Tuesday, June 20, 2017

China's Biggest Aluminum Producer to Cut Outdated Capacity

China Hongqiao Group Ltd., the nation’s biggest aluminum smelter, is curtailing outdated capacity amid a broader crackdown by the government on illegal production. Shares of aluminum makers gained in China.
The company, the main aluminum arm of Shandong Weiqiao Pioneering Group Co., declined to give the scale or timing of the reduction in an emailed statement. Two people with knowledge of the situation said Weiqiao’s aluminum business started cutting 250,000 metric tons of annual capacity from Tuesday, declining to be identified as the information is private. A Weiqiao spokesman couldn’t be reached for comment. 
China, the world’s top producer of the lightweight metal, has stepped up efforts this year to prune capacity to reduce excess supply. Its top economic planning agency issued an order in April for local governments to halt smelters that violate environmental guidelines, while a plan earlier in the year called for capacity to be shuttered during the peak pollution season over the winter. China’s total smelting capacity last year was about 40 million tons.

Market Confidence

Hongqiao’s move shows its commitment to the government’s directive and gives the market confidence that China’s capacity curbs are actually happening, Liu Xiaolei, an analyst with SMM Information & Technology Co., said by phone from Shanghai.
SMM reported Monday that Xinjiang province, China’s second largest production hub after Shandong, is beginning environmental checks on smelters this week.
China’s commitment to cutting capacity is the big unknown in the aluminum market, the top executive at at Norsk Hydro ASA, Europe’s third largest producer, said in an interview last week. Aluminum on the London Metal Exchange has outperformed other metals this year on the prospect of Chinese cuts, advancing 12 percent. It rose 0.3 percent to $1,892 a ton on Wednesday.
Aluminum Corp. of China Ltd., the nation’s second largest smelter, advanced as much as 2.2 percent in Shanghai to the highest level in seven weeks. Yunnan Aluminum Co. surged as much as 4.4 percent.
“We estimate that 3.1 million tons, or 8 percent of total operating capacity, is without proper approvals, hence we expect more production cuts in the coming months,” Jack Shang, an analyst at Citigroup Global Markets Asia, said in an emailed note. “Winter production suspensions in North China should help further tighten the aluminum market in China.”

Bribes, Borders and Middlemen: Why India's GST Is a Game Changer

Seized vehicles. Bribes. Days-long delays. Moving goods across Indian states isn’t exactly easy -- and that’s a major barrier to economic growth.
Rolling a truck of vegetables into Gujarat, the state once governed by Prime Minister Narendra Modi, requires a bribe of 500 rupees to 2,000 rupees even with your papers in order, according to Rakesh Kaul, vice-president of Caravan Roadways Ltd., which has about 400 trucks plying India’s pot-holed roads. 
But getting past the state tax collectors into Uttar Pradesh, India’s most populous state, will cost you more: Upwards of 20,000 rupees, Kaul says. The penalty for not paying off the right people is steep fines from factories whose raw materials are stuck at state borders -- sometimes for as long as five days.
 That’s why he and other companies are cheering the July 1 implementation of India’s biggest tax reform since independence in 1947. The move will replace more than a dozen levies with a new goods and services tax. That should help reduce the immense power India’s myriad middlemen wield at state borders, free up internal trade, make it easier to do business and widen the country’s tiny tax base. 
“Even if your documents are correct, they will find some small error and hold your vehicle,” Kaul says in his New Delhi office, located in a dusty trucking depot where hundreds of drivers sit near their brightly painted trucks in the 42-degree Celsius (108-degrees Fahrenheit) heat. “Once GST is there, all that is gone.”

Common Market

The new tax would be Modi’s most significant economic reform since coming to power in 2014. Yet with less than two weeks to go before its implementation, the government is still refining the details, announcing on Sunday it would relax initial filing requirements for July and August amid concerns businesses were not ready. Despite the last-minute tweaks, Finance Minister Arun Jaitley confirmed Wednesday the tax would roll out on July 1.
While India already boasts one of the world’s fastest growing major economies, architects of the reform say it will stoke efficiency and growth by creating a common market of 1.3 billion consumers -- a population greater than the U.S., Europe, Brazil, Mexico and Japan combined. 
 Take the border crossings: Lorry drivers in India lose 60 percent of transit time to road blocks, tolls and other stoppages, which means logistics costs are up to three-times higher than international benchmarks. While truck drivers may still need to stop to have their goods checked, cut that time in half, and logistics costs could fall by up to 40 percent, according to a 2014 World Bank report.  
There’s no shortage of hyperbole when it comes to describing the GST changes, which took more than a decade of protracted negotiations before Parliament pushed it through. The government’s chief economic adviser Arvind Subramanian described it as “transformational.”
"The GST is super important," he said in an April interview. "It is also a daring, bold experiment in what I call the good governance of cooperative federalism."

