It has been an awfully hot summer in Spain. I did well enough (you can always do better) while sail racing intensely with my team, and, sadly, it’s time to engage in something more substantial. Not that I really crave for substance at this “Prozac” time of the year. I love the pleasures inherent to my bourgeois way of life that, save for my adrenaline generating sail racing, and abundant brainstorming, blend nicely with “easy economics”. So let me disclose my current emotional bias in favor of the Welfare States, Easy money, Easy credit, Liestatistics, Hail Mary passes, NIRPs, QEs, and bubbles of all kinds. They all increase the apparent NAV of our accumulated wealth. Next step is hugging good old Heli-Ben -and I’m real close to that right now.
No, I am not drunk! But I’m not serious anyway. This summer has further eroded my year to date return, as the sovereign spreads -and all others- collapsed to mind-numbing figures (considering the underlying fundamentals). I underestimated the quest for yield, and CB resolve, once again. On top of that, and confirming the fact that bad news rarely travel on their own, the Fed managed to contain and reverse, USD appreciation -that didn’t help. My new updated return YTD is only 3% by now. When you are not happy, it helps to laugh at yourself -and anything that moves as well.
For an insight of the logic of these moves, I cherry picked two charts, on the fundamentals of the Italian Sovereign spread.
And another two, related to the consistency of the USD weakness of late. Of course, in the new CB economic textbook, an upswing in the Ted spread is a clear precursor of an imminent dollar depreciation (excess dollars around?!!!). Am I being too sarcastic for my own good?
Needless to say, depreciating the USD is the single most effective action against conspicuous weakness, both in world trade, and US economy recent stats. Just look at how it helps crude price stabilize. Ditto for collapsing company ROE. As a side effect, it also helps ameliorate the latest default data (mainly, but not only, from the energy sector). I should have seen it coming. CB targeting comes well before macroeconomic and financial sense. This is not a market economy anymore.
OK, enough whimpering for today. Confusion reigns supreme I said. Well, I hope my first paragraph confused you enough because confusion is what it is all about nowadays -when coming back to school right after this 2016, summer season. Broken markets, with most players renouncing their most deeply held beliefs in favor of survival (a powerful instinct if there is one), have now nearly completed their ongoing process of morphing into something of an entirely different kind. Price discovery has been abandoned as a discipline. Bond vigilantes died a long time ago. Everybody is stuck, and running back and forth between the different asset classes -changing course at every sigh from some CB deity. Some cling on to valuation, others screen the flow of funds underlying the recent risk asset rallies (hint: not pretty). The different investment tribes keep on highlighting classic TA figures, Elliot wave perspectives, macro developments, huge statistical resets (like wage growth in the US), new QEs with direct ETF buying included in the deal, plain Graham and Dodd valuations, investor behavioral patterns, or whatever. The odd one resorts to sarcasm. At this point in time, it doesn’t really matter.
The whole pricing mechanism is corrupt. Direct or indirect manipulation of prices has made them all, anything, but efficient. Trying to predict them makes little sense, considering:
- Central Bank (CB) constant intervention, be it jawboning participants with Fed-speak and related prose, be it trading the E-minis, or be it simply buying ETFs or common stock (BOJ and SNB). No to mention other subtle techniques or plain vanilla USD debasement. Basically, they get the pricing they want for the asset of choice, with low volatility, at the expense of dramatically increasing tail risks to that imposed pricing. Precisely the opposite of what an efficient pricing system should try to achieve. We need volatile prices with low tail risks and not the other way around. The latest Williams-Dudley dialogue (San Francisco Fed paper vs verbal comments by Dudley), should be featured on Broadway soon. Rates lower for longer, vs immediate rate rises, suggested within 24 hours by two top tier politburo members. Awesome theatrical display of FOMC cognitive dissonance. Or is it, once again, the timeless Starsky and Hutch good-cop-bad-cop behavioral pattern in play?
- The search for yield. Starving the population used to be an effective way of making fortified medieval cities open their doors to foreign armies. CBs starve savers from income and get desperate moves from them that jump start a virtuous (or vicious?) circle, bubble pricing the riskiest assets in earnest. Meaning those assets with a higher yield (inverse PE in equity, or real yield in bonds). I’m not playing war games when my counterpart can starve players to induce behavioral stampedes. And if I am, I ought to consider unconventional warfare, or else I won’t last long.
