The Economist

Ray Dalio, founder, Bridgewater Associates, explains why the 1930s hold clues to what lies ahead for the economy

This is not a normal business cycle; monetary policy will be a lot less effective in the future; investment returns will be very low. These have come to be widely held views, but there is little understanding as to why they are true. I have a simple template for looking at how the economic machine works that helps shine some light. It has three parts.

First, there are three main forces that drive all economies: 1) productivity; 2) the short-term debt cycle, or business cycle, running every five to ten years; and 3) the long-term debt cycle, over 50 to 75 years. Most people don’t adequately understand the long-term debt cycle because it comes along so infrequently. But this is the most important force behind what is happening now.

Second, there are three equilibriums that markets gravitate towards: 1) debt growth has to be in line with the income growth that services those debts; 2) economic operating rates and inflation rates can’t be too high or too low for long; and 3) the projected returns of equities have to be above those of bonds, which in turn have to be above those of cash by appropriate risk premiums. Without such risk premiums the transmission mechanisms of capital won’t work and the economy will grind to a halt. In the years ahead, the capital markets’ transmission mechanism will work more poorly than in the past, as interest rates can’t be lowered and risk premiums of other investments are low. Most people have never experienced this before and don’t understand how this will cause low returns, more debt monetisation and a “pushing on a string” situation for monetary policy.

Third, there are two levers that policy-makers can use to bring about these equilibriums: 1) monetary policy, and 2) fiscal policy. With monetary policy becoming relatively impotent, it’s important for these two to be co-ordinated. Yet the current state of political fragmentation around the world makes effective co-ordination hard to imagine.

Although circumstances like these have not existed in our lifetimes, they have taken place numerous times in recorded history. During such periods, central banks need to monetise debt, as they have been doing, and conditions become increasingly risky.

What does this template tell us about the future? By and large, productivity growth is slow, business cycles are near their mid-points and long-term debt cycles are approaching the end of their pushing-on-a-string phases. There is only so much one can squeeze out of a long-term debt cycle before monetary policy becomes ineffective, and most countries are approaching that point. Japan is closest, Europe is a step behind it, the United States is a step or two behind Europe and China a few steps behind America.

For most economies, cyclical influences are close to being in equilibrium and debt growth rates are manageable. In contrast to 2007, when my template signalled that we were in a bubble and a debt crisis was ahead, I don’t now see such an abrupt crisis in the immediate future. Instead, I see the beginnings of a longer-term, gradually intensifying financial squeeze. This will be brought about by both income growth and investment returns being low and insufficient to fund large debt-service, pension and health-care liabilities. Monetary and fiscal policies won’t be of much help.

As time passes, how the money flows between asset classes will get more interesting. At current rates of central-bank debt buying, they will soon hit their own constraints, which they will probably have to abandon to continue monetising. That will mean buying riskier assets, which will push prices of these assets higher and future returns lower.

The bond market is risky now and will get more so. Rarely do investors encounter
a market that is so clearly overvalued and also so close to its clearly defined limits, as there is a limit to how low negative bond yields can go. Bonds will become a very bad deal as ­central banks try to push more money into them, and savers will decide to keep that money elsewhere.

Right now, while a number of riskier assets look like good value compared with bonds and cash, they are not cheap given their risks. They all have low returns with typical volatility, and as people buy them, their reward-to-risk ratio will worsen. This will create a growing risk that savers will seek to escape financial assets and shift to gold and similar non-monetary preserves of wealth, especially as social and political ­tensions intensify.

For those interested in studying analogous periods, I recommend looking at 1935-45, after the 1929-32 stockmarket and economic crashes, and following the great quantitative easings that caused stock prices and economic activity to rebound and led to “pushing on a string” in 1935. That was the last time that the global configuration of fund­amentals was broadly similar to what it is today.

by Fitch Ratings
10 February, 2017
London

The Trump Administration represents a risk to international economic conditions and global sovereign credit fundamentals, Fitch Ratings says. US policy predictability has diminished, with established international communication channels and relationship norms being set aside and raising the prospect of sudden, unanticipated changes in US policies with potential global implications.

The primary risks to sovereign credits include the possibility of disruptive changes to trade relations, diminished international capital flows, limits on migration that affect remittances and confrontational exchanges between policymakers that contribute to heightened or prolonged currency and other financial market volatility. The materialisation of these risks would provide an unfavourable backdrop for economic growth, putting pressure on public finances that may have rating implications for some sovereigns. Increases in the cost or reductions in the availability of external financing, particularly if accompanied by currency depreciation, could also affect ratings.

In assessing the global sovereign credit implications of policies enacted by the new US Administration, Fitch will focus on changes in growth trajectories, public finance positions and balance of payments performances, with particular emphasis on medium-term export prospects and possible pressures on external liquidity and sustainable funding. US positions on some countries may change quickly, at least initially, but any potential rating adjustments will depend on consequent changes to sovereign credit fundamentals, which will almost certainly be slower to materialise.