Four Brackets 

The GST rollout comes less than a year after the government’s surprise movein November to remove 86 percent of currency in circulation -- a decision that contributed to a sharp slowing in growth during the January to March quarter. While the GST is seen as a leap forward in simplifying India’s system, getting the reform across the line has required compromises: India will have four tax brackets instead of the flat rate many other countries have.

Air conditioners, refrigerators and makeup will be taxed at 28 percent, for example, while toothpaste lands at 18 percent. Plane tickets attract a 5 percent GST rate, but business class tickets are 12 percent. Staples such as food grains and fresh vegetables are not taxed, while education and health services will continue to be exempted.
“India is obviously a huge and complex country in which governments’ ability successfully to implement major reforms is limited," said Ian Hall, acting director of the Griffith Asia Institute.

‘Different Countries’

The incoming GST will also force companies to consolidate their supply chain among fewer, larger facilities, says Vineet Agarwal, the managing director of Transport Corp. of India Ltd., which has about 10,000 trucks and around 11 million square feet of warehouses.
Currently, companies operate smaller factories and warehouses to take advantage of tax breaks offered by various states, as well as to avoid transporting goods over too many borders. "Literally, almost all states act like different countries," Agarwal said.
One of the biggest goals of the GST is to widen the tax net in an economy where more than 90 percent of workers are employed informally. Companies will need to be in the tax system and prove they paid taxes to claim a credit against their costs. Pressure to comply will increase along the line and the black economy should shrink.

Inevitable Disruption

Still, the tax may throw up losers. Manufacturing states may initially suffer as the extra revenue is generated in more populous consuming states. There are also sectors untouched by the new tax, including alcohol and real estate. Thousands of tax staff will also need to be trained and complex new IT systems adopted.
"There will inevitably be disruption as a result of the implementation of the GST," said Samir Saran, vice president of the New Delhi-based Observer Research Foundation.
To be sure, India isn’t alone in introducing a new tax that crosses jurisdictions and territories. More than 150 countries have a value added tax or GST including Canada, Australia and the European Union, according to Deloitte.
The optimistic case is that initial ruffles are soon smoothed over, according to Eswar Prasad, a professor at Cornell University in Ithaca, New York. "As in the case of the recent demonetization gambit, any disruption in commerce and economic activity is likely to be short-lived, while the longer-term benefits could be significant," he said.
Big companies will be prepared, Agarwal at Transport Corp. says, but he frets about the smaller, informal businesses. "There’s going to be chaos," he says.
That informal workforce includes Babu Ram Rajput, a 28-year-old trucker in jeans and sandals who regularly drives goods across a vast swathe of north India.
"I have not got any training," he says, holding up a sheaf of tattered, dirty documents related to his current cargo. "I only know that GST is coming."

