What to Worry About Today: Charles Kindleberger.

We don't pretend to know if the current stock market is a bubble. Greenspan said it's impossible to know until after a bubble bursts. But see the S&P chart in the chart package—the slope of the recent rise is unsustainably steep. A pullback is inevitable and nobody knows what will set it off—it can be Company X's earnings or something Trumpian or have no specific trigger at all.

The problem is that even if the Fed were to respond to a burst bubble by lowering rates, it wouldn't fix the bursting bubble. A little mitigation, maybe, but not a fix. That's because the price of borrowing on margin is only one factor. In fact, some analysts blame excess credit-creation as the cause of bubbles in the first place. A rise in money supply faster than economic growth is the classic Kindleberger cause of stock market bubbles (Manias, Panics and Crashes, 1978).

The Fed cannot cure a bursting bubble once the crowd is in the grip of panic. But can the Fed prevent a bursting bubble? Well, no, not unless it started some form of QE that involved buying equities. Don't laugh—they do it in Japan. But the conventional method, injecting more cash, into a bursting bubble is the same thing as injecting more germs into a diseased body.

This is not to say we have a bubble. Valuations are a tricky thing. We had a tech bubble, then a housing bubble. We might have a FAANG bubble now, despite the tech companies seeming to have lost leadership. The WSJ reports the FAANGs accounted for half the S&P rise to the high last summer, but only 17% of the rise in January.

This time it could be an "ignore-China" bubble. If we have a bubble, it doesn't have a name yet. Anyone with $100 in the US stock market should go out and buy the Charles Kindleberger book and also Robert Shiller's Irrational Exuberance (1st edition 2000, now in 3rd edition). They will set your hair on fire. Note that Kindleberger won the Nobel Price in 1999 and Shiller in 2013.

You can also consult Shiller's website for P/E and other data. Here is the current (Feb 1) S&P P/E updated from the book. You can't use this data for market-timing, but it can be a contributing factor to the decision process. Be afraid. Be very afraid.

The other side of a stock market crash is that it would scare the pants off everyone and they will buy dollars as the traditional safe haven. Indeed, when there is a sense of crisis afoot, the S&P and the dollar are inversely correlated. This is illogical and perverse. US investors who sell out of equities are not buying dollars—they already have dollars. It must be some outside parties getting out of their home currencies and into dollars.

 

Outlook:

We know the sense of crisis has abated because the dollar/yen has moved up and gold is retreating. We are not done with crises but the shape of the next ones is not clear. Is the US using Venezuela as a proxy to fight China? If Trump favors Russia, as the sanctions lifting and Trumpian rhetoric seem to indicate, does favoring Guaido over Maduro signal a break with Russia—a break of some hidden relationship we can't even define?

Both China and Russia back Maduro and have lent vast sums of money to him. Trump is not smart enough to play such an intricate game but it's probably not beyond TreasSec Mnuchin, who also must want to show up the less sophisticated TradeRep Lighthizer. And both of them are travelling together to China, probably next week, for another round of trade talks. The South China Post names Feb 27-28 as the date of the Trump meeting with Xi. Talk about cutting it close! The tariff deadline is March 1.

So far markets are fairly sanguine about the trade talks. We say any such hope is wishful thinking and misplaced. Trump needs to manufacture trouble to distract attention from the shutdown and the Wall, and China is a perfect foil.

Not everyone is fat, dumb and happy. As reported above, the BoA-ML fund tracker shows investors removed $15 billion from US equity funds in the week ended Wednesday, taking total outflows to $82 billion over the past three months. This is mere 2% of total assets, but not a trivial sum. And where does the money go? Bonds, of course--$9.4 billion in the latest week. The rest is presumably in cash or maybe real estate.

For equities and bonds to rally at the same time is weird and unusual. The WSJ opines that it may mean the "January rebound in equities is fated to run up against a painful reversal." The 3-month slide in 10-year yields—the longest drop since 2015 when China was also the main preoccupation—is a signal that the fixed income crowd sees an economic slowdown ahead, payrolls be damned. Look at the faltering real estate market, decelerating manufacturing and falling consumer confidence.

A recession may not be imminent, but a slowdown is firmly expected and can only be worsened if the US-China trade deal doesn't happen. China has only one option, anyway—debt, debt and more debt. Chinese debt is already overly high. On an overall basis, shows debt to GDP at only 47.6%, but the better measure is credit to the nonfinancial sector and that's about 285% (Bloomberg). A lot of it is to state enterprises that will not and cannot repay, but the government is hardly about to break up those companies. One of the central issues is the rate of credit growth—head-spinningly high. A country can hope to see repayment (and not massive bankruptcies) only if growth is the same or a little higher. And it's not. Therefore China has a debt bubble. Corporate defaults would be sovereign defaults by state-owned enterprises defaulting to the same state. Not gonna happen.

China has two bolt-holes—domestic demand by its growing middle class—already in the soup as we saw from Apple i-phone and auto sales—and exports. China would never show itself desperate in front of bullies like the US, but it is desperate. The threat is that the US pushes too far, a Trumpian bad habit—and the outcome is a one-time big yuan devaluation, aka currency war. We keep thinking the US would not be so stupid as to throw China out of the room onto its rear-end, but that may be wishful thinking.

The dollar "should" be softening on the looming slowdown, but may not because of the crisis it is about to manufacture.

 


 

This is an excerpt from “The Rockefeller Morning Briefing,” which is far larger (about 10 pages). The Briefing has been published every day for over 25 years and represents experienced analysis and insight. The report offers deep background and is not intended to guide FX trading. Rockefeller produces other reports (in spot and futures) for trading purposes.

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