The Cobden Centre

“I’m getting increasingly worried about the free movement of people across Europe. It’s a very competitive world out there and my constituents resent that.”

- Huddersfield Labour MP Barry Sheerman, defending comments he made on Twitter about Eastern European workers.

It was quite fitting that in a week that saw Britain slide into its first double-dip recession since 1975 we also saw evidence – notably from the political left – of the sort of insular bigotry and protectionist narrow-mindedness that one associates with that ugly decade. And if there was any doubt about the longevity of the UK’s fragile Con-Dem coalition, its honeymoon period is certainly over now. Nor were the signs of some kind of political unravelling confined to British shores. French voters in the presidential elections shocked markets by a) favouring the socialist Francois Hollande and b) giving almost a fifth of their votes to the far-right extremist Marine Le Pen. In another turn of the sovereign debt screw, Spain was downgraded toward reality. The Dutch government, meanwhile, collapsed altogether. Amazingly, the people of Europe just don’t seem that keen on austerity.

Richard Lambert for the FT anticipated Barry Sheerman’s nastier musings by a week, in a piece entitled ‘Why no British staff at Pret A Manger?‘ Part of his answer:

Restaurants, hotels and consumer-facing businesses of all kinds seem to have decided in recent years that young Britons are just not as good as others when it comes to friendly and reliable service, a serious work ethic – or simply turning up on time and on a regular basis.

This conclusion was supported by a subsequent letter to the paper’s editor from Tony Constance of Akramatic Engineering in Derbyshire:

After some 15 hours covering various form filling and choosing four possible candidates from CVs, the result was as follows:

Number one candidate – the job centre was told he was now off sick.

Number two – uncontactable.

The final two were due to start at 7.30am on Tuesday last week.

Number three – did not turn up as “my girlfriend is five months pregnant and I have been up all night”.

Number four – did turn up but after 10 minutes left stating: “I am not doing this job for nothing.”

The lady at the job centre was most embarrassed and said that the real problem is that “we have no sanction against them. We can’t reduce or take their benefits away.”

Not to be outdone, another journal of repute noted the case of Carl Cooper, who hired seven new recruits to his marketing firm in Hersden, Kent, only to find that none of them turned up to work; four of them failed to show because of the rain.

Perhaps this outbreak of workshyness is what happens after a champagne socialist administration urges half the school population towards university irrespective of any merit or underlying interest. As our disaffected youth are apparently prone to remark: whatever. Martin Spring’s latest ‘On Target’ newsletter (‘Britain: a culture hostile to growth’) separately contains a devastating blow-by-blow analysis of the difficulties facing Messrs Cameron and Osborne, and it is difficult to disagree with his suggestion that

There are ominous signs that the period of office of these two young and inexperienced leaders will be seen as ending in political and economic failure.

As Enoch Powell said, all political lives (unless cut off midstream at a happy juncture) end in failure, because that is the nature of politics and human affairs. The political life of the current coalition may end up being remarkable only for its brevity.

Chris Dillow quite reasonably asks why the recession of today hasn’t produced the sense of crisis manifest in the 1970s. His answer: that average real wages are much higher now so although standards of living are falling, they’re falling from a much higher level that softens much of the pain (of the austerity that hasn’t even really arrived yet). And that the working class is more atomized now, both geographically and ideologically. It may also be that back then the young by and large wanted to work and couldn’t, and now by and large don’t even want to, if the examples of Akramatic Engineering and Carl Cooper’s Car Smart are anything to go by.

But there is one outcome from the 1970s that is genuinely to be feared and it is called stagflation, the risk of which seems to be rising every day, if it has not indeed already arrived. Stagflation is and will be the natural side effect of extended QE during a period of widespread deleveraging – the printing of money that nobody wants. An outbreak of serious stagflation will also more than decimate conventionally managed debt and equity portfolios. But we live in strange times – times, for example, that reward bankers handsomely for bankrupting the economy. So the likes of the FT’s Chris Giles can insist with impunity that ‘The Bank of England must unleash more QE’ (26 April) without a scintilla of justification or any substantive evidence that it works. In a letter to the paper’s editor from the same day, economist Roger Alford remarked that

The utterly disparate time horizons and the very different experience and skills required.. make it virtually impossible for any one person to have the experience and depth of understanding to provide effective leadership [as Governor of the Bank of England].