Monday, June 19, 2017

Profiting from inflation

During inflation, Goodwill is the gift that keeps giving – Warren Buffett
Stocks are often held out as the best hedge against inflation. And indeed they are — if history is any indication.
Since 1979, equity annual returns have averaged 16 per cent as against inflation of about 6-7 per cent, beating inflation hands down. However, does this mean that corporate performance is better during inflationary periods?
The financials of companies move with inflation trends in four ways. First, it increases the cost of raw materials and labour as well as prices it fetches from selling their products. Second, it changes the cost of funding. Third, it impacts the tax bills. Lastly, it causes shifts in demand levels.
The last eight years have been quite a roller-coaster. Inflation, as measured by WPI (Wholesale Price Index), started at a lower level in 2009-10. For the next four years, it stubbornly remained ensconced at higher levels — averaging about 8 per cent. Subsequently, it cooled to 5 per cent levels in 2016-17.
We did a correlation analysis of inflation with the key financial metrics of BSE S&P 500 companies during this eight-year period. To understand granular realities, we did similar studies at the sectoral level. While inflation was analysed with the aggregate financials of 23 sectors, the study was based on inflation figures as reflected by both WPI and Consumer Price Index (CPI) numbers. While ‘all commodities’ indices were taken for WPI, indices of both ‘combined’ and ‘industrial workers’ were taken for CPI.
Correlation is a statistical measure that indicates the extent to which two or more variables move together. A positive correlation figure indicates that the two variables move in tandem, while a negative figure indicates that they move in opposite directions. The correlation figure varies between -1 and 1. A figure higher than 0.6 or lower than -0.6 usually indicates that the two variables have a strong correlation.
Salsa with sales
For starters, our analysis shows that sales growth of India Inc exhibits a strong positive correlation (0.86) with WPI inflation. Companies from FMCG, entertainment, capital goods, steel, oil and gas, textiles and tyre sectors show a strong positive correlation of their top lines with WPI inflation.
CPI inflation, in turn, has a strong positive correlation with sales growth of auto, construction and telecom services. In all, WPI appears to have a stronger link with the sales growth of India Inc than CPI.
It is not hard to see why inflation moves in sync with sales. Since the turnover of companies is expressed in nominal terms, increase or decrease in inflation tends to impact the realisation of companies as well.
In the two financial years of 2010-11 and 2011-12, when inflation was at its peak of about 9 per cent, sales growth of India Inc was also at its peak. Annual sales growth was at about 20 per cent during these two years. Subsequently, when inflation eased to 6 per cent in 2013-14, sales growth cooled to 14 per cent.
And when a deflationary situation set in, in 2015-16, when WPI contracted 2.5 per cent, sales growth was at its worst — growing by about 3 per cent.
Understanding inflation
In a cost-push scenario, prices rise from an increase in prices of inputs like raw material, labour, etc, which are required to produce goods and services.
And when input costs increase, producers typically try to inflate the prices of goods and services. And the ability of producers to pass on the increased costs separates the men from the boys.
In the past, some cement manufacturers — especially in oligopolistic regional markets — have managed to pass on rise in input costs to their customers.
However, our analysis shows that at the aggregate level, sales growth of cement manufacturers had a lower correlation of 0.54 with inflation. Lower capacity utilisation, coupled with increased competition from regional players, has perhaps impacted pricing discipline in many regional markets — especially central India.
However, it’s not the case for auto manufacturers like Maruti Suzuki that typically manage to fully pass on the higher costs to customers. And it’s no wonder CPI inflation has a strong correlation not only with sales growth (0.74) but also with its net profit growth (0.60) of auto companies.
However, same could not be said of FMCG players, including market leaders like HUL or Marico Industries. The companies have struggled to pass on the increased input costs to their customers. Therefore increasing inflation tends to hurt the bottom line of these companies.
Recently, when copra prices increased, Marico Industries didn’t pass on the higher costs to buyers of Parachute oil for fear of losing market share. A decade back, in 2008 and 2009, when HUL did otherwise and increased the price of its detergents to match rising input costs, it lost 6 per cent market share in detergents to the unorganised players.
Besides cost factors, inflation can also be triggered by demand factors. For instance, when demand outstrips supply. In such cases, the pricing power of the manufacturers plays an important role in their ability to charge a premium for their products.
Bottom-line disconnect
Interestingly, while our study shows a strong correlation of inflation with sales growth of India Inc, it is not the case with its bottom line. Except for banks and oil and gas, none have a positive relationship between net profit growth and inflation.
The weaker link can be explained by the fact that inflation pushes up the cost of inputs and wage, thereby hurting operating profits. Not all companies have the wherewithal to pass on the cost increase to their customers.
Moreover, companies in the B2B segment, such as steel, power distributors and oil & gas, have to absorb the increase in input costs due to regulations restricting their pricing freedom. But companies in the B2C segment, such as auto and FMCG, have greater autonomy to adjust their selling price to protect their margins.
Moreover, as inflation rises, the cost of running existing business goes up, as companies require more money to invest in inventory and fixed assets at inflated costs. The more capital-intensive the business, the more fund-guzzling it will be. Industrial cyclicals like steel, power distributors or construction, typically, face these issues.
Increasing leverage
