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By Steve Blumenthal, CMG August 18, 2017 “Anything that has happened economically, has happened over and over again.” – Ray Dalio, founder, Bridgewater Associates, in Bloomberg interview My thinking is impatient and mostly critical as I sift through research each week. I’m sure my “get to the point” personality frustrates my co-workers and I’m sure at times my beautiful wife. It’s a personality flaw, I know; but hey, I’m just not sure any amount of therapy can help. As I sift through research, my head clicks doesn’t matter, doesn’t matter… matters! Last week I wrote about Camp Kotok. There were some important “matters” moments. For example, there was an interesting moment when Bloomberg’s Mike McKee fired hard questions at the panel of economists and former Fed insiders. Stress test very bright thinkers on stage with their peers and you get to watch their body language as you listen to their answers. Further, you get to watch the movements and facial expressions of others in the room. The panelists debated what the Fed will do next. The most important takeaway from camp was confirmation of my view that the Fed, at the highest level, is heavily reliant on, if not married to, a limited equation called the Phillips Curve. The Fed’s goals are to keep employment strong and inflation in check. The Phillips Curve is a single-equation empirical model, named after William Phillips, describing a historical inverse relationship between rates of unemployment and corresponding rates of inflation that result within an economy. The Phillips Curve assumes that high levels of employment will pressure wages, increase incomes, increase spending and drive inflation higher. And that is true in the short-term debt (or business cycles) we move through over time, but is it always true? In my view, the answer is no. I argued they need to consider where we are in terms of both the short-term and the long-term debt cycle. A retired senior Fed economist said to me, “Until someone comes up with a better model, it’s the best we’ve got.” At this moment in time, they are looking at the wrong thing. “Matters!” Put “how the Fed will likely react” in the matters category. Put the Phillips Curve in the matters category simply because it is what the Fed is focused on and not because it is the right metric and put, as I mentioned last week, the understanding of short-term and long-term debt cycles and where we are within those cycles in the matters most category. Bottom line: We sit at the end of a long-term debt cycle. One very few of us have ever seen before yet one that has happened many times over hundreds of years. The data exists. The Phillips Curve doesn’t see it. I wrote last week, “… the Fed is Focused on the Obvious and the Unimportant.” That is important for us to know. But then, what should the central bankers and you and I be focused on? Let’s take a look at that today and see if we can gain a better understanding. Meeting Bloomberg’s chief global economist Mike McKee at Camp Kotok was a real treat for me. If you have listened to Bloomberg radio over the years, you’ll know him as Tom Keene’s co-host. So how will the next few years play out? What does it mean in terms of the returns you are likely to receive? In the matters category, I believe this is what you and I need to know most. Following are my abbreviated notes from a recent Keene-McKee-Ray Dalio video interview to better understand how the economic machine works and how Bridgewater uses this understanding to invest their clients’ money. ---
So there are three equilibriums we have longer term:
And there is an equilibrium that keeps working itself through this system and monetary and fiscal policy are the tools we use as we work through short-term and long-term debt cycles. Tom Keene asks, “…we’ve enjoyed the last seven years. Where are we now within that equilibrium?” Dalio answered, The United States is in the mid-point of its short-term debt cycle so as a result central banks are talking about whether we should tighten or not. That’s what central banks do in the middle of the short-term cycle and we are near the end of a long-term debt cycle.
Tom Keene asks, “Within the framework of your economic machine, do you presume a jump condition (a jump up in rates) as central banks come out of this or can they manage it with smooth glide paths?” Ray answered, I don’t believe they can raise rates faster than is discounted in the curve. In other words, the rate at which it is discounted to rise which is built into the interest rate curve (the curve is the different yields you get for short-term Treasury Bills to long-term Treasury Bonds). This is built into all asset prices. So if you raise rates much more than is discounted in the curve, I think that is going to cause asset prices to go down. Because all things being equal, all assets sell at the present value of discounted cash flow. All assets are subject to this so if you raise rates faster than what is discounted in the curve, all things being equal, it will produce a downward pressure on all asset prices. And that’s a dangerous situation because the capacity of the central banks to ease has never been less in our lifetimes. So we have a very limited ability of central banks to be effective in easing monetary policy. Mike McKee asks, “What does a central bank do when you are at the end of a long-term debt cycle? When the Fed is at the zero bound (meaning a Fed Funds rate yielding 0%)?” Ray believes the pressure on the central banks will be on easing monetary policy (lowering rates) vs. tightening (raising rates). Ray said, “We are in an asymmetrical world where the risks of raising rates is far greater than lowering rates (this is due to where we sit in the long-term debt cycle including emerging market U.S. dollar denominated debt, commodity producing dollar denominated debts, Japan, Europe and China debts relative to GDP or their collective income).” Meaning if you raise rates, it affects the dollar and it affects foreign dollar dominated debt. So the risks on the downside are totally different than the risks on the upside. Ray suggests that the next big Fed move will be to ease and provide more QE. McKee asks, “Do you think QE works anymore?” Ray said, “It will work a lot less than it did last time. Just like each time it worked a lot less.” He’s saying we can’t have a big rate rise because of the amount of debt, because of what it will do to the dollar, because of the disinflation it will cause and we will have a downturn. And the downturn should be particularly concerning because we don’t have the same return potential with asset prices richly priced, so each series of QE cannot provide the same bump. You reach a point where QE is simply pushing on a string. You get nothing. McKee asked if we are there yet. Ray responded, “No, we are not there yet, but we are close. Some countries are there. Europe is there. What are you going to buy in a negative interest rate world? Japan is there. The effectiveness of monetary policy then comes through the currency (SB here: currency devaluation makes your goods cheaper to buy than my goods).” (SB here: QE creates money out of thin air and central banks use that money to buy assets. That money buys bonds from you and you then have money in your account to put to work. What will you then buy? Which country might you choose to invest?) Ray said, “If you look at us (the U.S.), we have very high rates in comparison to those in Europe and Japan. So it comes through the currency. If you can’t have interest rate moves (like in Europe) it comes through the currency.” Countries need to get their currencies lower to compete and drive growth. Can you see the mess that debt gets us into and the challenges reached at the end of long-term debt cycles?) I’m going to conclude my notes from the Bloomberg interview with this last comment from Ray: If you can’t have interest rate moves, you’ve got to have currency moves. And that’s the environment we are in. OK, my friend, I believe the Fed should be studying history. As I mentioned last week, they do talk with the likes of Bridgewater but it stops short of the top. I believe the Fed should be looking at what happens at periods in time when debt had reached, like today, ridiculous debt-to-GDP levels. That’s the road map. That’s the seminal issue. There are other important issues, of course, but I believe this one matters most. What I gained from my time at Camp Kotok was that the Fed is not reviewing history. They are not considering the dynamics of were we are in the long-term debt cycle. They are wed to the Phillips Curve. “Matters!”
