Month: October 2014 | Vivek Kaul

28 October, 2014

Dragon slows down: Why China may not continue to grow at high growth rate

Vivek Kaul

Three recent pieces of data coming out of China suggest that all is not well in the Middle Kingdom. The economic growth (as measured by the rate of growth of gross domestic product) during July to September 2014 came in at 7.3%.
While the number is on the higher side in comparison to the economic growth rates that prevail all over the world, it isn’t in comparison to the rates at which China has grown over the last three decades. As The Economist put it “It[i.e. the Chinese economic growth] was well below the roughly 10% pace China had averaged from 1980 until two years ago.”
Over and above this, the consumer price inflation for September 2014 came in at 1.6% against 2% in August 2014. This is another sign of the Chinese economy slowing down. In fact, the producers price index (or what we call the wholesale price index) has been falling since early 2012. In fact, September 2014, saw the biggest month on month drop of 0.4%.
Over and above this, the foreign exchange reserves declined big time. As Albert Edwards of Societe Generale put it in a recent research note titled Once again the key Chinese data were overlooked and dated Oct 23, 2014 “I was also surprised to see that the $100bn decline in China’s Q3 FX[foreigh exchange] reserves, the largest quarterly fall ever. As I have explained, this reflects deterioration in Chinese competitiveness from its excessively strong real exchange rate.”
China has grown at a rapid rate since the late 1970s, when Deng Xiaoping took over the reigns of the country. And no country has ever come close to matching the astonishing growth that China has achieved since then.
As economists Lant Pritchett and Lawrence H. Summers of Harvard University point out in a recent research paper titled Asiaphoria Meets Regression To The Mean “Episodes of super-rapid growth (>6 percent) tend to be extremely short-lived…China’s experience from 1977 to 2010 already holds the distinction of being the only instance, quite possibly in the history of mankind, but certainly in the data, with a sustained episode of super-rapid (> 6 percent per annum) growth for more than 32 years.”
Very few countries have come close to achieving what China has. As the Harvard economists point out “The median duration of a super-rapid growth episode is nine years…There are essentially only two countries with episodes even close to China’s current duration. Taiwan had a growth episode from 1962 to 1994 of 6.8 percent (decelerating to growth of 3.5 percent from 1994 to 2010). Korea had an episode from 1962 to 1982 followed by another acceleration in 1982 until 1991 when growth decelerated to 4.48 percent—a total of 29 years of super-rapid growth (>6 percent)—followed by still rapid (>4 percent) growth.”
Given this, the Chinese economic growth is what we could call an exception to the rule that sustained rapid economic growth is a rarity. It is safe to say that beyond a point economic growth collapses more often than not. And once the growth starts to collapse it tends to come down to the mean growth rate of the world, which is just a little over 2%. “The typical (median) end of an episode of super-rapid growth is near complete regression to the world mean growth rate. The median of the growth episode that follows an episode of super-rapid growth is 2.1 percent per year,” write Pritchett and Summers.
In this scenario what are the chances that China will continue to grow at a high growth rate in the days to come? The China bulls would obviously like to tell us that people have talking about Chinese growth stalling for a while now. Nevertheless, even though Chinese growth has slowed down it hasn’t really crashed.
The trouble with forecasters is that they “invariably extrapolate recent growth”. They expect the present state of affairs to continue. But that as we know is not the case more often than not. As the Harvard economists point out “There was a widespread view right up until the end of the 1980s that Japan would continue to grow and outcompete the world….During the late 1980s, it was widely believed that Japanese-style industrial policy, Japanese emphasis on corporate linkages through keiretsu, and high levels of investment supported by financial repression were keys to rapid growth. A decade later, the conventional wisdom held nearly the opposite views.”
The same is true about Africa as well. “In the opposite direction, consider the pervasive pessimism of even a decade ago regarding Africa. Since then, African countries emerged as a majority of the world’s most rapidly growing nations.”
In fact in the 1960s there was even the belief that the Soviet Union would outgrow the United States. This was “based on an extrapolation of its recent growth performance.”
Another good example here is that of Brazil. As The Economist points out “Slowdowns often occur despite seemingly sound prospects: both Brazil in 1980 and Japan in 1991 looked like juggernauts, yet they managed scarcely any growth at all in real GDP per person over the following 20 years. A slowdown is not a sign of failure, they say; rather, persistent rapid growth suggests unusually good fortune or policy.”
To conclude, what all this clearly tells us is that Chinese growth will falter sooner rather than later. The only question is when. On that your guess is as good as mine.

