Why no visible inflation.

Mercenary Links: Inflation Already Happened

Mercenary Trader - Seeking Alpha - 6 mins ago

 

 

They say they need more time, that it could still happen. Paul Krugman, meanwhile, relentlessly makes fun of them. (See his latest piece in today's links, "Inflation derp abides," mocking Jim Rogers.)

In respect to timing, Krugman has a point. If money-printing was going to cause an inflation supernova, where the heck is it? And why is deflation, not inflation, the big worry now?

Shouldn't predictions have some kind of time limit? If someone has just been flat out wrong for five years running, at what point do they admit their view doesn't make sense?

 

We think both sides are misguided. The "inflationistas" (as Krugman calls them) never actually understood QE. Quantitative Easing was never "money printing" in the first place - that's not how the process worked. QE was basically an asset swap, which allowed liquidity to pool in bank vaults while increasing faith in the stability of asset values. Without monetary velocity - money moving rapidly through the economy, pushing up wages and prices and expanding credit as it gets borrowed and spent and reloaned - you don't have inflation.

(As a psychological experiment, imagine if your eccentric uncle gave you a million dollars in gold bullion but you weren't allowed to spend it. How much "inflation" would that money create in terms of your lifestyle? Zero. It's not the getting but the spending that matters.)
But Krugman is wrong too, in our view, in denying the distortionary effects of QE. Krugman acts as if the Fed did not cause great distortion with the potential for great damage, which is also incorrect.
While Quantitative Easing was never actually "printing money," it did in fact have real impact on market asset values and corporate borrowing and buyback activities. Zero interest rate monetary policy, coupled with the psychological impact of QE and the implied Fed backstop of rescuing markets, led to a frenzy of corporate debt issuance, corporate share buybacks, and increasing investor confidence leading to multiple expansion. Combined with tax deals, wage suppression and steadily rising corporate profits (in turn enhanced by crazy amounts of buybacks), asset valuations went crazy.

So QE is not "printing money" (and never was)… but it really did have serious impact on financial markets. Got that?
Hence our somewhat unorthodox view: Inflation already happened. We already had it! QE and all the other activities actually had their intended effects. It was just channeled into financial engineering and the rise of paper assets! This is counter-intuitive. It's not what the inflationistas expected. But what Krugman misses is that paper asset pump-jobs can be just as ugly in terms of long-run consequences…
See, here's the thing. No two inflations are exactly the same. There are different types and kinds of inflation. And what the Federal Reserve managed to create, quite deliberately we might add, was a QE-supported environment where ZIRP (zero interest rate policy) wound up creating an accelerating feedback loop of corporate debt leverage, share buybacks and investor complacency that hugely pumped up the value of assets.
The inflation was, quite literally, channeled into global stock and real estate markets. In China, this similar phenomenon played out through a white hot real estate bubble. Same idea: Inflation was channeled into assets.
What does this mean? Is there still a piper that needs to be paid? Yep, you bet. Global asset prices were supported by central banks for so long - via ZIRP and backstop complacency - that the withdrawal of central bank support now threatens to create an implosion of asset prices as risk premiums are completely revalued.
Oh, and meanwhile, all that inflation that got channeled into asset prices via financial engineering? It came at the expense of actual productive investment on the part of corporations.
Channeling inflation into assets, while starving the real economy, is like pumping hundreds of millions of gallons of water into lavish casino waterfall projects while the surrounding factories and farms wither in drought conditions. The US economy was largely spared the withering because the shale boom was such a massive "get out of jail free" card. But the impact is real.
As a matter of fact, the asset-inflationary impacts of QE make even more sense in light of the deflationary backdrop we see now. Maybe deflation is the "desert of the real"… and stimulus-created asset inflation was the mirage…

As far as US equity markets go, the dip buyers showed up again on Friday (though not with enough conviction to save small caps from a loss). Cramer even declared the market safe to buy! (Kind of like with Bear Stearns…)
In our view, the logic of the dip buyers is completely and utterly wrong.
For example: This summary excerpt from David Kotok, in his piece "Why We're Buying Stocks Today," is laugh-out-loud backwards:

"Now the basic question is very direct: Where are we going from here? Either the market riot will be validated as a full-blown recession evolves in the U.S., or-having lurched from one extreme to another in a highly emotional correction-the market will launch another upward trend as the U.S. economy continues its gradual recovery.
We believe what lies in store is the latter. We are positioning for the next upward move. We expect the U.S. stock market to be higher in price a half year from now, not lower."

