Brave New Financial World

On Valentine’s Day, the ECB twitted a feed that captures the mood in the market to a T:

“Roses are red, violets are blue,

We’ll keep financing conditions favourable

‘Til the crisis is through”.

That same day, Dr Parik Patel, BA, CFA, ACC…, the financial blogosphere’s comic relief and guru, reflected: “Love is temporary. Stocks are forever”. The Reagan-Thatcher revolution is long over. The Philipps Curve has been debunked. Drs Yellen, Krugman, and Rogoff all agree that the NAIRU concept c.2021 is plain and simple Voodoo Economics redux. Big Government is back with a vengeance. Hovering in the background an increasingly confrontational and assertive Chinese leadership is escalating a Cold War. Market observers generally agree that current levels of complacency have not been seen for many years. Investors are hyper-bulled up because of the twin engines of financial success: supersized fiscal and monetary stimuli. The oldest professionals in the industry remember very few times such as these. Negative real yields on Government securities underpin this upward and onward move nearly everywhere around the world. Even in the odd location where rates go higher, such as Turkey, this is also good news for financial assets. Not surprisingly, asset prices continue to rise, especially in the US.

Before we go any further with our discussion, we would like to point out the obvious caveats to the current justified excitement; this comment will of course be the source of much derision. Let us just say that if printing money to finance large deficits were such a no-brainer policy choice to mitigate in an effortless and costless manner the travails that have befallen humanity since the expulsion from the Garden of Eden, Argentina would look a lot like Switzerland today, and conversely Switzerland would look a lot like Argentina today. Perhaps Kenneth Rogoff is the most unexpected supporter of this new focus on employment and income redistribution to reduce inequality no matter the future costs. Where Wall Street and other market participants see a bull steepening in the US treasury curve, others may see as little information content in this sell-off of longer dated tenors as there was in the preceding rally, since most of the buying, and subsequent not buying, has been done by the Fed. In any case, inflation adjusted Treasury yields remain negative and not much higher than those in the euro sovereign curves, not a very conventional bullish sign either.

Dr Rogoff became world famous when he published “This Time is Different: Eight Centuries of Financial Folly”, an essay he co-authored with Carmen Reinhart in 2009 with perfect timing.  This best-selling book was the intellectual ammunition that fiscally conservative politicians used to impose “austericide” policies in the euro area and other countries. Back then, it seemed reasonable to many economists to reduce government spending in the midst of the worst economic downturn since WWII. The authors posited, with the great aplomb that characterizes economists – a group of pundits who are seldom right but are never in doubt- that when sovereign debt as a percentage of GDP reaches a certain threshold, calamity and financial crises inevitably ensue.

Actually, what happened then was that adopting their recommendations led to a countercyclical fiscal tightening, which resulted in an increase in disinflationary risks. This process singlehandedly ensured many perverse political developments including the extreme polarization of politics around the world culminating with the election of nationalist populists such as Narendra Modi, Donald Trump[contexto id=»381723″], Jair Bolsonaro, or Boris Johnson.  Some of these leaders obtained their mandates largely because the preceding fiscal austerity caused unnecessary underemployment and misery that marred the recovery from the Great Financial Crisis (GFC).  China levered up to escape the GFC unscathed and successfully, becoming the engine of global growth in the process. Yet today, at 310% of GDP, its non- financial sector debt burden is quite significant. Further, Xi Jinping crowning himself as sole leader (perhaps for life) may turn out to be a source of domestic instability, especially if employment does not recover to pre-CoVID levels. Dr Rogoff justifies his economic policy recommendation about-face because today we have a “political crisis” and rates are very low, thus, we can afford much higher debt burdens. While it is true that real yields are at all-time lows, there is some circularity in his argument. We may be in for another rough spell if our political leaders continue to listen to rear view mirror drivers such as him.  In the interim, anybody with savings is egged on to participate in a new Minsky Moment.

The concept of risk-reward has been absent from G3 fixed income markets for some time. We have discussed this problem at length, but we rarely have met anybody worried about it, until quite recently. So far this year, the 0% (yes, the coupon is 0%) 10 year German Government Bond of February 2031 is down 2 points to yield -0.375%. An investor who held these bonds on January 1, 2021 at a price of 105.816 had to be comfortable with an even worse outlook for her risk reward just a few weeks ago. Otherwise, there was no point in holding a security, which sole value derived from the speculation that somebody would buy it at a higher price before too long. This incipient bear market in global sovereign bonds is thus far inspiring a very bullish sentiment among equity investors. Conversely, a continued sell off in bonds may become a career ending development for many of those involved. How are these fixed-income “investors” going to justify not having sold their positions in long dated bonds with negative yields before it was too late?  More importantly, what are financial advisors going to tell their clients who in many cases are 60% to 70% invested in these time bombs?

