A puzzling disconnect – July 3rd 2014

To read the latest View from the Bridge click here to view pdf 

Summer is upon us and in the UK we are actually enjoying some sunshine as are equity markets notably in the US. Fixed interest markets too are still sitting close to all time low yields and “shock horror” Spanish ten year rates are now below both UK gilts and US Treasuries. No I don’t know why either but Dr Aghi is sitting comfortably at the ECB having told the markets yet again that the sanctity of the euro is sacrosanct and woe betide anyone who disagrees with him.

Without a doubt the central banks are now running the show which is unfortunate as their track record, particularly in avoiding stock market excesses, is patchy to say the least. Janet Yellen, the latest incumbent chair at the Fed is quoted as saying that she is not at all concerned about valuations on Wall Street

In other words she is complacent about complacency, but no different from her predecessors who couldn’t see a housing bust coming (Greenspan) and thought that the subprime debt market was under control (Bernanke).

The Bank for International Settlements (BIS – the central banks’ central bank whose mission is to serve central banks in their pursuit of monetary and financial stability) agrees with our view,

“Financial markets have been exuberant over the past year, dancing mainly to the tune of central bank decisions. Volatility in equity, fixed income and foreign exchange markets has sagged to historical lows. Obviously, market participants are pricing in hardly any risks.”

The S&P 500 Index, gained almost 20% in the 12 months to May 2014, whereas expected future earnings grew less than 8% over the same period. The cyclically adjusted price/earnings ratio of the S&P 500 stood at 25 in May 2014, six units higher than its average over the previous 50 years.

It is no different in bond world…”Low corporate bond yields not only reflect expectations of a low likelihood of default and low levels of risk premia, but also contribute to the suppression of actual default rates, in that the availability of cheap credit makes it easier for troubled borrowers to refinance. The sustainability of this process will ultimately be put to the test when interest rates normalize.” In other words how secure are the interest payments on the high yield bond you have just put into your retirement account?

“Once more, communication from the Federal Reserve and the ECB helped support credit and equity markets, with the major stock exchanges reaching record highs in May and June 2014.”

They go on to say that…”It is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally….As history reminds us, there is little appetite for taking the long-term view. Few are ready to curb financial booms that make everyone feel illusively richer. Or to hold back on quick fixes for output slowdowns, even if such measures threaten to add fuel to unsustainable financial booms. Or to address balance sheet problems head-on during a bust when seemingly easier policies are on offer. The temptation to go for shortcuts is simply too strong, even if these shortcuts lead nowhere in the end.”  Apart from driving asset prices higher and higher has QE really worked as intended? Answers on a very small postcard…or as the BIS puts it…

“The global economy continues to face serious challenges. Despite a pickup in growth, it has not shaken off its dependence on monetary stimulus. Monetary policy is still struggling to normalize after so many years of extraordinary accommodation.  Despite the euphoria in financial markets, investment remains weak. Instead of adding to productive capacity, large firms prefer to buy back shares or engage in mergers and acquisitions. And despite lackluster long-term growth prospects, debt continues to rise.” As does the ability of the creative accountants to produce “ever” rising earnings growth.

But don’t worry the central banks know what they are doing don’t they? “Market participants seem to have become convinced that monetary conditions will remain very easy for a very long time. But markets may be taking more assurance than central banks wish to give, and they may be considering only a very narrow spectrum of potential outcomes. Such overconfidence is dangerous. It may encourage excessive risk-taking, and may add to the pressure on central banks to postpone policy normalization.”

Their conclusion is based upon much common sense but don’t hold your breath waiting for it to happen.

“There is a common element in all this. In no small measure, the causes of the post-crisis malaise are those of the crisis itself – they lie in a collective failure to get to grips with the financial cycle. Addressing this failure calls for adjustments to policy frameworks – fiscal, monetary and prudential – to ensure a more symmetrical response across booms and busts. And it calls for moving away from debt as the main engine of growth. Otherwise, the risk is that instability will entrench itself in the global economy and room for policy maneuver will run out.”

Might we suggest that the BIS restate their mission which should be to “save” central banks from their pursuit of monetary policy? It would be a much safer world without them.