Elements of President Trump's economic agenda would be positive for growth, including the long-overdue boost to US infrastructure investment, the focus on reducing the regulatory burden and the possibility of tax cuts and reforms, assuming cuts don't lead to proportionate increases in the government deficit and debt. One interpretation of current events is that, after an early flurry of disruptive change to establish a fundamental reorientation of policy direction and intent, the Administration will settle in, embracing a consistent business- and trade-friendly framework that leverages these aspects of its economic programme, with favourable international spill-overs.

In Fitch's view, the present balance of risks points toward a less benign global outcome. The Administration has abandoned the Trans-Pacific Partnership, confirmed a pending renegotiation of the North American Free Trade Agreement, rebuked US companies that invest abroad, while threatening financial penalties for companies that do so, and accused a number of countries of manipulating exchange rates to the US's disadvantage. The full impact of these initiatives will not be known for some time, and will depend on iterative exchanges among multiple parties and unforeseen additional developments. In short, a lot can change, but the aggressive tone of some Administration rhetoric does not portend an easy period of negotiation ahead, nor does it suggest there is much scope for compromise.

Sovereigns most at risk from adverse changes to their credit fundamentals are those with close economic and financial ties with the US that come under scrutiny due to either existing financial imbalances or perceptions of unfair frameworks or practices that govern their bilateral relations. Canada, China, Germany, Japan and Mexico have been identified explicitly by the Administration as having trade arrangements or exchange rate policies that warrant attention, but the list is unlikely to end there. Our revision of the Outlook on Mexico's 'BBB+' sovereign rating to Negative in December partly reflected increased economic uncertainty and asset price volatility following the US election.

The integrative aspects of global supply chains, particularly in manufactured goods, means actions taken by the US that limit trade flows with one country will have cascading effects on others. Regional value chains are especially well developed in East Asia, focused on China, and Central Europe, focused on Germany.

Tighter immigration controls and possible deportations could have meaningful effects on remittance flows, as the US has the world's largest immigrant population. World Bank data confirm that the US and Mexico share the world's top migration corridor and have the largest bilateral remittance flows. Relative to GDP, remittances are even larger for Honduras, El Salvador, Guatemala and Nicaragua, all of which receive most inflows from the US.

Countries hosting US direct investment, at least part of which has financed export industries focused back on the US, are at risk of being singled out for punitive trade measures. The list of these countries is potentially long, since US-based entities account for nearly one-quarter of the stock of global foreign direct investment. Countries with the highest stock of US investment in manufacturing are Canada, the UK, Netherlands, Mexico, Germany, China and Brazil.

By Trevor Hunnicutt
Reuters
February 8, 2017

BlackRock Chief Executive Larry Fink on Wednesday said the U.S. economy is in the midst of a slowdown and financial markets could see a significant setback, because of uncertainty over global trade and the Trump administration's plan to cut taxes.  "I see a lot of dark shadows," he said at an event hosted by Yahoo. "The markets are probably ahead of themselves."

Fink, whose company manages $5.1 trillion in assets, said investors are caught up in the potential for a restructuring of U.S. tax policy, which may not take place until 2018.  But disruptions to trade are a possibility in the meantime, he said.  U.S. President Donald Trump has called for tax cuts as well as a wide set of changes to trade policy, including a renegotiation of the North American Free Trade Agreement with Canada and Mexico.  "We're living in a bipolar world right now," Fink said. "In my conversations with CEOs in Europe and CEOs in the United States they may be very bullish about what may come but most business people are not investing today."

Fink is the latest major figure to call for a dose of caution after Trump's election touched off a rally in U.S. stocks. Bond investors Jeffrey Gundlach and Bill Gross are among those who have said the same in recent weeks.  While noting that the benchmark 10-year Treasury yield could fall below 2 percent or, conversely, rise above 4 percent, Fink said he sees a greater probability of rates falling. He added that he sees the U.S. Federal Reserve raising interest rates in June and possibly again once more in the year.

And he warned that there could be tension between the Fed's dollar-boosting policies and those of Trump as a stronger dollar could make it harder to revive export-dependent manufacturers.

by Nouriel Roubini
The Gaurdian
2 February, 2017
 
When Donald Trump was elected president of the US, stock markets rallied impressively. Investors were initially giddy about Trump’s promises of fiscal stimulus, deregulation of energy, health care and financial services, and steep cuts in corporate, personal, estate, and capital-gains taxes. But will the reality of Trumponomics sustain a continued rise in equity prices?

It is little wonder that corporations and investors have been happy. This traditional Republican embrace of trickle-down supply-side economics will mostly favour corporations and wealthy individuals, while doing almost nothing to create jobs or raise blue-collar workers’ incomes. According to the non-partisan Tax Policy Center, almost half of the benefits from Trump’s proposed tax cuts would go to the top 1% of income earners.

Yet the corporate sector’s animal spirits may soon give way to primal fear: the market rally is already running out of steam, and Trump’s honeymoon with investors might be coming to an end. There are several reasons for this.