Also, when inflation is stubbornly higher, as it was during FY’11-13, getting debt becomes a stretch. While large and creditworthy companies face less hassle in getting funding, it’s a challenge for mid-sized companies. And even if such companies manage to get credit, it’s usually at higher interest rates. It creates a vicious circle; more debt weakening the balance sheet and increased financing cost eroding profitability. However, our analysis shows that there is less correlation (-0.25) between growth in interest payments and inflation for India Inc.
However, there are some sectors that are clear winners of an inflationary environment. Our empirical analysis shows that there is a strong correlation (0.76) between WPI inflation and net profit growth of banks. During the high inflation years of FY’11-13, net profit of banks grew at 10 per cent plus rates annually. Subsequently net profit in this sector fell 66 per cent — when inflation turned negative in 2015-16. And it bounced back to a strong 17 per cent growth in 2016-17, when inflation inched up to 5 per cent levels. Bank of Baroda, Canara Bank and Punjab National Bank were among the banks that saw a sharp turnaround in profits after 2015-16.
This is because the prospects of the banking sector and credit growth are linked to the nominal GDP growth of the economy.
While mild inflation and even bouts of higher inflation are good for business, sustained years of higher inflation could have deleterious effects on some businesses — for example, auto sales and entertainment.
For instance, during FY’10-12, when CPI inflation averaged 10 per cent, annual sales were up by a record 30 per cent in each of these years. However, in 2012-13 and 2013-14, when inflation persisted at higher rate of 10.4 per cent and 9.8 per cent, sales growth slowed down to 12-13 per cent levels.
So has been the case with the entertainment companies, when higher inflation years of FY11-13 for CPI are juxtaposed with consistent fall in sales growth rates of 20 per cent, 16 per cent and 12 per cent, respectively. Intuitively, it’s not difficult to understand why it happened. Typically, discretionary spends such as entertainment are among the first to feel the axe when inflation starts pinching consumer pockets.
Usually, investors track real GDP growth to find signs of pick-up in corporate earnings. If the real GDP grows at, say, 8 per cent, corporate earnings are expected to go up by a certain multiple at the aggregate level, say, 1.2-1.3 times that of GDP growth. For instance, cement manufacturers use the ballpark estimate of cement volumes to clock growth rates, that is about 1.2 times that of real GDP growth.
While GDP growth is a robust indicator, the data comes with a lag. Not so, the case with inflation, which is declared every month. By looking at patterns of behaviour of inflation with financials of various sectors, one could get contemporaneous signs of corporate health — especially sales.
While most analysts might be doing such exercises already, what is interesting is our empirical finding that inflation and sales growth do have a strong relationship.
Stock-picking tips
Once the relationship is established, how do we make the most of the inflationary environment? Essentially, it’s all about prudent stock picking and using two dip sticks. One, gauging the ability of the company to pass on the increased costs to its customers and finding capital.
While the former depends on its leadership position, bargaining power and product differentiation, capital requirements vary with the nature of the business.
If the company is able to bypass the deep moat of ‘price pass-through’ and do with little capex, it can tide over inflationary times better. After all, it is saved from the need to invest in inflated building and machinery costs.
In short, look for companies that are less capital guzzling. Or those that have fully done with their capex.They are more likely to do better in inflationary periods. This is because increase in revenue will straight away contribute to their bottom line. You are more likely to find such candidates in consumer-centric businesses than industrial cyclicals. FMCG, entertainment, auto and retail are amongst them. However, play it safe, by not ignoring these companies’ current valuations.
Here are some sector trends
Consumer Durables
If you can recall what you paid for a washing machine or a music system decades back, you will realise that the price has not changed much. Consumer durable players do not have too much pricing power, with intense competition among South Korean, Japanese and Indian manufacturers. It’s no wonder, there is no significant correlation (0.44) between CPI inflation and sales growth of consumer durable companies.
Among the market leaders, Videocon Industries, for instance, has seen its sales vacillate over the years. However, players like Whirlpool India and Bajaj Electricals have held their ground, managing to improve sales year after year.
Oil and Gas
This is one sector whose sales have shown the highest positive correlation (0.95) with WPI inflation. ONGC and Oil India largely make up this universe. Both net profit growth (0.62) and operating profit (0.72) of these companies have shown a strong positive correlation with WPI inflation.
Years of higher WPI inflation — FY‘11-13 — have coincided with higher oil prices, upwards of $80 per barrel. And the latter has usually benefited oil and gas exploration companies.
Construction and Capital Goods
The sales growth of construction companies shows a strong correlation (0.62) with WPI inflation. Interestingly, CPI inflation has an even stronger correlation of 0.81 with it. For capital goods, it’s just the WPI inflation that has a strong correlation with growth in sales. Land and environmental clearances typically delay the projects by a year or two for infrastructure projects, which in turn escalates project costs. Many of the construction companies have been able to pass on these costs to its customers and protect their margins.
Inflation (WPI) showed a weak correlation with sales growth (0.54). Annual sales growth of cement companies remained above 10 percent levels, when inflation levels were above 6 per cent. Cement companies over the years have put on a lot of capacity in anticipation of demand recovery. However, in the last four financial years, volume growth has still been below the long-term average of 6 per cent. It has impacted the pricing power of companies, especially the large companies. This weak correlation perhaps hints that the cement manufacturers have not been able to pass on higher input costs to consumers.

