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On Borrowed Time

By David Scott | Monday 17 July 2017


There are a number of things you don’t want to hear a central banker say. One of these was recently spoken by Janet Yellen when she said “I don’t believe we will see another financial crisis in our lifetime.” That has to be up there with Irving Fisher’s seminal observation of 17 October 1929 when he said "Stock prices have reached what looks like a permanently high plateau" or John Maynard Keynes’ equally adept forecast from 1927 that "We will not have any more crashes in our time." We are in the Mother of all bubbles and in relation to equity and bond markets we can define these bubbles by longevity (how long has the Bull Run lasted), or valuation (how expensive is the market now).

The global bond bull market began back in 1981, when 30 year US Treasury yields peaked at 15.2%. Now, over 35 years later, long bond yields are below 3%. The P/E ratio of bonds gives you a useful read across to bonds. To calculate the P/E ratio of a government bond, you divide one by the 10 year government bond yield. On this simple approach you do not need to be a financial market wizard to see that especially bond markets have reached bubble territory. Bond prices have become artificially inflated by central banks’ unprecedented monetary policies. For instance, the price-earnings-ratio for the US 10-year Treasury yield stands around 44, while the equivalent for the euro zone trades at 85. In other words, the investor has to wait 44 years (and 85 years, respectively) to recover the bonds’ purchasing price through coupon payments.

But now the US Federal Reserve is increasing its borrowing rate; and even the European Central Bank is now toying with the idea of putting an end to its expansionary policy sooner rather or later. Those, like me, who are hostile to central planning and who are also hostile to governmental interference in the pricing mechanism of the free market, which is what the misguided policies of printed money (QE) and zero interest rate policy (ZIRP) effectively are, fall back on historical president. As history has repeatedly shown government attempts to rig prices always fail, generally catastrophically. The problem facing the likes of Janet Yellen, Mark Carney and Mario Draghi is how can interest rates be raised meaningfully above zero without crashing the financial system? Perhaps it is this very dilemma as to why Warren Buffett is currently 40% cash and the most defensively positioned he has ever been. After our financial system has reset itself, which it has been trying to do since 1987, the question being asked will be how were unelected monetary bureaucrats ever allowed to take interest rates so much lower than there natural rate. There is a natural level for a reason and the economic laws of economic gravity can only be suspended for a while before they reimpose the natural order of things.

French President Emmanuel Macron has issued a harsh indictment of German economic policies, taking the country to task for benefiting from the difficulties of other euro countries and warning that the Eurozone cannot survive on such foundations. Macron said monetary union has become a deformed project that works in a corrosive fashion to the advantage of the creditor states. It must be rebuilt in a radically-different way, requiring sweeping changes to the EU Treaties. “Germany has benefitted from the dysfunctional character of the Eurozone, from the weakness of other economies. This situation is not healthy because it is unsustainable,” he told Ouest France, stressing that Germany has a shared responsibility to correct the Eurozone’s deep imbalances. His core argument is that the burden of adjustment through the crisis years has fallen entirely on the weaker states of the currency bloc.

Germany has done little or nothing to stimulate demand and to close the gap from its side. It has instead continued to amass a current account surplus of 8.5pc of GDP, sucking demand out of the system. Merkel cannot easily give ground. The German elections in September may propel the Free Democrats (FDP) into the ruling coalition. They are adamantly opposed to further Eurozone bail-outs or transfers. Germany’s top court has ruled that fiscal union and debt-pooling would infringe the budgetary prerogatives of the Bundestag and violate the country’s Basic Law. It would require a change in the constitution. Nevertheless, Berlin cannot just ignore the Macron phenomenon. Germany’s economic hegemony in Europe has peaked and will fade over coming years as its demographic crisis bites deeper. The working age population is contracting by 200,000 a year, accelerating to 400,000 by the early 2020s.

