Complacency in the Age of Uncertainty

Steven Mnuchin will soon become a former US Secretary of the Treasury, but very much like his boss, he is not going away without creating an ugly precedent. On Thursday, he decided the Treasury would discontinue some of the emergency backstops which were setup to limit the damage of the Pandemic on the economy and therefore on the US banking system.  His decision apparently handcuffs his successor as well. These Fed programs might have been the sole alternative to a new round of fiscal stimuli that a GOP majority in the Senate has scuttled thus far.  What is most interesting about this matter is that the Federal Reserve, in spite of all its might, was not ready to underwrite credit risk without a backstop from the Treasury.    We hope that some of the members of the Governing Council of the European Central Bank are taking notes. 

A quarter of a century of emerging markets’ crises informs our disbelief at the casual manner in which investors are taking to the general enthusiasm with which central bankers are debasing their currencies and thus the value of banks’ reserves.  It is one thing for people to believe that Central Banks may print money; it is quite another thing to realize that the money that they print becomes worthless very quickly should the assets they buy be not worth very much at all. Should you have any doubts or further questions on this weighty matter, look no further than the end of the convertibility regime in Argentina.  The moment the Central Bank there started buying Argentinian USD foreign debt bonds; the convertibility scheme was over for good. It is one thing to have your currency backed by US Treasury bills, to have your currency guaranteed by the full faith and credit of the Republic of Argentina is, as most of you know, not worth the paper that guarantee is printed on. Soon thereafter, the convertibility regime whereby Pesos were exchangeable for US dollars at a 1:1 ratio ceased to exist, the sovereign defaulted. Bank depositors were thrown into the infamous “corralito” we have revisited more recently in Cyprus and Greece. 

The liability side of a fractional reserve system central bank consist of the notes that the government, firms, and the public use as a means of exchange, but far more importantly, it consists of the mandatory reserves requirements held by commercial banks in order to guarantee the liquidity of their depositors. It is interesting to observe how most people sleep soundly at night in Europe when their claims on their hard earned deposits rests on the full faith and credit of such reassuring debtors as Greece, Portugal, Spain or Italy.  It is not impossible, that this spat between the Treasury of the United States and the Federal Reserve Bank may finally illuminate these complex issues for the average citizen in the euro zone as well. 

There is nothing quite like economic growth to escape from a debt trap, but a strong recovery seems elusive at best, at worst very protracted and timid.  The unintended consequences of many political decisions on the solution to a second wave of infections in Europe are dire.  Millions of Europeans are again in lockdown regimes even as news on Covid-19 keep getting better. A nearly defunct, and largely insolvent, news media introduces new fears to a population that is easily spooked.  The latest trending topic is fear of the vaccine itself! 

First, the press reported that contagion was likely from touching infected surfaces on little or no evidence. Now, we know that this virus, like most other viruses that cause respiratory diseases, is contagious principally when one breathes into the exhalation of an infected person (their aerosol). We have been cleaning surfaces indefatigably while infection numbers rose steadily. During the lockdowns of the spring, the cashiers’ lines of supermarkets became hotspots of infection in countries such as Spain where use of facemasks was not mandatory until May 21. Apparently, only now do we know that the immunity will last for years. This is great news that contradicts anecdotal accounts of relapses that were widely reported out of context by a generally yellow press.  

No matter the most probable outcome, the press insisted on the outliers because the most likely scenarios were inconvenient for both impecunious journalists and power hungry politicians. Why? Because it meant that, those who had recovered should be free to roam.  The idea of health passports is apparently undemocratic, and thus was summarily dismissed.  Certainly, it makes a big difference in personal choices and freedoms. For example, in our immediate family seven out of ten people have developed immunity.  Should we not be allowed to get together when groups of six are allowed to do so even when all of the members are at risk of infection because none is immune?  In addition, what if we can keep the same two meters safety distance between tables of six in our homes as is required in restaurants?  Why does the Government assume that all homes are the same size or have only one dining room? 

We are afraid that the same socialization that applies to speed limits will apply to everything else, because any other outcome is politically incorrect and thus costly.  For example, speed limits were imposed, or lowered, to obtain better fuel economy following the Arab Oil Embargo of 1973. These limits were kept in place even when oil prices declined markedly, this time around for safety reasons. They saved lives.  Thus, speed limits are set based on the breaking distance i.e. the distance it takes for the average car to come to a full stop from 100 kmh. Yet, even as a Ferrari will come to a complete stop in fewer than 28 meters while a Fiat500 will take at least 42 metres, or 50% more, the speed limit is the same for both cars. 

