Steen's Chronicle: Did gold give us a sneak peek at market reality?

Did gold give us a sneak peek at market reality?

We should feel sorrow, but not sink under its oppression – Confucius

Online version:  http://www.tradingfloor.com/posts/gold-give-us-sneak-peek-market-reality-1291245365

I feel bad having to write about something as unimportant as the macro outlook a day after several families lost a loved one and more than 100 people were seriously injured by the explosions in Boston. My thoughts go out to everyone in the US and I hope the people behind this outrageous crime are caught very soon.

In the dreamland of macro, things came to an abrupt stop yesterday when gold suffered one of its largest sell-offs in history - the absolute largest two-day sell-off, in fact, in nominal terms and the fifth-largest percentage-wise:

It's easy to ooh and aah and put up a table like the one above - but interpreting the move's implications is perhaps not so straightforward. Is it the beginning of the end of extend-and-pretend, a mere warning signal, or is it actually a great opportunity to put on more risk? Clearly the early lead is taking by BTFD (I leave you to Google the admittedly impolite, but also very apt origin of that term if you don't know it already...)

It's always dangerous to draw conclusions too soon and on too little data, but this move clearly didn't come out of nowhere.

Source: Mr. E

The reasons on offer for this crushing sell-off range from forced selling by Cyprus to the anticipation of the Fed tapering its quantitative easing in the US. But if we look back, the gold rally began stalling at least 18 months ago! This is hardly a new paradigm. Actually, what could and should concern the Masters of Money Printing, aka the central bank policymakers, is that despite a historic amount of printing money, inflation is falling again and its momentum is pointing towards disinflation and even deflation rather than reflation. No easy way out for central banks, it seems. They wanted inflation, but are risking the opposite as they failed to understand economics and, more importantly, the microeconomy.

A central banker's worst nightmare will always be deflation because it makes debt more expensive and means investors will spend less. Don't forget that 95 percent of all economists are trained to think only in terms of AGGREGATE DEMAND - expecting that aggregate supply will simply follow the lead from demand. If you tell them it does not work, they not only get upset but also anxious as it means all the theories and models they busy themselves with at their day job simply don't have two legs to stand on. Do not mention the microeconomy or The Individual to policymakers. They have never met a person from Main Street in their life - no, for them it's in and out of a meetings and cocktail parties with fellow policymakers and politicians; it's a bubble world that is hermetically sealed from the real consequences of their wrong decisions. 

My advice? We need to revisit Say's Law: "Supply creates its own demand." If for nothing else because during the Great Depression, the Keynesian school refuted Say's conclusion. A classic battle between what works and what does not!

Say's formulation

In Say's language, "products are paid for with products" (1803: p153) or "a glut can take place only when there are too many means of production applied to one kind of product and not enough to another" (1803: p178-9). Or "the supply creates its own demand". Explaining his point at length, he wrote:

"It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of creation of one product immediately opens a vent for other products. (J.B. Say, 1803: p138–9)^[4]

Look at the definition of business cycles and what drives people. Think about Microsoft - did they sit around and look at aggregate demand? No, they created a product without a demand and hence created more demand for other products. Voila! New products meant new jobs!  Heaven forbid! 

In the current market, everything is about printing money. Japan is fighting hard with the US and, from July onwards, the UK (upon Carney's arrival) to become the world leader in printing money.

Currency manipulation, currency manipulation, currency manipulation

I'm no diplomat, but printing money to offset relative external prices is currency manipulation in my book. Japan has less of a chance of reaching 2 percent inflation than I have of being selected to play for Denmark at the next FIFA World Cup. If - and I will not be - am wrong, then inflation will kill what's left of Japan. Imagine financing a debt to GDP of 240 percent at a 3 percent interest rate, when it can barely manage the interest payments on 0.5 percent.  

USDJPY could go higher - but the main point is that Prime Minister Shinzo Abe has his eyes on the Japanese House of Councillors elections in July, so the peak "politically" will be around July. After July, Abe will tone down the rhetoric, using what is probably a handsome majority to do so. 

The open manipulators of FX in my book are:

Switzerland, Japan and China (and their cohorts), while the rest are desperate to tag along and do the same. The irony should not be lost: When everyone is printing money and manipulating, we all end up back at square one having wasted time and resources on creating absolutely nothing.

World growth will be lower than in 2012 and significantly so.

The Emerging Market (EM) business model is one generation old and needs a change (like any other 34 year old!)

China's big economic experiment started in 1979 - yes the same year that Margaret Thatcher was voted into office (funeral tomorrow; she was the last of the EU politicians with a vision) - but it now needs changing. All of EM Asia needs two main things:

1.    Less corruption: Which is only achieved through increased competition. It will happen, but not without a fight first;

2.    Less savings: Lack of a social safety net and financial repression makes Chinese and Asians save too much - behaviour won't change until this is changed. 

The response from these economies has been to pump more credit into the economy or ease, but this is now failing. China and Asia need 2.5 to 3 units of credit for every unit of output. (The US uses 5 USD of credit for 1 USD of output) - and in the EMs, or "easy money land", inflation has become an issue. Below is my BRICs inflation (simple average of Brazil, Russia, India and China inflation levels). Clearly the BRICs, EM's in general and most of "new economies" are caught between the need for easing and potential runaway inflation. Bad luck. The only remedy is like in Europe and the US in the form of real reform. Create competition and social security and we will see the next growth path for EM, BRICs and Asia but for now they are all "buying time" - the new and already outdated panacea.

BRICs Inflation

 

EM has been seriously underperforming (The MSCI EM Index is the white line below):

 

So don't look for help on the global growth front from BRICs or EMs more generally. QE and the printing press is proving impotent. Growth is falling. Employment isn't improving and is even rising in many places. Politically, we have stalemates everywhere. Central banks are providing just enough painkillers to delay the will for reform, or perhaps better said, the crisis that creates a mandate for change. We will see more hair-cuts and templates in Europe. These are the facts, as is the current "climbing the wall of worry" - I love that argument as it's totally circular. It's an ex-ante argument. It explains nothing except what has happened, but let's stay with the premise. The market is stronger than the economy. 

How so? Only through paying higher multiples in stocks, for instance, paying more for each profit dollar. I happen to think the "real way" we make money in the market is to extract the liquidity premium of assets. The more illiquid, the more upside. Endowment and risk-parity portfolios teach us that. In today's market, there is hardly any difference in liquidity premium across all asset classes. All have the same the low-spread values or high valuations. The carpet bombing of liquidity has created a totally surreal and artificial price discovery in which everything is possible - yes, even me joining Denmark in the next World Cup.

The answer to my first question will have to be: Dependence. If gold's move was the start of a move back towards reality and fundamentals, then yes, it's the beginning of the end. But if this was merely another "blip" - and it seems that way with FED Governor Dudley on the wire this pm announcing: Don't worry. Ben, Janet and I will print more money because it has worked so well (for my 401K!).

No, the market is not ready for a move to reality - the one thing it fears more than anything else.

Finally, it's comforting to see how people in the US react with grace and help to the victims and families in Boston - herein lies our hope: We are strongest in times of adversity

Steen Jakobsen

Med venlig hilsen  |  Best regards
Steen Jakobsen  |  Chief Economist

 

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