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I just sent out these brief market thoughts to my favorite client (Of course I say this to each of my small number of clients. I learned this from the Sell Side).

Here they are:

• Market sentiment is not massively bearish. It seems mostly anxious and confused, though with an identifiable bearish hue. The overall set up going into the best seasonal part of the year is good. Good-to-quite good.
• The US continues its recovery with subpar growth and low (but growing as a function of time) odds of a recession.
• EM has begun its L-shaped recovery. I still like EM local ccy bonds more than equities, but EM equities over DM equities should work over the longer term too. Too many got caught out betting on the kind of EM washout many of us cut our teeth on. Many quietly still cling to that view. IMO too many things have changed for that to be the base case.
• I expect funding ccys vis-á-vis the dollar to decline somewhat, but risk ccys (EM) to appreciate gradually. The combo of L-shaped recovery and reach for yield will attract flows back to EM local ccy bonds now that the long bear market appears over.
• I don’t fear the Fed that much but from time to time fear others’ fear of it, contingent upon sentiment and positioning at those points in time. Why? Because IMO equity levels today are much less propped up by the Fed than the market is inclined to believe. The average investor doesn’t seem to understand the transmission mechanism of monetary policy any more than s/he did before the GFC.  Plus, investors systematically overstate the role of the price of money in risk appetite. Moreover, the obsessive lookout for bubbles kicks in periodically to help keep bubbles in check. Nonetheless, it is good for the Fed to have put FinStab on their radar last year because excessive risk build up is a positive function of time and we are inching in that direction, as memories of the GFC slowly fade.
• Europe is always my concern, but I do not for a second fear systemic shocks from DB or the broader banking system over the investment horizon. PTSD is easily awakened and policy makers would not be taken by surprise. They also have the benefit of numerous dress rehearsals  and extensive contingency planning. Longer term, however, I continue to be very pessimistic Europe’s prospects.

Over the post-GFC period, I’ve made many references to a new, structurally lower rate of growth in the US and in the other highly developed countries. Prompted by an interview last week with ETF.com, a tweet by @reformedbroker, and the Fed’s growing recognition of the phenomenon, I took a sec to boil it down to three paras. Because popular expectations are still being calibrated on the old reality, the message, IMO, can’t be stressed enough.

Why has the rebound from the great financial crisis been so tepid, so modest? In short, there are demographic, technological and globalization trends below the surface that we papered over for a long time with global credit boom. Median income hasn’t been good for a long time in the U.S., but we didn’t notice it because we had access to progressively more credit. Our growth numbers seemed faster as a result, and we felt richer. But the underlying growth rate was deteriorating.

Under the surface several things were evolving. The baby boomers were getting older and less productive. The US labor force was barely growing. The effect of women coming into the labor force had maxed out. At the same time, China joined the WTO, and fresh flowers that once had to be locally sourced, could now, thanks to supply chain technology, be brought in from Ecuador overnight. Technology and globalization worked together to create, effectively, a huge supply shock to the US labor market, dampening our growth rate and wages. As a result, the lion’s share of US growth accrued to those who controlled capital.

This—not the Fed, not Bush, not Clinton, not Obama—is the hidden reality the GFC laid bare. The global character of the phenomenon is why it’s basically been the hidden reality in Europe and Japan too. Hard to pin it on your favorite US political target when the phenomenon is global. Worse, unless you want to try to roll back technology, there’s not really all that much policy can do about it.

In April of last year, the market didn’t seem to be picking up on fairly heavy Fed hints about its thinking, so I wrote a quick post entitled Avalanche Patrol. This morning a friend asked me if I’d update the concept. Given that we just hit another patch where the market was again caught out shrugging off fairly heavy Fed hints, I though I would take a sec and post my response.

The biggest variable that’s changed is ‘remaining slack’ in labor market is now a live debate in a way it wasn’t in April of 2015. The uptick in wage growth, while low relative to the impulse we’ve received from job growth, is real.

However, the main reason many of the members are antsy to get off of war footing is still the understanding that financial stability risks are a positive function of time. I don’t think they believe there are systemically significant areas of excess in the US at present. They just want to stay out in front of that risk as best they can this time around. We’re not the only ones suffering from PTSD.

