January 26, 2015
Is Q-ECB a Favorable Development?
Last week, the ECB announced that it will begin a new program of quantitative easing on March 15 – a delay that allows plenty of time for various rugs to be pulled out, if the experience of recent years is informative. Assuming that the program proceeds as announced, the ECB envisions bond purchases of 60 billion euros per month. Fully 92% of these purchases must be made by the central banks of individual countries in the Eurosystem, with the ECB sharing the risk of losses on only 20% of it (12% being investment-grade institutional debt, and 8% being the sovereign debt of Euro-area countries). This was essentially as expected, but - thus far - without an option for national central banks to treat their share of purchases as discretionary. I still suspect that this shoe will drop in the weeks ahead, but there's actually a much more important factor driving our outlook.
Is Q-ECB a favorable development? With regard to the stock market, our immediate response is to examine market internals, credit spreads, and other measures that provide information about the risk-preferences of investors. The difference between an overvalued market that continues to advance, and an overvalued market that drops like a rock, is primarily determined by those risk-preferences. For now, we observe no meaningful evidence that investor preferences have shifted back to risk-seeking.
Put simply, quantitative easing “works” to inflate the prices of risky securities only to the extent that low-interest, default-free liquidity is viewed as an inferior asset compared to risky securities. We’re not seeing evidence of that to an extent that defers our concerns about extreme overvaluation, overbought market action, overbullish sentiment, widening credit spreads, a flight-to-safety in Treasury yields, and weakness in oil and industrial commodity prices that is consistent with an abrupt shortfall in global economic activity.
Investor preferences may change, which we’ll infer from market internals and measures sensitive to credit and risk tolerance. That sort of shift may significantly defer the immediacy of our concerns about market valuations, but it won’t make stocks any less hypervalued, and in any event, we don’t observe that kind of shift at present. Our outlook remains hard-negative for now.
Meanwhile, our joint-parity estimate of the value of the euro remains close to $1.35, at a time when the commitment of traders shows leveraged speculators massively short that currency (see our recent discussion of currency valuation in Iceberg at the Starboard Bow). While the recent weakness in the euro may continue, we’re quick to observe that currency valuations are far less sensitive to monetary aggregates than appears priced into both the euro and the yen at the moment. Moreover, the euro and the yen have anticipated and overshot to a degree that provides us with no expectation that they will depreciate further even if monetary expansion continues in Europe and Japan.
Recall, for example, that from the beginning of 2011 through March 2012, the ECB expanded the monetary base by 1.2 trillion euros. Linear thinking might lead one to expect that the value of the euro deteriorated sharply during this period. It did not. Similarly, from October 2010 when the Federal Reserve launched QE2 through September 2014, the U.S. monetary base expanded by more than $1.4 trillion. This might lead on to expect that the U.S. dollar index deteriorated during this period. It actually rallied considerably. Currencies frequently overshoot, and in the present case, they have overshot a great deal.
It’s not entirely clear what will happen in the near term, but the financial markets are already pushed to extremes by central-bank induced speculation. With speculators massively short the now steeply-depressed euro and yen, with equity margin debt still near record levels in a market valued at more than double its pre-bubble norms on historically reliable measures, and with several major European banks running at gross leverage ratios comparable to those of Bear Stearns and Lehman before the 2008 crisis, we're seeing an abundance of what we call "leveraged mismatches" - a preponderance one-way bets, using borrowed money, that permeates the entire financial system. With market internals and credit spreads behaving badly, while Treasury yields, oil and industrial commodity prices slide in a manner consistent with abrupt weakening in global economic activity, we can hardly bear to watch..
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Please see periodic remarks on the Fund Notes and Commentary page for discussion relating specifically to the Hussman Funds and the investment positions of the Funds.
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