2016 began with very heavy falls in equities meanwhile fixed interest Government bonds rallied even further driving more yields into negative territory, still investors piled in, guaranteed to lose money by holding bonds to maturity. Over $13 trillion sovereign bonds spent the past year in negative territory.
Then Trump unexpectedly won the US Presidential election in early November, bonds sold off, the animal spirits were released into US equities which hit fresh highs as markets bought into the Trump pivot, essentially a move to replace Central Bank money printing with Government infrastructure spending, cancellation of trade deals and an America First policy. It can all be undone in a Tweet of course.
Should you buy into Trump strategy? Not on your life. The truth is that financial markets have never been scarier. Now is not a time to buy into risk assets, it’s a time to hunker down. Trump is no Reagan inheriting a low deficit and high interest rates, giving huge scope to stimulate a moribund economy in the 80’s. Instead we begin 2017 in probably the worst possible shape with equities, property and bond values, all artificially inflated from eight years of vast money printing, meanwhile bank deposit safety is a thing of the past. That’s the truth of it.
Vast Money Printing Bubble
Central Banks have expanded their balance sheets, creating new money out of fresh air to the combined tune of $15 trillion across the big eight, including the ECB, FED, Bank of England, Bank of Japan etc., that’s equivalent to a third of the entire value of global equity markets, 50,000 PLCs worth a combined $48trillion. The global Government IOU market has expanded, not shrunk since the Global Financial Crisis to $70 trillion and on average national debt to GDP in the developed world has leapt by about 17% with Europe and the US nosing around 100% but ranging four to six times GDP when all off balance sheet unfunded liabilities like pensions and welfare are added to private and corporate debt. Japan whose stock market is still at half its peak in 1989 is running a national debt at nearly 250% of GDP and Italy, the world’s eighth largest economy is servicing national debt at over 130% while many of its banks are in crisis and require €40bn in fresh capital to shore up nine times that in non-performing loans on a €2 trillion loan book.
The global financial bubble can only be sustained by constant economic expansion propelled by vast money printing and monetary devaluation, still the consensus forecast for 2017 is to see a further gradual pick up in global economic expansion, low single digit returns on equities, further correction in bond values and the beginning of a replacement of monetary expansion by Central Banks, with fiscal expansion by Governments. This is led by Trump who wants to double the economic growth rate of the USA which would otherwise tip toe towards 2.7% or thereabouts, meanwhile Europe is expected to rally a little towards 2%, Japan towards 1.5% and China a little over 6%.
The consensus script is for more of their same, more credit creation, more pump priming and a gradual repair of the excessive debt load in the global economy to be repaid from higher future economic growth and future generations of taxpayers. But how is this possible, after all, bubbles naturally come to a tipping point, so what’s the implicit escape route, if we are to accept that this vast experiment in Keynesian economic theory might work?
The Escape Route Opens
When debt is excessive there are three choices to deal with it. Austerity has been tried but forcing harsh medicine on populations has proven to be politically impossible except in circumstances where small economies can be bullied into taking the beating ‘until morale improves’ or as European political leader put it-, we know what to do its just we don’t know how to do it and get re-elected.
Default is another route, but other than Greece, there’s been precious little defaulting on debt, quite the opposite, more debt has been added because default means investors get burned and that, in the asymmetrical world we live in, means toasting banks whose largest asset holdings, outside of loans, are Government bonds just as they are for most of the worlds worker pension funds.
Count out crushing austerity and shock default and, the road which will be travelled is to inflate way the excess debt by devaluing money, by crushing savers and robbing investors in fixed interest Government Bonds, paying back the IOUs in debased future currency values.
Price fixing is at the heart of monetary policy as Central Bankers attempt to dictate economic cycles while maintaining an inflation target of 2%. Fixing market prices as a general rule, creates dislocations reducing supply and stimulating demand, widening the gap even further. Propping up otherwise failed institutions is the essence of crony capitalism because it artificially sustains enterprises that ought, otherwise, to go burst, rewarding incompetence and punishing efficiency. It is an exercise in hubris to assume, incorrectly, that economies can be predetermined in labs using math formulae, when all of the evidence is that economic theory isn’t science, that it doesn’t work, that squillion- to- one probabilities keep happening, that the world is a far more volatile and unpredictable place than we’d like to think. Economic models and its legion of academics will, in time be replaced by modern game theory and artificial intelligence -it’s why it’s correct to distrust investments built on black box models and generally flee from Central Bank consensus.