Being hidebound by the intellectual constraints of his faux science “profession”, Mr. Alford does not take this argument to its logical conclusion – if the institution is so difficult to govern and the role so difficult to effect, why have it in the first place? We know why the Bank of England exists – to protect the banking system at all costs (including that of bankrupting the productive economy and the taxpayer), and to finance the government’s debts (the same point repeats). But ever more urgent austerity and an insoluble sovereign debt crisis are uneasy bedfellows. By definition we cannot shrink our way back to the sort of growth required to service the West’s accumulated debts. Something has to give. That something will ultimately be social disorder on a continent-wide basis, not least as an ever more put-upon taxpayer base is obliged to fund the increasingly untenable costs of Big Government. Out of that disorder perhaps will come genuine political leadership and the retrenchment, rather than the constant advancement, of the leviathan state. If that is what it takes to shift an unsustainable status quo in which vampire banks and clueless bureaucrats suck the life out of the productive economy, bring it on. “The last thing that the markets need right now is increased political uncertainty at the heart of Europe at a time when the economic outlook is already bleak,” commented Capital Economics. To which the only reasonable response is: tough.

Strange times and fundamentally distorted markets (see QE, again) require investors to possess unusual psychological fortitude. Two things are required to maximise the probability of meaningful capital growth or simply capital preservation in real terms within such a perilous environment. One of them is an attractive valuation at the inception of an investment. Pockets of value undoubtedly persist throughout debt and equity markets, though one may have to look harder than normal to identify them. (We leave momentum investing to others.) The other is patience. An easy philosophy to articulate, but a fiendishly difficult path to follow.

This article was previously published at The price of everything.

“The sea’s freezing. A man won’t last long in that. We’ve drawn a bad hand this time.”

“I’ve never been a good loser. I intend to get into a boat.”

- Conversation between two card-players on The Titanic, from Eric Ambler’s screenplay, ‘A Night To Remember’.

The Titanic centenary was always going to be the trigger for a plethora of tasteless attempts to cash in on the tragedy. The “best” we’ve seen so far was the Hotel Russell’s promotion of its ‘Titanic breakfast’ – which presumably goes down a treat, though not without a degree of attendant turbulence. Having considered for some time the most appropriate metaphor for the current market environment the cause sometimes seemed lost, but we think we have it now. There are a number of sequences in Roy Ward Baker’s 1958 classic account, ‘A Night To Remember’, that depict a lounge in one of the upper class quarters of the ship as it slowly sinks beneath the waves. Notwithstanding the vessel listing alarmingly, a motley band of toff revellers are determined to go out in the finest Hooray Henry style. Some continue to play at cards with a fatalistic resolve while behind them, a group of braying nobs determinedly quaff spirits direct from the bottle. One may be doomed, but one can still party on.

Jeremy Grantham’s latest market letter (PDF) is well up to his usual high standard. Grantham is particularly good on the professional asset manager’s need to navigate not just irrational markets but to cater to clients hungry for performance and intolerant of the bad kind:

Over the years, our estimate of “standard client patience time,” to coin a phrase, has been 3.0 years in normal conditions. Patience can be up to a year shorter than that in extreme cases where relationships and the timing of their [portfolio's inception] have proven to be unfortunate. For example, 2.5 years of bad performance after 5 good ones is usually tolerable, but 2.5 bad years from start-up, even though your previous 5 good years are well-known but helped someone else, is absolutely not the same thing ! With good luck on starting time, good personal relationships, and decent relative performance, a client’s patience can be a year longer than 3.0 years, or even 2 years longer in exceptional cases. I like to say that good client management is about earning your firm an incremental year of patience. The extra year is very important with any investment product, but in asset allocation, where mistakes are obvious, it is absolutely huge and usually enough.

