A 23rd February blog post by Sven Henrich hits a couple of nails on the head. Here’s an excerpt:

“…the virus…clearly has a short term effect, but rather the broader risk is the excess created by ultra-loose monetary policies that has pushed investors recklessly into asset prices at high valuations while leaving central bankers short of ammunition to deal with a real crisis. There was no real crisis last year, a slowdown yes, but central bankers weren’t even willing to risk that, instead they went all in on the slowdown. It is this lack of backbone and co-dependency on markets that has left the world with less stimulus options for when they may be really needed. Reckless.”

Yes, central banks present a vastly greater threat to the economy than the coronavirus. Unfortunately, however, there never will be a vaccine that could immunise the economy from the effects of interest rate manipulation. Also, Sven is wrong when he writes that central bankers are short of ammunition and when he implies that stimulus options of the central planning kind will be needed at some point in the future. These options are always counter-productive and therefore never needed.

Central banks are a long way from being short of ammunition, because there effectively is no limit to the amount of money they can create. They can monetise (purchase with money created out of nothing) pretty much anything. At the moment they generally have restricted themselves to the monetisation of their own government’s debt, but they could expand their bond-buying to encompass investment-grade corporate debt and, if that wasn’t deemed sufficient, high-yield (junk) debt. They also could monetise equities, perhaps beginning with ETFs and working their way down to individual stocks. If they wanted, with a change of some arbitrary rules they could even monetise commercial and residential real estate.

It could be argued that “inflation” (in the popular sense the word: an increase in the so-called general price level) limits the amount of new money that central banks can create, in that after “inflation” starts being perceived as a major threat the central bank will come under irresistible political pressure to tighten the monetary reins. This is one of the tenets of the idiocy known as Modern Monetary Theory, or MMT for short. According to MMT, the government should be able to create out of thin air whatever money it needs, with the “inflation” rate being the only limitation. However, in some developed countries, including the US, many people already are having trouble making ends meet due to the rising cost of living, and yet the central bank claims that the “inflation” rate is too low and senior politicians agree.

As well as distorting price signals and thus getting in the way of economic progress, when the central bank makes long-term additions to its balance sheet it is, in effect, surreptitiously nationalising part of the economy. For example, the Bank of Japan (BOJ) already has nationalised Japan’s government bond market and is well on its way towards nationalising the market for ETFs (the BOJ owns about 80% of all ETF shares listed in Japan).

The creeping nationalisation of markets is something that is rarely, if ever, mentioned during discussions of current and potential monetary stimulus, but it’s a big problem that looks set to get even bigger.

[This blog post is a modified excerpt from a recent TSI commentary]

The main purpose of the GDP growth numbers and most other economic statistics reported by China’s government is to tell the story that the central committee of the Communist Party wants to tell. In other words, the economic numbers form part of the State’s propaganda.

For example, during the first decade of this century the Party’s objective was to show that the economy was performing in spectacular fashion, so the reported GDP growth numbers were almost never below 8% and regularly above 10%. In more recent years the overriding concern has been to paint a picture of stability and sustainable progress, which has involved reporting consistent GDP growth in the 6%-7% range. Refer to the following chart for more detail. Amazingly, most Western analysts accept these figures as if they were accurate reflections of reality, partly, we suspect, because there is no way to prove that what’s being reported is bogus.

Once in a while, however, something happens that shines a light on the meaninglessness of the official numbers. An example was the claim by China’s government that its economy was still growing at an annualised pace of more than 6% during the worst point of the 2007-2009 global recession. Another example very likely will be the quarterly GDP growth that China’s government reports for the first quarter of this year.

The consensus view in the financial news media appears to be that due to the SARS-CoV-2 virus, China’s GDP growth rate in Q1-2020 will slide from 6%+ to ‘only’ 4%-5%. The reality, however, is that China’s economy could not be growing at the moment. Large sections of the country have been essentially put in lock-down mode, and many factories, restaurants, shops and other businesses have been temporarily closed. Tourism has ground to a halt, home sales have collapsed by 90% and vehicle sales are expected to fall by 50%-80% from the same period last year. In some large Chinese cities, including Shanghai, the government has directed state property owners not to collect rent from small- and medium-sized businesses during February and March.

