“The rate of interest, or income tax, is reduced in a slump, but not increased in the subsequent boom. In this case, the boom will last longer, but it must end in a new slump: one reduction in the rate of interest or income tax does not, of course, eliminate the forces which cause cyclical fluctuations in a capitalist economy. In the new slump, it will be necessary to reduce the rate of interest or income tax again and so on.
Thus in the not too remote future, the rate of interest would have to be negative, and income tax would have to be replaced by an income subsidy. The same would arise if it were attempted to maintain full employment by stimulating private investment: the rate of interest and income tax would have to be reduced continuously.”
Political aspects of full employment (emphasis mine). M Kalecki. Spring 1942 lecture.
The quote above is a great synthesis of the actual state of affairs. Obviously, the easy money FED chairs, Greenspan, Bernanke and Yellen (not to forget Arthur Burns, the hawk that morphed to Dove/Nixon-puppet) never read that paper. It’s not that this excerpt hasn’t been used before. Brilliant, it cuts to the chase, and therefore it comes as a surprise that it is not well known by mainstream economists. Really the text says it all -when judging economic policy in the last two decades. You just have to combine Kalecki’s implied prognosis for an easy money policy (lowering rates ends up in increasingly negative rates), with the well-known Von Mises statement about the inevitability of a melt-down after an easy money and credit orgy. Monetary and fiscal policies efficacy, truly revealed.
Seventy-some years after Kalecki wrote that lecture, we are now in the midst of the remote future suggested. We have negative rates spreading around, and income tax is about to be compensated with an entitlement scheme for every single citizen -in countries with an outstanding economic reputation. No other government than Finland is now suggesting a salary for all (employed or unemployed, rich or poor) of around 800 dollars a month, for a final cost of 20% of GDP annually, and coming close to the income levels of public sectors in Japan or the US. We are not far from Kalecki’s prediction of paying out in entitlements more than what we obtain with taxation. Yet this is only the beginning. Helicopter money and nirping of our savings (outlawing the use of cash just to make sure negative rates do their job) are being actively discussed. QE for the people (a nice slogan for a viral strain of “helicopter money”) is increasingly being touted as the new tool of (delusive) economic policy. The apex of economic madness it must all be. If not, what else (hat tip: Nespresso)?
What’s to follow next? Indefinite incrementally higher negative rates (lower rates again and again), and more and higher out payments financed with helicopter money? Do we have a roadmap to economic heaven?
To heaven, it sure will not be, but more likely to Dante Alighieri’s description of the reading on Hell’s entrance (“Lasciate ogne speranza, voi ch’intrate“). I must have seen that reading before (maybe in a previous incarnation I can’t remember) because it has been some time now since I ran out of hope that we could gradually solve our economic quandaries. Of course, we can live without hope if we are aged enough. But can millennials do well at that?
Fiscal stimulus (lowering taxes or increasing public expenditure above the government income level), and/or monetary stimulus (more money, cheaper money, or both) are a self-defeating strategy in the long run. By now even mainstream economists begin to grasp the inevitability of the route described by Kalecki. He really thought that fiscal spending stimulus (as opposed to lowering taxes) could do better than tax reduction stimulation. Maybe, but the dead end is equally clear to me. Overspending, relative to public budget income levels (be it lowering taxes or increasing public expenditure), or easy money, always end up somewhere in the Kalecki path. So much for Keynesian stimulus. To corroborate that, just ask the Finns in a couple of years.
When I began this blog, my line of reasoning was shared only by hard-core Austrians -and some isolated investment doomsayers and gurus. Today, few outside Princeton and the last die-hard Keynesian priests question our description and reasoning of the historic chain of events post-GFC. Mainstream economists have finally understood what took us here, and why Yellen’s actual tightening effort is fraught with dangers. What they are not aware of yet, is that normalization is unlikely to succeed. Incrementally easy money, and/or abundant public spending, is the only road left if we are to ensure economic stability. Anything else takes us to a global debt write-down in slow (or not that slow) motion. The chart below speaks for the difficulty of raising rates again.
The billion dollar question is the stream of future events to take place and their timing. Will Yellen and Fischer stop tightening soon (how many hikes to go before she changes course)? Will Chinese fiscal stimulus postpone their melt-down one more year? Will European QE support the obvious European Economic stabilization for long? Will Greece hold on to the euro much longer? Will radical parties that want to print to finance social spending massively gain power soon? Will Putin keep quiet for some time?