For starters, the anticipation of fiscal stimulus may have pushed stock prices up, but it also led to higher long-term interest rates, which hurts capital spending and interest-sensitive sectors such as real estate. Meanwhile, the strengthening dollar will destroy more of the jobs typically held by Trump’s blue-collar base. The president may have “saved” 1,000 jobs in Indiana by bullying and cajoling the air-conditioner manufacturer Carrier; but the US dollar’s appreciation since the election could destroy almost 400,000 manufacturing jobs over time.

Moreover, Trump’s fiscal stimulus package might end up being much larger than the market’s current pricing suggests. As Ronald Reagan and George W Bush showed, Republicans can rarely resist the temptation to cut corporate, income and other taxes, even when they have no way to make up for the lost revenue and no desire to cut spending. If this happens again under Trump, fiscal deficits will push up interest rates and the dollar even further, and hurt the economy in the long term.

A second reason for investors to curb their enthusiasm is the spectre of inflation. With the US economy already close to full employment, Trump’s fiscal stimulus will fuel inflation more than it does growth. Inflation will then force even Janet Yellen’s dovish Federal Reserve to hike up interest rates sooner and faster than it otherwise would have done, which will drive up long-term interest rates and the value of the dollar still more.

Third, this undesirable policy mix of excessively loose fiscal policy and tight monetary policy will tighten financial conditions, hurting blue-collar workers’ incomes and employment prospects. An already protectionist Trump administration will then have to pursue additional protectionist measures to maintain these workers’ support, thereby further hampering economic growth and diminishing corporate profits.

If Trump takes his protectionism too far, he will undoubtedly spark trade wars. America’s trading partners will have little choice but to respond to US import restrictions by imposing their own tariffs on US exports. The ensuing tit-for-tat will hinder global economic growth and damage economies and markets everywhere. It is worth remembering how America’s 1930 Smoot-Hawley Tariff Act triggered global trade wars that exacerbated the Great Depression.

Fourth, Trump’s actions suggest that his administration’s economic interventionism will go beyond traditional protectionism. Trump has already shown his willingness to target firms’ foreign operations with the threat of import levies, public accusations of price gouging and immigration restrictions (which make it harder to attract talent).

The Nobel laureate economist Edmund S Phelps has described Trump’s direct interference in the corporate sector as reminiscent of corporatist Nazi Germany and fascist Italy. Indeed, if Barack Obama had treated the corporate sector in the way that Trump has, he would have been smeared as a communist; but for some reason when Trump does it, corporate America puts its tail between its legs.

Fifth, Trump is questioning US alliances, cosying up to American rivals such as Russia, and antagonizing important global powers such as China. His erratic foreign policies are spooking world leaders, multinational corporations and global markets generally.

Finally, Trump may pursue damage-control methods that only make matters worse. For example, he and his advisers have already made verbal pronouncements intended to weaken the dollar. But talk is cheap, and open-mouth operations have only a temporary effect on the currency.

This means that Trump might take a more radical and heterodox approach. During the campaign, he bashed the Fed for being too dovish, and creating a “false economy”. And yet he may now be tempted to appoint new members to the Fed board who are even more dovish, and less independent, than Yellen in order to boost credit to the private sector.

If that fails, Trump could unilaterally intervene to weaken the dollar, or impose capital controls to limit dollar-strengthening capital inflows. Markets are already becoming wary; full-blown panic is likely if protectionism and reckless, politicised monetary policy precipitate trade, currency, and capital-control wars.

To be sure, expectations of stimulus, lower taxes and deregulation could still boost the economy and the market’s performance in the short term. But, as the vacillation in financial markets since Trump’s inauguration indicates, the president’s inconsistent, erratic, and destructive policies will take their toll on domestic and global economic growth in the long run.

by Robert Shiller
The Gaurdian
January 22, 2017

Speculative markets have always been vulnerable to illusion. But seeing the folly in markets provides no clear advantage in forecasting outcomes, because changes in the force of the illusion are difficult to predict.

In the US, two illusions have been important recently in financial markets. One is the carefully nurtured perception that President-elect Donald Trump is a business genius who can apply his deal-making skills to make America great again.

The other is a naturally occurring illusion: the proximity of Dow 20,000. The Dow Jones Industrial Average has been above 19,000 since November, and countless news stories have focused on its flirtation with the 20,000 barrier – which might be crossed by the time this commentary is published. Whatever happens, Dow 20,000 will still have a psychological impact on markets.

Trump has never been clear and consistent about what he will do as president. Tax cuts are clearly on his agenda, and the stimulus could lead to higher asset prices. Lower corporate taxes are naturally supposed to lead to higher share prices, while cuts in personal income tax might lead to higher home prices (though possibly offset by other changes in the tax system).

But it is not just Trump’s proposed tax changes that plausibly affect market psychology. The US has never had a president like him. Not only is he an actor, like Ronald Reagan; he is also a motivational writer and speaker, a brand name in real estate, and a tough deal maker. If he ever reveals his financial information, or if his family is able to use his influence as president to improve its bottom line, he might even prove to be successful in business.

