We are all kinda long “awe” today -aren’t we? Wait, better make it “shock and awe” for me. Yeah, even bulls are watching stupefied by now. I have no words to convey my feelings, or thoughts, for what we see in capital markets. A mind-blowing, once-in-a-lifetime experience I thought I would never endure -even after spending the best part of thirty years trading global markets.
We are all also short of time, so let’s get straight to the point. What on earth is propelling this “Everything bubble” blow-off top, and helping degrade the past bubbles to the child’s play category?
To follow up on my literary vein (see the previous post), I will paraphrase Ken Follet to try and synthesize the four main pillars of global financial insanity:
1.- The Fed/Central Bank Put and forward guidance.
2.- Debt, and sustained incremental debt growth.
3.- Fiat Money debasement by most CB’s (cum laude in 2017).
4.- Financially repressive interest rates.
So, we’ve got four pillars to explain insane behavior by investors. But it gets worse: I do not think we need all four pillars to keep this going. They are formidable pillars, and the excellent architectural design allows for some weakness in some of them at times (provided the rest remain powerful enough). The latest rate rises in the US are a case in point. Markets couldn’t care less. We just need two or three of the pillars to work simultaneously -and the induced “nirvana” could go on for long enough to surpass the effects of the time-worn widow maker trade in JGB’s. Central Banks have managed to blend absurdity with eternity. We have a planetary, fault tolerant, monetary boom!
I will admit to being unable to distribute uneven weightings between them four. Every single one of them implies a policy that is anathema to me, and thus I am incapable of underlining the particular incongruity of any of them. It is evident that Keynes was right when he stated that irrationality could outlast solvency. Some inconsistencies have gone on for decades now: think Japanese sovereign debt ratios to GDP, JGB yields and, of late, a stupendous money base increase up to 90% of GDP (no, no “typo” there, and no kidding either). Add European junk debt prices to the list more recently. Examples abound.
Of course, for our well-being and our future as a species, this global economic strategy is just brainless -and grossly negligent. At some point, we will all pay a hefty price for it: the longer it goes on, the higher the price tag. Regrettably, by then it probably won’t matter to a bunch of my macro colleagues or me. As I write, I am still nearly entirely stand-by regarding risk-on risk-off positioning, but this situation is unsustainable. For some of us, fear of missing out (FOMO) was never a sentiment to take care of, and, sure enough, I’ve not only missed out but lost significant money in these last ten months. The latest chain of monthly drains, even with low commitment in my positioning, is small but psychologically unbearable. Keynes did get a couple of things right: failing “unconventionally” is tough on anybody’s emotional equilibrium.
1.- The original Greenspan put -and iterations.
This term was coined in the late nineties to describe the Fed’s reaction to LTCM’s demise. In fact, by then it was also factoring in the previous response to the 1987 stock market crash. It was the second time in a row that the Fed bailed the market out. A lot more of the kind was to come later, but we did not know then.
Moral hazard is another way to describe what happened -and you can read tons of literature on the subject. The term has evolved and consolidated. Forcefull CB reaction to the tech bubble burst and, seven years later, to the sub-prime excesses, solidified the strategy providing risk-taking investors with a “de facto” riskless trip. Bernanke certainly helped make sure this “fully insured” feeling remained steadfast in the investor’s mentality.
Then year 2k happened -but the damage was relatively contained to some areas of the markets. 2008 was a different story, a global bust. It took a long time to get investor confidence back after CB’s miserably failed to honor that put in 2008/2009. Trust is essential in finance -and you know the saying: once bitten twice shy. But finally, they did it. A couple of forces played a role:
- Over time, TINA helped investors allow themselves to trust CB’s again. You want to “buy” that something will work when you have no alternative to keep your job or need to attain your financial targets (particularly if you need the money).
- ETF’s did their part as well. After all, if you buy the index basket you are buying “the system”. You are suppressing the manager/human error risk. If there is no financial system there is no life (or so we think), so we might just as well play along and accept whatever the future may bring for all.
- Lastly, the powerful CB volatility short (Powell, 2012 Fed minutes reproduced later) rubber-stamped the deal. Risk had been swapped for uncertainty. Uncertainty for the human race was the only consideration weighing against risky investments. Major Investment risk had all but disappeared (selling puts made a lot of sense). The only risk left is systemic uncertainty (I exclude the term risk because risk can be handled mathematically, while uncertainty can not: it is like flipping a coin just once).
Regrettably, unlike Rosalind did (“As you like it”, William Shakespeare), CB’s did not rhetorically question themselves if their desire to remove risk and volatility was “too much of a good thing”. Investors don’t know, but I am 100% sure they are now terrified (read Dudley’s latest speech) at the sight of the current “Frankeinsmarket”. A market that eases financial conditions with every “dovish hike”. I remember bashing dovish hikes a year ago as an absurd concept tailored to then CB’s needs. It is now coming back to haunt them. Once magnificent “Paint drying” descriptions to depict the consequences of QT look as if they will follow the same fate.
So what follows? We shall take our evidence as it comes because I’m fed up with trying to anticipate FOMC behavior: you cannot front-run paranoic decisions. But let me suggest that this quote hints at some understanding of the problem by top gun “Jay”.