The article originally appeared on www.FirstBiz.com on Oct 28, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

28 October, 2014

Jaitley again asks for interest rate cuts, needs lessons in basic economics

Vivek Kaul

It is fashionable in Delhi circles these days to ask for an an interest rate cut at a drop of a hat. The finance minister Arun Jaitley like his predecessor P Chidambaram likes to remind the Reserve Bank of India (RBI) now and then that the time is just right for a rate cut.
In an interview to The Times of India late last week Jaitley said “”Currently, interest rates are a disincentive. Now that inflation seems to be stabilizing somewhat, the time seems to have come to moderate the interest rates.”
Before Jaitley, the senior columnist Prem Shankar Jha became the newest interest-rate-wallah on the block and in a column in The Times of India held the RBI responsible for India’s slow economic growth over the last few years. As he wrote“[The] Indian economy is not on the road to recovery. The reason is the sustained high interest rate regime of the past four years. Industry has been begging for cuts in the cost of borrowing since March 2011… On August 5, RBI governor Raghuram Rajan surprised the country by announcing that he would not lower interest rates, because at 8% consumer price inflation was still too high.”
I guess Jha must have been among the few people surprised by Rajan’s decision given that among those who follow the workings of the Indian central bank closely, almost no one had expected Rajan to cut interest rates.
The premise on which interest-rate-wallahs work is that at lower interest rates people will borrow and spend more, which will lead to economic growth. But the entire premise that low interest rates will lead to a pick up in consumption and hence, higher economic growth, doesn’t really hold. (As I have explained here). Jaitley believes that “expansion in real estate will take place significantly only if the interest rates come down a little.”
This is what the real estate companies also like to believe. But the basic point is that people are not buying homes because home prices have risen way above what they can afford. As I have explained in the past, for an average Mumbaikar it currently takes around 34 years annual income to buy a home to live in. This is true for other cities as well, though the situation maybe a little better than that in Mumbai. So even a major cut in interest rates is not going to lead people buying homes to live in unless real estate prices fall. This is something that Arun Jaitley as the finance minister of this country needs to understand.
Having said that, those looking to move their black money around will always look at investing in real estate and for them the interest rates really don’t matter.
The other big reason offered is that companies can borrow at lower rates of interest. The idea being that lower interest rates might encourage companies to borrow and expand. Again it needs to be realized that companies don’t always decide to expand just because money is available at low interest rates, especially in difficult times as these.
Factors like ease of doing business and consumer demand play an important role. As I have explained in the past, due to many years of high inflation consumer demand in India continues to remain subdued. And unless it starts to pick up, there is no real reason for companies to expand.
Also, it is worth remembering here that a some of the major business groups in India have already borrowed a lot of money and are having tough time paying interest on the debt they already have. Hence, where is the question of borrowing more?
The bigger question that interest-rate-wallahs tend to ignore is how much control does the RBI really have over interest rates that banks pay their depositors and in turn charge their borrowers? Over the last few weeks, banks have cut interest rates on their fixed deposits. The list includes State Bank of India, Punjab National Bank and Central Bank of India. (You can read about here, here and here). The Indus Ind Bank also cut the interest it pays on its savings account to 4.5% from the earlier 5.5% for a daily balance of up to Rs 1 lakh, starting September 1, 2014.
All these cuts in interest rates have happened despite the RBI maintaining the repo rate at 8%. Repo rate is the interest rate at which the RBI lends to banks. So what has changed that has allowed these banks to cut the interest rates at which they borrow?