Cash is king – June 5th 2014

It’s been nearly a year since the last View hit the streets during which time your correspondent has gotten himself married which I hasten to add has had nothing to do with the lack of output or indeed its resurrection! Normal service is now resumed and you can expect further diatribes on a monthly basis. First up given that markets everywhere are being manipulated in one way or another and most of them are not cheap where do you put your money. Clue: buy a large mattress.

“Inflation is not measurable, money is poorly understood and the economy is a complex system. From these observations can be derived a straightforward corollary on economic policy makers: trying to control a variable you can’t measure (inflation) with a tool you don’t fully understand (money) in a complex system with hidden, unobservable and non-linear interrelationships (the economy) is a guaranteed way to ensure that most things that happen weren’t supposed to happen.” From the Edelweiss Journal November 2013 www.edelweissjournal.com

 Yet we all live in the thrall of central bankers the kings (and queens) of economic policy forecasting. It has ever been thus, but in the relatively modern era, Paul Volcker’s taming of inflation in the 1980s, by levying penal rates of interest, opened the flood gates for all kinds of economic chicanery experiments culminating in ZIRP, QE and the euro. None of these policy initiatives has demonstrably worked in the way intended, but if we persist for long enough, we will get the result we want, seems to be the mantra. Thus giving credence to Einstein’s observation that doing the same thing repeatedly, but expecting a different outcome, is the definition of madness.

 Today it is the ECBs turn to throw a spanner into the system. Having said that he would do whatever it took way back in July 2012, Dr Aghi has now actually had to pull his proverbial finger out as the Eurozone drifts inexorably towards deflation in a moribund economic environment. His first move was to reduce the rate at which banks lend to the ECB to minus 0.1%. It will now cost the banks money to park their cash in this particular safe haven. The theory being that they will now just have to lend the stuff out in order to make a turn. Problem is Rodney that no one with a decent credit rating wants to borrow from them.

 There will no doubt be lots of loans for car buyers, students and wanna-be home owners, but is this really going to make a lot of difference to the economic recovery. It certainly won’t in the periphery where austerity is still spoken by governments and the IMF and any dissent is being literally beaten out of the system. The EU are debating how “alternative views” can be supressed from the internet and people are being fined for going on anti-Government rallies in Spain; George Orwell was only 30 years early. It would never occur to the ECB that the recent election results giving voice to the anti-Euro brigade might just be the thin end of a very sharp wedge pointing in their direction. The politicians and their banking partners in crime are not going to be put off in their divine right to impose their will by a mere “protest” vote.

 The announcement today reiterated the do whatever it takes line and the initial market response was to sell the euro and gold and buy equities. Just as quickly those moves have been reversed and most things apart from gold are close to opening levels; buy on the rumour (July 2012) sell on the news (today) triumphs over conventional analysis (hot air) yet again…

 So in this crazy world just what are we to do. That other great “quant physicist” Keynes opined that “markets can stay irrational for longer than one can remain solvent” or “employed” if you are an investment manager with a bearish view on low interest rate / QE fuelled markets. If your investment universe is getting more expensive by the day, which asset class best serves the purpose of preserving your hard earned capital? The conventional risk off asset class used to be sovereign debt, but with yields at historic lows they really aren’t cheap or risk free anymore. In corporate bonds and high yield are you really being paid a big enough risk premium? Hedge fund strategies have had a tough time this year as the markets rotate from risk off to risk on and back again without any clear pattern and the historically successful funds are getting to be heroically large and geared to boot.

It may sound like heresy but the answer to the conundrum is cash; under that mattress and stacked on top of your gold bars.


Tapering to a fine point…July 23rd 2013

The words of central bankers have for a very long time been poured over by those believing their utterances to have mystic qualities, but we now live in an era where their fallibility is coming into question. The Governor of the San Francisco Fed has written a paper debunking the effectiveness of quantitative easing where monetary policy is “uncertain”, a state of affairs that has been with us since QE was started and reinforced by Bernanke’s two recent press conferences. To taper or not to taper; will he or won’t he? Your guess is as good as mine.

 In Europe Dr. Aghi has been given what in a true democracy would be deemed unconstitutional powers, but we are talking Europe here where the rules are made up after the event and then broken by those with the power to do so; a strategy long employed by France. Until the German elections are out of the way in September there will be more muddle through in southern Med economies as “Geli” doesn’t want her electorate to know that she will have to spend more of their money bailing out a long line of Greek, Portuguese, Spanish, Italian and probably French banks, lest the precious euro falls flat on its face. Some of us believe it already has and only heroic denial, on a scale that makes religious fervour look like belief in Santa Claus, is keeping it alive.