The closest we can come to Trump among former US presidents might be Calvin Coolidge, an extremely pro-business tax cutter. “The chief business of the American people is business,” Coolidge famously declared, while his treasury secretary, Andrew Mellon – one of America’s wealthiest men – advocated tax cuts for the rich, which would “trickle down” in benefits to the less fortunate.

The US economy during the Coolidge administration was very successful, but the boom ended badly in 1929, just after Coolidge stepped down, with the stock-market crash and the beginning of the Great Depression. During the 1930s, the 1920s were looked upon wistfully, but also as a time of fakery and cheating.

Of course, history is never destiny, and Coolidge is only one observation – hardly a solid basis for a forecast. Moreover, unlike Trump, both Coolidge and Mellon were levelheaded and temperate in their manner.

But add to the Trump effect all the attention paid to Dow 20,000, and we have the makings of a powerful illusion. On 10 November 2016, two days after Trump was elected, the Dow Jones average hit a new record high – and has since set 16 more daily records, all trumpeted by news media.

That sounds like important news for Trump. In fact, the Dow had already hit nine record highs before the election, when Hillary Clinton was projected to win. In nominal terms, the Dow is up 70% from its peak in January 2000. On 29 November 2016, it was announced that the S&P/CoreLogic/Case-Shiller national home Price index (which I co-founded with my esteemed former colleague Karl E Case, who died last July) reached a record high the previous September. The previous record was set more than 10 years earlier, in July 2006.

But these numbers are illusory. The US has a policy of overall inflation. The US Federal Reserve has set an inflation “objective” of 2% in terms of the personal consumption expenditure deflator. This means all prices should tend to go up by about 2% per year, or 22% per decade.

The Dow is up only 19% in real (inflation-adjusted) terms since 2000. A 19% increase in 17 years is underwhelming, and the national home price index that Case and I created is still 16% below its 2006 peak in real terms. But hardly anyone focuses on these inflation-corrected numbers.

The Fed, like the world’s other central banks, is steadily debasing the currency to create inflation. A Google Ngrams search of books shows that use of the term “inflation-targeting” began growing exponentially in the early 1990s, when the target was typically far below actual inflation.

The idea that we actually want moderate positive inflation – “price stability,” not zero inflation – appears to have started to take shape in policy circles around the time of the 1990-91 recession. Lawrence Summers argued that the public has an “irrational” resistance to the declining nominal wages that some would have to suffer in a zero-inflation regime.

Many people appear not to understand that inflation is a change in the units of measurement. Unfortunately, though the 2% inflation target is largely a feelgood policy, people tend to draw too much inspiration from it. Irving Fisher called this fixation on nominal price growth the “money illusion” in an eponymous 1928 book.

That doesn’t mean that we set new speculative-market records every day. Stock-price movements tend to approximate what economists call “random walks,” with prices reflecting small daily shocks that are about equally likely to be positive or negative.

And random walks tend to go through long periods when they are well below their previous peak; the chance of setting a record soon is negligible, given how far prices would have to rise. But once they do reach a new record high, prices are far more likely to set additional records – probably not on consecutive days, but within a short interval.

In the US, the combination of Trump and a succession of new asset-price records – call it Trump-squared – has been sustaining the illusion underpinning current market optimism. For those who are not too stressed from having taken extreme positions in the markets, it will be interesting (if not profitable) to observe how the illusion morphs into a new perception – one that implies very different levels for speculative markets.

Robert Shiller is a 2013 Nobel laureate in economics, professor of economics at Yale University and the co-creator of the Case-Shiller Index of US house prices. He is the author of Irrational Exuberance

by Mark Spitznagel
Business Insider
December 26, 2016

 There's a lot of talk these days about the so-called “neutral” (or “natural” or “terminal”) interest rate projections of the Federal Reserve. In fact, their projection of this number is a key argument in their ongoing decision to keep rates at historically very low levels for what has been an extended period of time. (Specifically, Federal Reserve officials have argued that the neutral interest rate has sharply declined in recent years, meaning that apparently ultra-low interest rates really do not signify easy monetary policy.)

What is this neutral rate? The neutral rate is simply the federal funds rate at which the economy is in equilibrium or balance. If the federal funds rate were at this mysterious neutral rate level, monetary policy would be neither loose nor tight, and the economy neither too hot nor too cold, but rather just chugging along at its long-run optimal potential. The underlying theory is that loose monetary policy—where the Fed’s policy rate is set below the neutral rate—can temporarily stimulate the economy, but only by causing price inflation that exceeds the Fed’s desired target (which, by the way, eventually causes overheating and a crash). On the other hand, if the Fed is too tight and sets the policy rate above the neutral rate, then unemployment creeps higher than desired and price inflation comes in below target.