- The need (angst) for return. Forget yield, let’s talk return as a more comprehensive concept. Return on investment (ROI). Pension funds, Mutual Funds, Hedge funds … We all need a return on investment to be able to remain in the business. Say 1% for expenses, and a meager 2% real on top of a decently calculated inflation around 2% long term. That gives you a minimum gross target of 5%. When there is no yield, there is a secondary effect: crowded speculative, leveraged trades. Players that shouldn’t be trading finally engage in speculative trading a lot more than they ought to. The result is frequent one-sided markets in VIX, EURUSD, Yen, Cable, Treasuries, Bunds, Gold, and the main financial products. People pile in and out of every available trade in a desperate way. Volume does not go up because normal rotational volume from conventional MF dries up as outflows remain solid. Trading desk head counts, and prop. trading fade as well. Slippage and timely CB intervention (whenever it suits them) burn us all. Only ETFs are not affected. Great! Outflows from MFs and inflows into ETFs is what CBs want. Precisely. And they are winning this battle as well (see Active Man chart).
- The thorough destruction of long-term correlations at the base of the financial system. CBs target different variables with no respect for the financial system. They may be targeting a stable price for gold, together with higher short-term rates in the US, a lower 10-year yield to support valuations, but with a lower USD to spice up the economy. Because players end up following targets outlined by CBs, we get crazy behaviors, with one-sided bets in short-term rates that oppose identical one-sided bets against the USD value. That destroys the system. Nothing makes sense, and it is impossible to set up coherent strategies. David Rosenberg wrote an interesting piece on the trading positions of smart money. We are no longer smart at all. Only ETFs and CBs are smart in this environment. Dumb money with no price sensitivity is now the smartest of all. Talk about interesting times.
- Insane corporate behavior. We don’t have enough prisons. We should jail most corporate managers together with most politburo members. Using cash flow, and even outright leverage, to further increase the debt to EBITDA ratio of listed companies is a criminal conduct. It is not regulated as such. But it ought to be. When the issuer of a security actively manipulates its EPS, it is not a conduct that favors the company (long term), the employees, or consumers. It benefits his stock option holders and the 1% of the population that run the show (the relevant shareholders). Want definite proof of misbehavior? Corporate management shuns personally, what they buy for their enterprise.
- Manipulated statistics. We have to invest blindfolded. The latest adjustment in the wage increase series in the USA speaks for itself. China is the ultimate liar’s paradise. Just look at their electricity consumption as related to reported GDP. Atrocious examples abound. Sometimes they don’t force the data, they just emphasize the wrong figures (labor stats for the US, or non-GAAP earnings stats for listed companies, are a clear example). Common investor Ignorance does the rest. Investors are manipulated. Try the Churchill method. A five-minute conversation with the average investor -after ingesting a generous dose of Prozac.
- Unlimited money printing, anywhere, anytime, with no regulatory limits. Politburos can print fiat currencies to the extreme -with the vote, or even just plain acquiescence, of their colleagues in power. The FOMC holds more power than the President. And they are not held accountable to the population. A unit of a fiat currency is worth as much as its politburo wants it to be worth. How can we measure supply and demand or investment value, if the units of measurement are manipulated?
- Unbridled credit growth, of unknown but suspect credit quality, and sweetened valuations of the underlying NPLs. China is the paradigmatic example of suspect credit aggregates. Do you doubt the quality of that fishy growth as well?
We got to a point where all this complexity is becoming outrageously simple. Too simple. I hate quandaries with binary outcomes. One or zero only are good inputs for computers but, I hope you will concede, not the best deal for our more complex neuronal system. And it’s all about one or zero right now. The world economy and financial markets are broken beyond repair, and only a system reset will open a new era for all of us.
Relentlessly, CBs have been cornering themselves into “Last Stand Hill”, right next to Little Big Horn river. And there sure is a lot of angry Indians, representing the different professional investor tribes, circling them out there. Yellen, Merkel (Draghi’s boss), and a few others face their last choice before passing into oblivion. They have only one wild card left: helicopter money in any of its forms, or a general deflation, hopefully, sugar-coated sooner or later with one last print to save the global ATM network. Reflation or deflation. To be or not to be. And finally, in any event, a massive global default to deflate our bloated balance sheets to realistic figures.
Most players have recently understood that, as Keynes presciently pointed out, we were all slaves in our economic thinking -to some defunct economist. The paradoxes of life. He happened to write his own epitaph! Keynesian monetary policies and their fiscal profligacy alternative (a euphemistic way to call for more debt) were never a part of the solution. They are the core problem, to begin with.
But as of yet, few understand that helicopter money, in any of its forms, is really the endgame. Higher yields are sure to follow, albeit with and unknown time lag. And higher yields will eventually bust the debt pile, eroding its sustainability. We can kick the can forward one last time but, after the equity outburst, and the consequential debacle in bonds to follow suit, a default chain will inevitably provoke the “curtains down”, grand orchestral finale, for the Keynesian utopia. I like the final strength (last three minutes) in this excerpt of The Magic Flute for that. I’m not sure Janet would enjoy the music though.