The Next Minsky Moment - John Mauldin

Hollywood thrives on tropes. Most things that are possible to portray on film have been portrayed at some point in the last century. Today’s producers mostly just rearrange those tropes – and that’s OK.
Much of what we think is new and different is actually one variation or another on ancient themes. My favorite book genre, science fiction, has many archetypal tropes that can be traced back to Greek mythology, which itself must have grown out of tales that must have been told for millennia. Thus it’s little wonder that the “zeitgeist” of our time seems to produce a lot of zombie movies or asteroid movies or bad-alien movies. These and many other tropes just “get in the air” and take on a life of their own.
It’s not just storytelling; it’s inventions, too. You must take a minute to read this quote from Matt Ridley’s critically important book, The Evolution of Everything:
Suppose Thomas Edison had died of an electric shock before thinking up the light bulb. Would history have been radically different? Of course not. Somebody else would have come up with the idea. Others did. Where I live, we tend to call the Newcastle hero Joseph Swan the inventor of the incandescent bulb, and we are not wrong. He demonstrated his version slightly before Edison, and they settled their dispute by forming a joint company. In Russia, they credit Alexander Lodygin. In fact there are no fewer than twenty-three people who deserve the credit for inventing some version of the incandescent bulb before Edison, according to a history of the invention written by Robert Friedel, Paul Israel, and Bernard Finn. Though it may not seem obvious to many of us, it was utterly inevitable once electricity became commonplace that light bulbs would be invented when they were. For all his brilliance, Edison was wholly dispensable and unnecessary. Consider the fact that Elisha Gray and Alexander Graham Bell filed for a patent on the telephone on the very same day. If one of them had been trampled by a horse en route to the patent office, history would have been much the same.
I am going to argue that invention is an evolutionary phenomenon. The way I was taught, technology was invented by god-like geniuses who stumbled upon ideas that changed the world. The steam engine, light bulb, jet engine, atom bomb, transistor – they came about because of Stephenson, Edison, Whittle, Oppenheimer, Shockley. These were the creators. We not only credit inventors with changing the world; we shower them with prizes and patents.
But do they really deserve it? Grateful as I am to Sergey Brin for the search engine, and to Steve Jobs for my MacBook, and to Brahmagupta (via Al Khwarizmi and Fibonacci) for zero, do I really think that if they had not been born, the search engine, the user-friendly laptop, and zero would not by now exist? Just as the light bulb was ‘ripe’ for discovery in 1870, so the search engine was ‘ripe’ for discovery in 1990. By the time Google came along in 1996, there were already lots of search engines: Archie, Veronica, Excite, Infoseek, Altavista, Galaxy, Webcrawler, Yahoo, Lycos, Looksmart . . . to name just the most prominent. Perhaps none was at the time as good as Google, but they would have got better. The truth is, almost all discoveries and inventions occur to different people simultaneously, and result in furious disputes between rivals who accuse each other of intellectual theft.
In the early days of electricity, Park Benjamin, author of The Age of Electricity, observed that ‘not an electrical invention of any importance has been made but that the honour of its origin has been claimed by more than one person.
This phenomenon is so common that it must be telling us something about the inevitability of invention. As Kevin Kelly documents in his book What Technology Wants, we know of six different inventors of the thermometer, three of the hypodermic needle, four of vaccination, four of decimal fractions, five of the electric telegraph, four of photography, three of logarithms, five of the steamboat, six of the electric railroad. This is either redundancy on a grand scale, or a mighty coincidence. It was inevitable that these things would be invented or discovered just about when they were. The history of inventions, writes the historian Alfred Kroeber, is ‘one endless chain of parallel instances’.
The Next Minsky Moment
Economics has its overused themes and phrases, too. One is “Minsky moment,” the point at which excess debt sparks a financial crisis. The late Hyman Minsky said that such moments arise naturally when a long period of stability and complacency eventually leads to the buildup of excess debt and overleveraging. At some point the branch breaks, and gravity takes over. It can happen quickly, too.
Minsky studied under Schumpeter and was clearly influenced by many of the classical economists. But he must be given credit for formalizing what were only suggestions or incomplete ideas and turning them into powerful economic themes. I’ve often felt that Minsky did not get the credit he deserved. I look at some of the piddling ideas that earn Nobel prizes in economics and compare them to the importance of Minsky’s work, and I get an inkling of the political nature of economics prizes.