In short, the neutral interest rate is one where the central bank is not itself distorting the economy. Monetary policy would really be nonexistent, as the Fed would not be altering the interest rate resulting from a free market discovery process between borrowers and savers. (This of course raises the question, why do central planners need to fabricate something that would naturally exist in their absence?) This is near where Yellen actually thinks we are these days, hence she sees little urgency in raising rates and thus lessening what, on the face of it, looks like a very loose current monetary policy.

Much of this neutral rate talk at the Fed is supposedly supported by the work of Swedish economist Knut Wicksell (1851-1926), who argued that the “natural” interest rate would express the exchange rate of present for future goods in a barter economy. If in practice the banks actually charged an interest rate below this natural rate, Wicksell argued that commodity prices would rise, whereas if the banks in practice charged an interest rate above the natural one, then commodity prices would fall. But that’s where Wicksell—often associated with the free-market Austrian School of economics—would cease to recognize his own ideas in current central bank thinking. Wicksell’s natural rate was a freely discovered market price in an economy, which reflected the implicit (real) rate of return on capital investments. For Wicksell, the natural interest rate was not a policy lever to be manipulated, in order to hit some employment or output goal. Yellen and the other Fed economists writing on this topic have conveniently (and probably unwittingly) co-opted Wicksell into their own Keynesian (and exceedingly un-Austrian) framework.

That’s the theoretical explanation of the neutral or natural rate. From a more practical standpoint, one must ask: How do we even know what that neutral rate is? The neutral rate is, by its current definition, inherently unobservable, as there is no discovery process in short term interest rates (and there hasn't been for as long as any of us have been around). Central banks calculate the neutral rate based on their formulas and identifying assumptions about output gaps and what interest rates, according to those models, will close those gaps. Here we have an immense circularity problem: Policymakers think they know the neutral rate because the assumptions of their interventionist model that they impose on the data say so, not because they have any insight that the market would actually clear at that rate, sans intervention. There is an underlying assumption that “markets, left on their own, are wrong, while our model is right.” Moreover, they are using observable data as model inputs that are the result of interventions that are already in effect. There are no controlled experiments in economics. Only market participants, acting freely in borrowing and lending at whatever interest rates make sense for that borrowing and lending, can ever discover what the neutral rate should be.

 (To give a specific example: One of the key alleged pieces of evidence that the neutral rate has fallen in recent years is the sluggish growth of productivity. But suppose the ZIRP of the Fed itself has been choking off real savings and distorting credit allocation among deserving borrowers, and hence has crippled sustainable growth in output? In this case, the Fed models would conclude, “Nope, our policy rate hasn’t been too low, look at the weak productivity growth,” confusing cause and effect.)

In fact, the circular logic is such that economists are far from an agreement on the current calculation, and their admitted model estimation errors are enormous. Contrary to Yellen’s recent monetary policy ruminations, reputable estimates using two different approaches have concluded that the Fed has set policy rates below the neutral rate since 2009.

(Things get worse. It’s not merely that we can’t know in real-time what the neutral rate is; we can’t even know after the fact. Suppose the Fed gradually hikes rates, and then the economy crashes. Dovish Keynesians would no doubt say, “We told you not to tighten! The neutral rate was obviously lower than the Fed realized, and they just raised the policy rate above it.” But this isn’t necessarily so. It could be that the policy rate had been below the neutral rate for years, fostering a giant asset bubble which eventually had to collapse. Both theories are consistent with the observed outcome of modest rate hikes leading to a crash.)

The great Austrian economist Friedrich Hayek stressed the role of market prices in communicating information to firms and households, and the impossibility that central planners can ever effectively calculate those prices. If the Fed’s economists think they are able to estimate what the neutral interest rate is, then we can dispense with prices altogether. The Fed’s economists can estimate the “neutral wage rates” for various types of labor, the “neutral commodity prices” for various inputs, and so forth, and issue comprehensive plans for the economy, all calculated in kind.

Of course, this is absurd. The point is, in a capitalist economy, the interest rates themselves—as determined in a competitive discovery process in the bond and credit markets—are central to the coordination of the economy. To assume experts at the Fed could determine the proper, optimal interest rate, without that discovery process, is to assume away the real-world information problems that we all can agree market prices solve. Indeed, perhaps this is why our economic problems persist?

Mark Spitznagel is Founder and Chief Investment Officer of Universa Investments. Spitznagel is the author of The Dao of Capital: Austrian Investing in a Distorted World and was the Senior Economic Advisor to Rand Paul.

by Danielle DiMartino Booth
21 December, 2016

“Gentlemen prefer bonds.” So quipped Andrew Mellon in 1929 as stocks fell and investors rushed into bonds, pushing their yields down and prices up. Historians recount that the flight to safety had anything but a smooth landing. Within two years, almost all of the sovereign bonds of foreign nations had defaulted, triggering massive losses for American investors and a stream of bank runs that would mark the darkest days of the Great Depression.

What cometh from this despair? Why hope, of course.

