US & Americas Political Macro Commentary – January 21, 2022

Nicholas Glinsman | January 21st, 2022

COMMENTARIES

·         Preview of next week’s FOMC meeting

·         US Fiscal Update according to Joe Manchin

·         The dangers of multiple asset bubbles at the same time – treacherous waters for the Fed

·         Some notable charts for the current market environment

Preview of next week’s FOMC meeting

As you may have gathered, I am very suspicious of this Fed and its determination to fight inflation. Hence, to be convinced otherwise will take action rather than words. So, at present, my base case is that the FOMC will simply say the conditions for a rate hike will soon be met, which will signal a rate hike at the March meeting, with no action taken to accelerate the end of QE.   

Nonetheless, the markets have moved quite some distance, in particular the bond market, which actually opens up a range of options that will be seriously considered at the FOMC, and a number of the alternatives have now become increasingly compelling to many policymakers.    

How did we get here?

After December’s meeting, the consensus view was that the FOMC was deliberately minimizing the probability of one mistake – raising rates too soon if inflation reverted to the pre-Covid dynamic – knowing it then elevated the probability of a different mistake – raising rates too late if inflation dynamics had indeed changed (Bill Dudley’s fear). However, the markets were not considering the possibility that the FOMC decided that higher inflation was more persistent than expected. There would be a negative reaction, and furthermore, the policy implications would be equally stark.

Consequently, even if inflation follows the FOMC median projections and decelerates later this year, policymakers now tend to think that the previous inflation dynamic has been broken decisively.  As a result, without actually changing its narrative on inflation (or inflation expectations or the labour force participation rate), the Committee has found it untenable to wait for that slowing before starting rate hikes.

The mistake of waiting too late did not mean a disaster in terms on the FOMC’s choice, because the Committee does not see a dire inflation outlook.  But it did mean that the changes to the policy outlook were not going to be incremental.  As such, there are now three main outcomes for the FOMC’s decision next week, in order of probability:

1.      Change the policy guidance to indicate a March rate hike.  Keep the March date for the end of QE.

2.      Change the policy guidance to indicate a March rate hike.  End QE immediately.

3.      Raise the policy rate target by 25 bp and end QE immediately.

The argument against taking some action in January now rests almost solely on the fact that no policymaker has signaled it, when the leadership had numerous and recent opportunities to do so.  That is not an economic argument.  Current market pricing suggests most investors see only very small odds of an actual rate hike next week, which is consistent with the Fed’s recent commentary.

The economic case is well established:  inflation well and persistently above target, employment at or near its current maximum, inflation dynamics are not reverting to the pre-pandemic case. However, given how fast the policy debate has advanced in recent weeks, the lack of guidance is not nearly as powerful an argument as it once was given that a consensus for immediate action could emerge quickly.  Indeed, the argument to wait until March is weak aside from its violation of the commitment to forward guidance.

Also, it is quite possible that a number of policymakers want to show that policy is not too far behind the curve.  In that way, a January surprise could be seen by some Fed officials as worth the shock and fallout in financial markets if it was an effective object lesson about the FOMC’s willingness to shrug off a norm that is simply slowing down the implementation of a decision that is in effect already made. Yet that norm is a powerful one, to which Jay Powell has adhered consistently.

Albeit the baseline remains that the FOMC will simply signal a March move (Option 1 above), it is not too much of a stretch to think that some sort of action next week will be compelling to many policymakers, damn the lack of guidance. Nonetheless, the cost of following either Options 2 or 3 above is that if the FOMC is willing to make a move without having given forward guidance, many bets are off and the distinctions between the remaining options will then not appear as great as they had seemed beforehand.

Let’s consider the language of the FOMC statement in each case.  Note, we think the economic assessment would be the same with any of the options; that will likely include the observation that there has been substantial progress/rapid progress toward maximum employment.  Only the conclusion in the policy paragraph would differ. Whatever decision is ultimately reached, there has to be some chance of drawing dissents, albeit a few.

US Fiscal Update according to Joe Manchin

One might have thought that Democrats would have nursed their wounds and regroup to start the new year and coalesced around a more targeted Build Back Better (BBB) plan, along the lines of what can actually be passed by the 50-50 Senate through reconciliation.  Following the political theatrics of the Voting Rights Act and Filibuster reform both being defeated, it would have made political sense for Democrats to pursue a more limited bill that can be passed.  But this being Washington DC. that does not seem to be the case, and after a week of internecine internal party sniping, including threats to primary the two Senators who did not go along with filibuster reform, Joe Manchin and Kyrsten Sinema, as well as other forms of pressure on those two Senators, Manchin today poured cold water on the idea that a revised BBB will likely see a vote anytime soon.