Let’s look at some numbers. As on October 3, 2014, over a period of one year, the loans given by banks rose by 9.87%. During the same period the deposits raised by banks rose by 11.54%. How was the situation one year back? As on October 4, 2013, over a period of one year, the loans given by banks had risen by 15.18%. During the same period the deposits had grown by 12.9%.
Hence, the rate of loan growth for banks has fallen much faster than the rate at which their deposit growth has fallen. Given this, it is not surprising that banks are cutting fixed deposit rates, given that their rate of loan growth is falling at a much faster rate.
As Henry Hazlitt writes in Economics in One Lesson “Just as the supply and demand for any other commodity are equalized by price, so the supply of demand for capital are equalized by interest rates. The interest rate is merely a special name for the price of loaned capital. It is a price like any other.”
As Hazlitt further points out “If money is kept…in…banks…the banks are eager to lend and invest it. They cannot afford to have idle funds.”
Hence, given that the rate of loan growth is much slower than the rate of deposit growth, it is not surprising that banks are cutting interest rates on their fixed deposits. Given this, the impact that RBI’s repo rate has on interest rates is at best limited. It is more of a broad indicator from the RBI on which way it thinks interest rates are headed.
Further, it also needs to be remembered that financial savings in India have fallen dramatically over the last few years. The latest RBI annual report points out that “the household financial saving rate remained low during 2013-14, increasing only marginally to 7.2 per cent of GDP in 2013-14 from 7.1 per cent of GDP in 2012-13 and 7.0 per cent of GDP in 2011-12…the household financial saving rate [has] dipped sharply from 12 per cent in 2009-10.”
Household financial savings is essentially the money invested by individuals in fixed deposits, small savings scheme, mutual funds, shares, insurance etc. It has come down from 12% of the GDP in 2009-10 to 7.2% in 2013-14. A major reason for the fall has been the high inflation that has prevailed since 2008.
The rate of return on offer on fixed income investments(like fixed deposits, post office savings schemes and various government run provident funds) has been lower than the rate of inflation. This led to people moving their money into investments like gold and real estate, where they expected to earn more. Hence, the money coming into fixed deposits slowed down leading to a situation where banks could not cut interest rates., given that their loan growth continued to be strong.
What also did not help was the fact that the borrowing requirements of the government of India kept growing over the years.
The RBI was not responsible for any of this. The only way to bring down interest rates is by ensuring that inflation continues to remain low in the months and the years to come. If this happens, then money flowing into fixed deposits will improve and that, in turn, will help banks to first cut interest rates they offer on their deposits and then on their loans.
The government needs to play an important part in the efforts to bring down inflation. In fact, it has been working on that front. In a recent research report analysts Abhay Laijawala and Abhishek Saraf of Deutsche Bank Market Research write that the “the government is firmly ‘walking the talk’ on fiscal consolidation” through a spate of “recent administrative moves on curbing food inflation (such as fast liquidation of surplus foodstock, modest single-digit hike in MSPs, an effort to eliminate fruits and vegetables from ambit of APMC etc.)”
This is very important given that once inflation remains low for an extended period of time, only then will inflationary expectations (or the expectations that consumers have of what future inflation is likely to be) be reined in. And consumer demand is likely to pick up after this.
The Reserve Bank of India’s Inflation Expectations Survey of Households: September – 2014 which was a survey of 4,933 urban households across 16 cities, and which captures the inflation expectations for the next three-month and the next one-year period. The median inflation expectations over the next three months and one year are at 14.6 percent and 16 percent. In March 2014, the numbers were at 12.9 percent and 15.3 percent. Hence, inflationary expectations have risen since the beginning of this financial year.
To conclude, RBI seems to have become everyone’s favourite punching bag even though its impact on setting interest rates is rather limited. It is time that interest-rate-wallhas like Jaitley and Jha come to terms with this.