How we reset the debt via a combination of monetary policy and fiscal policy will dictate a beautiful or ugly outcome. Risks are high because asset prices are significantly overvalued. Participate yes but have processes in place that protect. I believe the U.S. looks most favorable relative to the rest of the world and we will likely see more QE. I believe the Phillips Curve and the Fed’s desire to normalize rates (to put them in a better position to deal with the next cycle) will prove to be a mistake. As Ray said, “The risks are asymmetric.” The current rate hike period will be halted and more QE will follow. What happens between now and then? Don’t know. I suspect a shock followed by more global QE. The current state favors a stronger dollar and a strong U.S. equity market especially if there is a sovereign debt crisis in Europe. So yep… there’s that. Participate and protect and tighten your seat belt. Likely to be bumpy. Grab a coffee. There was a great piece from GMO titled, “The S&P 500: Just Say No.” It highlights how GMO comes to their 7-Year Real Asset Return Forecast. One that is currently predicting a -4.20% annualized real return over the coming seven years. As in a loss of nearly 4% per year. If true, expect every $100,000 of your wealth to equal $70,945 seven years from now. Ultimately, valuations do matter. So yep… that too. GMO has posted its forecast for many years. It is updated monthly. The accuracy rate has been excellent. Meaning the correlation to what they predicted to what returns turned out to be is very high. Not a guarantee, but put it too on your matters list. You can follow it here. You’ll find a few interesting charts. Thanks for reading. I hope you find this information helpful for you and your work with your clients. Have a great weekend. by Mark Spitznagel
The Mises Institute 14 August, 2017 Every further new high in the price of Bitcoin brings ever more claims that it is destined to become the preeminent safe haven investment of the modern age — the new gold. But there’s no getting around the fact that Bitcoin is essentially a speculative investment in a new technology, specifically the blockchain. Think of the blockchain, very basically, as layers of independent electronic security that encapsulate a cryptocurrency and keep it frozen in time and space — like layers of amber around a fly. This is what makes a cryptocurrency “crypto.” That’s not to say that the price of Bitcoin cannot make further (and further…) new highs. After all, that is what speculative bubbles do (until they don’t). Bitcoin and each new initial coin offering (ICO) should be thought of as software infrastructure innovation tools, not competing currencies. It’s the amber that determines their value, not the flies. Cryptocurrencies are a very significant value-added technological innovation that calls directly into question the government monopoly over money. This insurrection against government-manipulated fiat money will only grow more pronounced as cryptocurrencies catch on as transactional fiduciary media; at that point, who will need government money? The blockchain, though still in its infancy, is a really big deal. While governments can’t control cryptocurrencies directly, why shouldn’t we expect cryptocurrencies to face the same fate as what started happening to numbered Swiss bank accounts (whose secrecy remain legally enforced by Swiss law)? All local governments had to do was make it illegal to hide, and thus force law-abiding citizens to become criminals if they fail to disclose such accounts. We should expect similar anti-money laundering hygiene and taxation among the cryptocurrencies. The more electronic security layers inherent in a cryptocurrency’s perceived value, the more vulnerable its price is to such an eventual decree. Bitcoins should be regarded as assets, or really equities, not as currencies. They are each little business plans — each perceived to create future value. They are not stores-of-value, but rather volatile expectations on the future success of these business plans. But most ICOs probably don’t have viable business plans; they are truly castles in the sky, relying only on momentum effects among the growing herd of crypto-investors. (The Securities and Exchange Commission is correct in looking at them as equities.) Thus, we should expect their current value to be derived by the same razor-thin equity risk premiums and bubbly growth expectations that we see throughout markets today. And we should expect that value to suffer the same fate as occurs at the end of every speculative bubble. If you wanted to create your own private country with your own currency, no matter how safe you were from outside invaders, you’d be wise to start with some pre-existing store-of-value, such as a foreign currency, gold, or land. Otherwise, why would anyone trade for your new currency? Arbitrarily assigning a store-of-value component to a cryptocurrency, no matter how secure it is, is trying to do the same thing (except much easier than starting a new country). And somehow it’s been working. Moreover, as competing cryptocurrencies are created, whether for specific applications (such as automating contracts, for instance), these ICOs seem to have the effect of driving up all cryptocurrencies. Clearly, there is the potential for additional cryptocurrencies to bolster the transactional value of each other—perhaps even adding to the fungibility of all cryptocurrencies. But as various cryptocurrencies start competing with each other, they will not be additive in value. The technology, like new innovations, can, in fact, create some value from thin air. But not so any underlying store-of-value component in the cryptocurrencies. As a new cryptocurrency is assigned units of a store-of-value, those units must, by necessity, leave other stores-of-value, whether gold or another cryptocurrency. New depositories of value must siphon off the existing depositories of value. On a global scale, it is very much a zero sum game. Or, as we might say, we can improve the layers of amber, but we can’t create more flies. This competition, both in the technology and the underlying store-of-value, must, by definition, constrain each specific cryptocurrency’s price appreciation. Put simply, cryptocurrencies have an enormous scarcity problem. The constraints on any one cryptocurrency’s supply are an enormous improvement over the lack of any constraint whatsoever on governments when it comes to printing currencies. However, unlike physical assets such as gold and silver that have unique physical attributes endowing them with monetary importance for millennia, the problem is that there is no barrier to entry for cryptocurrencies; as each new competing cryptocurrency finds success, it dilutes or inflates the universe of the others. The store-of-value component of cryptocurrencies — which is, at a bare-minimum, a fundamental requirement for safe haven status — is a minuscule part of its value and appreciation. After all, stores of value are just that: stable and reliable holding places of value. They do not create new value, but are finite in supply and are merely intended to hold value that has already been created through savings and productive investment. To miss this point is to perpetuate the very same fallacy that global central banks blindly follow today. You simply cannot create money, or capital, from thin air (whether it be credit or a new cool cryptocurrency). Rather, it represents resources that have been created and saved for future consumption. There is simply no way around this fundamental truth. Viewing cryptocurrencies as having safe haven status opens investors to layering more risk on their portfolios. Holding Bitcoins and other cryptocurrencies likely constitutes a bigger bet on the same central bank-driven bubble that some hope to protect themselves against. The great irony is that both the libertarian supporters of cryptocurrencies and the interventionist supporters of central bank-manipulated fiat money both fall for this very same fallacy. Cryptocurrencies are a very important development, and an enormous step in the direction toward the decentralization of monetary power. This has enormously positive potential, and I am a big cheerleader for their success. But caveat emptor—thinking that we are magically creating new stores-of-value and thus a new safe haven is a profound mistake. Mark Spitznagel is Founder and Chief Investment Officer of Universa Investments. Spitznagel is the author of The Dao of Capital, and was the Senior Economic Advisor to U.S. Senator Rand Paul. by Nassim N. Taleb, Daniel G. Goldstein, and Mark W. Spitznagel
Harvard Business Review October 2009 We don’t live in the world for which conventional risk-management textbooks prepare us. No forecasting model predicted the impact of the current economic crisis, and its consequences continue to take establishment economists and business academics by surprise. Moreover, as we all know, the crisis has been compounded by the banks’ so-called risk-management models, which increased their exposure to risk instead of limiting it and rendered the global economic system more fragile than ever. Low-probability, high-impact events that are almost impossible to forecast—we call them Black Swan events—are increasingly dominating the environment. Because of the internet and globalization, the world has become a complex system, made up of a tangled web of relationships and other interdependent factors. Complexity not only increases the incidence of Black Swan events but also makes forecasting even ordinary events impossible. All we can predict is that companies that ignore Black Swan events will go under. Instead of trying to anticipate low-probability, high-impact events, we should reduce our vulnerability to them. Risk management, we believe, should be about lessening the impact of what we don’t understand—not a futile attempt to develop sophisticated techniques and stories that perpetuate our illusions of being able to understand and predict the social and economic environment. To change the way we think about risk, we must avoid making six mistakes. 1. We think we can manage risk by predicting extreme events. This is the worst error we make, for a couple of reasons. One, we have an abysmal record of predicting Black Swan events. Two, by focusing our attention on a few extreme scenarios, we neglect other possibilities. In the process, we become more vulnerable. It’s more effective to focus on the consequences—that is, to evaluate the possible impact of extreme events. Realizing this, energy companies have finally shifted from predicting when accidents in nuclear plants might happen to preparing for the eventualities. In the same way, try to gauge how your company will be affected, compared with competitors, by dramatic changes in the environment. Will a small but unexpected fall in demand or supply affect your company a great deal? If so, it won’t be able to withstand sharp drops in orders, sudden rises in inventory, and so on. In our private lives, we sometimes act in ways that allow us to absorb the impact of Black Swan events. We don’t try to calculate the odds that events will occur; we only worry about whether we can handle the consequences if they do. In addition, we readily buy insurance for health care, cars, houses, and so on. Does anyone buy a house and then check the cost of insuring it? You make your decision after taking into account the insurance costs. Yet in business we treat insurance as though it’s an option. It isn’t; companies must be prepared to tackle consequences and buy insurance to hedge their risks. 