It was always on the cards that the UK would have to extract itself from a venture that spends most of its energy trying to hold the euro together. Monetary union must evolve into a full-fledged federal state, with a single EMU treasury, fiscal system, and government, if it is to survive. Britain voted not to be a part of such a structure. Trying to obfuscate this constitutional fact helps nobody. The core problem remains: the conflicting needs of Germany and the South cannot be reconciled within EMU. The gap in competitiveness and debt burdens are too great. They should not be sharing a currency union at all.

An equally and more poisonous issue over the rule of law, is immigration this divides the EU on its other axis between East and West. It has and this matter reached the point of open defiance in Warsaw and Hungary. Whether it is this cycle or the next cycle, voters will ultimately elect a rebel government in a Eurozone state that is too big to be crushed. In the West, the EU faces Donald Trump. This is a US president who refused to shake the hand of German Chancellor Angela Merkel. For the first time since the launch of the European project in the 1950s, the US no longer sees the EU as an asset in the diplomatic equation. Many in the White House would happily see it broken up. This means that Washington will no longer allow the Eurozone to use, or misuse, the International Monetary Fund for its own internal purposes. The implications are already apparent in talks over Greece, but they do not stop there.

All knowledgeable economists in history have warned against debasing a country's currency. Lenin advised it was the most effective way to overturn the existing basis of any society, because it is so subtle and insidious. Observers as wide ranging as John Maynard Keynes and Ernest Hemingway have agreed. Keynes said, “Lenin was certainly right.” Hemingway, a true observer of everyday life, observed, “The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring temporary prosperity; both bring a permanent ruin. Both are the refuge of political and economic opportunists.” The idea of central banks and central bankers as gods who can weave magic is a phenomenon of only the last few decades in the West. Never in history have they enjoyed the elevated status they currently enjoy, where everybody knows the name of the head of the central bank in the United States or the name of the Chairman of the Bank of England. This is also a passing phenomenon. Bernanke presided over the Great Financial Crisis of 2008. Greenspan had the 1987 crash, along with the 2000 Dotcom bust. Volcker had the bond debacle of the early 1980’s and the subsequent Latin American debt crisis. For the past 35 years, every Fed Chairperson has been tested with some sort of financial event.

Janet Yellen was sworn into office as the Chair of the Federal Reserve on February 3rd, 2014 and since then, it has been fairly smooth sailing for financial markets. There have been bumps along the way, but in the grand scheme of history, they have been fairly benign. Yellen’s term ends in late January 2018, and although no one has confirmed it, it is increasingly looking that she isn’t staying on. She will be 71 then and although Greenspan stayed on as Chairman until he was 80, I cannot see her wanting to spend her golden years running monetary policy for the Trump administration. So Janet has six more months.

Currently too much of what passes for analysis these days is merely pundits trying to forecast Central Bankers’ next move. There is little doubt in my mind that two of the most important FOMC board members, Fischer and Dudley, are concerned about financial conditions becoming too easy, and are proponents of tightening every second meeting until the speculative fervour subsides. I had assumed Yellen was in the same camp, but last week’s meeting speech throws that into question. I wonder if Yellen simply doesn’t want to upset the apple cart towards the end of her term.

My worry is that very often when a team is up by a goal and trying to play out the clock, they inadvertently change the type of game they have been playing that got them there in the first place. By doing so, they cause the very outcome they hoped to avoid. In a world which is only used to credit expansion and has forgotten all thoughts of business cycles, one of the mistakes that many people make in the stock market is buying something, watching it go up, and thinking they are smart. They find themselves thinking it is easy. They make a big profit and immediately go looking for something else. But this is the time that they should really do nothing. Self-confidence leading to hubris leading to arrogance - that is when you really should put the money in something safe for a while until you calm down. There are not too many great investment opportunities that are ever going to come along, but you do not need many if you do not make many mistakes.

The coming shakeout may not be “the big one”, although it is increasingly looking like it maybe. If it is not at the very least it will create some very interesting buying opportunities for the prepared and positioned.

David Scott is an Investment Manager & Market Commentator at Andrews Gwynne

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