Baby Come Back, 1978
Remarkably, a little more than 6 months after the end of the terrorizing market declines in March this year, a full-blown bubble has again reappeared. It brings back to mind the 1978 #1 Billboard hit single, Baby Come Back. Indeed, the "bubble came back." (The Swiffer commercials lately make this ditty an earworm again.)
While strong rebounds were to be expected at least for a time -- after all, it's the normal reflexive nature of political economies and markets whether further stages of crisis are to be expected or not -- a wild gaming bonanza was thought less likely. In any case, that is indeed what has again unfolded.
"Bulge bracket" market participants have been quick to arb out trading opportunities and the "carry trade" is back in force though now the US dollar is the financing currency. By some estimates, "carry trade" positions already exceed pre- GFC levels. Over-the-counter derivatives positions are at new highs and virtually all markets are overvalued based on conventional valuation measures and asset quality considerations. The persistent decline of the US dollar in recent months is a confirming tell-tale of a funding currency being used for global leverage.
No doubt, the bubble is back. But this time there are new dimensions: It is "gaming gone global." How so?
Gaming Culture Gone Global
Wealth managers are dealing with unprecedented conditions where no prior experience in living memory can be drawn upon. As a result, behavioural economics and financial geopolitics are moving to the forefront of the investment process. This is one more indicator that global financial markets are in uncharted territory.
Of course, human behaviour was always at the very foundation of free market trends. That was the big lesson that the math wizards have again learned in the last 18 months, much as the LTCM fiasco of the late 1990s already forewarned. The freewilled, largely self-interested "homo economicus" has never been governed by the models of economic academia, no matter how sophisticated. That said, the popular mores and conventions have changed rapidly with respect to accepted market behaviours. In fact, a cultural change seems to have taken place. The speed of this transition seems remarkable, too. Lawrence E. Harrison comments that such pervasive cultural shifts have always been glacial. (See, The Central Liberal Truth: How Politics Can Change a Culture and Save it From Itself, Oxford University Press, 2006.)
Significantly, this shift has global dimensions. As such, these behavioural changes alone virtually guarantee that significant trend changes and volatility interruptions lie ahead.
How else to explain the recent Wall Street grab? A Wall Street Journal report provided an estimate that Wall Street firms will pay out $140 billion in bonuses this year, up from $130 billion in the year prior to the financial meltdowns. It is a remarkable spectre. From government hand-out to personal payout in less than one year? So far, the protests from Main Street have been muted.
One related perspective is provided by Peter Souleles, who recently writes:
"But something, unfortunately, has gone wrong, and it may possibly become far worse than we can imagine. What has been the source of this failure to compound progress? The answer is theft. Earthquakes, tsunamis and other such natural phenomena, as well as diseases, are of miniscule consequence compared to theft. Theft throughout history has manifested itself in the same forms again and again and each time it has resulted in resources either being destroyed or re-distributed in the process." (Source: www.prudentbear.com)
Big Macro Instabilities Now Normal?
There are no lack of unsustainable trends that can trigger sizable "macro" trend changes ahead. The encroaching global gaming culture virtually ensures this will be the case. But just what basis do we have for such a statement? Consider the following points and mega developments:
1. The Global Pump and Dump: Looking for the Ultimate Bagholder: For the first time in modern memory (perhaps with the exception of Japan's equity interventions more than a decade ago) major nations in the world are adopting the "pump and dump" techniques of penny stock promoters. The idea has been to use government money (and that of other participating conspirators who are in on the scheme) to create an uptrend in the asset prices sufficient to rebuild confidence. After all, confidence had been a necessary energizing elixir of prior asset bubbles -- equities, credit market risk and real estate -- and not drivers of real wealth.
As soon as a durable up-trend seems apparent, then, the promoter (government) and his accomplices (the big, politically-plugged-in financial institutions?) get their money back or make off with the profits, by selling these assets back to the private sector. Who will be the ultimate bagholder? The reality is that governments will not make any net recoveries on the toxic assets that they have bought. In the end, one way or another, the bagholders R' Us.
How can the Fed dispose of $1.25 trillion in junky assets? It would require a new bubble of at least twice the dimension prior to the deluge of the GFC. But what marginable asset could be conjured to rise in value to raise all the ships to a higher quality water line? The only plausible tactic for policymakers presently is to keep interest rates low ... coaxing them lower if possible. The reality is this for many governments today: Bubble, "I can't live without you."
2. Geopolitical Economic Gaming. China, though supposedly still a developing nation according to the rankings of the World Bank, has been a remarkably savvy player in geopolitical economics. Given its newfound size and status as the world's manufacturing hub, its actions have caused huge reverberations for the rest of the world. When was the last time that a government encouraged hoarding of commodities and strategic stockpiling on the scale witnessed over the past year?
Chinese imports of iron ore and other metals this past year are truly stupendous, far exceeding import volumes at the pre-GFC peak. Who can argue that this is not a brilliant way to insulate against its depreciating dollar hoard ... buy USD denominated commodities and drive them up in price? Whatever the motive, the fact remains that this qualifies as a "global macro" factor not driven by the laws of normal economic supply and demand. Such new unconventional factors certainly challenge the "traditional" approaches to asset management.
3. Government Debt Levels to Continue to Soar: A recent IMF report stated that the cost of a global aging crisis for the advanced nations of the world, would be 5 times that of the GFC. Really? IMF projections of this impact upon government debt levels are shown in the graph on the front page, indicating that debt-to-GDP levels will more than triple from today's levels. Government debt levels are soaring right now as budget balances have gaped into huge deficits. Based on these IMF projections, major challenges lie ahead. Actually, the IMF forecast is not a realistic outcome. It won't happen. Some major and painful adjustments will intervene first. But what?