Minsky’s model of the credit system, which he dubbed the “financial instability hypothesis” (FIH), incorporated many ideas already circulated by John Stuart Mill, Alfred Marshall, Knut Wicksell and Irving Fisher. “A fundamental characteristic of our economy,” Minsky wrote in 1974, “is that the financial system swings between robustness and fragility, and these swings are an integral part of the process that generates business cycles.” [Wikipedia]
Minsky came to mind because in the past week I saw yet more signs that financial markets are overvalued and investors excessively optimistic. Yet I still haven’t seen many references to Minsky. That’s a little surprising.
On reflection, I realized I hadn’t mentioned Minsky lately, either. That is a potentially dangerous oversight, because we forget his fundamental insights at our peril. Last week’s brief technology tumble should have been a wake-up call. So today we’ll have a little Minsky refresher and look at some recent danger signs. And I predict that we will soon see Minsky mentions popping up everywhere.
Natural Instability
Hyman Minsky, who passed away in 1996, spent most of his academic career studying financial crises. He wanted to know what caused them and what triggered them. His research all led up to his Financial Instability Hypothesis. He thought crises had a lot to do with debt. Minsky wasn’t against all debt, though. He separated it into three categories.
The safest kind of debt Minsky called “hedge financing.” For example, a business borrows to increase production capacity and uses a reasonable part of its current cash flow to repay the interest and principal. The debt is not risk-free, but failures generally have only limited consequences.
Minsky’s second and riskier category is “speculative financing.” The difference between speculative and hedge debt is that the holder of speculative debt uses current cash flow to pay interest but assumes it will be able to roll over the principal and repay it later. Sometimes that works out. Borrowers can play the game for years and finally repay speculative debt. But it’s one of those arrangements that tends to work well until it doesn’t.
It’s the third kind of debt that Minsky said was most dangerous: Ponzi financing is where borrowers lack the cash flow to cover either interest or principal. Their plan, if you can call it that, is to flip the underlying asset at a higher price, repay the debt, and book a profit.
Ponzi financing can work. Sometimes people have good timing (or just good luck) and buy a leveraged asset before it tops out. The housing bull market of 2003–07, when people with almost no credit were buying and flipping houses and making money, attracted more and more people and created a soaring market. The phenomenon fed on itself. Bull markets in houses, stocks, or anything else can go higher and persist longer than we skeptics think is possible. That is what makes them so dangerous.
Minsky’s unique contribution here is the sequencing of events. Protracted stable periods where hedge financing works encourage both borrowers and lenders to take more risk. Eventually once-prudent practices give way to Ponzi schemes. At some point, asset values stop going up. They don’t have to fall, mind you, just stop rising. That’s when crisis hits.
The Economist described this process well in a 2016 Minsky profile article. (Emphasis mine.)
Economies dominated by hedge financing – that is, those with strong cashflows and low debt levels – are the most stable. When speculative and, especially, Ponzi financing come to the fore, financial systems are more vulnerable. If asset values start to fall, either because of monetary tightening or some external shock, the most overstretched firms will be forced to sell their positions. This further undermines asset values, causing pain for even more firms. They could avoid this trouble by restricting themselves to hedge financing. But over time, particularly when the economy is in fine fettle, the temptation to take on debt is irresistible. When growth looks assured, why not borrow more? Banks add to the dynamic, lowering their credit standards the longer booms last. If defaults are minimal, why not lend more? Minsky’s conclusion was unsettling. Economic stability breeds instability. Periods of prosperity give way to financial fragility.
Minsky’s conclusions are indeed unsettling. He called into question the belief that markets, left to operate unimpeded, will deliver stability and prosperity to all. Minsky thought the opposite. Markets are not efficient at all, and the result is an occasional financial crisis.
Complacency in the midst of a wanton debt buildup was beautifully expressed in a remark by Citigroup Chairman Chuck Prince in 2007:
The Citigroup chief executive told the Financial Times that the party would end at some point, but there was so much liquidity it would not be disrupted by the turmoil in the US subprime mortgage market.
He denied that Citigroup, one of the biggest providers of finance to private equity deals, was pulling back.
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” [source]
Minsky wasn’t around to see the 2008 crisis that fit right into his theory. Paul McCulley attached Minsky’s name to it, though, and now we refer to these crises as “Minsky moments.”
Are we closing in on one now?