Picture the backdrop 85 years ago: Shanty towns that would come to be called ‘Hoovervilles’ had sprung up across the nation as the Clutch Plague took hold. The largest was located in New York’s Central Park. Suffice it to say, the men laboring a handful of city blocks south did anything but take their good fortune for granted. They knew penury was but a paycheck away. In response, they did as we all must during this season – they gave of what they had.

On Christmas Eve, 1931, workers at the Rockefeller Center Construction site pooled their money together to buy a 20-foot balsam fir tree. Erected at the work site, it was decorated with, “strings of cranberries, garlands of paper and even a few tin cans.” Today, a half a million people from all over the world will gaze with wonder at this humble tree’s successor. Another half million will follow in their footsteps tomorrow as will be the case every day it stands, shining as a beacon of hope in its purest form.

To mark the occasion of this holiday season, please accept all I can humbly offer you, week in and week out – my words. For those of you who have read these missives for some time or ever heard me speak, you’ll recognize what follows. For newer readers, settle back. You’re in for not one, but two, real treats, one of which is wrapped in an iconic robin’s egg blue box.

It will come as no surprise to any who have met him that the giver of the gifts you’re about to receive is Arthur Cashin, one of the greatest storytellers of all time. For over a decade, I’ve had the honor to call him friend. Readers of Cashin’s Comments, a daily offering that delights his followers the world round, would agree that it’s hard to pin down the very best story he has told over the years. These are my two favorites.

You may note that 2017 marks the 30-year anniversary of a momentous day in stock market history. It is Cashin’s recollection of the day that followed the 1987 crash that is among my favorites. On the Tuesday, October the 20th, the Dow initially opened up 200 points. But trading quickly turned negative. Adding fuel to the panicked fire, banks were in the process of cutting off lines of credit to the specialists on the floor. What would have followed, had the banks stood firm, could have been catastrophic.

At the moment bad was turning to worse, Alan Greenspan was on an airplane headed back to Washington DC. The freshly appointed Federal Reserve chairman had landed in Dallas on Black Monday just in time to learn that while he had been in flight, the Dow had fallen by 22 percent. This shocking news prompted Greenspan’s cancelling his Dallas engagement and heading back to DC. Unfortunately, for the markets, he was once again in the air, just as another historic sell-off ensued.

As Cashin wrote on the 25th anniversary of the crash, news that Greenspan couldn’t be reached was of little comfort to NYSE Chairman John Phelan: “Desperate, Phelan called the President of the New York Fed, Gerry Corrigan. He sensed the danger immediately and began calling the banks to reopen the credit lines. They were reluctant but Corrigan ultimately cajoled them. The credit lines were reopened and the halted stocks were reopened. Best of all, the market started to rally and closed higher on the day.”

I hope you agree the story of the day the NYSE didn’t crash harder is a classic. But it doesn’t resonate as much as it once did. Since October 19, 1987, the stock market has operated in an increasingly contained vacuum thanks in large part to overly-easy monetary policy. That makes the following story, generously gifted to me in its unabridged form by Cashin, the most relevant of the day as we look to the new year with stocks at record highs. The two main characters of this timeless tale are Charles Lewis Tiffany and John Pierpont Morgan.

Being the astute jeweler that he was, Mr. Tiffany knew that Mr. Morgan had an acute affinity for diamond stickpins. One day, Tiffany came across a particularly unusual and extraordinarily beautiful stickpin. As was the custom of the day, he sent a man around to Morgan’s office with the stickpin elegantly wrapped in a robin’s egg blue gift box with the following note:

“My dear Mr. Morgan. Knowing your exceptional taste in stickpins, I have sent this rare and exquisite piece for your consideration. Due to its rarity, it is priced at $5,000. If you choose to accept it, please send a man to my offices tomorrow with your check for $5,000. If you choose not to accept, you may send your man back with the pin.”

The next day, the Morgan man arrived at Tiffany’s with the same box in new wrapping and a different envelope. In that envelope was a note which read:

“Dear Mr. Tiffany. The pin is truly magnificent. The price of $5,000 may be a bit rich. I have enclosed a check for $4,000. If you choose to accept, send my man back with the box. If not, send back the check and he will leave the box with you.”

Tiffany stared at the check for several minutes. It was indeed a great deal of money. Yet he was sure the pin was worth $5,000. Finally, he said to the man: “You may return the check to Mr. Morgan. My price was firm.”

And so, the man took the check and placed the gift-wrapped box on Tiffany’s desk. Tiffany sat for a minute thinking of the check he had returned. Then he unwrapped the box to remove the stickpin.

When he opened the box he found – not the stickpin – but rather a check from Morgan for $5,000 and a note with a single sentence – “JUST CHECKING THE PRICE.”

Please share this timeless legend of price discovery far and wide. Do your part to make sure this priceless parable keeps giving the greatest gift of all — hope.

by Mark Spitznagel
December 15, 2016
New York Times

The “big, fat, ugly bubble” in the stock market that President-elect Donald J. Trump so astutely identified during his campaign now becomes one of the greatest potential liabilities of his presidency.