When asked about prospects for BBB, he replied: “we will just be starting from scratch [on BBB] … a clean sheet of paper.”  Manchin also clarified that his December offer is now off the table.  He then listed all the things that had to happen before he cuts a deal: “Get your financial house in order.  Get this inflation down.  Get COVID out of the way. Then we’ll be rolling.”

Those who have underestimated Manchin’s resolve in the past have learned that he is serious about his positions, and coming from a deep red state, he does not fear a Democratic party primary challenge.  As a result of his current stance, the chances of a slimmed down BBB agreed to in time for the March 1 State of the Union have further declined.  The ingredients needed to get Senator Manchin and the House progressives on the same page to get something passed (likely to include climate, ACA reform, and possibly early education) are not likely to come together based on any artificial timeline, but rather will hinge on recognition of the political realities of the 2022 midterms, and the fact that Democrats from across the political spectrum might ultimately seek to avoid the political costs of failing to capitalize on their control of both houses of Congress and the White House, by passing something.  From a broader perspective, the bill is moving from stimulus to neutral, which is more in line with the current inflationary environment and what Manchin will tolerate. 

The dangers of multiple asset bubbles at the same time – treacherous waters for the Fed

Let’s start in Japan. In this instance, one thing became pretty clear – while it is dangerous to have a bubble in equities – for the loss of value can cause a shock through the wealth effect that can get out of control, which was a part of the problem in 1929 and the ensuing slump – it is much more dangerous to have a bubble in housing, and it is very much more dangerous to have both together. The economic consequences of the double bubble in Japan are arguably still playing out. Exhibit 1 shows that neither the equity market nor land have yet recovered their 1989 peaks!

NIKKEI INDEX AND JAPANESE CITY COMMERCIAL REAL ESTATE, 1980-TODAY

But now, for the first time in the U.S. we have simultaneous bubbles across all major asset classes. To detail:

·         First, we are indeed participating in the broadest and most extreme global real estate bubble in history. Today houses in the US are at the highest multiple of family income ever, after a record 20% gain last year, ahead even of the disastrous housing bubble of 2006. But although the US housing market is selling at a high multiple of family income, it is less, sometimes far less, than many other countries, e.g., Canada, Australia, the UK, and especially China. (In China, real estate has played an unusually important and unique role in the extended boom and thereby poses an equally unique risk to the economy and hence the rest of the world if its real estate market loses air exactly as it appears to be doing as we sit.)

·         Second, we have the most exuberant, ecstatic, even crazy investor behavior in the history of the US stock market. The US market today has, in my opinion, the greatest buy-in ever to the idea that stocks only go up, which is surely the real essence of a bubble. (Interestingly, where other developed countries lead in housing prices, they lag the U.S. in equity prices. Some, such as Japan, by so much that they are merely slightly overpriced today.)

·         Third, as if this were not enough, we also have the highest-priced bond markets in the U.S. and most other countries around the world, and the lowest rates, of course, that go with them, that human history has ever seen.

Now, some would add a fourth bubble – commodities. However, we are of the view that commodities have entered a new super-cycle, which will now be driven by policy error. That is, the absence of any transition plan in the move towards clean energy targets agreed at COP26. However, let’s leave our thesis for another day. Suffice it to say that over the next 3-5 years, the commodities complex offers huge upside.

Getting back on point, what our financial leadership should know is that multiplying these risks – these three bubbles – will multiply the total shock if the damage occurs simultaneously. And this package presents more potential for writing down perceived wealth than at any previous time in history. In 2007, deflating US housing prices directly lost around $10 trillion or well over half a year’s GDP, even though house prices declined to moderately below trend. But at that tim,e the bond market was merely overpriced at the risky corporate end and the stock market merely normally overvalued. (The stock market still halved in price in sympathy, if you will, with the main event – housing and housing-related debt.) Yet despite that recent pain, all of the economic and financial dangers that are now building up from multiple major bubbles do not appear to be considered especially dangerous by the Fed or most of its equivalents around the world. In fact, the warning signs appear to be barely noticed at all.

As of today, the US has seen three great asset bubbles in 25 years, far more than normal. I believe this is far from being a run of bad luck, rather this is a direct outcome of the post-Volcker regime of dovish Fed bosses. It is a good time to ask why on Earth the Fed would not only have allowed these events but should have actually encouraged and facilitated them. The fact is they did not “get” asset bubbles, nor do they appear to today.

Ben Bernanke should have been wiser from the experience of this bubble bursting and the ensuing pain, and he might have moved against the developing housing bubble – potentially more dangerous than an equity bubble as discussed above. No such luck! It is pretty clear that Bernanke (and Yellen) were such believers in market efficiency that in their world bubbles could never occur.

