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Fears for 2018, same as fears for 2017 - complacency and overconfidence are the greatest leading indicators

By David Scott | Monday 8 January 2018


 


This time last year I was worried about stock markets. Most had been going up for too long and were too expensive and I thought that this great bull market must be near an end. I was worried about politics: the QE-driven rise in wealth inequality was having consequences – most obviously Corbynism and Trumpism. I expected to see growing state interference in the economy as governments tried to shift profits from managers and shareholders to workers and I was especially concerned that the monopolistic US tech stocks would end up at the centre of that storm. As usual I was a bit early. Last year offered a fair amount of political turmoil but not that much drama.

We have the same prime minister as in January last year. Brexit is turning out to be more a bit tricky and is starting to hit the consumer with car sales down and momentum slowing rapidly in house price inflation and retail sales. Importantly the jobs market has turned with the number employed falling for both of the last quarters. Donald Trump has not (yet) started a war but trade friction especially with China is on the increase. In the UK the only asset class that really started to move as the fundamentals suggested it should was prime London property – down 0.5%, but I expect 2018 will be the year when reality bits because the reversal of extreme monetary policy is now a real possibility with Quantitative Tapering which is long overdue given the economic distortions it has produced. But just as taking interest rates to record lows had unexpected side effects, raising them will too. The Fed found excuses – implausible as they now seem – to argue that there was no bubble in 1999 or in 2006 and Janet Yellen stated just months ago that she will not see another financial crisis in her lifetime. The central banks have since the mid-Nineties onwards, have falsely thought it safe to drive real interest rates ever lower with each cycle, until they have become ensnared in what the Bank for International Settlements calls a policy “debt trap”. This has gone on so long, and pushed debt ratios so high, that the system is now inherently fragile. The incentive to let bubbles run their course has become ever greater.

The main Central banks around the world are promising to "normalize" their monetary policy extremes in 2018. But you can't "normalize" markets that are now entirely dependent on extremes of monetary stimulus, as attempts to "normalize" will break the markets and the financial system. Modern finance has many complex moving parts, and this complexity masks its inner simplicity. Credit is the foundation of the current financial system, for credit enables consumers to bring consumption forward, that is, buy more stuff today than they could buy with the cash they have on hand, in exchange for promising to pay principal and interest with their future income. But Credit also enables speculators to buy more assets than they otherwise could were they limited to cash on hand. Buying goods, services and assets with credit appears to be a good thing: consumers get to enjoy more stuff without having to scrimp and save up income, and investors/speculators can reap more income from owning more assets. But all goods/services and assets are not equal, and all credit is not equal. There is an opportunity cost to any loan (i.e. credit), as the income that will be devoted to paying principal and interest in the future could have been devoted to some other use or investment. So borrowing money to purchase a product or an asset now means foregoing some future purchase. While all products have some sort of payoff, the payoffs are not equal. If I buy five bottles of £100/bottle champagne and throw a party, the payoff is in the heady moments of celebration. If I buy a table saw for £500, that tool has the potential to help me make additional income for years or even decades to come. If I’m making money with the table saw, I can pay the debt service out of my new earnings.

All assets are not equal, either. Some assets are riskier than others, with a less certain income stream or payoff.  Borrowing to buy assets with predictable returns is one thing, buying assets with highly speculative returns is another; regardless of the eventual result of the investment, the borrower still has to pay interest on the debt, even if the speculative investment goes bust. The basic idea here is the loan is based on collateral, that there is something of value that is anchoring the loan above and beyond the borrower’s ability to pay principal and interest. The classic example is a house: the lender issues a mortgage based on the market value of the house, i.e. what it can be sold for should the buyer default on the mortgage and the lender has to sell the collateral (the house) underpinning the loan. The value of the collateral is obviously contingent on the market; the value of the house goes up and down depending on supply and demand, the availability and cost of credit, and so on. If a lender loans me £500 to buy a new table saw, and I default on the loan, the table saw is the collateral. Unfortunately for the lender, the market value of the used tool is perhaps £250 at best.  So the lender loses £250 even after repossessing and selling the collateral. If the lender loaned me £500 to buy champagne and I default, there is no collateral at all; the loan was based solely on my ability and willingness to pay principal and interest into the future.