2. We are convinced that studying the past will help us manage risk. Risk managers mistakenly use hindsight as foresight. Alas, our research shows that past events don’t bear any relation to future shocks. World War I, the attacks of September 11, 2001—major events like those didn’t have predecessors. The same is true of price changes. Until the late 1980s, the worst decline in stock prices in a single day had been around 10%. Yet prices tumbled by 23% on October 19, 1987. Why then would anyone have expected a meltdown after that to be only as little as 23%? History fools many. You often hear risk managers—particularly those employed in the financial services industry—use the excuse “This is unprecedented.” They assume that if they try hard enough, they can find precedents for anything and predict everything. But Black Swan events don’t have precedents. In addition, today’s world doesn’t resemble the past; both interdependencies and nonlinearities have increased. Some policies have no effect for much of the time and then cause a large reaction. People don’t take into account the types of randomness inherent in many economic variables. There are two kinds, with socioeconomic randomness being less structured and tractable than the randomness you encounter in statistics textbooks and casinos. It causes winner-take-all effects that have severe consequences. Less than 0.25% of all the companies listed in the world represent around half the market capitalization, less than 0.2% of books account for approximately half their sales, less than 0.1% of drugs generate a little more than half the pharmaceutical industry’s sales—and less than 0.1% of risky events will cause at least half your losses. Because of socioeconomic randomness, there’s no such thing as a “typical” failure or a “typical” success. There are typical heights and weights, but there’s no such thing as a typical victory or catastrophe. We have to predict both an event and its magnitude, which is tough because impacts aren’t typical in complex systems. For instance, when we studied the pharmaceuticals industry, we found that most sales forecasts don’t correlate with new drug sales. Even when companies had predicted success, they underestimated drugs’ sales by 22 times! Predicting major changes is almost impossible. 3. We don’t listen to advice about what we shouldn’t do. Recommendations of the “don’t” kind are usually more robust than “dos.” For instance, telling someone not to smoke outweighs any other health-related advice you can provide. “The harmful effects of smoking are roughly equivalent to the combined good ones of every medical intervention developed since World War II. Getting rid of smoking provides more benefit than being able to cure people of every possible type of cancer,” points out genetics researcher Druin Burch in Taking the Medicine. In the same vein, had banks in the U.S. heeded the advice not to accumulate large exposures to low-probability, high-impact events, they wouldn’t be nearly insolvent today, although they would have made lower profits in the past. Psychologists distinguish between acts of commission and those of omission. Although their impact is the same in economic terms—a dollar not lost is a dollar earned—risk managers don’t treat them equally. They place a greater emphasis on earning profits than they do on avoiding losses. However, a company can be successful by preventing losses while its rivals go bust—and it can then take market share from them. In chess, grand masters focus on avoiding errors; rookies try to win. Similarly, risk managers don’t like not to invest and thereby conserve value. But consider where you would be today if your investment portfolio had remained intact over the past two years, when everyone else’s fell by 40%. Not losing almost half your retirement is undoubtedly a victory. Positive advice is the province of the charlatan. The business sections in bookstores are full of success stories; there are far fewer tomes about failure. Such disparagement of negative advice makes companies treat risk management as distinct from profit making and as an afterthought. Instead, corporations should integrate risk-management activities into profit centers and treat them as profit-generating activities, particularly if the companies are susceptible to Black Swan events. 4. We assume that risk can be measured by standard deviation. Standard deviation—used extensively in finance as a measure of investment risk—shouldn’t be used in risk management. The standard deviation corresponds to the square root of average squared variations—not average variations. The use of squares and square roots makes the measure complicated. It only means that, in a world of tame randomness, around two-thirds of changes should fall within certain limits (the –1 and +1 standard deviations) and that variations in excess of seven standard deviations are practically impossible. However, this is inapplicable in real life, where movements can exceed 10, 20, or sometimes even 30 standard deviations. Risk managers should avoid using methods and measures connected to standard deviation, such as regression models, R-squares, and betas. Standard deviation is poorly understood. Even quantitative analysts don’t seem to get their heads around the concept. In experiments we conducted in 2007, we gave a group of quants information about the average absolute movement of a stock (the mean absolute deviation), and they promptly confused it with the standard deviation when asked to perform some computations. When experts are confused, it’s unlikely that other people will get it right. In any case, anyone looking for a single number to represent risk is inviting disaster. 5. We don’t appreciate that what’s mathematically equivalent isn’t psychologically so. In 1965, physicist Richard Feynman wrote in The Character of Physical Lawthat two mathematically equivalent formulations can be unequal in the sense that they present themselves to the human mind in different ways. Similarly, our research shows that the way a risk is framed influences people’s understanding of it. If you tell investors that, on average, they will lose all their money only every 30 years, they are more likely to invest than if you tell them they have a 3.3% chance of losing a certain amount each year. The same is true of airplane rides. We asked participants in an experiment: “You are on vacation in a foreign country and are considering flying the national airline to see a special island you have always wondered about. Safety statistics in this country show that if you flew this airline once a year there would be one crash every 1,000 years on average. If you don’t take the trip, it is extremely unlikely you’ll revisit this part of the world again. Would you take the flight?” All the respondents said they would. We then changed the second sentence so it read: “Safety statistics show that, on average, one in 1,000 flights on this airline has crashed.” Only 70% of the sample said they would take the flight. In both cases, the chance of a crash is 1 in 1,000; the latter formulation simply sounds more risky. Providing a best-case scenario usually increases the appetite for risk. Always look for the different ways in which risk can be presented to ensure that you aren’t being taken in by the framing or the math. 6. We are taught that efficiency and maximizing shareholder value don’t tolerate redundancy. Most executives don’t realize that optimization makes companies vulnerable to changes in the environment. Biological systems cope with change; Mother Nature is the best risk manager of all. That’s partly because she loves redundancy. Evolution has given us spare parts—we have two lungs and two kidneys, for instance—that allow us to survive. In companies, redundancy consists of apparent inefficiency: idle capacities, unused parts, and money that isn’t put to work. The opposite is leverage, which we are taught is good. It isn’t; debt makes companies—and the economic system—fragile. If you are highly leveraged, you could go under if your company misses a sales forecast, interest rates change, or other risks crop up. If you aren’t carrying debt on your books, you can cope better with changes. Overspecialization hampers companies’ evolution. David Ricardo’s theory of comparative advantage recommended that for optimal efficiency, one country should specialize in making wine, another in manufacturing clothes, and so on. Arguments like this ignore unexpected changes. What will happen if the price of wine collapses? In the 1800s many cultures in Arizona and New Mexico vanished because they depended on a few crops that couldn’t survive changes in the environment.… One of the myths about capitalism is that it is about incentives. It is also about disincentives. No one should have a piece of the upside without a share of the downside. However, the very nature of compensation adds to risk. If you give someone a bonus without clawback provisions, he or she will have an incentive to hide risk by engaging in transactions that have a high probability of generating small profits and a small probability of blowups. Executives can thus collect bonuses for several years. If blowups eventually take place, the managers may have to apologize but won’t have to return past bonuses. This applies to corporations, too. That’s why many CEOs become rich while shareholders stay poor. Society and shareholders should have the legal power to get back the bonuses of those who fail us. That would make the world a better place. Moreover, we shouldn’t offer bonuses to those who manage risky establishments such as nuclear plants and banks. The chances are that they will cut corners in order to maximize profits. Society gives its greatest risk-management task to the military, but soldiers don’t get bonuses. Remember that the biggest risk lies within us: We overestimate our abilities and underestimate what can go wrong. The ancients considered hubris the greatest defect, and the gods punished it mercilessly. Look at the number of heroes who faced fatal retribution for their hubris: Achilles and Agamemnon died as a price of their arrogance; Xerxes failed because of his conceit when he attacked Greece; and many generals throughout history have died for not recognizing their limits. Any corporation that doesn’t recognize its Achilles’ heel is fated to die because of it. --- Nassim N. Taleb is the Distinguished Professor of Risk Engineering at New York University’s Polytechnic Institute and a principal of Universa Investments, a firm in Santa Monica, California. He is the author of several books, including The Black Swan: The Impact of the Highly Improbable (Random House, 2007). Daniel G. Goldstein is an assistant professor of marketing at London Business School and a principal research scientist at Yahoo. Mark W. Spitznagel is a principal of Universa Investments. by Danielle Dimartino-Booth