Unfortunately, it’s been a long time since I decided not to be in the business of predicting the future -I do not think that business model can generate value over time. So I decline the responsibility of writing a schedule of future events to take place. Instead, what I can do is understand what’s going on (Kalecki, Mises and many others can help us in this quest), and develop a strategy that minimizes the risk of being wiped out financially. Or give it a try.
Things are tricky now. We have all learned of late, that valuation matters a lot less in a fiat money, CB driven pricing environment -in which base money and total credit can be anything but stable magnitudes. Not that anybody ever thought that valuation was a short-term market driver, but it used to show the way prices were most likely to go. Not any longer. Global liquidity is something a lot less profound and consequential. But it is what matters, and the chart above is of utmost importance to financial pricing. Unless the tide turns on liquidity, financial market prices point down. As Milton Friedman once said: follow the money!
Yes, global liquidity is contracting. Some will be surprised to see global liquidity decrease when the media is constantly mentioning BOJ and ECB QE efforts. But with Yellen et al finished and done with printing for the time being, and with the reserve decline in China, BRICS, and oil producers (Saudi Arabia is the poster child for that), the net outcome is negative. CB reserves are down not only in Saudi Arabia or China (Charts) but also in Brazil, Russia, Malaysia and other OPEC countries.
Asset allocation, and consequently, investment decisions, are likely to be poor when liquidity is increased or decreased substantially over short periods of time. Another reason, as if we needed one, to ask for a stable environment in money quantities (defined as M1, or M2 including near money). If we move the amount of money in an economy up and down significantly, all historical ratios for asset pricing become useless. Take Schiller’s CAPE. You can’t compare CAPEs in the seventies with actual equilibrium CAPEs. All historic charts become trash. Previous relationships do not hold. Correlations are altered. Peak levels have to be redefined. With no viable or stable past references, investing becomes an activity akin to gambling. First class investors give their clients their money back. Youngsters and ETF’s thrive. Index funds flourish. Active management generates negative value more frequently than not (60% of US active managers have been underperforming benchmarks).
When you print or destroy money big time, you also generate new lows or highs in money velocity numbers. You alter excess reserves in the banking system. And you devalue or revalue your currency notably. It is, I hope, beyond question, that this is not the best approach to efficient pricing as defined by Fama’s EMH. Not that I think the standard herd thinking most market players use daily, can generate efficient prices. But unstable money aggregates make it all the worse for otherwise prudent value investors. And it has helped ensure that old bond market vigilantes are all dead by now. Herds, passive investors, suspect HFT, and CBs do the pricing. They are sure to get it wrong. Malinvestment growth is the result and the road to nowhere. Our itinerary.
Monetary policy not only does not tame the business cycle, it engenders larger fluctuations in financial pricing. Altering the amount of money in the system (printing or allowing for fractional reserve lending relevant increases), amplifies the business cycle. In fact, what Bernanke has been doing is the opposite of what he boasts. Not only he and Greenspan did not produce the great moderation, they turbocharged the standard business cycle. They have converted economic cycles into boom and bust financial ones. It’s a shame they are still entrenched in denial at all costs. To them, “denial” is indeed, as Mark Twain once sarcastically suggested, a river in Egypt.
So investment decisions have to exponentially ponder liquidity factors, and correspondingly downgrade the weighting of valuation measure or market internals. All that we, old investors, learned from Benjamin Graham is becoming close to useless. If you can fine-tune prospective liquidity variations, you are a winner. 2015 has been all about that. Equity, bond, and currency markets have been liquidity driven. And it’s tough to anticipate liquidity moves that are fostered by a closed and introvert elite of Central Bankers. Unless you go to the same cocktail parties -or have an affair with one of them. Sex can be a powerful drug to make any of us more outspoken than we should. Think Mata Hari. Don’t central bankers look sexier to you -now that you think of it?
This environment remains unchanged for 2016. In truth, even somewhat more challenging. With a possible recession in the US relatively near (see CS global industrial production chart), a potentially explosive meltdown in China barely contained by a fresh round of profligate fiscal policy (see chart), and a global market valuation starting point that leaves no room for error, things are getting interesting. Thrilling, I ought to say.
Stock and bond markets are as close to a Casino as they possibly can. The risk is everywhere because prices are being altered (read CB manipulated) daily, and economic time-worn manuals for investing have become obsolete. You have to invest in long volatility trades with tight stop losses, and at the same time maintain a low-risk profile in your buy and hold portfolio. A challenging strategy for most. And, by the way, don’t forget you can’t trust market volatility figures (not implied but past volatility) to fine tune your VaR because those readings have been adulterated by CB’s (chart vía Zero Hedge).