4. Global Warming. Whether one believes the warnings or not, the UN's Intergovernmental Panel on Climate Change (Copenhagen) estimates that the costs of regulatory and investment spending triggered by the new Copenhagen protocols will total between $70 to $140 billion per year. The total costs of global carbon capture expenditures (investment) is estimated to reach $3.4 trillion. This represents a huge social cost. Though perhaps necessary, it will have lifestyle implications for future retirees.
5. Global Energy Requirements: The IEA (International Energy Agency) estimates that the global attempt to reduce carbon emissions "will increase cumulative energy-related investment over the period 2010-2030 by $10.5 trillion." This does not include the costs of increased carbon taxes (which could easily exceed $1 trillion per year, or costs of carbon capture or storage.)
6. Global Financial Crisis #2? An even bigger one will be in the offing if present government policies are continued. When? Who can know exactly.
To be sure, there will be another financial crisis. They are a frequent and recurring part of financial history. If we are correct that global "macro" swings will now be more frequent and with greater amplitude, new asset management approaches are necessary.
Bubble, I Can't See You
As with most asset bubbles, the roots or the currently reappearing bubble are not visible to the average eye ... at least in its earlier stages. In fact, as we have pointed out, much of the bail-out and interventionary largesse poured out upon the world by central banks and governments alike, has indeed had an outsized effect. To date, much of its award has gone to the financial community itself in the form of huge trading profits and narrowing credit market spreads.
Excerpting a comment from the July 2009 Global Spin: "Monetary inflation has been expressly marshaled to tamper with risk spreads in the credit markets. Most monetary inflation hasn't gone much anywhere else to this point, certainly not in the US. The Fed itself has used its expanded balance sheet (which is monetary inflation) to buy assets other than treasuries. Also, other government programs have been funded to support "troubled assets."
A number of central banks, notably the U.S. Federal Reserve, have given speculation to the thought that they may soon be able exit from some of the unprecedented interventions and rescue operations that they have mobilized in the past year.
Apart from a few smaller countries being able to do so (case in point, Australia and Norway) this notion is really quite ridiculous. To do so would be the same miscalculation if you pulled yourself up on the end of a winch, to then think that you are free to let go of the rope as you have now risen to the top. One forgets that it is the rope that is holding you up in the first place.
In like manner, the very reason that financial markets and all types of suspect and risky assets have risen in price so markedly over the past 6 months or so, is because they were pulled up by a winch. Interest rates were slashed to near zero (denuding pensioner's income power, in the process) and government guarantees were sprinkled around liberally. For the U.S. there can be no exit. It is not possible for a government to be the beneficiary of a giant "pump and dump" scheme. Or can it?
What Behaviours Are Being Rewarded?
The recent GFC again confirmed a major truism: What is unsustainable eventually must come to an end. And, problems shoved off to the long-term future eventually arrive today. As we have outlined, there are plenty of problems and challenges lying ahead ... only having cited some.
Management theorists had long ago observed that a system narrowly incentivized by the invasion of the executive stock option (a phenomena less than 3 decades old) was liable to attract and award "psychopathic" behaviour in the executive suite. Boards under heavy pressure to order up positive stock price performance were liable to reward handsome employment contracts and "golden handcuffs" to "neutron-bomb" style managers who would get the job done at whatever human cost. And by gosh, by hook or crook, stock prices were ratcheted up far beyond real "income-producing" value in relation to underlying economic realities.
We therefore expect macro-volatility to remain very high over the next decade and more. This type of volatility is not the same as "daily volatility." It is "big picture" volatility where over short periods of time major "macro" (both financial and economic) and psychological trend changes can occur, environments rapidly oscillating between widespread investor fear and urgent (and necessary) opportunism.
New Approaches and Insights Required
As my colleague, Director of Research, Tyler Mordy, has written about in a recent ETFocus issue, a more "eclectic" approach is required. Hitching portfolio performance to a slower-growth world and traditional asset allocation theory will only yield returns far less than adequate for future retirees. For the Occidental nations, certainly including the U.S. and Canada, lower nominal GDP growth can be expected to result in an "income desert" like none experienced in living memory. A different approach is required. (Incidentally, that is why our firm launched its new and innovative portfolio series Precision3 Global Income Focus.)
To that challenge must be added the two-edged saber of "macro volatility" as already explained. If past history is any guide, this will prove to be the greatest tax of all to the middle class saver, if their retirement prospects haven't already been devastated by recent asset market gyrations. Emotionally driven investors, with little prospect of a timely understanding of the systemic traps of financial markets and monetary dynamics, are bound to be on the wrong side of macro trends ... most of the time.
This is not new. But, progressively, it adds a new challenge as the wealth distribution skew continues to widen. Much less money is available to drive current production and output (conventionally defined as GDP) unless through the intermediation of government allocated transfer payments. The result? As the chart on the front page also confirms (though for a different reason) it spells ever climbing government debt.
We expect big "macro" swings to continue. Presently, our ditty sings "I'm right back where I started again." The "bubble came back."
We now want to avoid "All my money going out on the town."
As such, we have again retreated to a lower risk stance. More optimistically, we identify many themes that we believe will allow us to steer the performance of our portfolios away from the restraining clutches of a lower-growth Occidental world.