Learning the Rules
As I mentioned, technology stocks suffered from a little anxiety attack in the markets last week. It didn’t not last long and really wasn’t all that serious. (Yet.) It was nothing worse than what everyone called “normal volatility” ten years ago. But the lack of concern it generated this time is not bullish, in my view. More than a few investors seem to think that “nowhere but up” is somehow normal.
Doug Kass had similar thoughts (there’s that Zeitgeist trope thing again) and reminded us all of Bob Farrell’s famous Ten Rules of Investing. You could write a book about each one of them. I’ll just list them quickly, then apply some of them to our current situation. (Emphasis mine.)
1. Markets tend to return to the mean over time.
2. Excesses in one direction will lead to an opposite excess in the other direction.
3. There are no new eras – excesses are never permanent.
4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.
5. The public buys most at the top and the least at the bottom.
6. Fear and greed are stronger than long-term resolve.
7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names. (Sound familiar? Can you say FAANGs?)
8. Bear markets have three stages: sharp down, reflexive rebound, and a drawn-out fundamental downtrend.
9. When all the experts and forecasts agree, something else is going to happen.
10. Bull markets are more fun than bear markets.
I think most of these rules are obvious to investors who experienced the 2008 mess, the dot-com crash, and (if you’re of a certain age) the 1987 Black Monday. Some of us can remember 1980 and ’82. ’82 was especially ugly. (I had just gotten my master of divinity degree, and all I knew was that the job market sucked.) Maybe we mostly forget these experiences, but hopefully we pick up a little wisdom along the way. The problem is that now a new generation of investors lacks this perspective. They had little or no stock exposure in 2008 and experienced the Great Recession as more of a job-loss or housing crisis than a stock market crisis.
Of course, the previous crises are no secret. People know about them, and on some level they know the bear will come prowling around again, eventually. But knowing history isn’t the same as living through it. Newer investors may not notice the signs of a top as readily as do investors who have seen those signs before – and who maybe got punished for ignoring them at the time.
Doug Kass notices. Here’s a bit from an e-mail conversation we had last week.
During the dot.com boom in 1997 to early 2000 there was the promise (and dream) of a new paradigm and concentration of performance in a select universe of stocks. The Nasdaq subsequently dropped by about 85% over the next few years.
I got to thinking how many conditions that existed back then exist today – most importantly, like in 1999, when there emerged the untimely notion of “The Long Boom” in Wired magazine. It was a new paradigm of a likely extended period of uninterrupted economic prosperity and became an accepted investment feature and concept in support of higher stock prices!
[JM note: Here’s the Wired article Doug mentions: “The Long Boom: A History of the Future, 1980-2020.”]
And in 2007 new-fangled financial weapons of mass destruction – such as subprime mortgages that were sliced and diced during a worldwide stretch for yield – were seen as safe by all but a few.
And, just like during those previous periods of speculative excesses, many of the same strategists, commentators, and money managers who failed to warn us then are now ignoring/dismissing (their favorite phrase is that the “macroeconomic backdrop is benign”) the large systemic risks that arguably have contributed to an overvalued and over-loved U.S. stock market.
Doug points especially to Farrell’s Rule 7, on market breadth. A rally led by a few intensely popular, must-own stocks is much less sustainable than one that lifts all boats. We see it right now in the swelling interest in FAANG (Facebook, Apple, Amazon, Netflix, Google). Tesla comes to mind, too. Their influence on the cap-weighted indexes is undeniably distorting the market. These situations rarely end well.
Chinese Minsky
What is behind these distortions? Ultimately, it’s about capital flows. Asset prices rise when demand outstrips supply, which is what happens when stocks or real estate or whatever are perceived as more rewarding than cash. Those with the most unwanted cash compete with each other to buy the alternatives.
The Fed and other developed-country central banks created a lot of liquidity in recent years, so that’s undoubtedly a factor. An even greater one may be China, though.
Consider China’s explosive growth. Its proximate cause is US demand and, to a lesser extent, European demand for Chinese exports. We sent them our dollars and euros; they sent us widgets and doodads. US dollars inside China are undesirable to wealthy Chinese and the Chinese government, so they send the dollars right back to us in exchange for other assets: homes, commercial real estate, stocks, Treasury bonds, entire companies.
Meanwhile, within China, the government aggressively encourages lending for projects a free economy would never produce. Let me make a critical point here: While the central bank of China is not doing much in the way of quantitative easing, the government’s use of bank lending gone wild is essentially the same thing. The banks have created multiple trillions of yuan every year for many years. If you add Chinese bank lending statistics to the quantitative easing statistics of the world’s major central banks, the number is staggering. I think it’s entirely appropriate to perform that calculation.
