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Sunday, January 11, 2015 11:28 PM

Biggest Bubble: Central Bank Credibility; Cautionary Tale of Global Gloom from Down Under

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Australian newspaper "The Age" has an interesting interview with Gerard Minack, former Morgan Stanley strategist.

Minack is now out on his own, publisher of "Downunder Daily". Minack says "I deliberately decided when I left to keep it balanced, not to start writing like Zero Hedge."

Nonetheless, Minack is a bear who thinks Australia is in for some tough times, the price of iron ore still has plenty of room to fall, and the most important monetary policy act of the last four years was European Central Bank president Mario Draghi's "whatever it takes" speech, but the eurozone will break up anyway.

Finally Minack calls "central bank credibility" the biggest bubble. Let's take a look.

Cautionary Tale of Global Gloom

Please consider a few snips from The Bear is Back: A Cautionary Tale of Global Gloom.

Fairfax Media: How do you think 2014 panned out in investment markets?

Gerard Minack: People look at the S&P 500 and think it was a good year; it was a rubbish year for equities in US dollar terms. The S&P is the [2002 Olympics speed ice-skating gold medalist] Steve Bradbury of financial markets – the only one that has kept on skating while the others wobbled and fell over.

Aussie shares are in a full-blown bear market, in US dollar terms. Credit markets are starting to wobble, commodities have been smoked. After two years of broad-based gains in risky assets, we're down to the last man standing.

Fairfax: What has supported the strong gains in asset markets up to recently?

GM: A couple of things. I think QE has been overrated, but six years of zero rates in the US is going to have an impact.

But for me the most important monetary policy act of the last four years by a mile was [European Central Bank president Mario] Draghi's "whatever it takes" speech. In the two years before that, every time we hit a soft patch you reintroduced the tail risk of a systemic European banking crisis. And by taking that risk away all of a sudden the market became inured to macro weakness and started this two year re-rating. It was a pure valuation rally. From the late 2011 lows in global equities to early this year the MSCI All Country Index was up 65 per cent. Earnings over the same period were down, so we had a pure P/E-led rally.

Fairfax: What about China as a potential source of returns this year?

GM: There are structural problems there. You've had 30 years of great growth in China and lousy equity returns, and that's because they can't allocate their capital. If they improve their capital allocation they will be better over the medium term, but you want to see those reforms put in place first.

The rest of Asia is an uneven story. Ultimately still a slow-growth world. If the US is growing at 2.5 per cent, and it's the world's locomotive, then you know the train is not moving very fast.

Fairfax: What's your outlook for the iron ore price?

GM: From here, iron ore will halve in US dollar terms, in my view. In the boom all the other commodities went up six- or seven-fold, while iron ore went up 15 times. So, sure, it's halved already, but it has further to go.

Fairfax: How vulnerable is our housing market?

GM: I don't think there's anything exceptional about our housing market, except that we've gone 23 years without a downturn. When we get across-the-board unemployment then we'll get an across-the-board downturn in house prices; it's just a matter of time.

Fairfax: What are the big global risks you see out there in the coming few years?

GM: The biggest bubble out there is central bank credibility. If Draghi was a stock he'd be on a P/E of 200! Yellen's on 100. When that bubble pops, all hell will break loose again, and there you really just want to be in cash.

Fairfax: So the biggest risks are in Europe?

GM: Yep. The problem is the next crisis will not be in the periphery and it will not be in the banks; it will be economic and it will be in the core.

The big problem is the internal competitive imbalances in Europe. The problem's not [that] the euro is too high against the dollar, it's not that the euro is too high against the yen. The problem is that the French franc is too high against the deutschemark, and Mr Draghi can't fix that. From the resulting economic stress you're getting political blowback. You're getting fringe parties flourishing everywhere. There are whole landmines of elections coming up in the next 18 months, any one of which could throw up a result that could get the crisis back as front page news.

Fairfax: So you still don't believe the euro can survive?

GM: That's still the case. You can't restore your competitiveness in a fixed-exchange-rate regime.

The solution is simple, and it's what the periphery has done: it's called having a depression. It's 20 per cent unemployment and large nominal wage cuts. The trouble is that the small economies can be bossed around, but you can't see the French taking the same medicine.
In Agreement

With slight differences on theoretical possibilities, Minack and I are in near-complete agreement.

Eurozone: It's certainly possible to restore your competitiveness in a fixed-exchange-rate regime, but there's a snowball's chance in hell socialist France will do that. Otherwise, I have stated on numerous occasions the eurozone will break up or Europe will remain in a depression for over a decade.

Productivity: The euro has many structural defects, including monetary policy that is absolutely not suitable for every country in the eurozone. Minack says "the problem is that the French franc is too high against the deutschemark, and Mr Draghi can't fix that." Correct. The ECB can't fix that. France could in theory fix the problem, but won't.

Draghi: Minack stated that "without a doubt the most important monetary policy act of the last four years was Draghi's 'whatever it takes' speech". That's something I have said as well.

Fringe Political Parties: We are certainly in agreement here, except I believe two of the alleged fringe parties are going to win the next election.

I expect wins by Podemos in Spain and Syriza in Greece. An outright win by the the 5 Star Movement in Italy is not out of the question.

If you win, are you a fringe party? 

Central Banks: Minack says "the biggest bubble out there is central bank credibility."

On numerous occasions I have made similar statements.

Please consider this reference from Sisyphean Fed Struggle to Create Inflation.
Bubbles of Increasing Amplitude

Via the moral hazard of bailouts, the Fed sponsors bubbles and crashes of increasing amplitude over time.

But the biggest bubble of all is belief central banks will always be able to handle these busts.
It's pretty rare for me to agree with someone on so many issues, especially an analyst (former in this case) at a big brokerage house, but there you have it.

Further Reading

Mike "Mish" Shedlock

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