Yield Shock On Wall Street, Conservative Default In Washington

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By David Stockman

During an appearance on Fox Business this AM, we were reminded once again why capitalist prosperity in America is so dangerously imperiled and why the great bubbles in the stock and bond markets are living on borrowed time.

It seems we got into a friendly but heated spate with the whole panel of Fox-style conservatives when it comes to the essence of Imperial Washington—–that is, war, spending, debt and printing press money.

Now, it’s not that Maria Bartiromo and her gang–including Wall Street Journal Fed reporter, Jon Hilsenrath—are some kind of big government socialists. Indeed, they nodded favorably when we slammed the Horribus appropriations bill and out-of-control Federal spending.

But that turned into a blizzard of disagreement and arm-waving when it came to the utterly wasteful $80 billion Pentagon increase, the Syrian gas attack hoax, the deficit-ballooning Trump tax cut, the destructive impact of the Fed money printers and the $1.8 trillion government debt bomb now fixing to slam into the bond pits.

In a word, capitalist prosperity depends upon keeping the state and its central banking branch at bay and out of the way. And once upon a time that pretty much happened because the conservative party in Washington adhered reasonably well to the pillars of sound money, fiscal rectitude, free markets at home and non-intervention abroad.

In the last three decades, however, the GOP has either jettisoned these pillars of capitalist prosperity or relegated them to ritual incantation. Either way, they have had virtually no role in real governance since the Gipper last nodded in their direction decades ago.

What has happened, instead, is that the neocons hijacked the GOP and turned it into the party of Empire—the very opposite of Robert Taft’s notion of homeland security and non-intervention.

Likewise, the supply siders spread the insidious lie that deficits don’t matter and that you can grow your way out of unfinanced tax cuts.

So, too, the devotees of Alan Greenspan and the Wall Street lobbies buried the storied idea of sound money–supplanting it with the new ideology of monetary central planning and stock market bailouts.

Stated differently, the GOP in Washington today is essentially useless because it has abandoned the pillars of prosperity and has become an opportunistic gang of neocons, social cons, tax cons and Wall Street hand maidens. As a result, we now have a financial system that is flying blind toward a monumental monetary/fiscal crack-up.

On the one hand, the monetary central planners at the Fed have destroyed honest price discovery and monetized vast amounts of public debt. So doing, they have fostered the massive inflation of financial assets on Wall Street and have accommodated any and all factions of the “deficits don’t matter” gang in the Washington GOP.

The latter was all well and good, of course, as long as the Fed was in a QE mode, vacuuming-up the public debt hand-over-fist, or its counterparts abroad were doing the same.

On the other hand, it would appear that even the Keynesian monetary central planners now realize that they have over-stayed their hand, and must therefore “normalize ” with all deliberate speed—if for no better reason than to reload their dry powder for their next recession-fighting encore.

Needless to say, this impending epochal shift to QT and normalization by the Fed and other central banks is fixing to leave the GOP’s gang of factions high and dry.

The GOP gangs still want to:

  1. police the planet via a massive Warfare State funded with borrowed money;
  2. leave the $2.5 trillion Welfare State and its 110 million beneficiaries politically undisturbed on the theory that deficits don’t matter;
  3. Cut Taxes for the donors, the business lobbies and the affluent classes whenever they get the chance on the theory that tax cuts pay for themselves; and
  4.  Throw Spending Bones to farmers, small business, exporters, veterans, border control nativists and law and order conservatives to keep the rest of the GOP voters happy.

As it happened, the Fox Business TV panel this morning represented most of the above. It amounted to a cross section of the Foxified, Trump-O-Lated Washington GOP.

Indeed, in less than 10 minutes the reason that the public debt is heading for $40 trillion within the next decade becomes readily apparent; and so does the role of monetary central planning in euthanizing fiscal rectitude.

Jon Hilsenrath has been covering the Fed for years, but is completely oblivious to the fact that it has monetized $4.3 trillion of Treasury and GSE debt since Greenspan took office in 1987; and that, therefore, crowding out and rising yields have been temporarily forestalled because bonds have been salted away on the balance sheet of the Fed and the other major central banks of the world.

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So, too, he somewhat snarkily wondered whether we think “markets discount the future”, asserting that if there was an actual deficit problem Wall Street would already have it “all priced-in”.

We suggested that his “beloved Fed” had ruined honest price discovery, and that “today” is the extent of the “future” being discounted in the casino (or perhaps the hours until the Donald’s next tweet-storm in the AM).

On the matter of tax cuts, however, the full, pernicious impact of what might be called the supply-sider/fiat money synthesis became evident. We were accused of being a Nancy Pelosi apologist when we said she had used the wrong metaphor when demagogueing about the GOP tax bill’s windfalls for the rich and corporations and “crumbs” for everyday Americans.

We suggested that the right metaphor was not “crumbs”, but the whole loaf of bread—-and that the latter had been stolen from future taxpayers who will service the $2 trillion of new debt it will generate forever.

What we are saying is that massive Fed monetization has made deficits so pain-free that conservatives now think tax cuts can be justified by the mere fact that the working people of America deservethem; and that the average GOP tax cut of $2,000 per family—even if temporary and written in disappearing ink after 2025—is not to be belittled or second guessed.

Yes, American taxpayers surely deserve a Federal government that taxes less than 18.0% of GDP, which was the “current law” level  for FY 2019 before the Christmas Eve bill reduced the take to 16.5%.

But even more so, they deserve one that spends well less than 21% of GDP today and upwards of 24%of GDP a few years down the road.

And that gets to the nub of the matter. Back in the days of the great Dwight D. Eisenhower, who was the last Republican to balance the budget (and three times at that), it wasn’t a question of whether the public “deserved” a tax cut: By our lights, taxpayers always do.