This an updated version of a column that appeared on Oct 22, 2014. You can read the original column here

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

27 October, 2014

The Wrong Causality

Vivek Kaul

Raghuram Rajan, the governor of the Reserve Bank of India (RBI), gave a spate of interviews to international publications in early August 2014. In these interviews he talked about the financial markets bubbles that have sprouted up all over the world, due to Western central banks printing a lot of money over the last six years.
In an interview to the Time magazine Rajan said that central bankers had constantly “infused liquidity into the markets” (basically printed money and pumped it into the financial system) in order to ensure that interest rates continue to remain low. The idea was that at low interest rates people would borrow and spend more money and this would lead to economic growth.
But that doesn’t seem to have happened. Instead a lot of this money has been borrowed at low interest rates and has found its way into financial markets all over the world. As Rajan told the Central Banking Journal “The problems arising are not so much from credit growth, which is relatively tepid in the industrial markets and has been much stronger in emerging markets, but from asset prices due to financial risk-taking and so on.”
With so much “easy money” floating in the financial system, investors have borrowed money at very low interest rates and invested them in financial markets all over the world. This has led to prices of financial assets (shares, bonds etc) being pushed way beyond their fundamentals justify.
Or to put in simple English financial markets through large parts of the world are now in a “bubble” (a word that central bankers do not like to use) phase.
This is something that economists who run central banks have refused to see. As Rajan put it “ Unfortunately, a number of macroeconomists have not fully learned the lessons of the great financial crisis. They still do not pay enough attention – en passant – to the financial sector. Financial sector crises are not as predictable. The risks build up until, wham, it hits you.”
The trouble is that no one really can predict when exactly will these bubbles burst. Rajan admitted to as much in an interview to the Financial Times when he said “the truth is, nobody really knows where the next one will come.” Nevertheless, when these bubbles start to burst, there will be trouble of the kind that the world experienced in 2008, all over again. As Rajan put it “We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost.”
The question is why has been there so much faith among economists when it comes to printing money. George Cooper explains this very well in his book Money, Blood and Revolution. As he writes “[The] monetarists economists believed the money supply controlled economic activity and therefore monitored it to measure and forecast economic activity. When they found that their forecasts were verified they naturally assumed that their thesis – money controls economic activity – was proven.” Hence, when the economy was not doing well, it made sense to crank up the printing presses, print more money, increase the money supply and get the economy going again all over again. QED.
This was the formula followed in the aftermath of the financial crisis that broke out in September 2008, with the investment bank Lehman Brothers going bust. Trillions of dollars, pounds, yen and renminbi, have been printed and pumped into the financial systems all over the world. This policy in central banking terminology has been referred to as quantitative easing.
The question is how effective has quantitative easing really been? As Cooper puts it “These policies have had, at best, mixed results so far. It is sobering to contemplate that all of this money may have been spent based on a basic misunderstanding of cause and effect.”
And what is this misunderstanding? Cooper explains this through an example of an economist who starts to study the number of trucks travelling on a motorway system. After having studied this for a while, it becomes obvious to the economist that there is a relationship between “the number of trucks travelling in a given period and the subsequent reported level of economic activity”. Hence, the economist draws the conclusion that road freight activity is a key driver of economic activity. So far so good.
This economist then goes on to found the freightist school of economics. The school then lobbies the government and policies that encourage the movement of trucks moving goods on the roads, are put in place.
Taxes are cut and schemes to subsidise the purchase and running of trucks are introduced. The first results of this experiment are positive as the economy grows. This leads to the government directly subsidising freight journeys. And this is where the problem starts. As Cooper puts it “Eventually truckers start driving freight up and down the country just to harvest subsidies. The economy stops growing but the freight statistics shoot through the roof. The relationship between economic activity and road freight breaks down.”
A basic mistake has been made here. “The freightist school has mistaken the direction of the causality between road freight and economic activity. Stronger economic activity causes more road freight but more road freight does not necessarily cause more economic activity,” writes Cooper.
A mistake along similar lines has been made by central banks all over the world, during the last few years. When economic activity picks up, money supply picks up as well. But that does not mean that the level of money supply can be manipulated to increase economic activity. As Cooper summarises it “Money is a measure of credit, and credit, like truck journeys, is created and destroyed according to the prevailing economic activity. Money supply, in its various forms, is an excellent measure of economic activity when left alone. But it cannot be used as an instrument to control the economy.”
In Cooper’s example we saw truck drivers driving freight up and down the country simply to harvest subsidies. Over the last six years, investors have worked along similar lines. They have borrowed money at very low interest rates and invested them in financial markets all over the world. And this has led to huge bubbles, which will burst in the years to come.