Other examples of the virus’s dampening effect on economic activity are included in articles published on 13th February at the South China Morning (SCMP) and Caixin. According to the SCMP article:

“Recruitment site Zhaopin said this week that around 10 per cent of firms they surveyed were “on the verge of death”, with around 30 per cent planning job cuts and another 30 per cent saying they could not pay their employees on time.”

Along similar lines, the Caixin article notes:

“Even before the outbreak, many small businesses were already grappling with shrinking sales as China’s economy logged some of its slowest growth in decades. With business now at a standstill during the outbreak, many are facing existential liquidity crises. Large numbers say they are having difficulties just paying salaries, adding they can only survive for a matter of months using their current resources, even if Beijing provides support.”

It should be obvious to anyone with at least rudimentary knowledge of the world that China’s economy is contracting right now. Therefore, if the government reports GDP growth of 4%+ for the first quarter of this year it will be a tacit admission that the official numbers are totally fictitious. By the same token, to retain any semblance of credibility China’s government will have to admit that its economy shrank during the first quarter of this year.

That’s why China’s next quarterly GDP number will be a test.

In a TSI commentary last November I wrote about adjustments I was making to my stock selection process. These adjustments weren’t due to issues with any individual stock(s) or the performance of any individual stock-market sector. In particular, the poor performance of the average junior gold-mining stock during 2019′s gold rally wasn’t the primary driver of my decision to make some changes, although it was the proverbial “last straw”. The primary basis for my adjustment was evidence that the investing landscape had changed in a permanent, or at least a semi-permanent, way.

Long-term changes in the investing landscape happen from time to time, that is, the future is not always a simple extrapolation of the past. This occurs not because of a change in human nature (human nature never changes), but because of a change in the monetary system. For example, the investment strategy that involved shifting from equities to bonds when the stock market’s average dividend yield dropped below the average yield on investment-grade bonds worked without fail for generations prior to the mid-1950s, but from the mid-1950s onward it didn’t work. The reason this ‘fail safe’ approach to asset allocation stopped working was the increasing propensity/ability of central banks to inflate the money supply.

As part of their attempts to encourage more borrowing and consumption, over the past few years the major central banks manipulated interest rates down to unprecedented levels. Ten years ago very few people thought that negative nominal interest rates were possible, but in 2019 we reached the point where 1) a substantial portion of the developed-world’s government debt was trading with a negative yield to maturity, 2) some corporate bonds had negative yields to maturity, and 3) banks in some European countries were offering mortgages with negative interest rates.

Due to the draconian efforts of central banks to promote more spending and borrowing, it’s possible that the public is now effectively ‘tapped out’. This would explain why the quantity of margin debt collapsed over the past 18 months relative to the size of the US stock market, something that NEVER happened before with the S&P500 in a long-term bullish trend and regularly making new all-time highs. Also, it would explain why the average small-cap stock (as represented by the Russell2000) is trading at a 16-year low relative to the average large-cap stock (as represented by the S&P500).

Linked to the relatively poor performance of the average small-cap stock is the increasing popularity of passive investing via indexes and ETFs. Over the past several years there has been a general decline in the amount of active, value-oriented stock selection and a general rise in the use of ETFs. This has caused the stocks that are significant components of popular ETFs to outperform the stocks that are not subject to meaningful ETF-related demand, regardless of relative value. There is no reason to expect this trend to end anytime soon. On the contrary, the general shift away from individual stock selection and towards the use of ETFs appears to be accelerating.

At this stage I’m not making dramatic changes to my stock selection approach. I will continue to follow speculative small-cap stocks, but my selection process will be more risk averse and I will reduce the potential tracking error during intermediate-term rallies in mining stocks by putting more emphasis on ETFs and mutual funds. Also, when making future speculative mining-stock selections I will pay greater heed to the attractiveness of the assets to large mining companies. The reason is that regardless of the public’s willingness to speculate, large mining companies will always be under pressure to replace their depleted reserves and add new reserves. The easiest way for large companies to do this is to buy small companies that have discovered mineral deposits of sufficient size and quality.

In summary, as a result of unprecedented manipulation of money and interest rates it’s possible that some of the investing/speculating strategies that worked reliably in the past will not work for the foreseeable future. I think it makes sense to adapt accordingly.