Back then, when confronted with a clear 3-sigma event in the US housing market, Bernanke insisted that “the US housing market merely reflects a strong US economy,” and that “the US housing market has never declined.” The information he meant to deliver was unsaid but clear: “and it never will decline because there is no bubble and never can be.” On a purely statistical basis, the history of US house prices had indeed never bubbled before, being so diversified collectively – booming in Florida while coasting in Chicago and falling in California. Until, that is, the sustained excess stimulation of the Greenspan and Bernanke era created a perfect opportunity to finally boom in every region together. 

Whereupon the unprecedented and apparently non-existent housing bubble retreated all the way back to its trend that had existed prior to the bubble, and then quite typically for a bubble, went well below. So, the 3-sigma event came and went, the best looking, most well-behaved bubble of all time, causing profound economic damage to the US and global economies, particularly because of the lack of regulation around the new mortgage-related instruments. Thus, the Fed had for the second time aided and abetted a great bubble forming. And this time the pain was augmented by the housing bust, associated mortgage mayhem, and the ensuing decline in the US stock market – merely badly overpriced but not a bubble – with the combined loss of “perceived wealth” threatening a depression and necessitating an unprecedented bailout and massive, but rather inept, stimulus. Yet, when society looked around to assign blame and process lessons learned, it was as if it tried very hard to miss the point.

THE US HOUSING BUBBLE

Yes, Bernanke and Paulson did a perfectly fine job of lobbying Congress for help, albeit after the fact. But overall it was as if the Fed was steering the Titanic at speed hoping not to hit an iceberg. Indeed, the previous captain of this Titanic, Alan Greenspan, had even fought to help the ship speed up, by trying to bully Brooksley Born at the CFTC to not regulate the growing wave of dangerous subprime instruments. When she refused to back off from a job that was clearly hers, he then resorted to lobbying Congress to change the law to leave these new “demons of our own design” altogether unregulated. In this infamous side job, he was joined by Arthur Levitt of the SEC (who apparently on this occasion saw “security” as a dirty word) and Larry Summers. What were they thinking with this reckless behavior? That bankers could regulate themselves? The episode was remarkable in many ways, as was our willingness to forget it. But what a good job it did in revealing where Greenspan’s heart really lay – in deregulation.

With the clear dangers of an equity bubble revealed in 2000 to 2002, the even greater dangers of a housing bubble in 2006 to 2010, and the extra risk of doing two asset bubbles together in Japan in the late 1980s and in the U.S. in 2007, what has the Fed learned? Absolutely nothing, or so it would appear. In fact the only “lesson” that the economic establishment appears to have learned from the rubble of 2009 is that we didn’t address it with enough stimulus. That we should actually have taken precautions to avoid the crisis in the first place seems to be a lesson not learned, in fact not even taught. So we settle for more lifeboats rather than iceberg avoidance. And we forgive and forget incompetence and fail to punish even outright malfeasance. (Iceland, pop 300,000, sent 26 bankers to prison; the U.S., pop 300,000,000, sent zero. Zero!)

So, here we are again. This time with world record stimulus from the housing bust days, followed up by ineffably massive stimulus for Covid, some of it of course necessary – just how much to be revealed at a later date. However, everything has consequences and the consequences this time is likely to include some intractable inflation. But it has already definitely included the most dangerous breadth of asset overpricing in financial history. At some future date, when pessimism rules again, as it does from time to time, asset prices will decline. And if valuations across all of these asset classes return even two-thirds of the way back to historical norms, total wealth losses will be on the order of $35 trillion in the US alone. If this negative wealth and income effect is compounded by inflationary pressures from energy, food, and other shortages, we will have serious economic problems, and dare I say it, societal problems too.

Some notable charts for the current market environment

Nasdaq Composite:

Then there is this. The chart below shows the index’s multiple of forward earnings (as calculated by Bloomberg) and of sales, going back to 2009. A rising trend in sales multiples is perhaps to be expected as industries grow more concentrated and bigger companies become more profitable. But both measures tell the same story. The Nasdaq 100 grew steadily richer in the 10 years after the crisis, and then took a massive step change higher in the aftermath of the Fed’s Covid desperations. Neither measure is yet particularly close to its pre-pandemic level. If a correction means correcting for fundamental valuation, there is a lot more to be done:

From the eminent Michael Hartnett at BAML:

Now, here is a chart from Mr Risk of State Street. My only problem with his inference of a weaker dollar is that if the US markets crash, the collateral damage elsewhere could be greater. Indeed, I view the increasing problems in the EU potentially existential – see our Europe Macro Dailies, where we cover the tsunami of problems therein. Nevertheless, I do adhere to historical reference:

However, to give Risk his credit, he does highlight that the dollar as a safe haven in times of uncertainty is backed up by the tight correlation to Global Economic Uncertainty. The higher the uncertainty, the stronger the dollar, and vice versa.