When I say that all credit is not equal, I’m referring to the creditworthiness of the borrower. Lenders make money by issuing credit to borrowers. The incentives are clear: the more credit they issue, the higher their income. Given this incentive, it’s easy to convince oneself that a marginal borrower is creditworthy, and that a speculative investment is a safe bet. This is especially true if like in the US the government guarantees the loan, for example, a home mortgage. With the government guarantee, there’s no reason not to take a chance on a marginal (risky) borrower buying a marginal (risky) house. If we take some home mortgages and bundle them into a mortgage-backed security, we can sell the future income stream (i.e. the payments made by the borrowers in the future) as securities that can be sold worldwide to investors.  I can make risky loans, make fat fees and pass the risk onto global investors. So now all this debt is now considered an asset to investors. But there’s one last feature of credit: liquidity. Liquidity refers to the pool of credit available to refinance or roll over existing debt.  If I’m having trouble paying my credit card, for example, and there’s plenty of liquidity in the credit system, I can obtain a larger line of credit and borrow enough to pay my monthly principal and interest on the existing debt. If I can refinance my existing debt at a lower interest rate, so much the better. Credit can be issued by private-sector lenders to private-sector borrowers, or by public-sector central banks to private-sector lenders.  Central banks can buy public and private debt (government and corporate bonds, mortgages, etc.), effectively transferring debt from the private sector to the public sector. These are the basic moving pieces of the credit expansion that has fuelled both the “recovery” and the reflation of asset valuations, which have now reached historic extremes.

To highlight just how unbalanced things are when the US expansion hits 9 years in June 2018 the market is expecting a Fed Funds rate of 1.50-1.75%. That is below the Fed Funds Rate at the time of the Lehman bankruptcy (2.00%) when the US economy was in the midst of its worst recession since the Great Depression. None other than Ray Dalio head of Bridgewater, the world’s biggest hedge fund group, has argued that our current situation resembles the late 1930s (1937 specifically), with populism on the rise, our economies still in recovery from a major banking crisis, and central banks looking to tighten monetary policy at a time of low but rising inflation. When you put it that way, the parallels seem pretty impressive And when you look back at how the Depression unfolded and compare it to the financial crisis of 2008, there are many similarities. They were similar types of crises. They were both preceded by unsustainable credit booms, and they were both very deflationary due to the precarious state of the banking sector (in the US during the Depression, and globally during 2008/09.The 1929 stock market bubble was built on the foundation of real economic prosperity during the roaring 20’s, but the late stages of that boom were largely fuelled by debt and easy money. Observing that there was persistent market rise, investors largely ignored the contribution of their own speculation in producing the increase and as traditional valuation measures became increasingly stretched, the first reaction of investors was to try to justify the elevated valuations in new and novel ways, which gradually became nothing but excuses for continued speculation, sound similar?

In response to the Global Financial Crisis (GFC) of 2008, central banks lowered interest rates to near-zero to boost private-sector lending, and increased liquidity to enable private-sector lenders and borrowers to refinance existing debt and generate new credit. They also bought assets: government bonds, corporate bonds and in some cases, stocks via ETFs (exchange traded funds). The goal here was to prop up the collateral underpinning all the debt.  If liquidity dried up, consumers and enterprises would default, handing lenders catastrophic losses, as the crisis had crushed the market value of the collateral that lenders would have to sell to recoup their losses. And so central banks pursued unprecedented policies aimed at pumping up private-sector lending and borrowing while boosting the markets for stocks, bonds and real estate—the collateral that supported all the debt that was at risk of default. All this low-cost and easily available credit, coupled with the central banks’ public messages that they would “do whatever it takes” to restore credit mechanisms and reflate the private-sector markets for stocks, bonds and real estate, worked: credit expanded and markets recovered, and then soared to new highs.