I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.
Jerome Powell. Excerpt from the official transcript of the Fed meeting in October 2012
And it does look as if he is aware of what is at stake:
When it is time for us (The Fed) to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position.
But don’t ask me what they are going to do about it. My bet? Nothing substantial, but they are scared by now. I would unwind the volatility short and try to shake the market up. We need ups and downs, extensions and retracements, more extensive intraday ranges and some squeezing of vol shorts now and then. And, no doubts, I would scrap forward guidance and dot plots. We have to go back to those times when if you thought you understood what Greenspan was saying “you were probably wrong”. I liked that situation (wow, how I miss those real markets when thinking made a difference).
All the same, I think we will need more than that to stop the massive stampede. Not infrequently, success has a bittersweet flavor to it. CBs now have to handle the investor charge for “risk” that they provoked.
2.- Debt and sustained and incremental debt growth.-
One chart is worth a thousand words. We are still notoriously indebting ourselves into growth. And we do it “in crescendo” (positive second derivative, with the tangent line below the function graph). We grow because we add to the debt pile and not only do we further indebt, we do not save near enough (the US is nearly savings-less). To add insult to injury, we then use fractional reserve banking and monetary debasement to fund that debt.
During the first nine months of 2017, the world added 16 trillion of new debt taking the total to 233 trillion (IIF chart via Business Insider). As a reference, let’s remember that world GDP is 78 trillion. The good news is that we are not increasing the debt to GDP thanks to healthy nominal global GDP growth. The bad news is that debt grows 2.5 times as much as nominal GDP. And, not to forget, it is not infrastructure-related or supply-side investment-related debt: we still anticipate future consumption effectively subsidizing aggregate demand.
Not only do we subsidize aggregate demand, blurring and softening the line of consequences of inequality, we also use debt to lever up the capital base of our supply side. You hear lots of stories about enterprise leverage above six times EBITDA. I heard of a new one last week. It will be Ok while the going is good. But, if at some point the consumer is forced to delever, we have also compromised the financial health of our NFC’s for our next recession. Never mind the inherently unstable banks (tier one ratios of 10 or even 12 are way too low, and fractional reserve banking should be outlawed). They are better off than in the past bubble -but the magnitude of the potential disruption is 2008 many times over. In a depression, they are financially dead. Nobody cares because we assume that the CBs will prevent the next recession forever.
For as long as debt thrives, and nobody questions its validity (people accept it will be paid) the show will go on. Debt growth helps generate liquidity, stimulates economic growth, alleviates the consequences of inequality and keeps families afloat. It helps markets and the wealth effect as well increasing demand for common stock and favoring healthy corporate buy-back demand. Great, but, for God’s sake, somebody ought to take a look at the long-term consequences!
3.- Monetary debasement of Fiat currencies.-
Albert Edwards produced this last chart in his latest London presentation -the Woodstock for bears annual event. I went last year. It shows the amount of printing that has taken place since 2007. And it puts the 2017 hallelujah in context. We are getting better at printing: we nearly beat 2008 figures!
Keynesians will say: what’s not to like about inflating CB balance sheets if there is no goods and services inflation? Well, not to forget, all reserves generated are high powered money and subject to second round growth using the fractional reserve banking system. That has not been particularly harmful up to now, what has been detrimental is that those funds, unable to creep into the ordinary business cycle, have found their way into financial products. And because positive real interest rates are for most currencies an obsolete concept, they have found their way into risk assets. An enormous percentage of them has been incremental demand for stocks and risky investments.
That’s not all. Some CBs have gone into overdrive: no need to use the banking system or induce investments by third parties. The SNB and the BOJ directly buy stock against their money base in the secondary market. It’s mostly Apple stock and other FAANGS for the SNB -and more subtle and more spread out ETF buying for the BOJ. But the money created out of nothing ends pressuring prices up.
On top of that, even if it is not strictly speaking freshly minted money, the almighty Jap public pension fund is switching to equities, and the Norwegian sovereign fund as well. And they are resorting to leverage! Pension funds are also “risking up” to attain impossible return targets. The public sector is a now a prominent bubble blower (and are even bragging about it).
What happens if this stops? Nothing, provided the other pillars are still in place. This is a very robust building we are looking at. The rest of the pillars are stable enough. The mother of all bubbles it is.
4.- Financially repressive interest rates.-
Bill Gross introduced the concept of financial repression in modern economic literature. I think it can be defined as the use of monetary power by CBs to deprive savers of their legitimate income. What income is legitimate? I think a decent starting point is nominal GDP growth. Or at the very least short-term rates higher than the GDP deflator.
Financial repression is key to the bubble. It indecently shoves everybody into risky assets. I am strongly against it (always have been save for exceptional moments when you have to try to keep the market functioning).
- It is never a good idea to be unfair to a portion of the economic players. They will take their punishment on the chin, but they will not help the economy prosper. Resentment is a nasty feeling with very long “duration”.
- Savers used to be a source of sustainable aggregate demand. And it was a low beta aggregate demand (with low sensitivity to the point of the cycle). We should be careful with aggregate demand preservation.
