-- John Kenneth Galbraith, A Short History of Financial Euphoria
The spadefoot frog makes its home in Australia. It is an explosively breeding, desert-dwelling amphibian. It may burrow underground for years, waiting for a seasonal rain or flood. However, when this "liquidity event" arrives, a period of frenzied mating ensues. Incredibly, in a space of as little as a month, its eggs advance through the tadpole stage to full metamorphosis. It needs to quickly reach adulthood before the pools of water again dry up. Fascinatingly, as the water puddles begin to get tepid, murky and shallow, the tadpoles grow teeth ... 3 rows of them. They then start eating each other to accelerate the growth of the survivors. Eventually, the frog must go back underground in order to survive the next dry season.
Sound a little like today's capital markets ... with 3 rows of teeth?
It makes an apt allegory for the explosive financial market rallies witnessed to date this year. From the March 9th lows of earlier this year, global equity markets have soared 68% (in USD terms) flushed by a veritable flash flood of liquidity.
There is more to this allegory as we will outline.
Strategy & Door #4
We have always said that the tough questions precipitated by the Global Financial Crisis (GFC) would come later ... at the end of the first major recovery rally. At the extreme equity market lows of late 2008 and into March 2009, the values were self-evident no matter that the world might have ended. It required precisely such scares to mobilize new and inventive interventions on the part of central banks and governments. The appropriate response at the time was to "buy" and ask questions later. There would be plenty time to assess the quality and sustainability of the recovery.
Now is the time to answer these questions. It is opportune in more ways than one. Not only are asset markets again over-valued, consensus opinion appears to be as unified and unsuspecting as at the previous equity market tops of 2007 (and the bond market top of February/March 2009.) Alarming -- as it always should be when this characteristic occurs -- is that correlation measures between markets, asset categories and sectors are again very high. (See the indicator of equity market correlations shown on the front page graph.) Without a doubt, it has been a liquidity and panic-driven recovery that has floated all ships and creatures, amphibious or not. But what of the recovery? Is it sustainable? We think not ... except for one possible development for financial markets -- Door #4.
Re-Assessment of Our Five Macro Scenarios
We have progressively dialled down risk in our portfolios since June of this year, making further downshifts recently. Lately, we are again underweight equities ... though only modestly. We are probably not as underweight as the dour long-term outlook for economic growth over the next few years would otherwise suggest. Why? Developments to date this year argue that we should raise the probability on scenario #4 of the five that we are currently considering -- Velocity Inflation.
Just what is velocity inflation? It is a type of price inflation that is driven by a change in preference between assets. For example, if everyone suddenly wishes to own tulip bulbs, beanie babies or pet rocks, their prices can rise to stratospheric levels. The asset mix shift itself from cash to tulip bulbs -- or as we think may be possible ... from bonds and cash to equities and other hard assets -- drives up the price of the attractive asset and deflates the asset being aggressively sold. This phenomenon need not even involve actual monetary inflation (of which there is plenty at the present time).
To illustrate, when a crowd runs from one side of a ship to the other, the average water displacement of the ship remains the same. Yet, the vessel will have experienced a significant movement and shift in mass. The boat will have changed its tilt ... one side rising, the other falling. Of course, monetary inflation can only serve to accelerate a shift from bonds to equities and hard assets.
Monetary Inflation: Where is it Going?
There is lots of monetary inflation in the system given the enormous balance sheet expansions initiated by central banks around the world. Many observers therefore worry about explosive inflationary conditions in ensuing years. What they expect is rising prices of the things that are the product of current economic output. In this sense, some even worry about an inflationary spiral similar to the one that occurred in Weimar Germany during the 1920s.
Vigilance against the effects of inflation are certainly not unreasonable. High alert is warranted. However, the type of inflation manifestation that Germany experienced and others since that time, is not likely to happen today. Why not? There are at least three major reasons. For one, the inflation chameleon is much too devious to follow any predefined script. A knowledge of history alone is not a reliable help without the understanding of underlying causality. Inflation can express itself in different ways, running in channels determined by the financial and economic landscape of the time. Its quixotic and wily nature was noted by Keynes: "By a continuous process of inflation [...] engages all of the hidden forces of economic law on the side of destruction, and does it in a manner that not one man in a million can diagnose."