We make just one cavil with Grantham’s observations. Like most of the financial services industry, he restricts his asset universe to the two conventionally dominant classes of listed equities and investment grade debt. The problem with this perspective is that the asset management industry tends to view those asset classes as both uncorrelated and representative of the entirety of investor choices available. But the reality is a) that investors can pursue other distinct types of assets (we would single out real assets as an obvious and relevant alternative), and b) that there can and will be times when both debt and equity markets together underperform, in both relative and absolute terms (the relative benchmark being cash since developed government debt can in no way now be considered a risk-free asset class). We may be fast approaching a macro environment that threatens conventional portfolios with exactly that outcome – a bear market in both stocks and bonds simultaneously. In other words, the authorities could attempt to throw a bull market party for both bonds and common stocks, but nobody would show up. (The ticket to entry is simply too expensive.) Having long since exhausted the armoury of conventional policies to keep the unsustainably indebted and now almost randomly deleveraging show on the road, increasingly desperate politicians are doing increasingly desperate things – be that gifting money to the IMF in a brazen display of fiscal denial that we can ill afford (George Osborne) or simply stealing from other sovereigns (Cristina Kirchner).

Project ‘End Up Like Japan’ continues to advance well throughout the western economies. The euro zone continues to perform like a group of drowning men lashed together for buoyancy. Here in the UK the Bank of England has the dubious privilege of being able to print money with abandon, and it is taking every opportunity to duly abuse the purchasing power of Britons with savings. We continue to hear Mr Takashi Ito’s sad refrain, published as a letter to the FT back in August 2010:

..after a huge housing bubble bursts, there is nothing to do except suffer many years of economic indignity.

Politicians, of course, are not in the business of sitting idly by while the country collectively suffers that economic indignity (the savers, at least). They must be seen to be doing something. The ironic triumph of the Keynesians means that in trying to save the economy, our central bank may end up destroying it completely by means of the printing press.

So we now get to experience some of the full-on horror of the Japanese malaise. As the debt burden and currency debauchery game rise together toward some form of climactic end-game, the sense of politicians simply not getting the point is almost comical. Just when it were most needed, evidence of urgency from government is invisible.

So in a portfolio sense, we close all water-tight doors. Debt holdings are restricted to those of only the most objectively creditworthy borrowers. Equity exposure is kept modest and restricted to only the most defensive. (Sustainable and relatively high dividend yields help.) We diversify further into the one actively managed strategy that doesn’t attempt to predict future market performance, namely systematic trend-following. And we diversify further still into the highest quality currency available, namely bullion. That this approach has not necessarily delivered whopping returns over the past 12 months is not an immediate cause for concern to us since we’re most focused on straightforward survival. All we need to do now is ensure that our clients are on message. They should be, because it’s their money at stake.

With Grantham’s sensible caveats about investor patience still ringing in our ears, we repeat our increasingly urgent suggestion that investors in debt and equity products (especially debt) enjoy the party but dance near the door. Developed market debt investors have enjoyed a 30+ year bull trend in interest rates (and credit creation) but the fat lady in the next room has started tuning up. In both asset allocation and instrument selection, having diversified well beyond quality credit and defensive equities into what we consider uncorrelated funds and real assets, we have already left the party. Our portfolios are not particularly dependent on the continuation of any kind of bull market environment for either conventional debt or equity markets. We are already sipping non- alcoholic drinks at the after-party. We look with keen interest at our watches to see how many other revellers will end up joining us. To put it another way, the ship is listing badly but has not yet sunk. So what colour is your life-jacket ?

This article was previously published at The price of everything.

“FTSE 100 could hit 7,000 if the Bank of England prints more money”
- Telegraph headline implicating Legal & General’s Ben Gill as the inflationist paper-bug.

Any Martian watching events down here would be scratching its head more than usual. The ONS reported that UK GDP contracted by a worse than expected 0.3% in the last quarter of 2011. Construction industry output fell by 0.2%; manufacturing output by 0.7%. And the OECD indicated that the UK was back in recession (no big surprise to us since we never believed we came out of the last one). So what was occupying the twittering classes more than anything else last week ? The tax rate on pasties. This supposedly punitive tariff has been seized upon by left-wingers as dark evidence of a Conservative plot against the lower orders; as political blogger Guido Fawkes pointed out:

We now live in a country where caviar is untaxed and a hot pasty is.. Go figure.

Or perhaps the furore over the tax rate on cheap pastries simply reflects the underlying absurdity of the ongoing annual irrelevance that is Britain’s Budget – an endless cycle of tinkering at the fiscal margin that ultimately benefits nobody other than a narrow clique of lawyers and accountants.