- Low rates favor debt growth. We have to stop that asap. Infinite debt is not a nirvana!
- Low rates favor playing games with the WACC and allow NFC’s gearing up.
- Low rates encourage risky behavior by individuals -when investing and when consuming as well.
Interest rates are at their most repressive point since 2007. They’ve been lower before (in some places) but not against current nominal GDP growth. The Bund is the paradigmatic example. Eurozone nominal GDP growth is roughly 3.5%. Inflation is 1.4%. Growth is 2.1%. Real rates are negative 200 bps (in the shortest end of the curve) and even negative 90 bps for the ten-year Bund. I can’t help scratching my head daily. I still don’t “get” the rationale behind this policy.
Trying to remain sane in an insane environment.-
This interesting time in which we are continually debating the burlesque insanity of the ineffable Trump is better than any other to introspectively question oneself thoroughly. Or, why not just blame others? Ought we be concerned instead about the sanity of the rest of the market players and their FOMO syndrome?
But, if I opt not to blame anybody else, does that mean I am a genetically engineered subspecies of the permabear? It is in those moments of despair that I find some solace in my reading. And, voilà, here comes no other than Powell, the new supreme God of the Keynesian mount Olympus, quoted above, voicing the same concern. Maybe, only maybe, it is justified that I find minor pricing discrepancies between sectors, asset classes, or individual stocks, so unmotivating. It is uncertainty that’s killing me. The elephant in the room is the herd’s en masse response to the Central Bank’s call for financial risk exposure as the ultimate cure for our economic ails. The Greek 10y bond price is a great example (chart zerohedge). The Argentine 100-year bond is a close second.
Labelling my disorder as obsessive-compulsive might be understating things. I toil day and night trying to find some alternative investments with even a pyrrhic return for a euro-based fund (something in the very low positive numbers after fund expenses). I see none. In this last “everything bubble” there is no place to hide.
- You could avoid Japanese stocks and real estate in 1989, or the 1987 October equity crash (with adequate diversification, interest rate income was good and improving seriously). I did.
- You could stand aside from the NASDAQ bubble easily. There was no scarcity of alternative playing fields to try and make money.
- It was harder to bypass the (2000-2008) real estate bubble and its deadly effect on financial markets. I played the run-up in Gold from the lows, the odd trade coming up, and a balanced portfolio to come out more or less satisfactorily (in the black).
- Then the last quarter of 2008 happened. 2009 looked like a planetary collapse saved “just in time” by the suppression of the “mark to market” rule for bank portfolios -together with a well-justified initial generous dose of QE. But then, and in the years that followed, there were abundant places to make money. The currency arena up to the Shanghai accord was fine. And the rally in bonds was great.
In all those instances there was no lack of investment opportunities compatible with a portfolio with low systemic risk. Or, in Hunt’s vocabulary, an asset management style with lots of risky trades but low uncertainty was feasible. Correlation coefficients between trades were still manageable. You could be a bubble skeptic and still make money.
Not anymore. Today you are faced with an uncertain decision that cannot be supplanted and bypassed by a series of risky decisions with moderate correlation. You are “in” with the CBs, or you are “out”. Of course, you can split your portfolio in two, but you cannot proceed with an integrated portfolio approach that uses a series of risky decisions to make money while avoiding systemic risk. An excellent, if somewhat long, post by Ben Hunt (Epsilon Theory. “The three-body problem”) explains this.
A risky decision is when you have a pretty good sense of the odds and the pay-offs. It lends itself to statistical analysis and econometrics, particularly if it’s a decision you will have the opportunity to make multiple times.
An uncertain decision is when you don’t have a good sense of odds and pay-offs. Here, statistical analysis may very well kill you, particularly if you’re not going to get many cracks at the game, or if you don’t know how many times you’ll get to make a choice. You need game theory to make sense of decisions made under uncertainty. (…)
Basis uncertainty is the core problem facing every investor today… There is a non-trivial chance that structural changes in our social worlds of politics and markets have made it impossible to identify predictive/derivative patterns. (…)
To make things worse, the colossal CB balance sheets and the infinite elasticity of their size adds a second layer of uncertainty over uncertainty. Ben Hunt again.
Henri Poincaré proved that the motion of the three objects, with the exception of a few special starting cases, is non-repeating. This is a chaotic system, meaning that the historical pattern of object positions has ZERO predictive power in figuring out where these objects will be in the future. (…)
What we have to accept is that there is an Object 3 that has moved into a position such that its gravity absolutely swamps the impact of Objects 1 and 2. This Object 3, of course, is extraordinary monetary policy, specifically the purchase of $20 TRILLION worth of financial assets by the Big 4 central banks — the Fed, the ECB, the BOJ, and the PBOC. (…)
I tried to be a hero and short some obscene valuations. I got crushed. I now stand aside and wait because, we can be heroes, but likely, just for one day. Lovable as they are, heroes never last long. It pays to wait. The four-pillared bubble building boasts robust construction and fault-tolerant functioning. Nevertheless, be sure that all bubbles burst -it just might take a long wait this time around unless something unexpectedly moves in the CB (object 3) space.