July 26, 2017 5:12 am, April 18, 1906. A foreshock rocked the San Francisco Bay area followed 20 seconds later by one of the strongest earthquakes in recorded history. The quake, which lasted a full minute, was felt from southern Oregon to south of Los Angeles and inland as far as central Nevada. In the aftermath, the shock to the financial system was equally violent. Precious gold stores were withdrawn from the world’s major money centers to address the City by the Bay’s devastation. What followed was a run on liquidity that culminated in a recession beginning in June 1907. A decline in the U.S. stock market, combined with tight credit markets across Europe and a Bank of England in a tightening mode, set the stage. Against the backdrop of rising income inequality spawned by the Gilded Age, distrust towards the financial community had burgeoned among working class Americans. Into this precarious fray, a scandal erupted centered on one F. Augustus Heinze’s machinations to corner the stock of United Copper Company. The collapse of Heinze’s scheme exposed an incestuous and corrupt circle of bank, brokerage house and trust company directors to a wary public. What started as an orderly movement of deposits from bank to bank devolved into a full scale run on Friday, October 18, 1907. Revelations that Charles Barney, president of Knickerbocker Trust Company, the third largest trust in New York, had also been ensnared in Heinze’s scheme sufficed to ignite systemic risk. Absent a backstop for depositors, J.P. Morgan famously organized a bailout to prevent the collapse of the financial system. Chief among his advisers on aid-worthy solvent institutions was Benjamin Strong, who would become the first president of the Federal Reserve Bank of New York. Nearly 100 years later to the day, on May 2, 2006, California-based subprime lender Ameriquest announced it would lay off 3,800 of its nationwide workforce and close all 229 of its retail branches. There’s no need to rehash what followed. It remains fresh in many of our minds. Still, as we few skeptics who were on the inside of the Federal Reserve at the time can attest, that watershed moment also shattered the image of the false era that had sowed so many doubts, dubbed simply, The Great Moderation. It is said that the Great Inflation gave way to the Great Moderation, so named due to the decrease in macroeconomic volatility the U.S. economy enjoyed from the 1980s through the onset of that third ‘Great,’ The Great Financial Crisis. This from a 2004 speech given by none other than Ben Bernanke, who presided over this magnificent epoch: “My view is that improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation.” How very modestly moderate of him. To be precise, standard deviation gauges the volatility of a given data set by measuring how far from its long-run trend it swings; the higher the number, the more volatile, and vice versa. According to Bernanke’s own research, the standard deviation of GDP fell by half and that of inflation by two-thirds over this period of supreme calm. In late 2013, Fed historians published a retrospective on The Great Moderation, which concluded as such: “Only the future will tell for certain whether the Great Moderation is gone or is set to continue after the harrowing interruption of recent years. As long as the changes in the structure of the economy and good policy explained at least part of the Great Moderation, and have not been undone, then we should expect to return at least partially to the Great Moderation. And perhaps with financial stability being a more prominent objective and better integrated with monetary policy, financial shocks such as those seen over the past several years will be less common and have less severe impacts. If the Great Moderation is still with us, its reemergence in the aftermath of the Great Recession will be as welcome now as its first emergence was following the turbulence of the Great Inflation. As for its causes, economists may disagree on the relative importance of different factors, but there is little question that ‘good policy’ played a role. The Great Moderation set a high standard for today’s policymakers to strive toward.” Strive they have, and succeeded spectacularly, by their set standards. It matters little. Insert the observable phenomenon with anything that pertains to the macroeconomy and the financial markets, and you will see that volatility is all but extinct. The volatility on stocks, as gauged by the VIX index, hit its lowest intraday level on record July 25 of this year. As for how much stocks are jostling about on any given day, that’s sunk to the lowest in 50 years. Treasury market volatility is at a…record low. A lack of volatility in the price of oil is peeving those manning the commodities pits. Even go-go assets are dormant. The risk premium, or extra compensation you receive to own junk bonds, is negative. Negative! But this non-news spreads far beyond asset prices and presumably hits policymakers’ sweetest spot. According to some excellent reporting by the Wall Street Journal’s Justin Lahart, “Over the past three years, the standard deviation of the annualized change in U.S. gross domestic product…is just 1.5 percentage points, or about as low as it has ever been. It is a trend that is being matched elsewhere, with global GDP exhibiting the lowest volatility in history.” Lahart goes on to add that job growth and corporate profits also seem stunned into submission. And then he goes for the jugular: “In the years since the financial crisis, the Federal Reserve and other central banks have acted like overprotective parents of a toddler, rushing in whenever the economy looks as if it might stumble. That risk-averse behavior has extended to businesses, making them unwilling to take chances.” The WSJ goes on to report that at no time in at least 30 years has not one of the three major stock indexes in the U.S., Asia and Europe avoided a five percent decline in a calendar year…until what we’ve seen thus far in 2017, that is. Is it any wonder the ranks of those who would profit from stocks declining have fallen to a four-year low? Why bother in such a perfect world? In other words, we’ve never had it this good, or perhaps this bad. In that case, this must be The Greater Moderation. And by the looks of things, it’s gone global. It’s no secret that the Bank of England, Bank of Japan and European Central Bank have been aggressively flooding their respective economies and in turn, the global financial system, with liquidity in some form of quantitative easing. If there is one lesson to be learned from The Great Moderation, it is that liquidity acts as a shock absorber. In a less liquid world, the crash in oil prices would have resulted in a bankruptcy bloodbath. In a less liquid world, the bursting of the housing bubble would have led to millions of foreclosed homes clearing at fire sale prices. In a less liquid world, highly leveraged firms would have been rendered insolvent and incapable of covering their interest costs. In short, a less liquid world would be smaller, for a time. But when the time came to allow nature to take its course, central bankers could not bear the pain, nor muster the discipline, to allow creative destruction to cull the weakest from the herd. Their policies have forced us to pay a dear price to maintain a population of inefficient operators. The Economist recently featured a report on “corporate zombies”, firms that in a normal world would not walk among the living. Defining a ‘zombie’ as a company whose earnings before tax do not cover its interest expenses, the Bank for International Settlements placed 14 developed countries under the microscope. On this basis, the average proportion of zombies among publicly listed companies grew from less than six percent in 2007 to 10.5 percent in 2015. So we have one-in-ten firms effectively sucking the life out of the world economy’s ability to regenerate itself. There is no such thing as a productivity conundrum against a backdrop of such widespread misallocation of capital and labor. There is no mystery cloaking the breakdown in new business formation. And there is no enigma, much less any reason to assign armies of economists to investigate, shrouding the new abnormality we’ve come to know as a low growth world. There is simply no room for an economy to excel when its growth potential is choked off by an overabundance of liquidity that is perverting incentives. What is left behind is a yield drought, one that has left the whole of the world painfully parched for income and returns and yet too weary to conduct fundamental risk analysis. You have Greece returning to the debt markets after a three-year exile and investors falling over themselves to get their hands on the junk-rated bonds; the offering was more than two times oversubscribed. Argentina preceded this feat, selling the first-of-its kind, junk-rated 100-year-maturity, or ‘century’ bond; it was 3.5 times oversubscribed. Closer to home, Moody’s reports that lending to corporations has gone off the rails. Two-in-three loans offer no safeguards to lenders in the event a borrower hits financial distress; that’s up from 27 percent in 2015. Meanwhile, the kingpins of private equity have assumed such great powers, they’ve built in provisions that prohibit secondary market buyers of loans from assembling to make demands on their firms’ managements. Corporate lending standards in Europe are looser yet. What are investors, big and small, to do? Apparently, sit back and do as they’re told to do: Buy in, but passively, and let the machines do their bidding. For institutions, add in alternative investments at hefty fees and throw in leverage to assist in elevating returns. In late June, the recently retired Robert Rodriguez, a 33-year veteran of the markets, sat down for a lengthy interview with Advisor Perspectives (linked here). Among his many accolades, Rodriguez carries the unique distinction of being crowned Morningstar Manager of the Year for his outstanding management of both equity and bond funds. He likens the current era to that of the nine years ended 1951, a period during which the Fed and Treasury held interest rates at artificially low levels to finance World War II. His main concern today is that price discovery has been so distorted by the Fed that the stage is set for a ‘perfect storm.’ His personal allocation to equities is at the lowest level since 1971. The combination of meteorological forces to bring on said storm, you ask? It may well be an act of God, an earthquake. It could just as easily be a geopolitical tremor the system cannot absorb; it’s easy enough to name a handful of potential aggressors. Or history may simply rhyme with the unrelenting shock waves that catalyzed the subprime mortgage crisis, coupled per chance with a plain vanilla recession. We may simply and slowly wake to the realization that the assumptions we’ve used to delude ourselves into buying the most expensive credit markets in the history of mankind are built on so much quicksand. The point is panics do not randomly come to pass; they must be shocked into existence as was the case in advance of 1907 and 2007. One of Rodriguez’s observations struck a raw nerve for yours truly, who prides herself on being a reformed central banker: “The last great central banker that we had in the last 110 years other than Volcker was J.P. Morgan. The difference is, when Morgan tried to contain the 1907 crisis, he wasn’t using zeros and ones of imaginary computer money; he was using his own capital.” It is only fair and true to honor history and add that Morgan’s efforts rescued depositors. Income inequality in the years that followed 1907 declined before resuming its ascent to its prior peak, reached at the climax of the Roaring Twenties. The Fed’s intrusions since 2007, built on the false premise of a fanciful wealth effect concocted using models that have no place in the real world, have accomplished the opposite. Income inequality has not only grown in the aftermath of The Great Financial Crisis and throughout The Greater Moderation; it has long since smashed through its former 1927 record and kept rising. The Fed’s actions have not saved the little guy; they’ve skewered him. “The world in which we live has an increasing number of feedback loops, causing events to be the cause of more events (say, people buy a book because other people bought it), thus generating snowballs and arbitrary and unpredictable planet-wide winner-take-all effects.” – Nassim Nicholas Taleb, The Black Swan By John Mauldin