Notwithstanding the above, this week’s letter may yet end up being positive. If it does, it will be in no small measure thanks to David Deutsch, whose recent book ‘The beginning of Infinity: explanations that transform the world’ seems little short of a masterpiece. Deutsch is a computational physicist. For the layman, this means that, unlike an economist, he actually has a clue what he’s talking about. And what he’s talking about boils down to a fundamental optimism about the nature of humanity, as the two stone carvings below might tend to suggest:

Source: David Deutsch, ‘The Beginning of Infinity’ (Allen Lane 2011)

In his words,

It is inevitable that we face problems, but no particular problem is inevitable. We survive, and thrive, by solving each problem as it comes up. And, since the human ability to transform nature is limited only by the laws of physics, none of the endless stream of problems will ever constitute an impassable barrier. So a complementary and equally important truth about people and the physical world is that problems are soluble. By ‘soluble’ I mean that the right knowledge would solve them. It is not, of course, that we can possess knowledge just by wishing for it; but it is in principle accessible to us.

Admittedly, Deutsch is referring to problems that can be observed, studied and resolved scientifically. But just because the scale of his landscape is cosmic and ours inhabits the more narrowly quotidian range of the investible does not invalidate the application of his method to the more behavioural problems of the financial. If human brainpower can split the atom, it can surely devise a prudent way of navigating through the investment excesses of these dismal times.

To solve a problem, you first have to identify it correctly. Know your enemy. Here, in no particular order, are our suggested big problems afflicting the investor’s world of today:

1. Too much debt
2. Insufficient economic growth to service that debt
3. Too many functionally insolvent banks
4. Too many off-balance sheet claims against finite government (taxpayer) resources
5. Central banks have utterly exhausted their armoury of the conventional and are now making it up as they go along
6. Uncontrolled and possibly uncontrollable monetary stimulus, in a general environment of fundamentally unsound money
7. Widespread currency debasement
8. Vast manipulation of all major asset classes courtesy of Problems 1-7
9. No objectively and unimpeachably safe havens
10. Politicians.

In the spirit of William of Ockham, the simplest investment response can be assumed to be the best. Nature may abhor a vacuum, but in the world of investments, there are no automatic penalties for non-participation in ugly markets. So if we take violent exception to a given asset or asset class, the simplest response is surely just to avoid it. (Note: institutional managers, especially product specialists and closet or explicit index-trackers, may not be able to operate to similar rules.) So at the risk of vast over-simplification, here are our responses:

1. Problem: Too much debt
   Solution: Avoid crappy bond markets.
2. Problem: Insufficient economic growth to service that debt
   Solution: Not actually our problem – we are investors, not policy-makers.
3. Problem: Too many functionally insolvent banks
   Solution: Ditto. But avoid crappy banks (that is to say, most of them – either as potential cash custodians or, just as importantly, as equity or bond investments).
4. Problem: Too many off-balance sheet claims against finite government (taxpayer) resources
   Solution: See 1.
5. Problem: Central banks have utterly exhausted their armoury of the conventional and are now making it up as they go along
   Solution: See 2.
6. Problem: Uncontrolled and possibly uncontrollable monetary stimulus, in a general environment of fundamentally unsound money
   Solution: Spend more time focusing on investments incorporating fundamental quality, creditworthiness, lack of counterparty risk and scarcity. E.g. precious metals in physical form.
7. Problem: Widespread currency debauchery
   Solution: See 6. If paper currencies are sought, vote explicitly for those of sovereign players which have objectively sound economies, banking systems and balance sheets. E.g. Singapore, which as Stratton Street Capital point out “is at the heart of the economy in Asia in many ways. Despite its small size it is a centre of trade, a financial centre, and a wealthy nation with an appreciating currency; the Switzerland of Asia. [And with a sound currency to boot. – Ed.] The recently released manufacturing figures give a picture of a country still succeeding in its goal of innovating in high value added industries. Overall manufacturing was “only” up 12.1% year-on-year to February, slightly lower than some expectations, but biomedical manufacturing (pharmaceuticals and medical devices) rose 38.3%, and marine and offshore engineering was up 41.7%, largely on the basis of oil-related technology.. Total trade rose by 26% year-on-year.”
8. Problem: Vast manipulation of all major asset classes courtesy of Problems 1-7
   Solution: In this environment, investments are only to be owned, not rented [1]. Lombard Odier’s CIO Paul Marson cites a coinage from the earlier, more successful version of Warren Buffett: “Only buy something that you’d be perfectly happy to hold if the market shut down for ten years.” Perhaps the most heavily manipulated market is that in crappy government debt, courtesy of the uneasy fusion of insolvent governments with insolvent banks, and helped on its way to untenably low yields by an institutionalised and largely price-insensitive agency player marketplace focused on benchmarks. Private clients need not participate in this market, except to laugh at the other players. But spillover from monetary stimulus is undoubtedly triggering waves in equity markets. To avoid sinking, focus on valuation, not momentum.[1] If renting turns out to be unprofitable, investments will end up being owned anyway.
9. Problem: No objectively and unimpeachably safe havens
   Solution: Notwithstanding the lack of “true” safe havens, bullion probably comes as close as we can get in this fallen world. But see also sensibly priced businesses with a genuine commercial edge and principled, as opposed to Wall Street-style, leadership.
10. Problem: Politicians.
    Solution: Elections. Not the finest answer, perhaps, but the only printable one we have.