While these policies accomplished the intended goals, boosting both new credit and asset valuations, they also generated negative consequences. By lowering interest rates and bond yields to near-zero, central banks deprived institutional owners who rely on stable, high-yielding safe investment income—insurers, pension funds, individual retirement accounts, and so on—of exactly what they need: safe, stable, high-yield returns. In this “do whatever it takes” environment, the only way to earn a high return is to buy risk assets—assets such as stocks and junk bonds that are intrinsically riskier than Treasury bonds and other low-risk investments. The Stark Conundrum that we face now is that Central banks are trapped. In a situation of their own making.  If they raise rates to provide low-risk, high-yield returns to institutional owners, they will stifle the “recovery” and the asset bubbles that are dependent on unlimited liquidity and super-low interest rates. But if they keep yields low, the only way institutional investors can earn the gains they need to survive is to pile into risk assets and hope the current bubbles will move higher. This traps the central banks in a strategy of pushing risk assets—already at nose-bleed valuations—ever higher, as any decline would crush the value of the collateral underpinning the unprecedented huge mountain of debt the system has created in the past eight years and hand institutional owners losses rather than gains. This conundrum has pushed the central banks into yet another policy extreme: to mask the rising systemic risk created by asset bubbles, central banks have taken to suppressing measures of volatility in markets, measures than in previous eras would reflect the rising risks of extreme asset bubbles deflating.


Bank of Japan Governor Haruhiko Kuroda keeps saying that the BOJ would “patiently” maintain its ultra-easy monetary policy and in his first speech of 2018 in Tokyo, on January 3, he said the BOJ must continue “patiently” with this monetary policy, though the economy is expanding steadily. Adding that the deflationary mind-set is not disappearing easily. On December 20, following the decision by the BOJ to keep its short-term interest-rate target at negative -0.1% and the 10-year bond yield target just above 0%, he dismissed criticism that this prolonged easing could destabilize Japan’s banking system. “Our most important goal is to achieve our 2% inflation target at the earliest date possible,” he said. But last week the Bank of Japan disclosed that total assets on its balance sheet actually fell by ¥444 billion ($3.9 billion) from the end of November to ¥521.416 trillion on December 31. Whilst small, this was the first month-end to month-end decline since the Abenomics-designed “QQE” kicked off in late 2012.Under “QQE” – so big that the BOJ called it Qualitative and Quantitative Easing to distinguish it from mere “QE” as practiced by the Fed at the time – the BOJ has been buying Japanese Government Bonds (JGBs), corporate bonds, Japanese REITs, and equity ETFs, leading to a massive increase in its balance sheet. But now the “QQE Unwind” has commenced, possibly in unison with the US Federal Reserve’s actions and the ECB’s slowing of QE.

The ECB began tapering in April 2017, slashing its monthly asset purchases from €80 billion to €60 billion. As of January 2018, the ECB has tapered further, cutting its monthly purchases to €30 billion. But unlike the BOJ, the ECB communicated this tapering via rumours, speeches, and finally press conferences that were spread all over the media. JGBs, the largest asset class on the BOJ’s balance sheet, fell by ¥2.9 trillion ($25 billion) from November 30 to ¥440.67 trillion on December 31. In other words, the BOJ has started to unload JGBs – probably by letting them mature without replacement, rather than selling them outright, as Some other asset classes on its balance sheet increased, including equity ETFs, Japanese REITs, “Loans,” and “Others “Whilst the first decrease of the BOJ’s assets in the era of Abenomics was barely noticeable, it is very important as is the fact that neither the 12 months of “tapering” nor now the “QQE Unwind”  was officially announced and happened despite pronouncements from the very top to the contrary.

Total assets are still a massive number amounting to about 96% of Japan’s GDP (the Fed’s balance sheet amounts to about 23% of US GDP. During peak QQE, the 12-month period ending December 31, 2016, the BOJ added ¥93.4 trillion (about $830 billion) to its balance sheet. Over the 12-month period ending December 31, 2017, it added “only” ¥44.9 trillion to its balance sheet. That’s down 52% from the peak. The BOJ has used QQE as an internationally accepted cover to reduce Japan’s public debt under control by removing much of it from the market by buying it itself with printed money in order to prevent a Greek-like debt crisis And it has worked. Japan’s national debt reached 250% of GDP at the end of 2016, the highest in the world. Between the JGB holdings by the BOJ and by state-owned institutions, such as the Government Pension and Investment Fund, Japanese authorities now control the majority of Japan’s national debt, so there cannot be a crisis as it will not panic out of it like international investors would in a debt crisis – though its actions could trigger other crises. So the high-octane QE juice that has powered global financial markets for years is beginning to evaporate, with the ECB being the last holdout among the biggest central banks.