In short, they need/want to hike ASAP in their minds but know they can only do it when there is a very, very low probability of having to reverse later. And the Fed knows there are still questions about slack, whether inflation will come back as much as they hope post-oil stability, and weakness/potential instability in the global economy.

The final thing that some on the Fed are mindful of is that the level of policy rates (within reason) is not as much a deterrent to leveraged financial risk-taking as uncertainty about the path (Just compare the risk-taking in 2005-06 with Fed Funds at 5% relative to post GFC with rates at zero). I’m not sure the freshwater guys get this; they tend to focus more on the level of rates, because that’s what theory has pounded into our heads for the past 25 years.

So, with the above, what would you do in their shoes? I know what I would do: In my talk, err on the side of hawkishness to signal my intent; in my actions, err on the side of dovishness until the issues of slack and oil price drop out become less ambiguous; and, finally, keep market participants from getting complacent with Fed path and don’t let them run too far with errant narratives (which can feed on themselves),

Market guys, old school economists, and free marketeers won’t like any of this. They still believe-despite all evidence to the contrary–that markets are mostly efficient and self-equilibrating, and that bubbles are caused by bad US government policy (ignoring the global nature of the GFC). But reality disagrees, and the Fed has to deal with our new reality. And this does complicate their mandate considerably.

It looks very much as though Brazil is about to impeach Dilma. In a country with a system of governance as deeply flawed as Brazil’s, it would be too much to expect that whoever comes next will simply flip a good governance switch. Yes, Brazil has had the occasional bout of good governance, as it did in the under Fernando Henrique Cardoso, but to old EM hands and Brasileiros this seems to have been the exception to the rule.

However, without getting into the weeds, there are two reasons why it would be wrong to assume things will automatically get worse. One, traumatic change tends to breed honeymoon periods. Hard to imagine there wouldn’t be a sense of relief—at least in the short term. Two, Brazil’s next leader is unlike to be the next FHC, but he or she will have degrees of freedom to jettison policies that didn’t work—including ones that even Dilma no longer liked but couldn’t afford politically to change. In short, a kitchen-sink-under-the-bus dynamic will provide political cover for a decent amount of low hanging policy fruit. And given the starting point of post five brutal years, the fruit tree is heavy, and deeply negative investor sentiment is ripe to be wrong footed.

This simple, behavioral take suggests to me that Dilma’s impeachment will mostly likely be a modest net positive—especially in the short term—with an option on a larger net positive if Brazil gets lucky with its next leader/governing coalition and/or investor sentiment in emerging markets starts to turn.

I often have exchanges with old friends who are institutional HF managers. I’m lucky to have such a sharp, experienced and dialed-in network. Sometimes I clean up my side and post it. Here’s the latest stream of consciousness on the current state of risk over the medium term. It lacks nuance and respectable syntax. But I hope you can still infer the questions and arguments that provoked it. And I hope it’s helpful.

Thanks for your thoughts. I think the rolling global deleveraging we’re going thru keeps a loose cap on Fed rate hikes. Also think the Fed wanted to get a hike on the books to shake the risk tree early and get out in front of growing financial stability concerns, what I call ’Avalanche Patrol’.

On oil, not sure where it goes, but the correlation to other assets has been dropping and guys have stopped trying to trade every tick. For me, this opens a lot of encouraging doors. I’m looking to a flip to positive in the euro and SPX corr to confirm USD M-T top. Could even happen w/o it, but I suspect not.

I think the selloff in equities was recession fear coupled with ‘QE coming out of system fear’, splashed with negative rates. Agree no recession, but I think the QE coming out of system was a scare, not a reality. It never really went into the system in the 1st place and the economy/earnings have largely caught up with asset markets. The effect beyond pockets of fixed income was mostly psychological, IMO. The new-found ‘impotence of the Fed’ argument is a reflection of that. The money trade last 8 yrs has been fading fear of Fed, and I think it still is; it’s just to a much lower degree these days, as many have figured the transmission mechanism of monetary policy out by now.