“We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand.”
- John Maynard Keynes.

An engineer, a biologist and an economist are washed ashore on a desert island. After a few days without food they are starving. Eventually, they stumble on a can of beans on the beach. They spend a few minutes considering how they might feed themselves. The engineer is the first to speak. “We could hit the can with a rock until it opens.” The biologist counters, “We could suspend the can in a seawater solution and wait for erosion to work its magic.” The economist is last to contribute: “Let us assume we have a can-opener.”

So it’s not the funniest joke in the universe. But it has the ring of truth. Nobel laureate William Sharpe, for example, established the capital asset pricing model in the 1970s in an attempt to establish the sort of risks that can be reduced by diversification. For anybody that cares (a category that does not include this author), the formula is as follows:

So far, so simplistic. But the CAPM (as it became known) also contains a number of assumptions about financial markets that can variously be described as either quaint or ridiculous. For example..

• Financial markets are perfectly competitive;
• Tax does not exist;
• Nor do transaction costs;
• All investors have the same time horizon;
• All investors have the same expectations of returns and volatility; All investors can borrow and lend at one risk-free rate;
• Investors can go short any asset and hold any asset fractionally.

What do you call a model that only works if you make some breathtaking assumptions about how the narrow little universe of that model works ? (A suggestion: it’s not even a model, it’s a hideous troll.) If the natural world we actually inhabit behaved according to the sort of models that economists use, then planes would drop from the sky on a daily basis; cars would routinely crash into each other or randomly explode; there would be a point to Jedward..

In ‘The Origin of Wealth’, Eric Beinhocker makes a convincing case that the rot set in to the then juvenile field of economics when serial French loser Léon Walras, having failed as engineer, novelist, journalist and banker, set his mind to this exciting new discipline:

One evening in 1858, a depressed Walras took a walk with his father, a teacher and writer, discussing what he should do with his life. The elder Walras, a great admirer of science, said that there were two great challenges remaining in the nineteenth century: the creation of a complete theory of history, and the creation of a scientific theory of economics.. Prior to Walras, economics was not a mathematical field.. Walras and his compatriots were convinced that if the equations of differential calculus could capture the motions of planets and atoms in the universe, these same mathematical techniques could also capture the motion of human minds in the economy.


And so erroneous, inappropriate and plain flawed models were lifted wholesale from the world of physics, and made to fit, somehow, jammed and crammed – no matter what pieces broke or flew off – into the unstable and probably unforecastably wild world of the economy. This matters, and may be one of the most overlooked aspects of the financial crisis to date, in that so much of what constitutes accepted economic wisdom may be fundamentally inappropriate to begin with in “the real economy”, and the scope for economic policy errors to scale up to huge potential losses in “the real economy” is almost infinite. A delicate machine, the working of which we do not understand.. Computer scientists coined the phrase “garbage in, garbage out” to describe the vulnerability of computers to process meaningless input data and produce comparably meaningless output. But only a comparative handful of sceptics have drawn attention to the vulnerability of the modern financial system to assumptions equating to economic garbage going in. The English “father of the computer”, Charles Babbage, once made the following observation:

On two occasions I have been asked, – “Pray, Mr. Babbage, if you put into the machine wrong figures, will the right answers come out ?” ..I am not able rightly to apprehend the kind of confusion of ideas that could provoke such a question.

