This Time May Be Different

X-factor Report, 01 February 2015

by Lance Roberts, StreetTalk Live

I am in Vancouver, BC this weekend as the keynote speaker for the 2015 World Economic Conference. I have been to a lot of investment conferences in my life, but this one is extremely impressive. There are more than 1000 attendees, and the schedule of presenters runs the gamut from money managers to investment gurus.

However, this also means that I am working on a laptop computer which is not conducive to building charts and analysis in my usual vein. Therefore, I want to use this opportunity to share with you some insights of some individuals that have important points I feel you should consider.

Let me preface their work with a few of my personal observations.

Over the last three years, in particular, the markets have been in a seemingly unstoppable advice to historic highs. Of course, that rise has fueled “bullish egos” to the point of hubris. It has become relatively commonplace during this time to suggest “this time is different” because of ultra-low interest rates and Central Bank interventions. I have repeatedly argued the opposite.

Bull markets do not usually end just because they are “old and tired.” It is when “old and tired” collides with a seemingly exogenous event that “no one could have seen coming.” That is simply wrong.

Bull markets die a slow death. The change begins at the fringes which is often subtle and always ignored. Just as we ignore the nagging pain that we assume is “part of getting old,” it could be a symptom of something far more aggressive.

Eventually, these ignored signs and warnings manifest themselves in a full-blown reversion. It is then that investors search for the “catalyst” and assign blame to it. The media is “shocked” that such an event occurred “out of nowhere” and scramble for the reasons as to why it happened. The reality is that there were plenty of warning signs – as I wrote last week “Signs, Signs, Everywhere Are Signs.”

This week, I will share with you a couple of views that align with my own. I want to suggest that this recent “sell off” in the market “is different.”

Is this the beginning of the great market reversion? I honestly don’t know. However, like a game of “Jenga,” enough bricks have been removed from the structure that each additional move has a geometrically increasing risk of sparking the collapse.

Enough of my ramblings for now. Let me leave you with some really smart people.

Bill Gross – Games People Play

My mother taught me how to play Monopoly – the game – and the markets over 40 years past have taught me how to play Monopoly – the financial economy. Financial markets and our finance-based economy are actually quite similar to the game in terms of the rules and strategies it takes to win. Monopoly’s real-time bank (the Fed) distributes money to players at the beginning and then continues to create more and more credit as the economy passes go. The cash in Monopoly isn’t credit and the player can’t borrow, so in this respect the game and the reality are quite different, but the addition of cash liquifies the player in a similar way that the Fed creates money out of thin air to liquify today’s finance-based system and create growth in the real economy.

Good players know that it is critical to move quickly around the board, make acquisitions and then develop the properties by creating hotels. Three hotels on each property are desirable and of course as every Monopoly pro knows, it’s not Boardwalk or Park Place that are the key holdings but the Oranges and the Reds. Same thing in reality’s markets, I would suggest. Which companies and which investments to overweight and how much leverage to use usually point to the eventual winners. But an ample amount of cash is important as well as you land on other owners’ properties. You need liquidity to pay rent or service debt – otherwise you sell assets at a discounted price and are swiftly out of the game. That reminds me of Lehman Brothers and its aftermath. Early in Monopoly, property is king but later in the game, cash becomes king and those without cash and the ability to get it go bankrupt.

It appears however, that since 2008 the rules of the finance-based economy have been substantially changed. Perhaps Parker Brothers will have to come with a new version of its own which incorporates the modern day methodology of central banks using Quantitative Easing and the outright purchase and occasional guarantee of private securities and public stocks to keep the game going. It’s as if Monopoly’s bank, which has a limited amount of 1, 5, 10 … dollar bills in each game box had “virtually” added trillions of dollars more in order to keep players solvent, in the hopes that some of it would trickle out to the real economy. With interest rates near zero and banks and other financial intermediaries sitting on trillions of Dollars, Euros, and Yen, why wouldn’t they lend it out to the private economy in hopes that they could obtain a higher return on their money? Sounds commonsensical, doesn’t it? Not in reality.

Well to be fair, in some cases and some countries they have. Bank loans in the U.S., for instance, are currently growing at 8% year over year and our economy appears to be growing at a 3% real and nominal growth rate with inflation at 0%. Still, even with the U.S. growing at an acceptable rate for now, its recovery over the past 5 years has been anemic compared to historic norms, and other developed economies are faring much worse. Many appear to be facing new recessions even with interest rates at 0% or – incredibly – negative rates. German and Swiss 5 year yields cost the lender money. Surreal to say the least. Before 2008, economists and historians would not have believed such a condition could exist, but here it is with individual sovereign countries and their respective central banks pushing each other out of the way in a race to the bottom of interest rates – wherever that is – and a race to the bottom in terms of currency valuations. Central bankers claim that they are doing no such thing, but that bravado should be dismissed out of hand. You can’t accuse them of lying but you can accuse them of distorting reality.