Mauldin Economics July 22, 2017 “What do you do?” is a common question Americans ask people they have just met. Some people outside the US consider this rude – as if our jobs define who we are. Not true, of course, but we still feel obliged to answer the question. My work involves so many different things that it isn’t easy to describe. My usual quick answer is that I’m a writer. My readers might say instead: “He tells people what could go wrong.” I like to think of myself as an optimist, and I do often write about my generally optimistic view of the future, but that optimism doesn’t often extend to the performance of governments and central banks. Frankly, we all face economic and financial risks, and we all need to prepare for them. Knowing the risks is the first step toward preparing. Exactly 10 years ago we were months way from a world-shaking financial crisis. By late 2006 we had an inverted yield curve steep and persistent enough to be a high-probability indicator of recession 12 months later. So in late 2006 I was writing about the probability that we would have a recession in 2007. I was also writing about the heavy leverage in the banking system, the ridiculous level of high-yield offerings, the terms and potential turmoil in the bond and banking markets, and the crisis brewing in the subprime market. I wish I had had the money then that a few friends did to massively leverage a short position on the subprime market. I estimated at that time that the losses would be $400 billion at a minimum, whereupon a whole lot of readers and fellow analysts told me I was just way too bearish. Turned out the losses topped well over $2 trillion and triggered the financial crisis and Great Recession. Conditions in the financial markets needed only a spark from the subprime crisis to start a firestorm all over the world. Plenty of things were waiting to go wrong, and it seemed like they all did at the same time. Governments and central bankers scrambled hard to quench the inferno. Looking back, I wish they had done some things differently, but in the heat of battle – a battle these particular people had never faced before, with more going wrong every day – it was hard to be philosophically pure. (Sidebar: I think the Fed's true mistakes were QE2, QE3, and missing their chance to start raising rates in 2013. By then, they had time to more carefully consider those decisions.) We don’t have an inverted yield curve now, so the only truly reliable predictor of recessions in the US is not sounding that warning. But when the central bank artificially holds down short-term rates, it is difficult if not almost impossible for the yield curve to invert. We have effectively suppressed that warning signal, but I am laser focused on factors that could readily trigger a global recession, resulting in another global financial crisis. All is not well in the markets. Yes, we see stock benchmarks pushing to new highs and bond yields at record lows. Inflation benchmarks are stable. Unemployment is low and going lower. GDP growth is slow, but it’s still growth. All that says we shouldn’t worry. Perversely, the signs that we shouldn’t worry are also reasons why we should. This is a classic Minsky teaching moment: Stability breeds instability. I know the bullish arguments for why we can’t have another crisis. Banks are better capitalized now. Regulators are watching more intently. Bondholders are on notice not to expect more bailouts. All that’s true. On the other hand, today’s global megabanks are much larger than their 2008 versions were, and they are more interconnected. Most Americans – the 80% I’ve called the Unprotected – are still licking their wounds from the last battle. Many are in worse shape now than in 2008. Our crisis-fighting reserves are low. European banks are still highly leveraged. The shadow banking system in China has grown to scary proportions. Globalization has proceeded apace since 2008, and the world is even more interconnected now. Problems in faraway markets can quickly become problems close to home. And that’s without a global trade war. I am concerned that another major crisis will ensue by the end of 2018 – though it is possible that a salutary combination of events, aided by complacency, could let us muddle through for another few years. But there is another recession in our future (there is always another recession), and it’s going to be at least as bad as the last one was, in terms of the global pain it causes. The recovery is going to take much longer than the current one has, because our massive debt build-up is a huge drag on growth. I hope I’m wrong. But I would rather write these words now and risk eating them in my 2020 year-end letter than leave you unwarned and unprepared. Because I’m traveling this week, this letter will be just a few appetizers –black swan hot wings, black swan meatballs in orange sauce, teriyaki swan skewers, and the like – to whet your appetite and help you anticipate what’s coming. Seriously speaking, could the three scenarios we discuss below turn out be fateful black swans? Yes. But remember this: A harmless white swan can look black in the right lighting conditions. Sometimes that’s all it takes to start a panic. Black Swan #1: Yellen Overshoots It is increasingly evident, at least to me, that the US economy is not taking off like the rocket some predicted after the election. President Trump and the Republicans haven’t been able to pass any of the fiscal stimulus measures we hoped to see. Banks and energy companies are getting some regulatory relief, and that helps; but it’s a far cry from the sweeping healthcare reform, tax cuts, and infrastructure spending we were promised. Though serious, major tax reform could postpone a US recession to well beyond 2020, what we are going to get instead is tinkering around the edges. On the bright side, unemployment has fallen further, and discouraged workers are re-entering the labor force. But consumer spending is still weak, so people may be less confident than the sentiment surveys suggest. Inflation has perked up in certain segments like healthcare and housing, but otherwise it’s still low to nonexistent. Is this, by any stretch of the imagination, the kind of economy in which the Federal Reserve should be tightening monetary policy? No – yet the Fed is doing so, partly because they waited too long to end QE and to begin reducing their balance sheet. FOMC members know they are behind the curve, and they want to pay lip service to doing something before their terms end. Moreover, Janet Yellen, Stanley Fischer, and the other FOMC members are religiously devoted to the Phillips curve. That theory says unemployment this low will create wage-inflation pressure. That no one can see this pressure mounting seems not to matter: It exists in theory and therefore must be countered. The attitude among central bankers, who are basically all Keynesians, is that messy reality should not impinge on elegant theory. You just have to glance at the math to recognize the brilliance of the Phillips curve! It was Winston Churchill who said, “However beautiful the strategy, you should occasionally look at the results.” Fact is, the lack of wage growth among the bottom 70–80% of workers (the Unprotected class) constitutes a real weaknesses in the US economy. If you are a service worker, competition for your job has kept wages down. The black-swan risk here is that the Fed will tighten too much, too soon. We know from recent FOMC minutes that some members have turned hawkish in part because they wanted to offset expected fiscal stimulus from the incoming administration. That stimulus has not been forthcoming, but the FOMC is still acting as if it will be. What happens when the Fed raises interest rates in the early, uncertain stages of a recession instead of lowering them? I’m not sure we have any historical examples to review. Logic suggests the Fed will extinguish any inflation pressure that exists and push the economy in the opposite direction instead, into outright deflation. Deflation in an economy as debt-burdened as ours is could be catastrophic. We would have to repay debt with cash that is gaining purchasing power instead of losing it to inflation. Americans have not seen this happen since the 1930s. It wasn’t fun then, and it would be even less fun now. Worse, I doubt Trump’s FOMC appointees will make a difference. Trump appears to be far more interested in reducing the Fed’s regulatory role than he is in tweaking its monetary policies. I have no confidence that Yellen’s successor, whoever that turns out to be, will know what needs to be done or be able to do it fast enough. Let me make an uncomfortable prediction: I think the Trump Fed – and since Trump will appoint at least six members of the FOMC in the coming year, it will be his Fed – will take us back down the path of massive quantitative easing and perhaps even to negative rates if we enter a recession. The urge to “do something,” or at least be seen as trying to do something, is just going to be too strong. Black Swan #2: ECB Runs Out of Bullets Last week, news reports said that the Greek government is preparing to issue new bonds for the first time in three years. “Issue bonds” is a polite way of saying “borrow more money,” something many bond investors think Greece is not yet ready to do. Their opinions matter less than ECB chief Mario Draghi’s. Draghi is working hard to buy every kind of European paper except that of Greece. Adding Greece to the ECB bond purchases program would certainly help. Relative to the size of the Eurozone economy, Draghi’s stimulus has been far more aggressive then the Fed’s QE. It has pushed both deeper, with negative interest rates, and wider, by including corporate bonds. If you are a major corporation in the Eurozone and the ECB hasn’t loaned you any money or bought your bonds yet, just wait. Small businesses, on the other hand, are being starved. Such interventions rarely end well, but admittedly this one is faring better than most. Europe’s economy is recovering, at least on the surface, as the various populist movements and bank crises fade from view. But are these threats gone or just glossed over? The Brexit negotiations could also throw a wrench in the works. Despite recent predictions by ECB watchers and the euro’s huge move up against the dollar on Friday, Anatole Kaletsky at Gavekal thinks Draghi is still far from reversing course. He expects that the first tightening steps won’t happen until 2018 and anticipates continued bond buying (at a slower pace) and near-zero rates for a long time after. But he also sees risk. Anatole explained in a recent report: Firstly, Fed tapering occurred at a time when Europe and Japan were gearing up to expand monetary stimulus. But when the ECB tapers there won’t be another major central bank preparing a massive balance sheet expansion. It could still turn out, therefore, that the post-crisis recovery in economic activity and the appreciation of asset values was dependent on ever-larger doses of global monetary stimulus. If so, the prophets of doom were only wrong in that they overstated the importance of the Fed’s balance sheet, compared with the balance sheets of the ECB and Bank of Japan. This is a genuine risk, and an analytical prediction about the future on which reasonable people can differ, unlike the factual observations above regarding the revealed behavior of the ECB, the Franco-German rapprochement and the historical experience of Fed tapering. Secondly, it is likely that the euro will rise further against the US dollar if the ECB begins to taper and exits negative interest rates. A stronger euro will at some point become an obstacle to further gains in European equity indexes, which are dominated by export stocks. Anatole makes an important point. The US’s tapering and now tightening coincided with the ECB’s and BOJ’s both opening their spigots. That meant worldwide liquidity was still ample. I don’t see the Fed returning that favor. Draghi and later Kuroda will have to normalize without a Fed backstop – and that may not work so well. Black Swan #3: Chinese Debt Meltdown China is by all appearances unstoppable. GDP growth has slowed down to 6.9%, according to official numbers. The numbers are likely inflated, but the boom is still underway. Reasonable estimates from knowledgeable observers still have China growing at 4–5%, which, given China’s size, is rather remarkable. The problem lies in the debt fueling the growth. Ambrose Evans-Pritchard reported some shocking numbers