Secondly, and importantly, there exists today an enormous traded bond market. Any sniff of an inflationary spiral (if not temporarily outweighed by fear and a run to quality) would soon trigger the deflationary impact of rising bond yields. Thirdly, the structure of financial assets and their distribution is entirely different today. This is likely to direct inflation and investor behaviour into an entirely different channel. Allow us to explain.
Several factors -- both psychological and structural -- working together, could set up conditions of possible "velocity inflation" with respect to equity assets and other more (monetary) inflation-proof assets.
1. Structure and Distribution of Global Financial Assets. Though a long-running trend, the bulk of investable assets in securities markets (equities, fixedincome, and derivatives) are more centrally managed by professionals than ever before. This effects market behaviour. Here are several factors to note:
Concentrated Owners. Consider that latest available year-end 2006 data shows total institutional investors -- defined as pension funds, investment companies, insurance companies, banks and foundations -- controlled assets totalling $27.1 trillion, up from $24.4 trillion in 2005. This level represents a ten-fold increase from $2.7 trillion in 1980. The equity market value of total institutional equity holdings increased from $571.2 billion in 1980 (or 37.2% of total U.S. equity markets) to $12.9 trillion (or 66.3% of total U.S. equity markets) in 2006. This represents a historic alltime high in the amount of total U.S. equities controlled by these institutional investors. (Source: Conference Board)
More Evidence of Concentrated Holdings. A pair of physicists at the Swiss Federal Institute of Technology in Zurich recently published preliminary findings of their network analysis of the world financial economy as it looked in early 2007. Stefano Battiston and James Glattfelder extracted the information for 24,877 stocks and 106,141 shareholding entities in 48 countries. It revealed what they called the "backbone" of each country's financial market. These backbones represented the owners of 80% of a country's market capital, yet consisted of a remarkably small number of shareholders. The most pared-down backbones exist in Anglo-Saxon countries, including the U.S., Australia, and the U.K. Paradoxically; these same countries are considered by economists to have the most widely-held stocks in the world, with ownership of companies tending to be spread out among many investors. But while each American company may link to many owners, Glattfelder and Battiston's analysis found that the owners varied little from stock to stock, meaning that comparatively few hands are holding the reins of the entire market. (Quoted from GlobalResearch.ca) (Source: Backbone of complex networks of corporations: The flow of control, J.B. Glattfelder and S. Battiston, Chair of Systems Design, ETH Zurich, Kreuzplatz 5, 8032 Zurich, Switzerland.)
Financial Institutions Become More Concentrated. Perversely, financial institutions continue to become larger, despite the clear "moral hazards" of "too big to fail." Quoting an article on this topic: "Survivors to emerge from the turmoil with strengthened market positions, giving them even greater control over consumer lending and more potential to profit. J.P. Morgan Chase, an amalgam of some of Wall Street's most storied institutions, now holds more than $1 of every $10 on deposit in this country. So does Bank of America, scarred by its acquisition of Merrill Lynch and partly government-owned as a result of the crisis, as does Wells Fargo, the biggest West Coast bank. Those three banks, plus government-rescued and -owned Citigroup, now issue one of every two mortgages and about two of every three credit cards, federal data show." (Washington Post, August 28, 2009)
Global Wealth Skew. In December 2006, a groundbreaking report entitled The Worldwide Distribution of Household Wealth (World Institute for Development Economics Research, UN University -- UNU-Wider) was released. The results were much more pronounced than had been previously indicated by other studies that surveyed income. Wealth and income, though surely related, are quite different. Income is generally defined as the annual flow of earnings and incomes, while wealth is the accumulation of income and hoarded assets. According to its authors' research, the top 10% of adults in the world own 85% cent of global household wealth (2005). The average member of this wealthy group therefore has 8.5 times the holdings of the global average. Furthermore, the top 2% and 1% of the world's population is estimated to own 51% and 40% of world household wealth, respectively. This is a more extreme distribution than had been estimated by surveying global incomes in previous studies.
2. Psychological. Here, two factors may act to promote velocity inflation risks.
Investor Desperation. A sense of desperation has set in. Consider that the prominent U.S. demographic group (45 to 64 year-olds) has discovered that accumulated pension assets are insufficient to support an agreeable retirement lifestyle. This realization, combined with the fact that net worth of the middle class has been decimated (both financial and real asset declines impacting household net worth) while alleged cronyism between Wall Street and the Beltway has either enriched or bailed-out a select few "bulge bracket" chiefs, may cause individuals to "swing for the fences."