The column originally appeared in the Wealth Insight magazine for Sep 2014

(Vivek Kaul is the author of Easy Money: Evolution of the Global Financial System to the Great Bubble Burst. He can be reached at [email protected])

27 October, 2014

Yun hota to kya hota?

Vivek Kaul

In August 2014, the world marked the hundredth anniversary of the outbreak of the First World War. Over the years, a lot of analysis has happened on why the First World War happened. But what most historians do not talk about in their elaborate theories is that the War might have started just because a car happened to take a wrong turn.
At around 11 AM on June 28, 1914, a chauffeur of an automobile carrying two passengers in Sarajevo, happened to make a wrong turn. The car wasn’t supposed to make this turn and leave the main street. But due to the mistake of the chauffeur it ended up in a narrow lane and stopped right in front of a Gavrilo Princip, a 19-year-old student. But that wasn’t Princip’s only identity. He was also a member of the Serbian terrorist organization Black Hand.
Princip couldn’t believe his luck. He drew out his pistol and fired twice killing the two passengers in the car. Princip had recognized them and gone ahead and pulled the trigger. They were Archduke Franz Ferdinand and his wife Sophie of the Austro-Hungarian Empire. Earlier in the day, Princip and his friends who “wanted to promote the cause of a greater Serbia,” had unsuccessfully tried toassassinate Archduke Ferdinand by lobbing a grenade at him. The attempt had gone wrong and Princip had escaped and walked into the narrow lane to have a light snack. And there he ran into Archduke Ferdinand.
The assassination led to a series of events in a politically fragile Europe and started what was first known as the Great War and later came to be known as the First World War. As Mark Buchanan writes in Ubiquity “The First World War is the archetypal example of an unanticipated upheaval in world history, the war sparked by ‘the most famous wrong turn in history,’ and one may optimistically suppose that such an exceptional case is never likely to be repeated.
Historians over the years have analysed a number of reasons that caused the First World War. As Ed Smith writes in Luck—A Fresh Look At Fortune “In this version of history, the assassination merely lit the fuse, but the tinderbox would have surely exploded anyway.”
Would that have been the case? “Perhaps. But had Princip not killed Ferdinand in Sarajevo, the outbreak of the First World War would have at the very least been delayed. A war delayed is a war averted.”
Hence, it is a very interesting “counterfactual” to consider as to “what if” the Archduke’s chauffeur had not made that wrong turn that he did in June 1918. Possibly, the First World War would have never happened and the world would have turned out to be a much safer place. As Buchanan writes “When the First World War ended five years later, 10 million lay dead. Europe fell into an uncomfortable quiet that lasted twenty years, and then the Second World War claimed another 30 million. In just three decades, the world had suffered two engulfing cataclysms. Why? Was it all due to the chauffeur’s mistake?”
A few years after the chauffeur’s wrong turn, on December 13, 1931, an English politician “perhaps forgetting that American cars drive on the right-hand side of the road” met with an accident. The car was travelling at the speed of 35 miles per hour and could have easily killed him. But he survived and even wrote a 2400 word article detailing his “near-death” experience and made £600 in the process. The politician was Winston Churchill, who would successfully defend the United Kingdom against Germany during the course of the Second World War.
The question to ask if what would have happened if Churchill had died on that day. “There would have been no Churchill…to take over from Neville Chamberlain, no Churchill to galvanize Britain as it stood alone in 1940. What then? A successful German invasion…an occupied Nazi Britain…an isolationist America staying out of the War…And the whole history of the second half of the twentieth century would have been radically different,” writes Smith.
All this because there would have been no Winston Churchill to take on Adolf Hitler. But what if there had been no Adolf Hitler? A few months before Churchill was knocked down in New York, a young Englishman called John Scott-Ellis was spending sometime in Munich, Germany so that he could learn a new language.
As Smith points out “After a week in his new city, on a clear sunny day, Scott-Ellis bought his gleaming red Fiat and gave it a test drive around the streets of Munich…But a pedestrian crossed the road without looking left – just as Chruchill would do on Fifth Avenue[New York] four months later. ‘He walked off the pavement, more or less straight into my car,’ Scott-Ellis recalled.”
The pedestrian did not seriously injured himself. Three years later while waiting for an opera to start Scott-Eliss ran into that man again and introduced himself. He asked the man, whether he remembered about the accident, the man did.
Scott-Ellis did well in life and “became one of the great British racehorse owners”. As Smith writes “He often told the story of that crash in Munich in 1931: ‘For a few seconds, perhaps, I held the history of Europe in my rather clumsy hands. He was only shaken up, but had I killed him, it would have changed the history of the world.”
Scott-Ellis had run his car into Adolf Hitler.
History is influenced by fairly random small events, which have an overbearing impact on it. But these small random events do not make for ‘sexy’ theories that historians and analysts like to come up with and in the process these events get lost from public memory.
As Buchanan writes about all the history that has been written around what caused the First World War: “On the matter of the causes and origins of the First World War, of course, almost nothing has been left unsaid…The number of specific causes proposed is not so much smaller than the number of historians who have considered the issue, and even today major new works on the topic appear frequently. It is worth keeping in mind, of course, that all this historical ‘explanation’ has arrived well after the fact.”
To conclude, it is worth remembering, what the great Mirza Ghalib, who had a couplet for almost everything in life, had to say on this: “hui muddat ke ghalib mar gaya par yaad aata hai wo har ek baat par kehna ke yun hota to kya hota.”