If that bubble bursts soon, the pain will correctly be understood to be the result of monetary manipulations during the Obama years. But if it persists and the United States economy manages to further postpone its long-overdue recession (following an expansion that was barely that), Mr. Trump’s ostensibly “free-market” policies will unfairly bear the blame when the markets finally do return to reality — perhaps a year or two down the road.

The postelection Trump rally in the stock market is evidence of euphoric optimism about the fiscal stimulus, reduced regulations and lower taxes that are hoped for. And yet we mustn’t forget where we are today, with distorted pricing in virtually all markets and extremely levered public and private balance sheets, all driven by monetary interventionism on a scale never seen before: By most measures, the stock market is as expensive as it has been for a century, save only the giddy late 1990s.

We must also remember what got us to this spot: namely, extreme, collectivist interventionism by the heavy hand of the state. Perhaps never before have we had such a clear case of a controlled experiment in the effects of economic (and especially monetary) interventionism. Problem is, the election of Mr. Trump is adding noise to this otherwise transparent experiment, and is extremely risky for supporters of his policies because he is poised to take office near such a peak in economic distortion.

The challenge, therefore, is for the incoming administration to let the authorities own the initial pain that is sure to come, such as the pain of pulling off the bandages, while letting the later recovery be his — as it should be. Though the Obama administration was able to blame a previous administration’s presumed free-market policies for eight years of lackluster recovery, it will be much harder for Mr. Trump to transfer blame for any economic crisis that occurs on his watch.

There’s something about a government that steps back to let free markets fix themselves that invariably renders it a ripe target for blame. “Couldn’t you have done something?”

After all, if the rally following his surprise election bears Mr. Trump’s name, the danger is that so, too, will the inevitable correction that neither he nor the Fed can stop. What could result — and what we should all fear, specifically — is the political pendulum swinging violently back toward big government and even greater market interventionism.

If Mr. Trump can focus on the long term and encourage asset prices and investments to correct themselves early (to the extent that he even holds such sway over them), perhaps this controlled experiment can remain obvious to everyone. Worthy or not, as the current general for advocates of the free market, he should hope to lose the short-term battle to win the bigger war, to gain positional advantage for the looming contest ahead.

CNBC
by Silvia Amaro
24 November, 2016

The increasing political uncertainty across advanced economies is risking the stability of the euro zone, the region's central bank warned in a new biannual report on Thursday.

The uncertainty surrounding upcoming key referendums and elections across the 19-member euro zone bloc, along with expected policy changes in the U.S. raise inflation and growth challenges for euro area countries, the European Central Bank (ECB) said. Such uncertainty could lead to a global asset market corrections, it stated.

"The financial stability implications for the euro area stemming from changes in U.S. economic policies are highly uncertain at this point in time," the bank said.

"The euro area economy may be directly impacted via trade channels and by possible spillover effects from higher interest and inflation rate expectations in the U.S.," it added, hinting at the election win for Donald Trump and increased market expectations regarding his investment expenditure.

"Market movements after the U.S. election indicate a rotation from bonds to equities. Bond valuations declined by 1 trillion euros ($1.06 trillion) worldwide in the first week after the election, with European markets also being affected, albeit to a smaller degree than U.S. markets. It is uncertain whether these developments will set a trend for the future."

However, it added that European banks are also a current risk to the bloc's financial stability. Profitability is set to remain low given the moribund economic recovery and the high-level of non-performing loans remains to be addressed, it added.

"Risks extend also to the real economy. In particular, concerns about debt sustainability might re-emerge despite relatively benign financial market conditions," the ECB also warned.

The Guardian
by Patrick Collinson
19 November, 2016

Steve Eisman saw the last crash coming and was portrayed in an Oscar-winning film. Now he believes Europe’s banks, especially Italy’s, are at risk

In the Oscar-winning The Big Short, Steve Carell plays the angry Wall Street outsider who predicts (and hugely profits from) the great financial crash of 2007-08. He sees sub-prime mortgages rated triple-A but which, in reality, are junk – and bets billions against the banks holding them. In real life he is Steve Eisman, he is still on Wall Street, and he is still shorting stocks he thinks are going to plummet. And while he’s tight-lipped about which ones (unless you have $1m to spare for him to manage) it is evident he has one major target in mind: continental Europe’s banks – and Italy’s are probably the worst.

Why Italy? Because, he says, the banks there are stuffed with “non-performing loans” (NPLs). That’s jargon for loans handed out to companies and households where the borrower has fallen behind with repayments, or is barely paying at all. But the Italian banks have not written off these loans as duds, he says. Instead, billions upon billions are still on the books, written down as worth about 45% to 50% of their original value.

The big problem, says Eisman, is that they are not worth anywhere near that much. In The Big Short, Eisman’s staff head to Florida to speak to the owners of newly built homes bundled up in “mortgage-backed securities” rated as AAA by the investment banks. What they find are strippers with loans against multiple homes but almost no income, the mortgages arranged by sharp-suited brokers who know they won’t be repaid, and don’t care. Visiting the housing estates that these triple-A mortgages are secured against, they find foreclosures and dereliction.