Beijing thinks this massive bank lending is useful in keeping the population happy, employed, and satisfied with their government. It has worked pretty well, too. It can’t work indefinitely, but the government seems bent on trying. Consider this June 14 Wall Street Journal report.
While Beijing is carrying out a high-profile campaign to reduce leverage in its financial markets with one hand, with the other it is encouraging more potentially reckless borrowing. This week, the regulator put pressure on the country’s big banks to lend more to small companies and farmers, while the government announced tax breaks for financial institutions that lend to rural households. That follows recent guidance that banks should set up “inclusive finance” units.
If the goal of lending to poorer customers sounds noble, the concern is that the execution will only worsen Chinese banks’ existing problems, namely high levels of bad loans and swaths of mispriced credit. Bank lending to small companies is already growing pretty fast, with non-trivial sums involved: It jumped 17% in the year through March to 27.8 trillion yuan ($4.084 trillion). That compares favorably with the 7% rise in loans to large- and medium-size companies over the same period.
Observers like me have been saying for years that China’s banking system is overleveraged and will eventually collapse. We’ve been wrong so far. Beijing’s central planners may be Communists, but they use the capitalist toolbox to their advantage.
 China will eventually face a reckoning. When it does, the impact will spread far outside China. What do you think will happen when Chinese money stops buying Vancouver real estate and US stocks? The outcome won’t be bullish.
The Swiss National Bank Is Doing What?
Pity the poor Swiss government. They have run their country well and don’t have a great deal of debt. They are a small country of just 8 million people, but they make an outsized impact on economics and finance and money.
Because Switzerland is considered a safe haven and a well-run country, many people would like to hold large amounts of their assets in the Swiss franc. Which makes the Swiss franc intolerably strong for Swiss businesses and citizens. So the Swiss National Bank (SNB) has to print a great deal of money and use nonconventional means to hold down the value of their currency. Their overnight repo rate is -0.75%. That’s right, they charge you a little less than 1% a year just for the pleasure of letting your cash sit in a Swiss bank deposit.
And the SNB is buying massive quantities of dollars and euros, paid for by printing hundreds of billions in Swiss francs. The SNB owns about $80 billion in US stocks today (June, 2017) and a guesstimated $20 billion or so in European stocks (which guess comes from my friend Grant Williams, so I will go with it).
They have bought roughly $17 billion worth of US stocks so far this year. They have no formula; they are just trying to manage their currency. Think about this for a moment: They have about $1000 in US stocks on their books for every man, woman, and child in Switzerland, not to mention who knows how much in other assorted assets, all in the effort to keep a lid on what is still one of the most expensive currencies in the world. I gasp at prices every time I go to Switzerland. (I will be in Lugano for the first time this fall.)
Switzerland is now the eighth-largest public holder of US stocks. It has got to be one of the largest holders of Apple (see below). What happens when there is a bear market? Who bears the losses? Print just more money to make up the difference on the balance sheet? Do we even care what the Swiss National Bank balance sheet looks like? More importantly, do they really care? We all remember European Central Bank President Mario Draghi’s famous remark, that he would do “whatever it takes” to defend the euro. We could hear the Swiss singing from the same hymnbook, by and by.
The point is that central banks and governments all the world are flooding the market with liquidity, which is showing up in the private asset markets, in stock and housing and real estate and bond prices, creating an unquenchable desire for what appear to be cheap but are actually overvalued assets – which is what creates a Minsky moment.
Now, remember what Minsky said. When an economy reaches the Ponzi-financing stage, it becomes extremely sensitive to asset prices. Any downturn or even an extended flat period can trigger a crisis.
While we have many domestic issues that could act as that trigger, I see a high likelihood that the next Minsky moment will propagate from China or Europe. All the necessary excesses and transmission channels are in place. The hard part, of course, is the timing. The Happy Daze can linger far longer than any of us anticipate. Then again, some seemingly insignificant event in Europe or China – an Austrian Archduke’s being assassinated, or what have you – can cause the world to unravel.
It’s a funny world. We have our rashes of zombie moves and 20 people in all corners of the planet inventing the same thing at the same time. And we have our central banks and governments exhibiting unmistakable herd behavior and continuing to do the same foolish things over and over. They never really intend to have the crisis that ensues.
 Remember Farrell’s Rule 3: There are no new eras. The world changes, but danger remains. Gravity always wins eventually. It will win this time, too. And when it does, we will begin undergo the Great Reset.