Central Banks, basing their intervention on Keynesian economic theory, are going to attempt a Goldilocks, a reversal of money printing and gradual increase in interest rates, without letting the genie of high inflation out of the bottle. This was always going to be the hairiest moment. Declaring money with key strokes, lending at no cost to zombie banks and buying Government debt at prices nobody wanted, that was the easy bit, but now, led by the FED, rates are rising two, possibly three times in 2017, followed by the ECB in a couple of years’ time.
But Central Banks have to get the complex porridge just right, rising rates without strangling nascent economic recovery as consumers service debt loads at higher prices but still raise them strong enough to head off inflation before it becomes embedded. It’s a huge risk especially in economies with near full employment and in those like the UK pursuing a competitive devaluation of currency. So far, while inflation indicators are creeping up there is no consumer price surge, just yet. Inflation however is a burglar that’s announces itself often when it’s too late to stop. It is a function of the volume of money supply created and there’s been plenty of that, times the velocity at which it circulates and velocity has yet to speed up.
So which is it to be, a gradual repair of excess debt from a gentle economic recovery with low inflation or a violent swing into a new long term high inflationary cycle? Problem is that it may be neither if you consider that the GFC is not over but merely delayed. Much can still go badly wrong when you take an orbital view of the past few decades, beginning in 1971.
The Break from Gold
President Nixon severed the link between gold and the US dollar in August 1971 to prevent a run on US gold reserves. The break from the gold standard was to be a temporary arrangement, instead it begot decades of money printing and vast credit creation and where the US monetary base has expanded several times faster than its GDP. Total US national debt has doubled in size every decade ever since. The policy response to the gigantic debt bubble that led to the GFC was to be even more money printing despite the rather obvious law of nature that nothing can expand forever.
Perhaps we’ve become inured to the scale and lured into complacency by the softening impact of ongoing money printing by Central Banks, but the cost to the USA alone of the GFC, dwarfed the inflation-adjusted costs of World War II. The blowout in 2008 followed a series of near misses, each gaining in scale, the 1989 Savings & Loans blow out cost $160bn, the collapse in 1998 of Long-Term Capital Management which was leveraged 200 times its capital base and was crushed by the Russian debt default, cost $3.6bn across 16 financial institutions supervised by the FED. Part of the rescue was financed by Lehmann and Bear Stearns.
Banks who’d put LTCM into an orderly wind up would go on to underwrite the Dot-com IPOs despite the price of technology stocks on the NASDAQ hitting 200 times earnings, two and a half times higher than the outsized prices of Japanese stocks before their blowout ten years before. Three months into the millennium the index reached a peak price of 5,132. It was to crash by 78% triggering widespread bankruptcies and losses of $5trillion from March 2000 to October 2002.
The response of the FED was to reduce the cost of money dropping the Fed Funds rate to as low as 1% by 2004 and reflating the debt and property bubble which would finally pop four years later and reveal sub-prime lending practices that included NINJA loans which required no income, no jobs and no assets, to be later sold in AAA packages by Wall Street banks.
The response by Central Banks to the toxic infection of the global banking system was to hose down the conflagration with ever more debt, dropping servicing costs to levels unseen in banking history and introducing fresh jargon like ZIRP, zero interest rate policy and NIRP the negative kind, while buying up Government bonds at prices no one would and lending to their own Governments to finance deficit spending.
What is the Tipping Point?
After 8 years of vast money printing and further credit creation, the question is not if, but when we will reach a tipping point. By the end of 2016 a dangerous new phase in the game is beginning; Trump wants to take the lead in Government investment capital, taking over the baton from fading money printing, bond yields are rising and the FED is signalling a series of interest rate rises.
Vast money printing operations, have for the past eight years, reflated the value of property and equities and pushed up bond values. Asset owners have benefitted at the cost of workers whose taxes have risen to support bailout programmes, widening inequality. Those who continue to hold these assets are, in effect, relying almost entirely on the willingness of Central Banks to continue liquidity operations indefinitely. Now the FED begins the high risk task of weaning the US economy off excessively easy money, hoping to raise rates in a race against inflation.
Rising interest rates in global bond markets is a signal that losses will be made by bond holders who bought at much lower fixed yields. The question is if there will be an orderly retreat towards the exit door or a crush, stampeded by the spectre of an inflation surprise or by devalued currencies or by panic.
