talks rate hikes, the markets pause (for milliseconds sometimes) and asks if the higher rate will have a negative impact of economic activity, and thus on market value, or if Treasury Bills will deliver a higher capital growth, and therefore, is it time to leave one market and enter another (leave stocks, enter treasuries or other bonds). Business and investors have become so numbed to ZIRP (Zero Interest Rate Policy) that they have come to see any hikes as potential speed bumps on the economic highway.

Continued ZIRP has resulted in behavioural distortions, with a new set of assumptions, including current market reactions reinforcing self-delusional assumptions of market rationality. In the middle 2000s we were convinced that we had become expert at managing risk, now we believe in the power of monetary policy to ensure ever-expanding market value. This cannot end well.

In the UK, the change in the "Ogden rate" (the discount rate applied to large insurance claims, predicated on the assumption that large claims will be invested in the most conservative manner) in early 2017 provides a wonderful example of a political decision designed to reinforce the "end of boom and bust" narrative. A change in a long term discount rate from 2.5% to -.75% both boosted insurance pay-outs and imposed massive loses on the insurance industry (The rate is now under review). The political nature of the decision was in effect a reiteration of the UK government’s assumption or expectation that interest rates would remain in the ZIRP range for the foreseeable future.

ZIRP ensured a limiting of the range of options for capital, be effectively removing treasuries, US, British Gilts, Japanese, from the portfolios of available return generating assets.

The end of ZIRP has seen a steady increase in the retail cost of money. At some stage, that increase will be perceived as reaching a point at which users of credit will begin to make decisions to not invest, or not spend. Owners of capital will begin to ask if the markets will therefore continue to increase at a rate significantly higher than "safe haven" investments.

So what is that interest rate number that will move the markets?

Only this past week the Chairman of the Federal Reserve presented to Congress for the first time, with his upbeat assessment of the US economy having quite a strange impact. The Wall Street Journal reported: "On Tuesday, Mr. Powell made his first Capitol Hill appearance since taking over as Fed chief this month, where he underscored the improvement in economic prospects, which many investors took as a suggestion that the central bank will lift borrowing costs four times this year. “It now looks more likely that the Fed is going to tighten more quickly,” said Peter Elston, chief investment officer at Seneca Investment Managers."

The markets seem to be at a point where positive economic news itself causes concerns about interest rates, upsetting the fragile balance between shares as the probably area of best return on capital, and fear that shares will fall resulting in negative returns.

That fragility could tip either way, although the messaging would suggest a greater probability of a negative shock. Bad economic news (such as the reported fall in new housing starts) could hint at a slower pace of rate hikes while at the same time undermining confidence. Alternatively, stronger economic news could cement more rate hikes sooner, again undermining confidence in the markets as the source of future capital appreciation.

Further, that fragility is all about perceptions and perceptions of perceptions. Will rates increase? If rates increase, will shares fall? If shares fall, will that force rates higher, or will a continued fall in shares erase gains. Should gains be "locked in" by selling now and putting the capital into "safe" options, and ride out a fall in share values, while earning more interest on the bonds / treasuries?

The Fed rate after all flows through into mortgage rates, auto loan rates, student loans, and credit card interest rates. All of these have a direct impact on individuals' economic behaviours and choices.

So if we game this situation, it looks something like:

  1. Fed increases interest rates, reaching an eye-watering 2.5% by mid-2018.
  2. Following a Fed rate rise event, markets expect reduction in mortgage lending, increase in credit card interest, reduction in auto loans.
  3. Market data is released showing a drop in new mortgage applications.
  4. Home builder and real estate stocks hit.
  5. REITs drop on expectation that housing prices will stabilize or fall.
  6. Contagion across industries creates further falls in equities.
  7. Holders of capital determine that treasuries will provide a "no loss of capital" position and that shares have created a "capital at risk" situation.

As the "rational" market distributes and creates information with an inequitable and non-transparent distribution, individual market participants reach widely different conclusions, ultimately coalescing into a consensus that the stock markets are no longer the best place to hold or invest capital for a time long enough for stable bottom to be found.

In this way Interest Rates may provide one of the catalysts for a substantial and sustained drop in market values. This is only one of the seven situations that I discussed last week. Next week we'll look at another of the seven.

What remains clear is that in a world with so many potential contributors or drivers of a change from Bull to Bear, there is no single non-interconnected economic or political situation that will be "the cause" of the coming end of this expansion. The big question will be which, through the lens of history, will carry the "blame".