Nobody today questions rules such as these, and therefore nobody questions why governments abandoned the idea of issuing immunity certificates so that certain people could go about their lives as before the pandemic. The increasing tolerance for governmental invasion of privacy, the decades-old pursuit of socialism in the form of one size fits all solutions bespoke for the lowest common denominator, the growth of a nanny state that always knows better; in other words, all that is wrong with western democracies is enjoying a revival of enormous popularity in a society scared into submission thanks to a smart manipulation of facts and statistics.  Thus, many people today have an exaggerated sense of their risk of contagion and worse yet of the risk of a fatality if positive. It is difficult to reconcile the ebullience in financial markets with this timidity and caution in most individuals and thus we worry that there is too much complacency in some corners of the financial markets. 

We have learnt over the years not to take at face value anything that transpires from the meetings of the EU Heads of Government. Nonetheless, maybe this time around a question of principles may scuttle the whole EU project.  The heads of government of Poland Hungary are vetoing the disbursement of EU reconstruction funds should these moneys come with conditionality as demanded from the frugal four.  Theirs is not a concern on fiscal or economic orthodoxy; they worry about the EU Commission’s meddling in their internal affairs as they pursue towards their home-grown versions of authoritarianism. Needless to say that this is not good news for the solvency of the periphery.  However, why worry as long as the ECB keeps buying their sovereign bonds. Perhaps the ECB and the Fed have both discovered how to eliminate the credit cycle, but we would not hold our breath because the magnitude of the downside far outweighs the small upside in being constructive on these issuers, if there is any at all.

What is the next-best new-new thing to part with your hard-earned euros?  Periphery bank stocks are again popular. A merger wave is sweeping Spain just as the Bank of Spain warns that banks are not setting aside enough reserves for loan losses and should not even think of resuming paying dividends.  Dividends that history tells us they should not have paid to begin with, as they have raised far more equity that they paid out in dividends during the previous credit cycle.  Ten years later, rating agencies are coming to the rescue trying to shed some light over these issues.  It is extraordinary how many people are buying into the benefits of these mergers when all the evidence points in the opposite direction.  Since the announcement of its acquisition of Argentaria in October 1999, BBVA has returned -24.25% cumulatively with dividends reinvested in the stock. Since its acquisition of Banco Popular in June 2017 an investment in Banco Santander has returned -20.4%. Needless to say that the merger of Caja Madrid and Bancaja that sprung Bankia was an unmitigated disaster until rescued by the Spanish state.  Even the merger of Banco Santander and Banco Central Hispano in January 1999 has only returned 0.6% per year. So what is all the fuss about with this new merger wave in the middle of an unprecedented economic collapse? We are afraid that once again it is the triumph of hope over experience or As Jim Grant puts elegantly puts it “Knowledge in science is cumulative, knowledge in finance is cyclical”.

Just last week, Standard & Poors downgraded Telefonica’s rating to BBB-, one notch above junk.  Telefonica is the largest non-financial private debt issuer in Spain, so large in fact, that management gets easily confused about how much debt they really have. When the largest corporate credit in the country is barely investable by reasonable people, why would anybody believe that the average corporate credit is any better? Should you follow the travails of Prisa, Abengoa, OHL, Celsa, Sacyr or any other in the long list of zombie companies, you may concur with the Bank of Spain. This news, like so many other bad news, has gone largely unreported by the impecunious and therefore far from independent local press. The third quarter 2020 earnings for most euro area banks lie somewhere between a bad joke and utter cynicism. These banks will have to raise equity as many loans will sour over the next few months.  For most small and medium size companies state support will lapse eventually, but many of them will exit the pandemic with much more debt than is salutatory.

In the interim, PM Sanchez is doing everything within his vastly enhanced powers under the new State of Alarm to divide the country and scuttle any chances of a recovery. To choose terrorists’ sympathisers over centrist pseudo-liberals to support his inane 2021 budget is a first step in the right direction if one’s intention is to revive historical enmities and further sink the economy. To confront foreign investors and the banking system with wanton curtailments to property rights in the program of their Communist allies is near-sighted and frivolous.  Very soon, the government and the country will need support from both these sources of financing.  Yet nothing shocks the Spanish public anymore, not even the mendacity of the nefarious Minister of Health who suggested that a large-scale vaccination drive would start very soon. As things stand today, it is highly unlikely that vaccines will be widely available in Spain before the summer.

In spite of all these clouds, 30. We shall soon see how well the bulls take the massive equity issuance that is lurking in the shadows. We dare say that as was the case in 2013 or 2003, rights issues announcements may be met with significant rallies initially, as some investors will feel vindicated for having caught the bottom while others will suffer from FOMO and will embark on a mad dash for trash once again.  We will quietly seat on the side-lines, adopting a now very fashionable JOMO attitude. When partisan acrimony pushes a seating President of the US to make a fool of himself and his Secretary of the Treasury to pursue a policy that purposely throws a wrench at the recovery of the largest economy in the world, it may be time to take some profits. We may be too timid or easily discouraged, but we certainly do not believe that there will never again be a better time to buy stocks in our lifetimes.  There is no harder position to be in than being the odd man out.  When this happens, we find solace in Keynes’s words: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”