 Shinzo Abe now has a majority in both Houses of Parliament in Japan so he has free reign over economic policy until 2016 which should be plenty enough time to put the final nail in the Japanese economic miracle. Their latest foray into QE dwarfs the Feds efforts and will almost certainly have a similar effect; an asset bubble, stubbornly low growth and a debauched currency; join the club!

 “No pain no gain”, is what my fitness trainer tells me with irritating relish and frequency, but you know what? He’s right! So what should our central banks and politicians be doing? Debt is the problem so deleveraging has to be the answer. This has been going on for some time, but is a very slow process and it will be a long time before growth picks up to levels that will inject some serious pace into the global economy.

 To short circuit the process requires massive debt write offs, which requires equally massive funding and in turn means wealth redistribution from those who have got it to those that don’t. This is why the politicians wont contemplate the pain as it is a policy that won’t get the backing of their sponsors ie the tiny percentage among us who have not only “got it”, but have got nearly all of it. They truly believe that the citizens are “revolting”; believe me, unless action is taken now, one day very soon they will be. 


Mind the gap! – May 21st 2013

In the 70’s, when I was cutting my teeth in investment management, we were in a bizarre world, which included the Sex Pistols and a phenomenon known as the reverse yield gap. For many years I pondered the use of the word “reverse” because as far as I was concerned the gap between bond (mostly in double figures) and equity yields (significantly lower) was just that; a yield gap. It had not occurred to me that at a much earlier and more rational time equities yielded more than bonds because they were more risky.

But the ‘70s saw the rise and rise of inflation which of course is anathema to bonds so yields went into orbit until Paul Volker, the last Fed Chairman who knew what he was about, put the genie back in the bottle by raising the Fed funds rate to 20% in 1981. 20%!!

Ten year Treasury yields were sub 4% in the early ‘60s and it was 50 years before the rate settled below that level again and the yield gap again became the norm, but for a whole new set of reasons. Volcker was followed by Greenspan who achieved a God like status; his every word was treated as the ultimate truth when it reality he hadn’t got a clue, but before we all worked that out the cult of central bank interference was embedded in the investment psyche.

Here was a man who called a market top in 1996 as irrational exuberance only for the S&P to double over the next four years. He also thought that Y2K was a huge threat and kept downward pressure on rates until mid-1999 when the aforementioned irrationality was gathering pace. His next mistake was not to lower the funds rate until December 2000, well after the top of the tech bubble and then drive it down to 1% by 2004 a move that begat the next bubble in property and the resulting CDS/CDO melt down.

Pushing the rate back over 5% didn’t stem the property surge and in 2006 he handed over to Bernanke who very quickly opined that the housing market was not in a bubble and that the proliferation of mortgage backed securities was never going to be an issue and we trust central bankers to run monetary policy with these sort of insights…BoE, ECB, BoJ are all in it together.

Since the Lehman bust they have struggled to get the economies going again and deliberately kept rates low in the belief that this will encourage borrowing and spur demand. It has failed to do either, but created yet another bubble, this time in the bond markets. The yield gap, should be telling us that bonds are less risky than equities, but with yields at all-time lows, that does not look to be the case.

The assumption to validate such low yields is that the central banks will keep up the money flow, but already the Fed has started to debate just when QE might stop and the latest suggestions are that it will be some time this year. Treasury, Gilt and Bund yields are now off their lows, and equities may just be getting the message that rapidly rising bond yields are not good for stock markets. Where does the risk off money go then??

When yields got down below 4% in 2008 we were saying much the same thing about bond valuations and then the conversation moved on to whether we were becoming Japanese and about to move towards eternal deflation. Now the Japanese want to become good inflationistas. They have got off to a good start with the “J” curve effect upping import costs. It remains to be seen whether increased export competitiveness actually translates into more exports. The yield on 10 year JGBs has gone from 0.3% to 0.9%; still under 1% for now but inflation is back on the menu. If they do manage to stoke it up they might want to revisit Volcker’s methods for getting it back down again. If you want a real shock put his 1981 Fed funds rate in your risk free return calculation and extrapolate just how “cheap” equities are….Mind the gap!