Earlier today, we showed that on the 9th anniversary of the so-called “bull market”, central bank balance sheet accounted for over 40% of global GDP, amounting to no less than $21 trillion. That in itself, should explain why the “most hated bull market” of all time is not a bull market at all, but the world’s biggest experiment in central planning.
Yet the time of this unprecedented monetary experiment is coming to an end as we are finally nearing the point where due to a growing shortage of eligible collateral, the central bank support wheels will soon come off (the ECB and BOJ are still buying massive amounts of bonds and equities each month), resulting in gravity finally regaining control over the market’s surreal trendline.
It’s not just central banks, however: also add the one nation which 5 years ago we first showed has put the central bank complex to shame with the amount of debt it has injected in the global financial system: China.
Appropriately, this central bank handoff is also the topic of the latest presentation by Matt King, in which the Citi credit strategist once again repeats that “it’s the flow, not the stock that matters“, a point we’ve made since 2012, and underscores it by warning – yet again – that “both the world’s leading marginal buyers are in retreat.” He is referring to central banks and China, the world’s two biggest market manipulators and sources of capital misallocations.
And yet, we all know this, and that’s precisely the problem, one which has served as a persistent source of confusion for one of Citigroup’s brightest minds in the past decade. And, as Matt King puts it in a slide titled announced ≠ discounted, “we know what central banks are doing, so why are we so slow to price it in” especially since the marginal buyer – central banks – sets the price, and the marginal buyer will be gone by this time next year?
Translation: we all know how this ends, so when will we finally admit it?
This is shown in the two charts below which suggest that both the global stock and bond markets are headed for a major crash as a result of the slowdown in central bank purchases.
King previously opined on this paradox last July, when he suggested that not only have markets lost their ability to discount future news, but that central banks – unable to grasp this – believe that in a perverse case of reflexivity, the market is actually giving the “all clear” to their actions, when it is their actions themselves that have broken the market, which effectively encourages central banks to break it even more. To wit:
central banks still cling to the textbook model in which the market discounts all available information ahead of time, meaning that by the time they actually come to do their reduction, provided they’ve telegraphed it beforehand, the effect is already priced in. Unfortunately they seem to have neglected the textbook footnote that states that markets function this way only when they are deep and liquid. That might have been a reasonable description of pre-crisis markets; it seems a deeply unreasonable assumption for post-crisis markets in which leverage is constrained and one set of buyers have come along and absorbed virtually all of the world’s net new issuance.
So where does that leave markets?
According to King there are 5 key lessons investors appear to have forgotten, so here is a reminder.
1. “Mind the flow, not the stock”, which of course refers to the ongoing slowdown in central bank purchases as shown in the charts above.
2. “Announced ≠ already discounted“, or why just because markets have had time to “price something in”, never means that they have priced it in. Also see: markets are deeply irrational (especially if you are trying to stay solvent as a bear).
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King’s third “reminder” is to “think global not local.”
In a slide showing that “everything is interconnected”, he makes another point we frequently discuss, namely that when it comes to the global economy, it’s all about China, and specifically its credit impulse. Here King notes that whereas trailing growth numbers look great, their drivers likely lie elsewhere… like in China, for example…
… where the Li Keqiang index has posted a sharp drop in recent months, and could be the catalyst behind the recent topping in German manufacturing and export sentiment. Here’s Citi: “The latest decline in German manufacturing sentiment follows 6 months after the Li Keqiang (LKQ) index, which tracks Chinese growth, peaked last summer. Likewise, the previous surge in German industrial confidence began in spring 2016, 6 months after the LKQ troughed.”
Germany, China – Li Keqiang Index (YY %), Ifo Index (Index), 2011-2018
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King’s 4th lesson is that “a diverse market is a resilient market”, pointing to the Italian BTP market specifically, where he urges investors to “beware markets with only one buyer”, in this case the ECB, something we also noted three months ago. Here, King also warns that volatility may have slumped in the past year as VIX crashed to all time lows before its recent vol flaring episode, risk remains as seen by the Skew between ATM and OTM volatility, and which is near all time highs.
Citi’s words of caution here: “herding begets fragility.“
This then takes us to the 5th and final lesson from the Citi strategist: “beware of circular logic”, in this case as referring to the US Dollar, because while $ weakness does make for a risk on environment, that trend is about to be challenged. Or said otherwise, enjoy the recent move while you can, because “self-reinforcing processes can run in both directions.“
This brings us to Matt King’s conclusion, which comes in three very simple parts:
- strong markets can make a strong economy…
- and bubbles bring in new buyers…
- what happens when the music stops?
As for King’s chilling assessment of how this all ends when “the music stops” and central banks lose control and can no longer inflate another bubble to offset the bursting of the last one, namely that “markets need backstops, but are being given bubbles“, something tells us that just like Marko Kolanovic, King is a closet fan of both the “barbaric relic” and one or more cryptocurrencies.