The Austrian school recognised the limitations of economic theory. We cannot model “the market” with precision, because the market is us. Another colossal presumption of mainstream economic theory holds that the economy mean reverts to some form of stable equilibrium; all that is required from our enlightened monetary leaders, we are led to believe, is a gentle nudge of this policy lever or that, and the path back to stability is assured. But what if the analogy is fundamentally wrong at its core ? What if the economy is never destined to reach a stable equilibrium – a state in any case analogous in its cold sterility to the dynamism of air molecules in a perfect vacuum ?

Judging by recent market action (on the part of equities and euro zone government bond yields), investors would appear to believe that the euro zone debt crisis has been largely resolved. The market’s supposed saviour has been the European Central Bank, benignly tipping half a trillion euros of liquidity onto the continent’s banks. In the first instance, making any kind of assumption about financial market dynamics when that same market is a) a plaything of algorithmic machines as much as more traditional human speculation, and b) prone to the sort of distortions that come with, say, half a trillion euros of liquidity, is a dangerous business. More pertinently, a crisis of overmuch credit provision seems to have been resolved through the medium of …more credit provision. Perhaps Ludwig von Mises’ most quoted construction since the crisis began is also amongst his most ominous:

There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved.

Abandoning credit expansion does not seem to be on the ECB’s agenda. So it should come as no surprise that German commentators are watching the ECB’s massive credit expansion with growing alarm. The Frankfurter Allgemeine Zeitung wrote last week:

Government financing may not be the goal of the ECB’s money glut. But the side effect of the massive sums that the bank has released for the second time at the unusual lifespan of three years is that interest rates have sunk on the bond markets. Most countries can now finance their debts at tolerable conditions again. That also stabilizes the banks, which is thoroughly pleasing to the central bank. This is because it aims to eliminate every doubt about the financing of solvent banks with the emergency loans. It has achieved this, in addition to hindering an accelerated downward spiral of emergency asset sales.

But what may have a short-term calming effect can also complicate the recovery of the currency zone through the lowered interest rates on the market. This is because falling risk premiums and cheaper financing conditions could lead some politicians to the erroneous belief that spending policies financed with even more debts is still possible. The ECB must counteract this by creating a timely shortage of money and credit.

FT Deutschland wrote:

Nobody can calm the markets better than the ECB. The three-year tender has already shown that. No rescue packet, no austerity package and no crisis summit has as much persuasive power as the money-slingers in Frankfurt. Since the euro boon in December, the situation has calmed noticeably and confidence has returned. This will surely be strengthened by yesterday’s long- awaited and generous new round of loans from the ECB.

It’s also clear that the loose policies of the ECB are anything but harmless. After all, it wants the money to be invested, perhaps in government bonds, which would be much to the satisfaction of finance ministers — perhaps. Alternatively, the money could be invested in other assets, such as mining, real estate or shares. But the confidence inspired by the ECB goes hand in hand with an increased willingness to take risks. That doesn’t necessarily amount to an investment bubble, but it could become one. In that case, if the bubble were to burst, we would have to start crisis management over again from scratch.

In the financial markets, as opposed to the CAPM model, taxes and brokerage costs exist. They penalise the flighty and those who prefer to make their strategy reactive to market movements as opposed to pre-emptive. We do not have the same time horizon or expectations of volatility (we suspect) that others have. Nor, for that matter, does our core asset allocation (we suspect) remotely resemble those which most of our putative competitors use. Our dependency on the stock market for return is modest, and explicitly biased towards the defensive. Ditto our reliance on debt instruments, where our approach, we like to think, is extremely discerning. We value instruments that we believe will offer decent returns with roughly zero correlation to traditional asset markets. We love real assets. We attach a more or less equal significance to investments that we believe have a strong likelihood of preserving capital in an inflationary environment as we do to those that we believe will hold up in a deflation. This sort of asset diversification may strike some as a capitulation, evidence of a lack of conviction. We prefer to see it as a rational response to the uncertainties of our time – we have very clear views about those instruments we don’t want to hold, and as a result we don’t hold them.