The column originally appeared in Mutual Fund Insight magazine dated Oct 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

27 October, 2014

Central bankers are morons: Why bad economic news is treated as good news by stock market

Vivek Kaul

When it comes to investing in the stock market, there used to be two kinds of investors: those who invested on the basis of the fundamentals of a stock and and those who invested on the basis of non fundamentals.
Investors like Warren Buffett specialise in investing on the basis of fundamentals. These investors go through balance sheets, annual reports etc., in great detail, trying to figure out how well a company they want to invest in is doing in terms of sales, expenditure and profits.
On the other hand, the non fundamental investor most of the times is trying to do what John Maynard Keynes described best. John Lanchester writes about this “famous description” in his recent book How to Speak Money” “He (i.e. the non fundamental investor) is looking at a photo of six girls and trying to pick, not which girl he thinks is the prettiest, and not which he thinks most people will think is the prettiest, but which most people will think most people will think is the prettiest…In other words the non-fundamentals investor isn’t trying to work out what companies he should invest in, or what company most investors will think they should invest in, but which company most investors will think most investors will want to invest in.”
Or as Keynes put it in his magnum opus The General Theory of Employment, Interest and Money “It is not a case of choosing those [faces] that, to the best of one’s judgement, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
And this is how the stock market investors were neatly divided with the majority of them trying to figure out “ what average opinion expected the average opinion to be”. This neat division was broken down in the aftermath of the current financial crisis which started in September 2008. The markets are now ruled by the central banks.
As Ben Hunt wrote in the Epsilon Theory investment letter dated August 5, 2014, and titled Fear and Loathing on the Marketing Trail, 2014 “Today, everyone believes that market price levels are largely driven by monetary policy and that we are all being played by politicians and central bankers using their words for effect rather than direct communication.”
Monetary policy is essentially the process by which a central bank controls the amount of money in the financial system of a country. In the aftermath of the financial crisis, central banks of Western economies started printing money.
Economist John Mauldin in a recent column titled The End of Monetary Policy estimates that central banks have printed $7-8 trillion since the start of the financial crisis. It is worth pointing out here that this money is not actually printed, but created digitally, nonetheless “money being printed” is an easier way to talk about the whole thing.
Once this new money is created it is used to buy bonds, both private as well as government. This has been done to pump money into the financial system and ensure that there is enough money going around to keep interest rates low.
At low interest rates the hope was that people would borrow and spend more. This would create some demand and help economic growth. But that did not happen. What happened instead was that this newly created money found its way into financial markets all over the world.
This broke down the link between economic performance of a country and the performance of its stock market. The stock markets rallied anyway. This point was very well made recently by Claudio Borio, the head of the Bank of International Settlement’s monetary and economic department: “Buoyant financial markets are out of sync with the shaky global economic and geopolitical outlook. Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally. Financial markets are euphoric, in the grip of an aggressive search for yield, and yet investment in the real economy remains weak while the macro-economic and geopolitical outlook is still highly uncertain.”
