Party time or time to be scared, very scared?

9 min read

The Nasdaq index both traded and closed above 6,000 points for the first time ever, the S&P closed just seven points below its own record of 2,388.61 and the Dow is, at 20,996.12 so very close to getting back above 21,000 and its own record high close of 21,115.55 achieved on March 1.

The question as to whether this is a bubble is fatuous because it is as close to axiomatic in markets that a bubble only becomes a bubble by bursting.

The French election effect, which truly troubles me for its blindness to the realities of managing a country that is still quite firmly in the hands of trades unions, themselves as mad as a box of frogs, is being turbocharged by some pretty ritzy corporate results out of the US and then fired up further by the anticipation of radical corporate tax reform at the hands of Trump the Disruptor. Buy on rumour, sell on fact?

Not for the first time in the past couple of years I have wondered how and where the stock rally stops – no asset class is better at convincing itself that it is correctly priced – and I keep on coming back to the very basic argument that until bond yields are significantly higher than dividend yields the beat will go on. And that brings me back to bonds and to the yield curve.

CASH AND CARRY

I heard a strategist recently suggest that the strong rally in bank stocks had been driven by the steepening of the curve. Let me explain.

Borrow short and lend long has been one of the drivers of the banking industry. The positive slope of the curve enables banks to borrow short term funds from the central bank, only to lend the money back to the government through the purchase of longer dated bonds. Older members of our guild will recall the time when Alan Greenspan froze short term rates at 3% in the aftermath of the great Savings and Loans crisis in the early 1990s. Without knowing it, taxpayers were bailing out the banks because the authorities, through the money markets, were giving the banks cheap money that they lent back to the authorities at significantly higher rates. The positive carry, or profit if you like, was there to rebuild the banks’ balance sheets. It was, in other words, an invisible bailout and one of huge proportions.

The losses in the post-2008 crisis were far too large for a bit of yield curve manipulation to suffice for the purpose of recapitalisation of the banking system while at the same time QE was aimed at flattening the yield curve in order to encourage long-term capital investment. The authorities might be able to regulate the banks but they can’t regulate the corporate sector as a whole and, having taken the cheap long-term money with thanks, companies have simply gone out and bought back shares. Let’s face it, if long- term executive incentive schemes, the flavour of the last decade or so, are linked to stock price performance, what is better than for the authorities to hand the boards a bunch of cheap cash with which they can implement a buy-back programme, pump up the share price without taking any entrepreneurial risk whatsoever and still get paid as though they had.

Cheap long-term money might be good for the corporate sector or at least for its grandees but it’s not a money-spinner for the banks. Oh, and just to help the executives get richer quicker, the ECB has bought and holds €81bn in corporate bonds.

So whence the huge rally in bank stocks? In a feat of extraordinarily un-joined-up thinking, investors in bank stocks are expecting a steepening yield curve and hence for better earnings for the financial sector. I continue to believe this to be wishful thinking.

BALANCING ACT

I glanced over some piece yesterday that suggested the Fed shrinking its balance sheet would be tantamount to monetary easing. The author had some spurious argument about a reduction in bond purchase by the Federal Reserve leading to the release of funds from private sector sources and….I didn’t get the argument. If shrinking the balance sheet were to be easing, then Fed bond purchases would have meant a tightening effect. The chap who was trying to argue this quite seriously had his knickers in a twist.

My contention is that the long period of ZIRP and NIRP has created an interlocking system of false values that can be stopped no more gradually than can a bicycle by prodding a stick into its spokes.

The leakage around the Trump tax reform went on with a repeat of the idea that repatriated corporate profits would be waved through with a nominal 10% taxation applied. This would not be, by the way, the first time that tax breaks have been offered for on-shoring stacks of earnings and if Trump thinks he can hypothecate these earnings for capital investment and not for dividend payouts, history is not a good place to look.

The issue of the missing US$1.5trn, which the healthcare reform was supposed to release to the Treasury, cannot simply be dreamt away and whatever fandangos have been built into the revised packet of tax proposals, they can’t be replaced. Since the financial crisis a trillion doesn’t seem to quite as much as it once was. To put it in context, however, total annual US federal US tax-take amounts to “only” US$3.35trn. We don’t of course yet know how much the proposed tax reform will take out of this figure but you can be sure that whatever supplementary economic growth the dynamic model projects going forward, it will not result in anything that helps to bring the budget back into balance. At best it will lead to new credit cards being taken out in order to pay off the old credit cards, at worst it will be taking out new cards to pay the interest on the old ones and taking out even more new ones to meet the minimum repayments.

I read Michael Lewis’s book “The Big Short”, the story of the collapse of the sub-prime mortgage bond market, when it first came out all those years ago but I was only recently presented with a DVD of the film version. It brought back a lot of memories, both good and bad. It also left me thinking that what the Donald seems to be doing is turning the US government into one huge sub-prime CDO, albeit one where all tranches are erroneously imbued with a AAA rating.

The book raises a very good point and one faced by me and my old chum Ifti Ali, erstwhile head of proprietary credit trading at Bank of America in London, when in 2007 we bought US$300m five-year CDS protection on US sovereign risk at 7bp from Bayerische Landesbank in Munich. If the brown stuff really hits the propeller, will the counterparty still be there in order to honour the obligation? What if you had bought protection on your sub-prime CDOs from Bear Stearns or Lehman Brothers? Currently we are living with the Treasury being guaranteed by the Fed.

In 2008 the failing financial edifice was propped up by government. The debt didn’t go away, it was just owned by the taxpayer. I can’t see the private sector being willing or able to take it back, least of all at such derisory interest rates and at zero to negative real returns and hence I don’t think central bank balance sheets will shrink in the foreseeable future by more than the minimal amount needed for a press release. Thus the yield curves cannot and will not steepen by as much as bank stocks would need to justify current valuations.

I rest my case.