Original draft published by http://cervinocapital.blogspot.com on January 9, 2007. Revised version reprinted below published by Managed Account Research, Inc. on December 18, 2007. It is republished here by permission.
"Perhaps when a man has special knowledge and special powers like my own, it rather encourages him to seek a complex explanation when a simpler one is at hand."
-- Sherlock Holmes, The Adventure of the Abbey Grange (1904)
It now seems so long ago, but it is only a year since global equity markets were entrenched in a relentless march upward, spurred by the "world growth story" and a wave of global liquidity. U.S. and European stock markets gained double-digit returns in 2006 while the emerging markets did even better. Alongside the upward trajectory came a remarkable decline in volatility with the VIX, known as the "fear gauge," falling to 13-year lows in November and December that same year.
For those taking stock (pun intended) all was rosy from that time as strategists at twelve of the biggest Wall Street firms agreed that US equities would rally again in 2007. If one recalls, the going assumption was that Greenspan/Bernanke had maneuvered the economy into a "soft-landing" and the markets could look forward to more of Kudlow's "goldilocks scenario." So what went wrong?
Problem is that most Wall Street professionals are more suggestible than a layman might imagine. Try as they might, they can never know the one thing they really want to know--the future. Not knowing, they compare notes. Invariably, most are brave together at the tops, and meek together at the bottoms.
Consensus now is that current market volatility has its roots in the sanguine environment of record low interest rates which also helped propel the booming real estate market. The first real shock occurred on February 27, 2007 when the market hit a wall, bounced after becoming short-term oversold in the middle of March (expected), and then fully retraced the "correction" without looking back (unexpected). That is, until shockwaves from mortgage-related credit issues again reverberated across Wall Street resulting in another market downturn in July and August. Interestingly, rumblings of credit problems came even earlier when Dillon Read, a hedge fund subsidiary of UBS, ran into problems due to its subprime exposure.
Yet, the subprime contagion is only the tip of a much more complex situation. Investors therefore should be concerned with a potential reversal of the liquidity tide that has sustained asset prices in recent years. The objective here is to provide readers with a better understanding of the monetary pyramid the economy is standing on, and why market volatility will likely persist for the near- and intermediate-term future.
History shows that when mass scale market restructurings occur, they tend to do so very rapidly like tsunamis, often triggered by an unexpected economic downturn or political missteps which cause fiscal blunder. Monetarists such as Milton Friedman, who passed away this year at age 94, believed that "money supply" was the key to the ups and downs in the economy. Further, Friedman thought that the Federal Reserve Bank's sole job was to "expand the money supply in a steady manner by 3% per year."
The Greenspan legacy, however, is for the Federal Reserve Bank to intervene in the markets strategically during times of financial crisis. He first did so early in his career back in 1987 when the Fed added heavy doses of liquidity to arrest the stock market crash. Then there was the expansion of money supply in the weeks leading up to the end of the 20th century when the so-called Y2K computer bug was expected to disrupt financial systems. Lastly, in response to the 2001 recession Greenspan lowered overnight rates to a 1958 low of 1% resulting in record mortgage refinancings that minimized the impact of the 2001-2002 recession. Intervention, rather than being a brief rescue effort, seems to have become a permanent policy.
Another wave of stimulus came from the 2001 and 2003 "Bush tax cuts." There are two ways in which tax cuts can stimulate growth--in the near term by generating extra demand, and in the long run by encouraging increased supply, labor or capital. Add to this the 108th and 109th Congress gone-amuck earmark spending as well as the increased military budget to finance two wars (as of the end of 2007 the Iraq war is estimated to have cost $600bn), and the combination of monetary and fiscal stimulus in the first half of this decade had set the stage for a tidal wave of liquidity.
The overhang of fear resulting from the 2001-2002 bear market also contributed to the current environment as money gravitated from the stock market into "safe assets" such as government and agency bonds. This in turn drove down interest rates on the long end of the yield curve which further lowered borrowing costs. Helpfully, lower rates functioned to help corporations get their balance sheets in order as well as support real estate prices from declining through the 2001-2002 recession.
Ultimately, however, lower interest rates led to a boom in home buying which caused real estate prices to double and triple in some locations. One result was owners taking advantage of their increased home values in the form of mortgage equity loans. The impact was not insignificant on the economy. According to Calculated Risk, GDP as reported for the last six years appreciably improved as a direct result of home equity withdrawals, a trend that first began in 2001 but which came to a halt in 2007.
Not surprisingly a feedback loop developed. Because of the very fact that home valuations were inflated, the use of exotic mortgage products such as ARMs, I/Os, etc. increased from very limited usage in 2001 to approximately 50 percent of the mortgages used to finance homes in California. What should be noted is that the process of incurring debt collateralized by an inflated asset is similar to margining a securities brokerage account as stock prices go up. The benefit is additional liquidity and leverage when asset values increase, but the downside comes when asset prices decrease.