Do you see the gigantic fallacy here? Kotok makes a huge assumption that has no reasonable basis. He directly assumes that continued US economic recovery is bullish for stocks.
By Kotok's logic, if we get recession stocks go down. If we keep recovering stocks go up. It looks like the US will keep recovering, so stocks should keep going up. Easy, right? No. The argument is based on a ridiculous assumption. It is chock full of holes.

Stock market valuations hit extreme highs because of perceived central bank support and financial engineering. Corporate profits, two standard deviations above normal, also hit highs because of ZIRP-enabled financial engineering. (Massive buybacks reduced share counts, while dividend payouts convinced investors to drive stocks to historically high multiples.)

If the US economy continues to show signs of recovery - as it appears to be doing - central bank support goes away. Fed withdrawal is part of the fear paradigm in the first place! And the financial engineering of corporate buybacks is definitely going away. Corporations cannot borrow for a song anymore, for one. US Treasuries are strong but the corporate debt market is in turmoil.
Basic point: US recovery is not a reason to bullish on US equities. If anything it is a reason for worry, due to dislocations from central bank support withdrawal, turmoil in the corporate debt market, and the incredibly stretched valuations that are strongly likely to mean revert along with profits (as Warren Buffett could have told you, were he not a massive hypocrite).

On a broader level, it's just foolish to assume "recession means stocks down" and "recovery means stocks up." The cycles never worked like that in the first place. Did stocks have any trouble going up in 2009 when the US economy was on incredibly shaky ground?
There are plenty of reasons to be gravely concerned for the equity market outlook here - not least turmoil in the credit markets, the still super-strong US dollar, and the closing of tax loopholes that added to corporate profits. (Some major hedge funds got sucker-punched this week when the AbbVie / Shire tax inversion deal collapsed, and now a major Irish tax loophole is closing.)
Meanwhile the fall in commodity prices is so painful, there are almost certainly some debt blow-ups lurking in the energy and mining space. Shareholder lawsuits against collapsing shale companies for misrepresentation of their reserves and prospects? Don't count it out.
But what about hopes that the Fed will come to the market's rescue with another shot of stimulus? Bwahaha.

We doubt the Federal Reserve would be foolish enough to try for "QE4." And even if they tried, it might easily backfire and make everything worse. Why? Because QE is a sort of magic trick. Faith in the magician is everything - liquidity itself does not magically make stocks go up. If there is no risk appetite in the market, liquidity doesn't do anything at all.
Imagine what would happen if the Fed announced some version of QE4 and then, after a week or two of giving the market some gas, investors realized it wasn't actually making a difference this time around. Mr. Market would then be staring into the abyss.
But the Federal Reserve is less likely to follow through on stimulus help anyway - because remember, the US economy is basically healing (and low oil prices are acting as a consumer stimulus). As today's links show, US jobless claims are at a 14-year low. That type of strength is likely to stay the Fed's hand. And if they act and reveal themselves impotent - giving the market a whiff of desperation - it could lead to disaster.

Stocks are incredibly overvalued by most rational measures. Their valuations are only justified against corporate profits two standard deviations above normal, now deeply prone to mean reversion. The health of the US economy will remain the backbone of a strong US dollar, along with record inflows into US treasuries as Europe and Asia falter.

The dollar in turn is a dagger at the heart of multinational profit outlooks, even as various tax loopholes slam shut and financing costs threaten to rise. The major indices are broken… US economic strength is a headwind, not a tailwind… credit risk is high and rising… and the threat of further downside is extreme. We say complacent buying here is a foolhardy sucker play.
In our upcoming Strategic Intelligence Report, to be broadcast on October 19th, we will reveal a new short idea that will directly profit from global economic contraction and strong dollar trends. We actually wouldn't mind a market bounce - one that lasted a few days or even a few weeks - to the extent it will set up attractive rebound entry points for many of the juicy shorts we now see setting up.
Mercenary Links October 18th: Deflation risks mount… Foreign treasury holdings top six trillion… Greek bond yields spike… Ballmer's new life, Monaco billionaire murder plots, and more.