in his July 17 Telegraph column. A report from the People’s Bank of China showed off-balance-sheet lending far higher than previously thought and accelerating quickly. (Interestingly, the Chinese have made all of this quite public. And President Xi has taken control of publicizing it.) The huge increase last year probably reflects efforts to jump-start growth following the 2015 downturn. Banks poured fuel on the fire, because letting it go out would have been even worse. But they can’t stoke that blaze indefinitely. President Xi Jinping has been trying to dial back credit growth in the state-owned banks for some time; but in the shadow banks that Xi doesn’t control, credit is growing at an astoundingly high rate, far offsetting any minor cutbacks that Xi has made. Here are a few more juicy quotes from Ambrose: President Xi Jinping called for a hard-headed campaign to curb systemic risk and to flush out “zombie companies”, warning over the weekend that financial stability was a matter of urgent national security. It is the first time that a Chinese leader has chaired the National Finance Work Conference – held every five years to thrash out long-term plans – and is a sign of rising concern as debt reaches 280pc of GDP. In a move that will send shivers up the spines of local party officials, he said they will be held accountable for the rest of their lives for debts that go wrong. Any failure to identify and tackle risks will be deemed “malfeasance”. Ambrose then quotes Patrick Chovanec of Silvercrest Asset Management: “The banks have been selling products saying it isn’t our risk. Investors have been buying them saying it’s not our risk either. They all think the government will save everything. So what the markets are pricing is what they think is political risk, not economic risk,” he said. A market in which “they all think the government will save everything” is generally not one you want to own – but China has been an exception. It won’t remain one forever. The collapse, when it comes, could be earthshaking. Chinese growth has been fueled by a near doubling of both GDP and debt over the last nine years. One reason why so many people are complacent about China is that they truly believe that “this time is different” applies to Chinese debt. Maybe in 10 years I will look back and say that it really was different, but I don’t think so. As is often the case with China, China’s current circumstances are without a true equal in the history of the world. And if Xi is really serious about slowing the pace of growth (another form of tightening by a major world economy), that move would just add to overall global risk. It is very possible that any of these black swans could trigger a recession in the US. And let’s be clear: The next US recession will be part of a major global recession and will result in massive new government debt build-up. It will not end well. by Mohamed A. El-Erian
21 July 2017 Bloomberg View Over the past few months, government bond yields have fallen, the dollar has weakened and financials have underperformed, yet the major stock indexes are at or very near record highs, as persistently supportive liquidity conditions have more than compensated for policy and growth disappointments. By boosting returns and repressing volatility, ample liquidity is a gift for investors. It makes the investment journey pleasing, comfortable and lengthy. But it is not a destination. With the exception of buoyant stock market indexes, it is hard to find many financial markets that have managed to retain their post-U.S. election mood. Specifically:
Much of this reflects the process of markets repricing to lower expectations for U.S. growth and for Federal Reserve policy tightening compared to the rest of the world, and especially relative to Europe and the European Central Bank. The main reason for this is reduced hopes for a rapid economic policy breakthrough powered by the implementation of tax reform and infrastructure programs. Despite Republican majorities in both chambers, Congress has struggled to come together on major legislation, most visibly health care (an issue that dominated the party’s narrative during the campaign). This has delayed pro-growth economic bills, while making their prospects more uncertain. With Fed monetary measures already stretched, there has been little policy offset to a soft patch in indicators of household and corporate economic activity. Yet none of this seems to have been reflected in the major stock indexes. All three -- the Dow Jones, Nasdaq and S&P -- registered more record highs this week. In the process, the leadership of the market has returned to tech and other disruptors, after a brief but intense post-election romance with financials and industrials deemed to be the largest beneficiary of Trumponomics. The markets’ overall sense of "goldilocks" -- not too hot, not too cold -- explains much of the gap between buoyant stock indexes and lagging economic and policy fundamentals. Growth may be low, but the markets perceive it as relatively stable. The Trump administration has not followed through on protectionist measures that would threaten a global trade war. Concerns about disruptive European politics, to the extent they even registered in stock markets, have been alleviated by President Emmanuel Macron’s victory in France. Interest rates continue to be low throughout the advanced world, with markets also marking down their expectations of Fed tightening in the last few weeks. Two systemically important central banks, the ECB and the Bank of Japan, continue to provide a lot of liquidity, and on a predictable monthly schedule; and, as signaled on Thursday by ECB President Mario Draghi, they seem in no rush to taper, despite the improvement in economic conditions. Moreover, with corporate balance sheets flush with cash, valuations are also influenced by understandable expectations of more dividends, stock buybacks, and mergers and acquisitions. Liquidity, especially when ample and predictable, can fuel markets and condition investor behavior in a supportive manner for quite a while. But when judged against the objective of durable long-term gains, it is best seen as part of the investment journey. The destination, however, doesn't depend on liquidity alone. Economic and corporate fundamentals play a much larger role. So far, equity investors have experienced an unusually long and fulfilling journey -- one that, absent a major accident, could last a little longer. What remains more elusive, however, is confidence that this will end up at an enjoyable destination. But the most reassuring factor for traders and investors remains very loose financial conditions. by Mark Spitznagel
The Mises Institute 14 July, 2017 There seems to be no shortage today of investors and pundits criticizing the market interventions of the world’s central banks. Monetary stimulus in the form of artificially low interest rates and bloated central bank balance sheets ($18.5 trillion, to be exact), the argument goes, have created another dangerous financial bubble (evidenced by ubiquitously bubbly stock market valuation ratios) that ultimately threatens the financial system yet again. The author shares wholeheartedly in this criticism. The ethical problem is, where were these voices when this all started, with Greenspan in the 1990s and, more specifically, with Bernanke in 2008? The central bank critics today who were not critics of — and in most cases were even sympathetic to — the great bailouts and stimulus that started almost a decade ago have reserved their criticisms only for those interventions that appear to hurt their interests, as opposed to those that have helped them. After all, no one would disagree that bailouts and monetary stimulus got us out of the last financial crisis, but they also certainly got us to where we are today, vulnerable to another even bigger one. We are so concerned about our friend the strung-out junkie, though we paid little mind when they were but a casual user. It is so easy to care when problems become obvious and critical, so hard when they are subtler and nascent. Artificial stimulus in an economy is the same: it is easily ignored as a problem in its infancy, but it always develops into a huge problem. Economies and markets are structurally altered and distorted by such stimulus, such that it cannot be removed without breaking those new structures. It must rather be ever increased, though even this will only delay an inevitable collapse. It is just too easy in today’s investing environment, and even necessary for most participants, to sympathize with and even exploit central bank interventions. Doing otherwise creates an opportunity cost in one’s career and investments. But doing so puts one in the position of enabler to the economic system’s self-destructive dependence on artificial stimulus. One cannot be a part-time classical liberal, criticizing central planning only when it runs contrary to one’s interests. Indeed, this is the very problem of Socialism: there are winners and losers; the winners are in the here and now — the seen; the losers are in the future — the unseen. The winners don't complain, and the losers can‘t until it is too late. But as the future becomes the here and now, the unseen becomes the seen, those who now think they are anticipating a problem and its cause, yet supported that same cause when they stood to benefit, must be seen for what they are: fellow travelers in the central planning ideology that grips today’s financial markets. They are too late. by R. Christopher Whalen
Institutional Risk Analyst July 6, 2017 News last week that European Central Bank chief Mario Draghi was considering an end to the ECB’s extraordinary purchases of securities quickly let some air out of the Great Rotation into EU stocks. Sure the euro surged against a weakening dollar, but Europe’s mountain of bad debt remains unresolved -- even after the election of Emmanuel Macron to the French presidency. Yet hope springs eternal in some quarters after Draghi’s claim of a successful “reflation.” “All the signs now point to a strengthening and broadening recovery in the euro area,” Draghi told the ECB’s annual conference. “Deflationary forces have been replaced by reflationary ones,” the former head of the Bank of Italy declared. Draghi’s bull call on inflation provides optimism for relief on excessive levels of bad debt, albeit in a context where the EU’s rules on resolving dead banks remain entirely subjective. The July 4 approval of the latest state-supported rescue for Banca Monte dei Paschi di Siena (Montepaschi) illustrates the deflationary challenges still facing Europe. As part of the overhaul, Reuters reports, Montepaschi “will transfer 26.1 billion euros to a privately funded special vehicle on market terms, with the operation partially funded by Italian bank rescue fund Atlante II.” The bank will receive 5 billion euros in new public equity funds for its third bailout in a decade. Two weeks before the EU decision on rescuing Montepaschi, the Italian government supported the sale of two profoundly insolvent Italian banks. The assets of Popolare di Vicenza and Veneto Banca were sold to Intesa SanPaolo Group at an estimated cost to the government of 10 billion euros, marking Italy’s latest breech of the EU’s rules on state support for failing financial institutions. Like Montepaschi, where retail investors were heavily subsidized, the Intesa SanPaolo transaction avoids imposing losses on senior debt and depositors, but wipes out the equity and junior debt. This outcome reflects political as well as financial constraints in Italy, but shows how far there is to go in the process of resolving bad banks in Europe. Of note, Italy is being given control over the remaining “bad bank” to wind down as the assets and deposits are conveyed to Intesa SanPaolo. This permits a bailout of senior unsecured creditors. So