In a mix of moral outrage at the banks – and investing acumen – Eisman and his colleagues bought as many “swaps” as possible to profit from the inevitable collapse of the mortgage-backed securities, making a $1bn profit along the way.

This time around, Eisman is not padding around the plains of Lombardy because he says the evidence is in plain sight. When financiers look to buy the NPLs off the Italian banks, they value the loans at what they are really worth – in other words, how many of the holders are really able to repay, and how much money will be recovered. What they find is that the NPLs should be valued at just 20% of their original price. Trouble is, if the Italian banks recognise their loans at their true value, it wipes out their capital, and they go bust overnight.

“Europe is screwed. You guys are still screwed,” says Eisman. “In the Italian system, the banks say they are worth 45-50 cents in the dollar. But the bid price is 20 cents. If they were to mark them down, they would be insolvent.”

Eisman is careful not to name any specific Italian bank. But fears about the solvency of the system – weighed down by an estimated €360bn in bad debts – are not new. In official “stress tests” of 51 major European banks in July by the European Banking Authority, Italy’s third largest bank, Banca Monte dei Paschi di Siena, emerged as the weakest. It triggered a rescue package – and soothing words from Italy’s finance minister, who said there was no generalised crisis in the banking system. But MPPS’s share price remains at just 25 cents, down more than 90% from two years ago.

How worried should British bank account (and shareholders) be? “I’m not really worried about England’s banks,” says Eisman. “They are in better shape than most in Europe.” When it comes to the US, Eisman’s outrage, so central to the plot of The Big Short, has melted away (just don’t start him on Household Finance Corporation, the HSBC-owned lender at the heart of sub-prime crisis). “I think the regulators did a horrendous, just horrendous job pre-crisis. But under the Fed, the banks have been enormously deleveraged and de-risked. There are no sub-prime mortgages any more... the European regulators have been much more lenient than the US regulators.”

Eisman was of the view that US banks were rather boring as an investment – although Donald Trump’s victory has changed that. “I have a feeling there could be a softening in the Department of Labor rules (an Obama-led crackdown on how banks sell financial products) and the regulatory environment has now changed in favour of the banks.”

Trump’s victory has sent the bond markets into disarray, with the yield on government bonds rising steeply. While this sounds good for savers – interest rates could rise – it is bad news for the holders of government bonds, which fall in value when the yield rises. Eisman sees that as another woe for Europe’s banks, who hold vast amounts of “sovereign bonds”.

“What is very negative is that in every country in Europe, the largest owner of that country’s sovereign bonds are that country’s banks,” he says. As the bonds decline in value, then the capital base of the banks deteriorates.

He doesn’t share the optimism around Deutsche Bank since Trump’s victory. The troubled German bank, facing a $14bn fine in the US for mortgage bond mis-selling, was for a long time one of the biggest lenders to the Trump business empire. In the three days after Trump’s victory, shares in Deutsche Bank, regarded as Europe’s most systemically important bank, jumped by a fifth from €12.90 to €15.30 as traders bet on Trump-inspired leniency over the fine.

But Eisman doesn’t buy it. By his reckoning, Deutsche Bank was less fundamentally profitable than its rivals, and relied more on leverage to boost earnings. His analysis suggests it will struggle to return to its former profitability.

Critics will point out that shorting the likes of Banca Monte dei Paschi di Siena or Deutsche Bank sounds fine – except that the share price of both have already fallen so dramatically the bad news is already in the price. But we don’t know for sure if they are Eisman’s precise targets – because he’s not willing to say unless you give him at least $1m to manage in one of his “personal accounts”.

Eisman now effectively runs his own “boutique” operation within a bigger Wall Street firm, Neuberger Berman. His “Eisman Long/Short SMA” account has opened to wealthy investors, and in January he will be in London drumming up interest among investors.

But not everything Eisman touches turns to gold. He declines to say how much he made during the financial crash, when he was manager of funds at FrontPoint Financial Services, though it was reportedly as much as $1bn. But in 2010 FrontPoint ran into trouble after one of its manager pleaded guilty to insider trading and was given a five-year prison sentence.

Eisman later set up a hedge fund, Emrys Partners, gathering nearly $200m from investors, but its returns were relatively humdrum compared to the drama of the great crash, making 3.6% in 2012 and 10.8% in 2013, according to the Wall Street Journal.

Did he think the film accurately portrayed what went on? He visited the set, and gave Carell and the other actors (Brad Pitt and Christian Bale also starred) advice and notes.

“When I saw the film, I thought it was great and that Steve Carell was wonderful. But I thought, hey, I wasn’t that angry. After the crash I was interviewed by the Federal Crisis Inquiry Commission, and I saw a transcription later on. After reading it, I realised that ‘yes’, I really was that angry... but the Fed has done a very good job since.”