The seriousness of the fallout is now not lost on the public with many of the exotic mortgage products resetting their interest rate after an initial low-rate discount period. Essentially mortgage payment resets are acting like "margin calls" and the "payment shock" is causing a wave of foreclosures. Foreclosures are depressing home prices, which in turn aggravates the problem. Such resets are expected to continue through 2012. The question is whether a moral hazard is created by the government intervening.
Earlier this year, the Center for Responsible Lending published a report which suggested that 2.2 million American households could lose their homes, and as much as $164 billion due to foreclosures. To put this report into historical perspective, at the peak of the credit boom in the 1930s home mortgage loans were offered without the usual documentation, a practice that in the last few years had again become popular through so-called "stated income," "low-doc" or "no-doc" loans. Stated income loans, which were originally conceived to improve access to prime credit for self-employed people with irregular income, had spread like a virus through the lending industry. Unfortunately, it is a virtual invitation to fraud.
Credit fraud is a liquidity multiplier. In fact, the link between fraud and liquidity is documented by several academic papers in relation to international banking. A paper written by Dr. Wimboh Stantoso, Senior Researcher at the Directorate of Banking Research and Regulation Bank Indonesia, points out that the 1998 Pacific Rim currency crisis resulted in the Indonesian government revoking permits on 16 private national banks whose "sources of problems for those banks were mainly illiquidity and insolvency as a result of credit defaults, fraud and liquidity mismatches." Another paper by Jean-Claude Berthelemy on "Financial Reforms and Financial Development in Arab Countries" writes about non-performing loans (NPLs) and "cases of fraud and liquidity problems faced by the banking sector" due to bad debt.
The topic of NPLs brings us overseas to the shores of China. China has been dealing with a mountain of bad loans--how much is the question. In May 2006 Ernst & Young reported that NPL exposure for China was estimated at US$911 billion, but subsequently withdrew the report. According to the China Banking Regulatory Commission, as of the end of the third quarter of 2006 the total number of NPLs in China's commercial banks was only US$160 billion. However, this amount does not include NPLs that are presently held by foreign investors such as hedge funds that have been on a buying binge in Chinese distressed debt. Based on the 1999 transfers that investors have resolved, the implication is that E&Y's NPL estimate is not miscalculated. The point here is that these NPLs represent a significant liquidity multiplier and risk.
China's economy, in the meantime, is on track to grow by more than 10 percent for the fourth year in a row. In November 2006 China reported that its foreign currency reserves, the world's largest, had exceeded $1,000 billion for the first time. China has effectively outsourced its monetary policy to the U.S. resulting in talk of pressure from Congress in the form of "currency manipulation anti-subsidy laws" to persuade China's government to revalue its currency. Even Fed Chairman Bernanke stepped into the fray with his remarks branding China's undervalued currency an "effective subsidy" for exporters that was distorting trade. At the same time, China's monetary policy committee complains that the main responsibility for this imbalance lies with the U.S. Treasury printing too much money. The upshot is that a fundamental change in reserve allocation/diversification away from the dollar is taking place and not just with China.
The subject of dollar imbalances brings us to the Japan carry-trade. With the Bank of Japan keeping rates pegged to a measly 0.50 percent, a bubble had been ballooning in which people borrow cheaply in yen and then invest in higher-yielding assets abroad. The economic effect is again similar to leveraging your brokerage account with margin, except that this is taking place on a global scale with hedge funds leading the way. Concern is that a sudden flowback of yen, such as what happened in 1998 when the yen went from Y140 to the dollar to Y110 in just two days, could trigger financial chaos as far abroad as Iceland and India. And the U.S. is not immune as market participants note a correlation between the unwinding of the carry-trade and sharp declines in the U.S. stock market.
Another liquidity multiplier is all the petrodollars that have been created with oil prices rising from the $20-$30 range to nearly $100 dollars in November. This decade will be remembered in the Middle East for Iraq's tragic slide into sectarian conflict and Israel's war in Lebanon. Less noticed, though no less dramatic, has been the oil-fuelled economic boom in the Gulf and a surge in financial liquidity that has been transforming the face of the region. Oil wealth translates into political advantage on the world stage as petrodollars are deployed and recycled in the local region and abroad. The key question is whether oil producers can turn this boon into a lasting opportunity and create more robust economies that can sustain themselves through periods of low oil prices. Referring once again to reserve diversification, Russia and Opec have reduced their exposure to the Dollar and shifted oil income into Euros, Yen and Sterling.
But more interestingly has been the proliferation in the issuance of "sukuk" or "Islamic bonds." Usury in Islam is prohibited, but banks today are adopting methods to get around this by combining Islamically-permissible contracts to produce what is effectively interest-bearing loans. The effective result is not only the leveraging of petrodollars, but the evolution of an Islamic monetary system similar to modern Western banking system, which had historically evolved from the practices of European goldsmiths in the 17th century. Back then, the receipts issued and backed by deposits of gold coins on deposit for safekeeping with goldsmiths transformed these merchants into money-lenders who manufactured "bank money" on such receipts, giving rise to the concept of money supply.