But we still have to invest our money, and try to avoid gambling. The odds are strongly against value-oriented money managers, but we have to try to excel. Do not despair. There are better times ahead -once this mess has been cleaned up.
Cash is the obvious de-risked asset in crowd wisdom. False. Cash is also risky if only because it shows in your bank account balance (Bank balance sheets continue to look suspect to me and imaginary bail-ins haunt me daily). Cash also generates real, or even nominal, negative returns almost everywhere. Moreover, if you consider wealth taxes, negative returns begin to hurt, and thus, it is not a sustainable position for too long. You have to hold on to some cash though. It is obviously best to hold it in the most aggressively nirped currencies. But cash, in high percentages of your assets, or for long periods of time, is not as safe as it sounds.
Bonds have also always been considered a safe haven. Not anymore, or at least not to the same extent. Very short duration bonds are a cash equivalent. You have to go further out in the yield curve. And that’s risky today. In fact, all directional trades in bond yields are high risk now. I cannot feel sure enough of the value of going long or short duration in bonds (unless you like gambling). The odds are almost evenly split. Deflation could go on for a time, but cost push inflation is not that far away. Core inflation is not that low, considering the deflationary impact of commodities and resources pricing. All in all, I am unable to see a trade offering an acceptable risk-reward ratio in a duration play. US Treasuries look like the obvious candidate for a short (looking for higher yields), but it’s a crowded trade. Beware crowded trades in a potentially disruptive environment, with low daily liquidity. Australian long bonds would be the candidate for the opposite trade side, long duration bonds (looking for lower ten-year yields).
Long “credit spreads”, and short the “term spreads” (yield curve flatteners), in USD, have been (see previous posts), and still are, the only reasonably safe bets today. But both trades come with a big “If” attached to them. If Janet Yellen prints, the downside is huge. If she doesn’t, and I think she won’t in the near term, both offer a decent return perspective.
The chart shows that in the US a substantial flattening has already taken place, meaning the easy money has already been made, but I think there is more to be made -at a higher risk.
The rest of the currencies are still mired in zirp or nirp, so curve flattening offers a reduced risk reward ratio. But credit risk spread widening is likely to be OK over the next couple of months if liquidity does not increase again. As I said before, a big if. In any event, no way I’m going to find myself long HY or low investment grade bonds -just in case they do not ease again.
My position in equities is clear enough (previous posts have been particularly explicit regarding equities). Equity markets merit only a “short” or “flat” positioning. I include “flat” or “stand aside” as an option, only because liquidity is a wild card. If liquidity continues to ebb, I think a short remains appropriate, for European and US markets, but also for China, Japan or EMs as a whole.
It really all comes down to USD printing, or monetary expansion, to be allowed or not by Yellen. For a proxy on USD M2 expansion, something we might be late to know (no affairs with FOMC members or Fed officials that could provide updated nightly info at this time), you can chart the trade-weighted USD index. If the dollar continues to firm after the flat December performance, it shows that USD liquidity is unlikely to be rising. If the USD is strong, remain flat to short equities, and if it turns, it might be validating another ¿last? bullish tranche for risk. The USD uptrend is a key tell-tale for the next couple of months because on top of pressuring debt related structural dollar shorts (see previous posts), it indicates the degree of liquidity in the global financial system.
Currencies are as manipulated as ever. At the risk of boring readers, I will insist once more that USD can only be a long or stand aside. With the euro, it is the other way around. But there are lots of tradeable currency pairs out there, other that the USD or EUR. Nordic currencies are a long only (particularly SEK), and CNY is the short of the century, but you have to find a way to do so efficiently. Beware any apparent improvement in BRIC or EM currencies. Their wash-out is not finished yet. I think there is more pain to come for them (unless Janet prints).
Reading this post again, I realize I am not being too helpful, but I am not trying to protect my reputation at all. I just see few high conviction trades that fit my ever stricter risk-reward ratio. If risk-reward is not heavily biased in your favor, you are not investing, you are gambling. I didn’t train myself well enough for that purpose (according to my wife, likely for no other as well). When odds are roughly balanced, I stand aside and wait. No need to be fully risked up, in my portfolio, all the time. It will not be well rewarded in our returns, and … we do have to give ourselves a break every now and then as well.
We are just past Christmas, and its spirit should still remain inside our souls. If you want to relax and self-indulge (not a bad thing at all), this “Ave María” video is a masterpiece. I wish you all a nice and prosperous 2016. Thank you all for your support.