If all of them collectively could be labeled “Parker Brothers,” like the creator of the board game, players would be justified in saying that competitive devaluations and the purchase of bonds at near zero interest rates is indeed a significant distortion of the markets and – more importantly – capitalism’s rules which have been the foundation of growth for centuries, long before Parker Brothers central bankers came into existence in the early part of the 20th century. Even as the financial system morphed from the gold standard, to the Bretton Woods Dollar standard in 1944, and then the abandonment of any standard in 1971, capitalism seemed to be on firm ground. Incentives to lend, borrow, and invest for a profit were never challenged on a secular basis prior to 2008, except in Japan. There may have been recessions where such an appeal was eliminated at the margin, but no – capitalism was king. It was, as Francis Fukuyama proclaimed, “The End of History” – game, set, match – as Communism and other similar economic systems headed for the trash bin.

But the distortions created by post 2008 Parker Brothers have called Fukuyama’s forecast into question. There can be no doubt that negative or even zero percent interest rates cannot be a permanent rule on Monopoly’s new board. Investors and game players do not logically give money away; a mattress ultimately becomes a more attractive haven. And most importantly – because the markets and the financial sector are ultimately the servants of the real economy – growth is challenged and stunted.

In a new world, returns on real investment – ROI’s and ROE’s – become so low that the risk of a new project or the purchase of green hotels offer too little return for too much risk. Like the endgame in Monopoly where cash becomes king at the game’s conclusion, cash accumulates in corporate coffers or is used to repurchase stock in the financial economy. Investment in plant and equipment is deferred. Structural headwinds such as aging demographics and abnormally high debt/GDP ratios do not offer the player a “get out of jail free” card, in fact they help keep the cell door closed. Hope is challenged.

In the final analysis, while there is no better system than capitalism, it is incumbent upon it and its policymakers to promote a future condition which offers hope as opposed to despair. Capitalism depends on hope – rational hope that an investor gets his or her money back with an attractive return. Without it, capitalism morphs and breaks down at the margin. The global economy in January of 2015 is at just that point with its zero percent interest rates.

Officials at the Federal Reserve – the most powerful and strongest of Parker Brothers – seem to now appreciate the hole that they have dug by allowing interest rates to go too low for too long. Despite reasonable growth, some of them recognize the system’s distortion if only because inflation is going down, not up, in the process. Other Parker Brothers countries face deflation in the midst of negative interest rates. But the Fed, uniquely in my opinion, will move up the Monopoly board’s interest rates in late 2015, hoping to avoid landing on the figurative Park Place and Boardwalk in the process. It won’t however, move quickly – capitalism has been damaged by the change in rules since 2008. Caution, therefore will prevail in the U.S. and elsewhere for a long time. Bonds despite their ridiculous yields will not easily be threatened with a new bear market. Investors should expect as well, that because of the slow unwinding of zero percent rates in the U.S., that U.S. and global stocks will be supported. Their heyday is over however. In effect, equity holders now own the Greens, the Blues and the railroads on Monopoly’s board while the Reds and the Oranges belong to another era. Returns in the real economy are too low partially because of the misguided efforts of Parker Brothers bankers. There is no doubt that structural secular stagnation factors such as demographics, high debt, and technology have contributed significantly as well. Fiscal policy has been anemic since 2010.

In the final analysis, an investor – a player – must be cognizant of future low and in some cases negative total returns in 2015 and beyond. Capitalism’s distortion, with its near term deflation, poses a small but not insignificant risk to what my mother warned was the final destination for all games – entertainment or real. “In the end,” she said:

“All of the tokens, all of the hotels, all of the properties – they all go back in the box.”

The strong odds are that 2015’s distorted capitalism continues with anemic growth, but the box rests on the family room coffee table, waiting, waiting, for its turn.

Crispin Odey – Odey Asset Management

Odey Asset Management (report for Dec 2014)

The themes I have been outlining since the second quarter of 2014 are now establishing themselves:

• A faltering Chinese economy with growth ultimately slowing down to 3%.
• A hard landing for those countries plugged into China’s growth – especially Australia, South Africa and Brazil.
• A fall in commodity prices bringing with it pain to those heavily exposed. For oil this is the Middle East, Venezuela, Argentina, mid-west USA, Canada, Norway and Scotland.

No one forecast how fast and how far those commodity markets would fall. However, the same people who singly failed to see this coming are the first to say that the benefits of falling prices will outweigh the costs. My problem with such a hopeful outcome is that, in my experience, those that lose out from a fall in their income are quicker to adjust than those that benefit. In that intertemporal space lurks a recession.