The interesting thing about world reserve currency status is there have been lots of them over time. Americans on the whole think that the US dollar has always been the world reserve currency, but it’s only been so since 1944. What’s interesting is that the transition from one to another can take a long time. The sun never set on the British Empire for 70 years. They had the world reserve currency and they had the strongest navy. Then in 1913 they invaded Mesopotamia, incurred huge of debt, the pound collapsed and the dollar started its ascent. Then 31 years later, the US dollar became the world reserve currency. In 2013 US invaded Mesopotamia, was weighed down with record of debt and the the started its Renminbi ascent on the world stage. Currently As I look around the world, I think it’s supremely clear that China have a plan to unseat the dollar but this will be a slow and methodical change to global economic forces. The US on the other hand are not going to pass on the privilege willingly.

History shows that crises arise unexpectedly from corners of the economy that fell beyond the conventional radar screen in such corners, regulations are light or non-existent, information is thin, the players are relatively unknown, and flows of capital in and out are particularly hot. Human ingenuity will always create such corners of the economy, either to serve new needs or to arbitrage around regulations. To eliminate every ounce of systemic risk in the financial sector would be extraordinarily costly and would breed an intolerable regime of surveillance.

To understand what the world economy will do in 6-9 months you only have to follow China's debt creation and housing market today."  after $15 trillion in liquidity has been conjured out of thin air by the world's central banks, and the tens of trillions of credit money created (and misallocated) by China - a country which was the world's growth dynamo for the past three decades and which is now rapidly slowing down - the entire world is floating on an ocean of excess money, which for one more year has succeeded in masking just how ugly the truth beneath the calm surface is. Now, with the Fed hiking and actively shrinking its balance sheet and the ECB and BOJ set to join in the not too distant future, and as the global growth dynamics shifts from monetary to fiscal policy, as the liquidity tide starts to come out, those swimming naked will finally be exposed, especially if as we expect, the hand over from monetary to fiscal policy is far more volatile than what the market currently prices in.

Central banks all over the world including the Fed, ECB, BoJ and the People’s Bank of China are in the early stages of ending their decade-long (or longer) easy money policies. This tightening trend has little to do with inflation (there isn’t any) and more to do with deflating asset bubbles and getting ready for a new downturn. But, in following this policy, central bankers may actually pop the bubbles and cause the downturn they are getting ready to cure. This is one big reason why the current stock market bubble will implode.

It’s important to realize that market crashes happen not when everyone is worried about them, but when no one is worried about them, this is because Complacency and overconfidence are good leading indicators of an overvalued market set for a correction or worse.

  • Investing is no different than gambling– both are “guesses” about future outcomes based on probabilities.  The winner is the one who knows when to “fold” and when to go “all in”.
  • No investment strategy works all the time. The trick is knowing the difference between a bad investment strategy and one that is temporarily out of favour.
I am fully aware that if I protect my client’s investment capital in the short term – the long-term capital appreciation will take of itself. Our central bankers and political leaders constantly say that deficits don’t matter.  But they do matter and soon they will matter an awful lot.
 
The current market advance both looks, and feels, like the last leg of a market “melt up” as we previously witnessed at the end of 1999. How long it can last is anyone’s guess. However, importantly, it should be remembered that all good things do come to an end. Those endings tend to be very disastrous to long-term investing objectives. This is why focusing on “risk controls” in the short-term, and avoiding subsequent major draw-downs, the long-term returns tend to take care of themselves. Now is the time to remember that Bull markets are born on the largesse of central bankers, grown on the popularity of ETFs, mature on fanatical speculation (in cryptocurrencies) and in corporate tax reductions and die on the fear of missing out.
 
The present is not the time to be going all in, rather the opposite.
 
David Scott is an Investment Manager & Market Commentator at Andrews Gwynne


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