While bonds deflate, other asset classes continue their relentless ascent. The recent frenzy in capital markets activity is testimony in real time to the desperation of investors awash in liquidity. Most investors have become experts at analysing the Fed’s balance sheet and the impact of open market operations on bank deposits and liquidity. The conclusion is that liquidity is overabundant thanks to the monetization of large US deficits. A second conclusion is that the combination of the Treasury drawing down on its deposits at the Fed, which should take place before May; while a new vast incomes support fiscal package is implemented will continue to lift risk assets’ prices for some time.

Economists expect US household savings to decline markedly in 2021 with normalization. While this is bullish for consumption undoubtedly, perhaps one should be prudent in assigning a multiple to what may be a one-off fulfilment of pent up demand, then again perhaps not. There is also much discussion about growth in monetary aggregates such as M1 and M2 adjusted for various factors, as well as the ratio of Equity Markets Market Capitalizations to M1. It might be prudent to make such comparisons on an Enterprise Value basis as corporate debt has been on the rise. In addition, it might be a good idea to check the ratios of profits to GDP and the ratio of M1 or M2 to GDP before stating that the ratio of Equity Market Value to M1 is much lower than in 2000 or 2007 as a conclusive bullish argument. In the short run, these technical factors will dominate but before you know it, earnings will also matter. Clearly, the overriding factor supporting the market is that whereas real yields were nearly 4% in 2000 and above 2% in 2007, today real yields are at an all-time low close to -1%. The meek may inherit the earth, but they will not become wealthy on Wall Street today.

In any case, equity indices continue their upward march even as IPOs are setting all types of records, especially Special Purpose Acquisition Companies (SPACs) which are going public at break neck speed, one hundred so far this year. High yield issuance is breaking all records, especially for the lowest rated issuers. Flows into ETFs and other mutual funds are breaking all records as well. Private Equity firms are riding the wave raising multiple times the commitments they can invest; yet their dry powder is yet another source of comfort for investors in equities.

We are not reliving Goldilocks, there is no such thing as neither too hot nor too cold in today’s economic indicators. This environment feels a lot more like the Wolf of Wall Street’s early years except that today policy makers are purposely risking reigniting runaway inflation for the first time in decades. The Independent Central Banks, a new development of the 1980s to fight stagflation, has become a historical curiosity. The issue here is that some monetary areas are more likely to reflate than others are. We have far more faith in the US or the UK reflating than we have on China or the EU doing so, unless China devalues or the euro breaks up.

There are pockets of the market that seem parsecs away from the standard and perhaps old-fashioned investment technique that involves investors estimating a rate of return which hopefully turns out to be well above the risk adjusted cost of capital of the investment by projecting cash flows. Who needs cash flows today, when the cost of capital for some firms may have turned negative as well? A Wall Street analyst suggested recently that this is the case for Tesla. This may well be the case. Just last year, a leading hedge fund manager estimated a target $1 trillion equity market value for Tesla by 2030; this target has been reached already on a fully diluted basis. The question is what to do now, do you raise you price target because every indicator is so much more bullish today than just 9 months ago? Do you take some profits? The latter used to be a good tactical move when there were market corrections from time to time, but is this a good idea when the monetary and fiscal authorities have agreed to put an end to the credit cycle? Soon enough some equity investors will find out that they hold a sizable part of their portfolio invested in companies that have similar characteristics to the zero coupon German Sovereign bond trading at a premium to par. What ensues after that realization will not be pretty.

What are the immediate consequences of all of these developments? For US residents much higher home prices, for one. The last time this happened, it was not a good political development, but that was then and this is now. This housing price trend also reflects that lenders are willing to take on risk. Conversely, in the EU, there is a much smaller fiscal stimulus and it comes with many strings attached because the EU recovery programs are a fiscal transfer from wealthier countries to less affluent ones. Also in the EU, we do not see banks display much appetite for risk. In essence, EU banks have off loaded most of the worst loans onto government guarantee schemes that will soon collapse. These schemes are a source of moral hazard and corruption not seen for decades. Once again easy monetary conditions do not convert into easier lending conditions in this God forsaken corner of the world. There is a blot in the landscape though, the latest inflation prints in China are the least talked about data points so far this year because they do not conform to the bullish reflationary script, even as the Chinese economy did not suffer much last year.  We shall soon see whether China, the engine of global growth for much of the past decade, is idling or sputtering. Whatever happens there will be of the utmost importance to keep the party going strong