A similar sense of desperation is evident in professional money management circles. Given the deep financial destruction of the GFC, market rallies simply cannot be missed. Every rally must be traded and capitalized upon, seen from an individual's perspective. In the overall, of course -- what economists call the "Fallacy of Composition" -- the average investor will be chained to the market returns at best.
Globalization of Sentiment and Feedback Loops. As the GFC (and recent recovery rallies to date) illustrate, never before in history has global opinion been galvanized by financial events so quickly. This is remarkable. Never before has the entire financial world behaved so much as one monolithic culture as is now evident in global capital markets.
Robert Shiller, in a recent commentary in the New York times, provides an insightful perspective:
"It is a large and diverse world, after all, so why should confidence have rebounded so quickly in so many places? The popularity of the term 'green shoots' shows the kind of social epidemic underlying our changing thinking. The phrase was propelled in Britain by Shriti Vadera, the business minister, in January, and mutated into a more contagious form after Ben Bernanke, the Federal Reserve chairman, used it on '60 Minutes' on March 15. The news media didn't need to change the term for different cultures around the world. With nothing more than a quick translation -- brotes verdes, pousses vertes, grüne Sprösslinge, etc. -- it is now recognized as a symbol of a revival coming soon. All of this suggests that a social epidemic is supporting renewed confidence. This confidence can keep growing by contagion, as a kind of self-fulfilling prophecy, and we may see the markets and the economy recover further. But in an economy that is still unstable, the stories could also morph into different forms, the price feedback could turn downward and the dynamic could turn ugly again -- just as it has in the past." (Source: Robert Shiller, An Echo Chamber of Boom and Bust, New York Times, Economic View, August 30, 2009.
Putting it all together, we crucially now recognize that the economic, financial and psychological conditions of global markets have come to the point where the mood can change quite suddenly. A viral media-generated chain can impact the sentiment of the entire world rapidly. This is a developing factor that needs to be reflected in investment strategy.
Given the convergence of the above-mentioned trends, it is not unreasonable to remain alert to the potentiality of a wild "velocity inflation." But what are the odds? History suggests that these types of conditions do not come about very often. But when they do, they can launch very suddenly.
While the Weimar-era hyperinflation is not likely to be repeated with all the same characteristics, there remain lessons that apply today. Certainly, the manifestations of inflation are different. This time, the wealth-dislocating effects are through asset markets and credit systems. The net effect, however, is the same. Quoting from Otto Freidrich's book (Before the Deluge: Berlin in the Twenties): "[...] the inflation was by far the most important event of the period [...]. It wiped out the savings of the whole middle class [...]..Nothing ever embittered the German people so much -- it is important to remember this -- nothing made them so furious [...] as the inflation."
True to form, to date the middle class today has already been bruised with respect to relative net wealth declines. The inflationary effects of too much credit and the recent bust of asset inflation (both equities and real estate) accomplished a similar outcome. The final impact of inflation is the same ... but happening differently ... with different colors. Not to be forgotten, is the potential for a rapid behavioural change. This is a common feature of all major inflations. There comes a point where everyone finally wakes up to what is actually happening. They then can change behaviour en masse.
However, a point we make is that "mob behaviour" today is not likely to be limited to the private individual. It also applies to professional circles (and probably always did.) If anything, institutional investors are most prone to herd behaviour. What we witness, then, are some very large financial beasts that are desperate and startled, and are subject to stampedes such as already appear to have been witnessed over the past several years ... certainly this past 6 months! Mr. Market may not be above the ancient tactic of North American natives -- hunting buffalos by stampeding them over a cliff from time to time.
Precisely at times were investment returns are perceived to be meagre longer-term, conditions are most conducive to desperate "velocity inflation" behaviour. We are worried that such a scenario could play out sometime over the next 5 years. Of the five that we are currently probability-weighting, we have moved up its probability from 20% to 22.5%. We will want to continuing monitoring these conditions very attentively.
Shades of the Velocity Inflation scenario already appear evident. Commodity and equity prices are higher than is usual for this stage of economic recovery.
However, after observing the explosive breeding of financial markets so far this year, the ponds have become tepid and carnivorous of late. The Australian spadefoot frog would already be heading back to the safety of the underground at this stage. So are we.