Chinese depreciation is likely. Agree they need it. Dollar unit labor costs went up massively there. A euro rally would take much of that pressure off. Muddle thru way more likely than collapse.

The deval play in CNY IMO is not a good one. The ‘they’ll be forced to print and this means big depreciation’ story has too many holes in it, empirically, for me to even start rebutting here. China will go slow and take every precaution not to do anything destabilizing. This has long been their MO. And the outsized reaction to their small Aug. move scared them.

Also, much of my broader view on risk assets is really about how much sentiment swung. The breakout in things like iron ore and AUD is much more about reversion from extreme sentiment than identifiable fundamental change. But it could run a long way–possibly long enough to give fundies a chance to come around. Late last year I started saying it was too late to short EM and commodities, and now, at this stage, I want to be with it, not just not against it.

Agree Brexit has long term implications for the EU–which is L-T unsalvageable–but I don’t think it would be a huge market mover in the near term: if it happens it will have largely bled in prices by then. The really bad stuff in EU (I think) will now be well into the future and driven by politics, not market-induced financial shocks. ECB et al have finally got out in front of this concept.

Lastly, look at the chart of BBDXY (most representative USD index IMO). It’s on the cusp. All the macro guys I talk to are still bullish USD (tho less positioned; tell me if you hear/see differently). If you add to that the stretched move in EM FX, the move I cited in iron ore and AUD (and other assets), the deepening realization that the Fed, structurally, is going to go super slowly and is not committed to its dots, I want to bet on a weaker USD. I am waiting for Draghi next week and corr to SPX for definitive signs. Had a really good year trading last year which, paradoxically, may have made me too cautious–afraid of the hubris effect, or that the luck has run out. In short, I want a really good pitch. Hope Mario and market reaction don’t disappoint!! It’s really easy to be wrong at junctures like this. But the asymmetry here is good (e.g. euro stop at 1.08 vs, say, 1.22 upside).

The Bank of Japan’s recent decision to join the ranks of central banks adopting negative policy rates caused a huge stir in financial markets, for two reasons. One, it pushed the US further out of sync with the central banks of the two other developed economic blocs. Two, the market reaction made it clear that the psychological boost markets used to feel from exceptional monetary action is all but dead.

This left markets with two unsettling—if slightly contradictory—thoughts. On the one hand, markets quickly started speculating as to whether the Federal Reserve would also resort to negative policy rates if conditions deteriorated sharply. And, on the other, it signaled to many that the safety net of the central bank backstop has finally been pulled out of under us. No more Fed put. No more Bernanke blanky.

I see three simple reasons Fed shouldn’t react to a sharp downturn with
negative rates:

We have all witnessed the diminishing marginal effects from exceptional monetary policy. As I’ve long argued, if we understood monetary policy better it would work less well.  Guess what? We’re starting to understand it. People need to want to take risk if the economy is to grow, and the price of money is a much smaller factor in these decisions than traditional economic theory leads us to believe. Monetary policy liquidity can short circuit financial runs, buy time to fix balance sheets, and encourage financial risk taking.  But it can’t force the economy to drink. Negative rates aren’t likely to change this.

The US is not Uganda (#GIK). Confidence is at the heart of the global credit-based system, and the US dollar is the system’s lynchpin. Whether you like it or not, whether you think its role is waxing or waning, the USD is like no other currency in the world. I am usually a big fan of looking around the world to see what we can learn from other countries’ experiences, but I’m afraid in this case there are no clean comps.

And the shock to confidence from negative policy rates in the US could be strongly adverse. Money illusion is real. When you say negative rates, Americans hear confiscation. USD holders around the world might too. This—real or imagined—undermines confidence. In a multi-equilibrium world, it is confidence that most often determines which equilibrium you land on. The downside is large.

USD plumbing is different. It is not clear how well the architecture of dollar-based finance would hold up under negative rates. Money markets and other short-term funding markets would come under serious stress. Systems may or may not be able to handle it. We—or at least I—just don’t know. But we do know the scope for unintended consequences is meaningful.