A rout in weakest parts of the bond market would take with it much of the attached banking system, hair cutting deposits and bond holders and triggering a collapse in equity prices as positions are liquidated. That is the risk.
Either we will enter a period of higher inflation for longer and escape by devaluing debt through money debasement or the GFC will revisit bigger and uglier than ever.
How to Position
Economics is not a physical science. The world is complex with many interconnected moving parts and beyond the calculus of economic models. No one can accurately predict what will happen but one thing is clear from episodes in history, debt cannot expand exponentially, not without collapsing under its own weight. It’s impossible to say whether this is imminent or further off or whether it will be avoided altogether through corrective actions like inflation which, after all, is a policy response.
But being unprepared is not an option, an inflation breakout or a repeat of a GFC is a real and present danger.
Earlier this year we added a London-based asset manager to our client choices, precisely because the asset mix provided for active management to mitigate these risks by a team that shares similar concerns. Today, this fund which is hedged to the Euro is 32% in cash, 10% in gold and 22% in Index-Linked Government bonds with the remainder spread across 22 global stocks that the fund has being investing in since 2001. The Fund was established to manage private wealth with a mandate to avoid capital loss. It has generally outperformed the FTSE 100 over most periods at less than half the volatility despite being heavily in cash and cash equivalents like ‘linkers’ and gold. It’s asset allocation history quite clearly shows pulling heavily out of equities before Dot-com and again in the run up to the GFC and notably it started taking positions in gold as early as 2004 because of concerns back then about having assets outside of the banking system.
Trend-following funds which were confounded by wildly swinging risk off and risk on directions in 2016, still remain a viable vehicle. These mandate the asset manager to hit target return above cash by following trends whether up or down by going long or short markets –in other words it ought not to matter once the right trend is taken near the turn of the tide. There are a range of choices available from large international asset managers to small specialists, each with its own pros and cons but all giving the potential to surf the trends to come without taking large, concentrated risks.
There is a comfort and a credible investment argument to hold physical gold and the sale off at year end 2016 is a buying opportunity. Gold started 2016 at €975, peaked in July at €1,228 and looks like ending the year in and around €1,100. If the gold price is correlated to Central Bank balance sheet expansion it’s heavily undervalued at these prices. Except for large sums we favour Perth Mint certificates backed by the AAA rated Australian Government, these are tradable certs backed by unallocated gold at one of the world’s largest mints. For very large purchases gold can be allocated and stored in specialist vaults in Zurich. For pensions and life insurance investments two Life offices provide retail products with gold funds as options in the Irish marketplace.
Banks are no longer safe as we once knew them, without the bailout the entire Irish banking system faced ruin as did most of the US majors including Merrill Lynch, Goldman Sachs and several more. Banks go burst all the time the difference now is that, depending on the severity of the burst, external assistance will not be forthcoming until bond holders and deposit holders take write downs. It makes common sense to have an escape route while watching bank vigilantly, especially those with inferior credit rating. The depositor protection schemes that populate Europe’s arrangements are only as reliable as their guarantor, the Government balance sheet standing behind them. These protections are not sacred and can be breached in extreme circumstances as the Cypriots learned to their shock in the early part of their banking crisis.
Banking systems themselves can be shut down overnight and exchange controls raised, capturing digital money which now accounts for over 90% of money, before reopening and rationing cash as one would do at petrol pumps during an oil crisis.
The bond market is not one homogenous whole but, instead a large series of tradable credit to a wide variety of countries that have very different balance sheets. A flight to safety would mean a selloff in weakest parts of the bond market in favour of strongest, countries that are well managed with low debt to GDP and with surplus net foreign assets or backed by commodities.
What not to do is just as important in these times. Do nothing about investing in illiquid Irish property right now, let it go. Do not leverage up your balance sheet, reduce debt where you can to well below half your net investible assets. Be careful of committing to private equity funds or other illiquid investments and, especially avoid, structured notes and ‘tracker bonds’ that lock away your money and where capital guarantees are provided by guarantors with poor investment grade credit rating.
Do not ignore financial assets, have your funds carefully examined for these risk exposures, get out of long equity and bond funds. Keep your cash deposits within the Depositor Guarantee limits and where scale makes that impossible keep accounts ready to go in the strongest banks in Europe. Look especially closely at how your financial investments would react to a lurch into a high inflation era and be ready to act.
If you’d like to discuss further pop an email to firstname.lastname@example.org
Ladytown Business Park,
Tel: 045 409364