Investing in today’s financial markets is relatively easy. You simply have to believe that governments in the US, Japan and Europe will continue to provide plenty of free cash to investors as part of their Recovery Scenario of a quick return to ‘normal growth’. It doesn’t matter whether the investor believes in the Scenario, the driver is simply the fear of missing out on their share of the cash.
Equally, what is the alternative? Part of the central banks’ policy is to hold interest rates as low as possible for as long as possible as the chart above from the Financial Times shows. This is painful for anyone trying to save for the future, and so essentially forces many people to invest in the market despite any worries they may have.
So far, therefore, the central banks and those investors who follow them have been winning. As the blog’s latest 6-monthly review of global stock markets showed, most have doubled since their market lows in 2009. The trend has indeed been your friend.
Equally supportive has been the lack of any major downturn along the way. A normal rally sees prices move up for a while, and then slip lower as some investors take profits. But not this time, as any sign of weakness brings a rush of new cash from the central banks to support the markets:
- Thus a 16% fall in the S&P 500 after the end of QE1 led to the US Federal Reserve’s decision to start QE2
- A 17% fall after the end of QE2 then led to QE3
- May’s 6% fall, after the Fed suggested ‘tapering QE3’, led even this slowing of stimulus to be delayed till now
This argument works, of course, as long as investors continue to chase return on capital. Nobody with any sense would bet against a Fed Chairman who is prepared to print as much money as it takes to keep stock markets moving higher. And after 5 years, anyone without that instinct for self-preservation is probably bankrupt.
But what about an investor who was worried about return of capital? This is also a legitimate objective, and for a long time was the motive behind the rise in prices for government bonds issued by the major governments – or the JUUGS as the blog named them (Japan, US, UK, Germany, Switzerland).
Those investors also had a good run until May. US 30-year interest rates were then 2.8%, but are now up by a third to 3.8%. Anyone still holding these bonds has therefore lost money, as prices move inversely to yields.
In the blog’s mind, this suggests some investors are starting to worry about the unthinkable – the prospect of default. And this thought is confirmed by its discussions with some major investors in recent weeks. The Default Scenario is easily described:
- Central banks fail to restore growth to previous levels, whether because of demographics or some other cause
- They also fail to stimulate inflation, so the value of the debt they have created does not get inflated away
- If inflation turns to deflation as demand continues to slow, then the value of the debt actually rises in real terms
The second chart shows the incredible amount of debt that the central banks have created. For Japan it is nearly 50% of GDP, whilst for the US, Eurozone and Bank of England it is around 25% of GDP. Without growth, and with deflation, default is inevitable as this amount of debt can never be repaid.
One type of default is that governments break their promises to electorates. They increase taxes and cut pensions/spending in order to pay back the debt. This, of course, is the policy that has been followed since 2011 in the PIIGS (Portugal, Ireland, Italy, Greece and Spain). But would this be accepted more widely? And would it be accepted as a long-term policy rather than a supposedly temporary hiccup?
The other type of default is that governments decide not to repay borrowers. Greece has already done this with its enforced ‘haircut’, and many countries have done it in the past. Of course, investors who have lent the money would get rather upset, but what could they do – apart from refuse to lend more money? Fighting a legal battle with a G7 government in their own courts, against hostile public opinion, would not be the blog’s idea of a winning strategy.
This default option would not be painless, of course:
- China, for example, holds $3.6tn of foreign debt built up as a type of ‘vendor finance’ – where it lent money to countries to help them afford to buy Chinese exports. So it might decide to retaliate by nationalising Western assets back in China, which would create further defaults in the corporate sector
- Japan would be in a worse position. Its total government debt is already the highest in the developed world and more than double GDP. Its $1.2tn holding of US government debt is also the second largest foreign holding after China, but it has less foreign assets to nationalise back in Japan.
All this may seem very far-fetched today. But then most people said similar things between 2006-8, when the blog argued that there a strong potential for a global financial crisis focused on US sub-prime lending, and later became known as The Crystal Blog. The consensus may be loud, but it is not always right.
The problem for investors is that they are not used to thinking about political risk. Those around in the 1970s remember when New York nearly went bankrupt in 1975, and the UK had to be rescued by the IMF in 1976. But younger investors have always assumed that investing in the debt of major economies was ‘risk-free’.
But that situation may be changing. At least, that is what the rise in bond yields seems to be telling us. As the blog warned presciently in September 2008, a long period of stability, such as that seen during the supercycle, leads investors to become complacent about risk:
“They believe that a new paradigm has developed, where high leverage and ‘balance sheet efficiency’ should be the norm. They therefore take on high levels of debt, in order to finance ever more speculative investments. “Eventually, however, a ‘Minsky moment’ occurs. Earnings from the new investments prove too low to pay the interest due on the debt. Confidence in the ‘new paradigm’ disappears and, with it, market liquidity. Investors find themselves unable to sell the under-performing asset, and suddenly realise they have over-paid. In turn, this prompts a rush for the exits. Prices then begin to drop quite sharply, as ‘distress sales’ take place.”
The blog has argued for some time that we are now in the ‘melt-up stage’ of the central bank-inspired financial market rally. Everyone is buying and nobody is selling, because we all ‘know’ governments won’t let markets fall.
What happens if that belief starts to be shaken, perhaps in 2014? If deflation gets closer in the West, and China continues to ‘cut its own wrist’ as it rebalances its economy? Or when Japan’s ‘new policies’ turn out to have the same non-effect as their predecessors for the past 20 years?
“now focus on the possibility of a” T junction” investment future where markets approach a time-uncertain inflection point, and then head either bubbly right or bubble-popping left due to the negative aspects of fiscal and monetary policies in a highly levered world. We (Bill Gross and Mohamed El-Erian) are both in agreement on the perilous future potential of market movements. Mohamed’s T, I believe, was meant to be more descriptive than literal, and is a concept, like the New Normal, that may gain acceptance over the next few months or years. But aside from a financial nuclear bomb à la Lehman Brothers, our actual scenario is likely to play out more gradually as private markets realize that the policy Kings/Queens have no clothes and as investors gradually vacate historical asset classes in recognition of insufficient returns relative to increasing risk.”
As the blog learnt years ago when an oil products trader in Houston, Texas, ‘the trend is your friend, until it isn’t’. Anyone who hasn’t worked out what might happen next well in advance, and prepared for it in detail, could find themselves in a very scary position indeed.
What we do know is that the thoughtful amongst the very wealthy are already worried. Peggy Noonan of the Wall Street Journal is not a left-wing extremist or a writer who thrives on sensation. She got her big break, after all, as President Reagan’s speechwriter. And when she wrote this in her column yesterday, the blog paid great attention:
“A billionaire of New York, in conversation: “I hate it when the market goes up. Every time I hear the stock market went up I know the guillotines are coming closer.” This was interesting in part because the speaker has a lot of money in the market. But he meant it. He is self-made, broadly accomplished, a thinker on politics, and for a moment he was sharing the innards of his mind. His biggest concern is the great and growing distance between the economically successful and those who have not or cannot begin to climb. The division has become too extreme, too dramatic, and static. He fears it will eventually tear the country apart and give rise to policies that are bitter and punishing, not helpful and broadening.”