Italy gets what it wants – continued circumvention of EU bailout rules. If a bank disappears, notes a well-placed EU observer, “state aid rules do not apply." Compare the sale of these two insolvent Italian banks with the resolution in early June of Banco Popular Espanol, which became the first EU bank to be resolved by the EU’s Single Resolution Board (SRB). Banco Popular had a third of total assets in bad loans and real estate owned, double the 15% average for all banks in Spain. (In the US, by comparison, non-performing loans plus real estate owned equaled less than 1% of total assets for all banks at the end of Q1 2017.) “The resolution of Banco Popular, under which it was acquired by Banco Santander S.A., is consistent with the EU’s Bank Resolution and Recovery Directive (BRRD),” Moody’s notes, “which restricts the use of public funds to rescue failing banks. The route followed by the EU authorities in the case of Banco Popular contrasts with the approach taken elsewhere to other ailing banks, notably in the case of the troubled Italian lender Banca Monte dei Paschi di Siena S.p.A.” The state bailout of Montepaschi, like the sale of the two smaller banks to Intesa SanPaolo, reflects political realities in Italy. “Montepaschi’s liability structure includes large volumes of bonds purchased by retail investors before the [Bank Resolution and Recovery Directive] introduction,” Moody’s continues. “Retail investors also accounted for around 40% of Banco Popular’s share capital and also held an undisclosed share of the bank’s Tier 2 instruments.” Well-advised institutional investors fled Italian banks years ago, partly because they could not trust official disclosure. So the Rome government countenanced the sale of “deposits” to retail investors by Montepaschi and other Italian zombie banks. The process of selling the deposits and good assets of the two Italian zombie banks to Intesa SanPaolo, while retaining the toxic waste in a “bad bank”, represents the true cost of this latest example of moral hazard in Europe. Draghi deserves considerable credit for the worsening situation at Montepaschi, starting with his tenure at the Bank of Italy. When the bank merged with Antonveneta, a troubled bank it bought from Spain’s Santander, Montepaschi’s troubles accelerated. Italy's third-biggest lender, received a 4 billion euro state bailout in 2012. The negative political consequences for the current government in Rome of the latest Montepaschi bailout are still unfolding, but Draghi and his fellow technocrats are the true authors of this mess. More, EU banks still face levels of bad debts that not only indicate insolvency, but under the EU’s often ignored fiscal rules, suggest a haircut for senior debt and depositors without state aid. As with the EU today, American officials in the late 1970s and 1980s bent the rules regarding bank disclosure to enable most of the larger, internationally active US banks to avoid a painful debt restructuring. The Latin debt crisis, trouble in the oil patch, and the S&L debacle pushed some of America’s largest banks to the edge of bankruptcy, starting a process of deregulation that is still little understood by investors and analysts. The Federal Reserve Board under Chairman Paul Volcker and other regulators allowed large banks to engage in off-balance sheet financial transactions that concealed tens of billions in loan exposures. This loosening of prudential standards regarding the treatment of off-balance sheet securities deals eventually led to the 2008 financial collapse. Three decades later, when concealed structured investment vehicles came back to issuers like Citigroup (NYSE:C), the results were disastrous. Today, officials in Europe led by ECB chief Mario Draghi are playing a similar game, pretending that bad public and private debt on the books of EU banks and investment houses, and held by individuals, is somehow money good. As with the US in the 1980s, the stark reality inside the EU banking system is being concealed under a heavy dose of technocratic obfuscation. Mountains of public debt in Europe also indicate proponents of the bullish EU equity trade may be a tad exuberant. Europe just dodged a bullet in Greece, where a last-minute deal with the International Monetary Fund allowed the member nations to kick the can down the road until next year. With debt at 200% of GDP, Greece is crippled economically and requires debt reduction in order to attract new investment. Over the past few months, investors have driven yields on Greek debt to the lowest level in years. To that point, investor optimism on the EU is predicated on an eventual debt bailout for Greece. Yet investors won't see any details on a long awaited Greek debt restructuring plan before the German elections later this year. The EU trade, as it were, depends an awful lot on what happens to Angela Merkel’s coalition this September. Economic reality is slowly leading the EU down the road to the assumption of bad debt of weaker states by the stronger members of the federation led by Germany. EU economic commissioner Pierre Moscovici has called for “debt reduction” in Greece, a proposal that is met with a lukewarm response by Germans. But will Merkel ultimately go along? "In the long run, in a completely integrated euro zone, we would talk about a ‘communitization’ of new debt, but we're not going to start with that," Moscovici told reporters last week. The necessary condition for the bull case on the EU is that the Germans must eventually embrace a federated structure for Europe, this as part of a gradual approach being advanced by leaders such as Macron in France and Moscovici in Brussels. Joint and several responsibility for all EU debts is the cost of unity. Such a scenario faces significant political and practical obstacles, most notably in Germany but also in France, where Macron must somehow convince his citizens to embrace German style economic behavior. A gradualist plan for a European federation seems unworkable so long as member states are able to borrow against Europe’s collective credit without toeing the line on fiscal reforms – as in the case of Italy and its troubled banks. “The euro crisis resulted from the fallacy that a monetary union would evolve into a political union,” writes Yanis Varoufakis, a former finance minister of Greece. “Today, a new gradualist fallacy threatens Europe: the belief that a federation-lite will evolve into a viable democratic federation.” by John Mauldin
Mauldin Economics June 18, 2017 The Next Minsky Moment Economics has its overused themes and phrases, too. One is “Minsky moment,” the point at which excess debt sparks a financial crisis. The late Hyman Minsky said that such moments arise naturally when a long period of stability and complacency eventually leads to the buildup of excess debt and overleveraging. At some point the branch breaks, and gravity takes over. It can happen quickly, too. Minsky studied under Schumpeter and was clearly influenced by many of the classical economists. But he must be given credit for formalizing what were only suggestions or incomplete ideas and turning them into powerful economic themes. I’ve often felt that Minsky did not get the credit he deserved. I look at some of the piddling ideas that earn Nobel prizes in economics and compare them to the importance of Minsky’s work, and I get an inkling of the political nature of economics prizes. Minsky’s model of the credit system, which he dubbed the “financial instability hypothesis” (FIH), incorporated many ideas already circulated by John Stuart Mill, Alfred Marshall, Knut Wicksell and Irving Fisher. “A fundamental characteristic of our economy,” Minsky wrote in 1974, “is that the financial system swings between robustness and fragility, and these swings are an integral part of the process that generates business cycles.” [Wikipedia] Minsky came to mind because in the past week I saw yet more signs that financial markets are overvalued and investors excessively optimistic. Yet I still haven’t seen many references to Minsky. That’s a little surprising. On reflection, I realized I hadn’t mentioned Minsky lately, either. That is a potentially dangerous oversight, because we forget his fundamental insights at our peril. Last week’s brief technology tumble should have been a wake-up call. So today we’ll have a little Minsky refresher and look at some recent danger signs. And I predict that we will soon see Minsky mentions popping up everywhere. Natural Instability Hyman Minsky, who passed away in 1996, spent most of his academic career studying financial crises. He wanted to know what caused them and what triggered them. His research all led up to his Financial Instability Hypothesis. He thought crises had a lot to do with debt. Minsky wasn’t against all debt, though. He separated it into three categories. The safest kind of debt Minsky called “hedge financing.” For example, a business borrows to increase production capacity and uses a reasonable part of its current cash flow to repay the interest and principal. The debt is not risk-free, but failures generally have only limited consequences. Minsky’s second and riskier category is “speculative financing.” The difference between speculative and hedge debt is that the holder of speculative debt uses current cash flow to pay interest but assumes it will be able to roll over the principal and repay it later. Sometimes that works out. Borrowers can play the game for years and finally repay speculative debt. But it’s one of those arrangements that tends to work well until it doesn’t. It’s the third kind of debt that Minsky said was most dangerous: Ponzi financing is where borrowers lack the cash flow to cover either interest or principal. Their plan, if you can call it that, is to flip the underlying asset at a higher price, repay the debt, and book a profit. Ponzi financing can work. Sometimes people have good timing (or just good luck) and buy a leveraged asset before it tops out. The housing bull market of 2003–07, when people with almost no credit were buying and flipping houses and making money, attracted more and more people and created a soaring market. The phenomenon fed on itself. Bull markets in houses, stocks, or anything else can go higher and persist longer than we skeptics think is possible. That is what makes them so dangerous. Minsky’s unique contribution here is the sequencing of events. Protracted stable periods where hedge financing works encourage both borrowers and lenders to take more risk. Eventually once-prudent practices give way to Ponzi schemes. At some point, asset values stop going up. They don’t have to fall, mind you, just stop rising. That’s when crisis hits. The Economist described this process well in a 2016 Minsky profile article. (Emphasis mine.) Economies dominated by hedge financing – that is, those with strong cashflows and low debt levels – are the most stable. When speculative and, especially, Ponzi financing come to the fore, financial systems are more vulnerable. If asset values start to fall, either because of monetary tightening or some external shock, the most overstretched firms will be forced to sell their positions. This further undermines asset values, causing pain for even more firms. They could avoid this trouble by restricting themselves to hedge financing. But over time, particularly when the economy is in fine fettle, the temptation to take on debt is irresistible. When growth looks assured, why not borrow more? Banks add to the dynamic, lowering their credit standards the longer booms last. If defaults are minimal, why not lend more? Minsky’s conclusion was unsettling. Economic stability breeds instability. Periods of prosperity give way to financial fragility. Minsky’s conclusions are indeed unsettling. He called into question the belief that markets, left to operate unimpeded, will deliver stability and prosperity to all. Minsky thought the opposite. Markets are not efficient at all, and the result is an occasional financial crisis. Complacency in the midst of a wanton debt buildup was beautifully expressed in a remark by Citigroup Chairman Chuck Prince in 2007: The Citigroup chief executive told the Financial Times that the party would end at some point, but there was so much liquidity it would not be disrupted by the turmoil in the US subprime mortgage market. He denied that Citigroup, one of the biggest providers of finance to private equity deals, was pulling back. “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” [source] Minsky wasn’t around to see the 2008 crisis that fit right into his theory. Paul McCulley attached Minsky’s name to it, though, and now we refer to these crises as “Minsky moments.” Are we closing in on one now? Learning the Rules As I mentioned, technology stocks suffered from a little anxiety attack in the markets last week. It didn’t not last long and really wasn’t all that serious. (Yet.) It was nothing worse than what everyone called “normal volatility” ten years ago. But the lack of concern it generated this time is not bullish, in my view. More than a few investors seem to think that “nowhere but up” is somehow normal. Doug Kass had similar thoughts (there’s that Zeitgeist trope thing again) and reminded us all of Bob Farrell’s famous Ten Rules of Investing. You could write a book about each one of them. I’ll just list them quickly, then apply some of them to our current situation. (Emphasis mine.) 1. Markets tend to return to the mean over time. 2. Excesses in one direction will lead to an opposite excess in the other direction. 