Money supply creation is no longer something constrained to banks, but now something that is easily produced between two parties through derivatives trading. When Greenspan took over the Federal Reserve Bank much attention was focused on gauges of money supply defined as M-1, M-2 and M-3. Disregarding the debate on the importance money supply as a reliable measure and indicator of future inflation, a new type of money supply which we've coined "M-∞" has increased explosively alongside the growth of derivatives. M-∞ is the "notional" valuation associated with a derivatives contract. For example, the difference between the $350,000 nominal value of an S&P 500 futures contract and the $22,500 actual cash good faith deposit required to trade the instrument.
The definition of financial leverage is liquidity magnified. Derivatives, while very effective as a risk diversifier, arguably has also had the effect of leveraging asset values throughout the economic system. However, non-transparency of instruments such as collateralized debt obligations (CDOs) is just the tip of another iceberg. According to the Financial Times a "plethora of opaque institutions and vehicles have sprung up in America and European markets this decade, and they have come to play an important role in providing credit across the financial system." Hedge funds, structured investment vehicles (SIVs), and "dark pools of liquidity" have all conspired to create a "shadow banking system" outside regulators control.
And round and round it goes--the examples of liquidity expanding throughout our global monetary system are nearly endless. Many would argue this is good and point to how robust the world economic landscape has been in the last few years as globalization has spread. On an encouraging note, the World Bank recently hypothesized in a report that if growth around the world continues at about its current pace, by 2030 the number of middle-class people living in developing nations will triple to 1.2 billion.
Key to the creation of liquidity is credit. "Credit" is a financial term with a moral lineage. Its first meaning is "debt." John Locke once wrote "Credit is nothing but the expectation of money, within some limited time." To credit is to believe, and to lend money it is necessary to trust someone. Yet, financial history is rife with periods when prolonged prosperity wore down the skepticism of creditors only to result in eras of economic hardships. Are we now entering into such a period?
The problem with liquidity is that it is like an addictive drug--initially it produces euphoria which then disappears with increasing tolerance. Once an economy is hooked it needs more and more in order to sustain itself and withdrawal can be difficult. The riddle is whether the central banks have succeeded in breaking the cycle, not the inflationary cycle which in fact it has enthusiastically subsidized, but the deflationary cycle. Has the sheer bulk of global liquidity forestalled the kind of contraction that paralyzed business activity in the Depression and demoralized speculative activity for a generation after that?
We started out by asking what could go wrong... As previously stated, sudden economic downturns are typically instigated by event risks from unexpected places. Looking at the tea leaves we've identified several areas of concern going forward into 2008:
The price of oil recently rose to nearly $100, but earlier this year oil dropped to $55. An implosion in the price of oil would undermine a major source of revenue for countries that produce this commodity. The recent windfall has allowed such nations to build foreign reserves and improve the quality of their debt resulting in lower interest rates and helping drive an infrastructure investment binge. This could unwind if investors begin to pull money from emerging equity and debt markets, and which would likely cause an increase in interest rates. In this scenario, the combination of reduced oil revenue and higher interest rates would cause infrastructure projects to grind to a halt triggering a global recession.
Another area of concern is geopolitical risk where mismanagement of monetary and fiscal policies spreads to other markets. For example, the Asian financial crisis of 1997-98 began in Thailand with the devaluation of the baht. And earlier this year, Thailand's newly minted military government stumbled badly by imposing capital controls. Such controls demonstrated a poor grasp of such action's consequences. In a world where China, Japan, Taiwan, South Korea, Russia and Singapore control two-thirds of the world's reserves, the U.S. finds itself exposed to these nation's monetary or fiscal policies. Who knows where its starts: a miscalculation by China's central bank in its efforts to manage excess liquidity, or a return to protectionism spurred by sovereign fund acquisitions--either could trigger a global recession.
A third concern is that the U.S. economy will grow as expected, but the markets come to realize that growth rate is in fact not so great. Analysts close to the Fed believe most policymakers now see U.S. potential growth as being between 2-2.5 percent, a decline from the 3-3.25 percent range commonly cited a few years ago. Many private sector analysts interpret a decline in productivity growth as likely to put upward pressure on inflation and interest rates. Given that the stock market is "fairly valued" at earnings ratios based on record productivity levels, if corporate earnings cool off the U.S. stock market could begin to melt down. Add to this an economy that had been fueled by leveraged loans and looser lending standards, and a change in appetite from investors will force banks to absorb large leverage loans on to their own balance sheets, as has happened with Citi with respect to their SIV. This in turn triggers further re-pricing of credit risk resulting in higher interest rates causing the economy to spiral downward.
Then again, perhaps given the enormous attention to the riddle of liquidity in the financial press, this is all but a tempest in a teapot--economists can't seem to agree whether there's too much or too little. Our thinking is that liquidity is like cholesterol--there is both the good kind and the bad kind. As so eloquently said by Sherlock Holmes, "My dear Watson, there we come into those realms of conjecture where the most logical mind may be at fault." In any case, it is likely market volatility is here to stay for the immediate future. In the meantime, the "smart money" looks to volatility as an investment strategy.