Unfortunately, the stereotype of Central Banker acts now and thinks later. It makes sense. Gods need not think. They are, literally, in their own words, “magic people” (I loved that self-serving quote at the time). They really think Heli-money is an option! Maybe they have no other emotional option left. Kuroda-san explained the scientific depth of their reasoning in pure Peter Pan terms: if you think you can’t fly … you are no longer able to do so. It follows that they must think they can “fly” at all times. No thinking, just faith of the religious kind. CBs and priests have a lot in common. I feel sorry for the Japanese!
They might just consider the only alternative they can see. Waiting out. But wait, there is no glamor in that. An unlikely choice for such beautiful people. On top of that, for once, they happen to be right. Standing pat is not a viable alternative either. At least with the cards, they have been dealt (they actually helped themselves to). If debt mutualization (in Europe), direct fiscal financing and or perpetual zero interest debt (Japan), blatant money printing (China), or some serious dollar debasing (USA), do not take place soon, it is “time out” for this global pantomime we are graciously living.
I do not think they are even giving thought to the only controlled way out. Deflate everything, lifting rates to the 2% real level, allow for defaults and repricing, and print as much as necessary to keep the financial system working (after bailing in investors, but, crucially, sparing depositors). The money created can be compensated scheduling a gradual reduction of fractional reserve banking and banning it altogether for the future. The target would be to minimize volatility in True Money Supply (TMS) figures, increasing M1 as needed, and decreasing credit correspondingly. Of course, there will be mismatches, but they should do their best at handling this transition between the different monetary aggregates, as smoothly as possible. The “corpse” of fractional reserve banking can be used to alleviate the M1 explosion needed to stabilize the ATM global network, while we deflate back to reality. XXL Balance sheets at CBs are here to stay -and even increase further.
So, all in all, most likely it will be helicopter money, the umpteenth erreur flagrante in economic thinking by global institutions. In any event, meaning whatever the option chosen, the great moderation and the crisis solving decade that followed are finished. It was good while it lasted, but it came well short of eternal. In my Roman Catholic background, there is always a day of reckoning. Regrettably, that goes for real life as well. I wish it came two decades from now, but have to acknowledge that CBs postponed it with utmost determination -and they couldn’t force a larger delay. I wouldn’t have done better.
Let’s smile and try to see the positive side of this situation. No doubt it is the best probabilistic chance most are going to get if they want to make a fortune in the markets -in a lifetime. In a binary outcome, the fact is that you have a 50% chance of getting it right. That is as good as it gets for ordinary, or even educated, but unspecialized investors, trying to outguess financial markets. Odds are normally a lot worse for them.
If you think it will be helicopter money, buy stocks and sell bonds. Sell the USD and buy EUR. Don’t short the CNY, or risk at all. Hold tight throughout reflation, buy physical assets, and make sure you jump ship at the right time. We will see Bolivarian stock prices all over the world, but I am not sure you can forego the need to accumulate toilet paper. Shortages, and urban violence aplenty, will be will be with us in no time at all. There is a real supply side working out there and, after decades of neglect, it happens to be in a shambles (more or less so, depending on your country).
On the other side, if you think they will not do that, sell credit risk, and risk as a whole, take no duration (after the default is done and over, rates will go up), sell equity, buy USD (the cleanest dirty shirt), and bid your time. Prices will be halved at the very least. Make sure your bank is OK, or at least make sure it is only a depositary institution for your money, hopefully well invested in safe bonds.
If you live in a Club Med country, you must pray as well. Yes, it is a “must”. We need the real God to come down and give us a hand here. Country bankruptcies are not much good at enhancing wealth preservation probabilities. Local politicians will do their best to make you pay your share of the mess. No remorse.
It sounds too simple. I am aware of that. But, on occasions, life is that simple. The accumulated debt pile, the hopeless NIRP epidemic (a 13 trillion USD float by now), productivity trends, exponential money supply growth, widespread asset mispricing, demographic data, unfunded liabilities, and actual and prospective global aggregate demand, leave no other option by now. Reflate wildly, or deflate. You can fool some people all the time, or everybody, but then, only for so long. We all (I mean 80% or more of the decent global strategists) know what it is all about by now. Play your hand Janet, and recall all your childhood prayers!
My choice? It is not really my choice. I gave you mine, and I think they wouldn’t even consider it an option. So, investing in this environment (in fact, I doubt we can use the word investing to a full extent anymore), is best done like taking a penalty shot. It is always preferable to wait for the goalkeeper to move -in your run up to the ball. I will remain liquid and wait to see Janet and Angela’s move, and then do my best. Janet has to move soon because economic stats are steadily deteriorating, and Angela has to make up her mind on debt mutualization. Italian Banks are pressing her to move soon as well. Portugal and Spain are right behind with desperate fiscal deficits.
This is a mind-blowing penalty kick, but I hate binary outcomes because, after three decades of global trading my odds had become better than those implied by a binary event. CBs have leveled us all. It’s Heads or Tails … and remember to Pray your Gods (no Central Bankers please!) as well.