The bottom line is if the marginal benefits have demonstrably decreased, and the risk—however small you think the probability may be—is the potentially huge downside of undermining confidence in the
central feature of the global financial system, expected value tells you not to take that risk. To paraphrase Vizzini, “Never go in against confidence when death is on the line”.

Around the same time every winter I have the great fortune of getting together with a small group of ex-colleagues/friends from Hedgistan in an undisclosed mountain location for skiing and the best hot chocolate on the planet. And market talk. Lots of market talk.

It always ends up bearish. I don’t know if it’s the calendar or some kind of perverse self-selection process, but by the time we’re ready to head home it seems that the end of the world is always nigh. And, just as regularly, the trip is usually followed by a short-term market bottom. Let’s hope that happens again this year–or I’m going to have get a bigger bunker.

Market topics this year ranged through the ones you’d expect: Chinese capital flight, profit margin reversion, US recession/no recession, income/wealth inequality, technology and globalization. Honestly, fun and stimulating though it was, we came away with no iron clad answers. Except one.

As you’d also expect, we talked a bit about oil as well. What would end the bear market? Would Saudi and Russia combine forces and reduce supply? How quickly can shale producers turn production on and off? But on this subject we came away with an answer, something wiser (not smarter, wiser) market types have been susurrating for several months: the supply pressures won’t stop until debt-financed production becomes equity-financed production. It really is that simple.

The reasoning is clear: We know you can’t hold back production to get higher prices later if you have debt to service. Only equity financed production has that luxury.

The process is also clear: The highly leveraged producers drown each other with supply in an attempt to be the last man floating, but ultimately all sink. The equity holders get wiped out and the bond holders become the new equity holders in exchange for writing off their debt claims.
Sometimes the new equity holders sell their claims to others in the process. Sometimes they hold on. But either way the new owners have made time their friend instead of their enemy.

This debt for equity swap is the sine qua non for swing production to begin the long awaited, over forecast pull back in supply.

Did you see what just happened to the stock prices of Chesapeake Energy and others producers of its ilk?

The process started today.

NB: I am not saying buy oil today, that oil will be a moon shot, or that the process will be rapid or clean. In fact, the ability of shale producers with today’s technology to ‘turn the spigots back on’ very quickly should dampen any large upward thrust in the price of crude. ‘L’ is still more
likely than ‘V’. But at least it begins the process. And maybe with it we can hope against hope that the correlation between crude oil and other risk assets can begin their process of reverting to their means.

Bring on the bankruptcies.

Apologies to those who have heard me make this argument and to those who have figured this out already. You all can stop here. Others may want to read on.

The Brazilian economy boomed in the decade that started in 2003. The story was they were selling iron ore and soy beans to China and this drove growth. Simple, intuitive, compelling–and demonstrably wrong.

Brazil’s a closed economy in terms of exports as a share of GDP, but, tellingly, it became even more closed over the course of the boom. In 2003, Brazilian exports amounted to 15% of GDP. And while this is fairly closed as economies go, the part that many will find counter-intuitive is that this ratio fell to 11% by the end of the boom. Even if you adjust for exchange rate/terms of trade moves, it strains credulity to ascribe the Brazilian boom to its exports.

What did drive growth, then? Simple: domestic credit. As part of the massive global financialization that led to the Global Financial Crisis in developed economies, emerging markets, importing many of the very same ‘financial innovations’, saw cohorts that had never previously had access to credit buy on installment. Successful macro stabilization polices across EM in the early 2000s added a Minsky element to the borrowing spree.

And boy did they go on a spree. Brazil, Turkey, South Africa, Korea, etc. ‘enjoyed’ unprecedented consumer credit booms. (China had a credit boom as well, but of a slightly different nature.)

In the case of Brazil, domestic credit to the private sector grew from 28% of GDP at the beginning of the boom to 70% by 2014. This series makes it pretty hard to argue Brazil’s boom was export led. (In the case of Turkey, this ratio went from 14% to 74% over the same period.)

This is not about making the bull case for Brazil. In fact, that it is about working out from under a rapid rise in domestic credit arguably makes it a tougher slog and more prone to policy errors. But if you understand that domestic credit to the private sector, not exports to China, drove the boom, you’ll have a better idea of what to look for when the next turn comes.