For me, the slowdown/recession finds a secondary downturn thanks to the immediate closing down of any discretionary capital expenditure in the affected industr es and countries, something we are only just seeing. This obviously has knockon effects for incomes and employment. At that time the exchange rate is likely to be falling to give some support. In my world this slowdown in the commodity producer’s economy is felt via falling exports back in the beneficiary’s economy, which finds external markets weaken. Again, if I am right on timing, the effect can be great because it is not yet affected by a pickup in spending in the beneficiary’s economy.

As always, that is the theory and markets will show whether it works in practice. In my world, this hit to the world economy is the first experience of a business cycle since 2008. Most investors do not believe we can experience such a downturn. They rely upon Central bankers who they think have solved the problem.

This down cycle is likely to be remembered in a hundred years, when we hope it won’t be rated for “How good it looks for its age!”. Sadly this down cycle will cause a great deal of damage, precisely because it will happen despite the efforts of the central banks to thwart it.

Today we get excited about what Draghi is going to with his QE plans for Europe. However, buying government bonds yielding 1.2% does not move the dial for European borrowers. Moreover it is almost impossible with negative short rates of 0.2%, because why would anyone sell a bond to the government, even if the yield is only 0.4%, to get a -0.2% yield on their cash? It looks like Draghi’s measures will disappoint markets. Faced with a deflationary bust, monetary policy will prove to be but “pushing on a string”.

There will be a strong temptation for individual countries to act independently of each other to soften the downturn. In this regard the story looks like it is only half way through. Russia will necessarily have to introduce exchange controls, and that really quite soon. Australia, where the average wage is over $70,000, while the USA is creating jobs at $28,000, will have to allow the currency to fall further. Japan has shown, under Abe, how it intends to react. ‘Everyman for himself’ puts enormous stress on a world trading system which has watched world trade rise from 12% to 32% of world GNP in little over 20 years.

So, where am I placing my money?

• Firstly, I think equity markets will get devastated. Un-announced business cycles ensured Japan’s stock market rating fell by two thirds over 20 years.
• Equities are priced for perfection, pushed up by SWF and high yield investors looking for higher yields and better covenants than high yield bonds.
• Commodity-related sectors look unappealing and dangerous.
• International consumer companies look overexposed to EMs.
• Fund management companies look overexposed to the wrong assets, especially EMs.
• Volatility is rising. Not every trade will work.
• Australia is still to see rates down to 0.5% at the short end, 1.5% at the long end, down from 2.5% currently.
• Currency trading is still to make the money. It made money last year as it was where the ‘tyres hit the road’ – equities are just the residual.
• Equity markets will struggle to understand the quarterly translation and transaction effects of these currency moves on corporate profits, starting with Q1 2015.

We have seen though some strange things, with economics 101 turned on its head. We’ve seen that falling prices produce more supply, as the biggest producers see that they can take market share and use the opportunity by reducing average costs through excess production. We’ve seen that in the oil, minerals and iron ore industries. We have also seen in the last couple of years that as bond yields fall, governments are able to issue more debt.

But this time round the problem we have as well is that politics will start to rear its head and we are left to deal with politicians who are increasingly critical of the capitalist system’s ability to allocate capital and provide for society.

For me the shorting opportunity looks as great as it was in 07/09, if only because people are still looking at what is happening and believe that each event is an individual, isolated event. Whether it’s the oil price fall or the Swiss franc move, they’re seen as exceptions.

After the 1987 crash, a friend of mine, then a young Director of Sotheby’s, was sent to consult an old Partner who had been at Sotheby’s during the 1930s and was still alive, albeit in a nursing home. My friend asked the question:

“What was it like in the 30s?”

And the man replied:

“It was like being bitten by a tarantula.” My friend didn’t really understand that, but later on in the conversation the old Partner said “A spasm of activity followed by a death.”

My point is that we used all our monetary firepower to avoid the first downturn in 2007-09, so we are really at a dangerous point to try to counter the effects of a slowing China, falling commodities and EM incomes, and the ultimate First World effects. This is the heart of the message. If economic activity far from picks up, but falters, then there will be a painful round of debt default.

We are in the first stage of this downturn. It is too early to see what will happen – a change of this magnitude means the darkness and mist is very great. We will make some mistakes but with our thinking we won’t make the major mistakes. The problem is where you stand – I am amazed to see so many are fully invested given that equities are already fighting the downtrend.

See you next week

Disclaimer: All content in this newsletter, and on Streettalklive.com, is solely the view and opinion of Lance Roberts. Mr. Roberts is a member of STA Wealth Management; however, STA Wealth Management does not directly subscribe to, endorse or utilize the analysis provided in this newsletter or on Streettalklive.com in developing investment objectives or portfolios for its clients. Please read the full disclaimer at the bottom of this report.