This has led to a situation where bad economic news is treated as good news by the stock markets because the investors know that this will lead to central banks printing more money as they try and get economic growth going again. As Gary Dorsch, Editor, Global Money Trends newsletter, wrote in a recent column “Bad economic news is treated as Bullish news for the stock market, because it lead to expectation of more “quantitative easing.” And the easy money flows that are injected by central banks go right past goods and services (ie; the real economy) and are whisked into the financial markets, where it pushes up the prices of stocks and bonds. In simple terms, what matters most to the stock markets are the easy money injections from the central banks, and to a lesser extent, the profits of the companies whose stocks they are buying and selling.”
This single paragraph explains all the stock market rallies that have happened all over the world in the last few years. At the same time the “easy money” created by central banks has also helped boost corporate profits. As Dorsch puts it “The boom in corporate profits has been heavily subsidized by cheap and easy credit, which has allowed big companies to boost returns by paring down interest costs and buying back shares.” And this has also boosted stock market performance. The question is till when can this last? Do investors really believe that central banks will keep coming to their rescue forever? These are not easy questions to answer and on this your guess is as good as mine.
Hunt who writes the Epsilon Theory newsletter believes that “No one requires convincing that market price levels are unsupported by real world economic activity. Everyone believes that this will all end badly, and the only real question is when.”
Albert Edwards of Societe Generale is a little more direct about the issue. As he wrote in recent research note dated October 23, 2014: “The central banks for all their huffing and puffing cannot eliminate the business cycle. And they should have realised after the 2008 Great Recession that the longer they suppress volatility, both economic and market, the greater the subsequent crash. Will these morons ever learn?” He also quotes Guy Debelle, head of the BIS market committee, as saying that “investors had become far too complacent, wrongly believing that central banks can protect them, and many staking bets that are bound to “blow up” at the first sign of stress.”
The Federal Reserve of the United States has gradually been winding down its money printing programme. Currently it prints $15 billion every month. The Federal Open Market Committee is supposed to meet on October 28-29, later this month. The expectation is that the committee will wind up the money printing programme.
The stock market in the US has remained largely flat over the last two months. In case it starts to fall, once the Federal Reserve stops printing money, it is likely that the American central bank will start printing money again. As Christopher Wood wrote in the Greed and Fear investment newsletter in November last year “The key issue is what might trigger a market correction. The market consensus continues to focus on the tightening in financial conditions triggered by “tapering”. Still such a hypothetical correction is not so big a deal to GREED & fear, since any real equity decline caused by tapering is likely to lead, under a Fed run by Janet Yellen, to renewed easing.”
So what is the real threat then? “The real threat to US equities is when the American economy fails to re-accelerate as forecast,” wrote Wood. And that is something worth worrying about.

The article originally appeared on www.FirstBiz.com on Oct 26, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)