Instead, it was a question of whether the politicians had “earned” the fiscal right to give them a tax cut by first reducing spending by a commensurate amount. Accordingly, Ike resolutely refused to sign tax cut bills until the vast over-spending he inherited from Truman—most of it in the defense budget—had been deeply cut first.

Even in 1981, the GOP elders on the Hill feared what Senator Howard Baker had aptly termed the “riverboat gamble” embedded in the Kemp-Roth tax cut. So they had to be dragged along kicking and screaming, and even then they supported the Reagan tax bill only on the condition that a giant reconciliation bill cutting entitlements and other domestic spending would be enacted first.

In the end, of course, the principle was right. However, the math got thrown into a cocked hat when the tax cut ballooned to double the intended size during a legislative bidding war in the summer of 1981—even as the initial spending cuts got stealthily restored by Congressional saboteurs in future years.

Needless to say, back then interest rates mattered (they happened to peak at 15.6% in September 1981), price discovery was honest under the Volcker Fed, and the bond vigilantes ruled the roost in the trading pits. So politicians did indeed have to ask not simply whether their constituents deserved it, but also whether as stewards of the public fisc they had earned the right through spending cuts to even consider a tax reduction bill.

To be sure, today’s GOP mantra that “deserve” is all you need to justify a tax cut is accompanied by a fig leaf of economic rationalization— the supply side canard that tax cuts pay for themselves. But that is so math challenged that it isn’t even necessary to bother with the theory.

At the post-tax cut 16.5% take rate, the $300 billion per year “static” cost of the tax bill would have to raise nominal GDP by $1.8 trillion per year or nearly 10% in order to pay for itself.

We’ll take the unders on the GOP/Trumpite tax bill because it reduces marginal rates by only a couple percentage points on the individual side, while more than 80% of the corporate rate cut to 21% will be puked back into Wall Street in the form of dividends and stock buybacks, and that will add virtually nothing to GDP.

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Needless to say, the GOP gang of factions has essentially substituted fact-free rhetoric for the old pillars of capitalist prosperity. Even Maria Bartiromo, who does know a thing or two about finance, fell into that trap, hectoring us about the “animal spirits” that Trump had unlashed, and the resulting surge in corporate investment.

Say what?

During Q4 after a year of purported Trumpian animal spirits and a huge stock market boom, real CapEx was only 5% higher than it had been three years earlier in Q3 2014.

Other than a slight upturn owing to the round trip of the global energy/commodity/industrial trade sub-cycle, there are no animal spirits evident in the data at all.

We thus arrive at the essential point of today’s post.

To wit, you can’t have capitalism priced for perfection on Wall Street, when Washington is knee dip in assaulting the key pillars on which prosperity depends.

In that context, the Fed’s belated pivot to normalization and QT is part and parcel of the bad money story. That’s because the massive bond-dumping campaign dead ahead would never have been necessary had the insanity of QE and ZIRP not been imposed on the financial markets in the first place.

Likewise, the nation would not be entering the zone of massive demographic/Welfare State danger—the baby boom retirement bow-wave of the 2020s—with massive structural deficits and a 100% debt-to-GDP rati0 if there had not been 30 years of massive debt monetization previously.

But now it is too late to recall either the monetary or fiscal history. A multi-trillion collision in the bond pits is unavoidable–meaning that the mother of all “yield shocks” is foreordained.

In that baleful context, pricing the stock market for perfection was the height of folly. Yet at its late January peak of 2871, that’s exactly where we were.

Then and there the S&P 500 was trading at 26.1X the freshly minted corporate earnings ($110 per share) for the December 2017 LTM period. As it happened, that was also month #103 of the current so-called business expansion—meaning that the cycle was pushing its nose up against the 1990’s record of 119 months.

So even apart from the folly at the Washington end of the Acela Corridor,  you absolutely had to say that Wall Street was priced for perfection. After all, the business cycle has not been outlawed, and common sense should remind that one size does not fit all when it comes to PE multiples.

For instance, it’s one thing to put a frisky multiple on earnings posted during, say, the second year of  a recovery when the macro-economy is rebounding smartly from a deep recession. But it’s an altogether different proposition when the cycle is way long in the tooth, and when the economy is freighted down with massive debts and internationally uncompetitive costs and wages, to boot.

You don’t even need theory to recognize that much—just a small dose of history should suffice. For example, during the prior cycle when S&P 500 earnings peaked at $85 per share in the June 2007 LTM period, the index was trading at around 1500, thereby implying a 17.5X peak earnings multiple.

Alas, the market crashed a year later and the economy plunged into the Great Recession—causing earnings to tumble for seven straight quarters, finally hitting bottom at about $7 per share in March 2009. More importantly, the S&P index plunged by 55%—-and actually did not recover 1500 until March 2103.

Stated differently, the cost of paying 17.5X for the June 2007 peak earnings was an investment dead in the water for six years—to say nothing of the investor brain damage that perforce occurred when the market bottomed at 670.

Likewise, when S&P earnings peaked at $54 per share in September 2000, the PE multiple was 26.5X. This time earnings kept falling for six quarters—again by more than 50%—while the stock index did not actually bottom until 10 quarters later in Q1 2003.

Ironically, the peak 2000 index price of 1500 was not regained until June 20007. That is, on a peak-to-peak basis, your money was dead in the water for seven years if you jumped in at the prior top.

History and probability alone, therefore, should have warned against the danger of pricing for perfection at 26.1X earnings back in January.

But pricing for perfection when the pillars of prosperity are being crushed in Washington—that’s folly with malice aforethought.


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