3. There are no new eras – excesses are never permanent. 4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways. 5. The public buys most at the top and the least at the bottom. 6. Fear and greed are stronger than long-term resolve. 7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names. (Sound familiar? Can you say FAANGs?) 8. Bear markets have three stages: sharp down, reflexive rebound, and a drawn-out fundamental downtrend. 9. When all the experts and forecasts agree, something else is going to happen. 10. Bull markets are more fun than bear markets. I think most of these rules are obvious to investors who experienced the 2008 mess, the dot-com crash, and (if you’re of a certain age) the 1987 Black Monday. Some of us can remember 1980 and ’82. ’82 was especially ugly. (I had just gotten my master of divinity degree, and all I knew was that the job market sucked.) Maybe we mostly forget these experiences, but hopefully we pick up a little wisdom along the way. The problem is that now a new generation of investors lacks this perspective. They had little or no stock exposure in 2008 and experienced the Great Recession as more of a job-loss or housing crisis than a stock market crisis. Of course, the previous crises are no secret. People know about them, and on some level they know the bear will come prowling around again, eventually. But knowing history isn’t the same as living through it. Newer investors may not notice the signs of a top as readily as do investors who have seen those signs before – and who maybe got punished for ignoring them at the time. Doug Kass notices. Here’s a bit from an e-mail conversation we had last week. During the dot.com boom in 1997 to early 2000 there was the promise (and dream) of a new paradigm and concentration of performance in a select universe of stocks. The Nasdaq subsequently dropped by about 85% over the next few years. I got to thinking how many conditions that existed back then exist today – most importantly, like in 1999, when there emerged the untimely notion of “The Long Boom” in Wired magazine. It was a new paradigm of a likely extended period of uninterrupted economic prosperity and became an accepted investment feature and concept in support of higher stock prices! And in 2007 new-fangled financial weapons of mass destruction – such as subprime mortgages that were sliced and diced during a worldwide stretch for yield – were seen as safe by all but a few. And, just like during those previous periods of speculative excesses, many of the same strategists, commentators, and money managers who failed to warn us then are now ignoring/dismissing (their favorite phrase is that the “macroeconomic backdrop is benign”) the large systemic risks that arguably have contributed to an overvalued and over-loved U.S. stock market. Doug points especially to Farrell’s Rule 7, on market breadth. A rally led by a few intensely popular, must-own stocks is much less sustainable than one that lifts all boats. We see it right now in the swelling interest in FAANG (Facebook, Apple, Amazon, Netflix, Google). Tesla comes to mind, too. Their influence on the cap-weighted indexes is undeniably distorting the market. These situations rarely end well. Chinese Minsky What is behind these distortions? Ultimately, it’s about capital flows. Asset prices rise when demand outstrips supply, which is what happens when stocks or real estate or whatever are perceived as more rewarding than cash. Those with the most unwanted cash compete with each other to buy the alternatives. The Fed and other developed-country central banks created a lot of liquidity in recent years, so that’s undoubtedly a factor. An even greater one may be China, though. Consider China’s explosive growth. Its proximate cause is US demand and, to a lesser extent, European demand for Chinese exports. We sent them our dollars and euros; they sent us widgets and doodads. US dollars inside China are undesirable to wealthy Chinese and the Chinese government, so they send the dollars right back to us in exchange for other assets: homes, commercial real estate, stocks, Treasury bonds, entire companies. Meanwhile, within China, the government aggressively encourages lending for projects a free economy would never produce. Let me make a critical point here: While the central bank of China is not doing much in the way of quantitative easing, the government’s use of bank lending gone wild is essentially the same thing. The banks have created multiple trillions of yuan every year for many years. If you add Chinese bank lending statistics to the quantitative easing statistics of the world’s major central banks, the number is staggering. I think it’s entirely appropriate to perform that calculation. Beijing thinks this massive bank lending is useful in keeping the population happy, employed, and satisfied with their government. It has worked pretty well, too. It can’t work indefinitely, but the government seems bent on trying. Consider this June 14 Wall Street Journal report. While Beijing is carrying out a high-profile campaign to reduce leverage in its financial markets with one hand, with the other it is encouraging more potentially reckless borrowing. This week, the regulator put pressure on the country’s big banks to lend more to small companies and farmers, while the government announced tax breaks for financial institutions that lend to rural households. That follows recent guidance that banks should set up “inclusive finance” units. If the goal of lending to poorer customers sounds noble, the concern is that the execution will only worsen Chinese banks’ existing problems, namely high levels of bad loans and swaths of mispriced credit. Bank lending to small companies is already growing pretty fast, with non-trivial sums involved: It jumped 17% in the year through March to 27.8 trillion yuan ($4.084 trillion). That compares favorably with the 7% rise in loans to large- and medium-size companies over the same period. Observers like me have been saying for years that China’s banking system is overleveraged and will eventually collapse. We’ve been wrong so far. Beijing’s central planners may be Communists, but they use the capitalist toolbox to their advantage. China will eventually face a reckoning. When it does, the impact will spread far outside China. What do you think will happen when Chinese money stops buying Vancouver real estate and US stocks? The outcome won’t be bullish. The Swiss National Bank Is Doing What? Pity the poor Swiss government. They have run their country well and don’t have a great deal of debt. They are a small country of just 8 million people, but they make an outsized impact on economics and finance and money. Because Switzerland is considered a safe haven and a well-run country, many people would like to hold large amounts of their assets in the Swiss franc. Which makes the Swiss franc intolerably strong for Swiss businesses and citizens. So the Swiss National Bank (SNB) has to print a great deal of money and use nonconventional means to hold down the value of their currency. Their overnight repo rate is -0.75%. That’s right, they charge you a little less than 1% a year just for the pleasure of letting your cash sit in a Swiss bank deposit. And the SNB is buying massive quantities of dollars and euros, paid for by printing hundreds of billions in Swiss francs. The SNB owns about $80 billion in US stocks today (June, 2017) and a guesstimated $20 billion or so in European stocks (which guess comes from my friend Grant Williams, so I will go with it). They have bought roughly $17 billion worth of US stocks so far this year. They have no formula; they are just trying to manage their currency. Think about this for a moment: They have about $1000 in US stocks on their books for every man, woman, and child in Switzerland, not to mention who knows how much in other assorted assets, all in the effort to keep a lid on what is still one of the most expensive currencies in the world. I gasp at prices every time I go to Switzerland. (I will be in Lugano for the first time this fall.) Switzerland is now the eighth-largest public holder of US stocks. It has got to be one of the largest holders of Apple (see below). What happens when there is a bear market? Who bears the losses? Print just more money to make up the difference on the balance sheet? Do we even care what the Swiss National Bank balance sheet looks like? More importantly, do they really care? We all remember European Central Bank President Mario Draghi’s famous remark, that he would do “whatever it takes” to defend the euro. We could hear the Swiss singing from the same hymnbook, by and by. The point is that central banks and governments all the world are flooding the market with liquidity, which is showing up in the private asset markets, in stock and housing and real estate and bond prices, creating an unquenchable desire for what appear to be cheap but are actually overvalued assets – which is what creates a Minsky moment. Now, remember what Minsky said. When an economy reaches the Ponzi-financing stage, it becomes extremely sensitive to asset prices. Any downturn or even an extended flat period can trigger a crisis. While we have many domestic issues that could act as that trigger, I see a high likelihood that the next Minsky moment will propagate from China or Europe. All the necessary excesses and transmission channels are in place. The hard part, of course, is the timing. The Happy Daze can linger far longer than any of us anticipate. Then again, some seemingly insignificant event in Europe or China – an Austrian Archduke’s being assassinated, or what have you – can cause the world to unravel. It’s a funny world. We have our rashes of zombie moves and 20 people in all corners of the planet inventing the same thing at the same time. And we have our central banks and governments exhibiting unmistakable herd behavior and continuing to do the same foolish things over and over. They never really intend to have the crisis that ensues. Remember Farrell’s Rule 3: There are no new eras. The world changes, but danger remains. Gravity always wins eventually. It will win this time, too. And when it does, we will begin undergo the Great Reset. |
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