Asset managers, we surmise, are not meant to be equivocal. The investment media have an absolute bias in favour of the grandstanding big prediction. But as Voltaire said, while doubt is not a pleasant condition, certainty, in the present circumstances, is absurd. As the rather wonderful Slog puts it,

There are so many imponderables, unknowns, poison pills and impracticalities involved, so many different geopolitical agendas in play, and so many vested interests breaking or spraining the rules, it can only end in tears: the timing and volume of tears are the only things left. But if I may twist the allusion kaleidoscope just one more time, Greece-guessing is like a passenger on the Hindenburg watching his skin burn, and worrying about that nice new set of luggage he bought specially for the maiden voyage.

This article was previously published at The price of everything.

“No government has ever commanded the resources at the disposal of our ungodly Leviathan, which consumes about 25% of the product of the world’s richest country. It is driven by a voracious alliance of government’s own employees, and those who receive benefits from the state. At least 90 million Americans either depend directly on government handouts or jobs, and each private worker must support not only himself and his family, but also carry a government worker on his shoulders.”

- Tom Bethel, ‘Freedom and its enemies’, June 1999.

Financial markets don’t really do the long term anymore, but if they did, they might spend less time drooling at the prospect of more monetary crack, and more time wondering who will be funding all the government debt that now towers above everyone further than the eye can see. CLSA’s Russell Napier (hat tip to Macro Advisors’ Filip Ruszkowski) recently pointed to an ominous development from the summer of 2011:

..a terrible burden fell upon the people of the USA. For the first time in 15 years, those who had money (savers) began to fund their government, rather than the printers of money (central banks). This shift has already hurt private-sector growth and asset prices, and as federal debt to GDP reaches 100%, it will squeeze out private-sector activity. Structural moves to coerce markets into funding government have begun in Europe and will come to the USA too..

The chart above confirms that US corporate profits have now reached record levels as a percentage of GDP. They are unlikely to stay there. Napier suggests, perfectly logically, that when the government needs money to fund itself, it will target those constituents that actually have some. That is, in other words, wealthy individuals and corporations.

What will be awkward about this financial repression of the moneyed classes, if it comes (which it surely will), is the timing. Well, not just the timing, but the yields on offer consistent with that timing. With the benefit of hindsight it would have been no bad thing to be coerced into buying US Treasuries when they yielded, say, 16% (the chart below shows generic 10 year yields going back to 1979; source: Bloomberg). But now that they yield 2% or so (a negative real yield of 1% or so using official inflation data), well, who wants that ? Answer: not foreign central banks, many of whom have stopped buying this yieldless junk.

But somebody will have to buy it. As bank-robbers and their public sector rivals, governments, know, if you need money, go where the money is. Napier points out that previous peaks in the corporate profit-to-GDP ratio were 1966, 1997 and 2006. Subsequent long-term returns from equities were uniformly poor. As he makes clear, there is a difference between central banks and the private sector when it comes to buying government debt. Central banks can print money to finance their purchases, which makes them more or less wholly price-insensitive. But the private sector cannot print money — it will be forced to sell other assets to pay for the government debt it will soon be coerced into buying. Perhaps some of those other assets will be stocks. Stocks will get smashed in any case, because the private sector will also have to get used to paying more tax. (The government will get its money one way or another.) More tax = lower net profits, obviously. Tax paid by corporations is close to its average level of the past 30 years. More awkwardly, the federal debt to GDP ratio over the same period, Napier observes, has risen from 32% to 100%. The UK faces a similar problem, which makes the current euphoria in FTSE-land just as difficult to rationalise. Absent QE, and given the potential for a rather messy bang emanating from Greece over the coming months, and accepting an economy facing dollops of austerity well into the future, should UK stock markets really be as euphoric as they currently are ?

UK government bonds are comparably unattractive to their American cousins. The chart below (source: Bloomberg) shows generic 10 year Gilt yields over the past 20 years. Being forced to buy them at 10% might not have been so bad. Being bludgeoned into buying them at 2% will be a little more painful.

So how precisely will governments go about stealing savers’ money ? The Dutch pensions regulator gave an indication of one possible wheeze back in February 2011 when it ordered the Stichting Pensioenfonds Vereenigde Glasfabrieken (bless you !) pension fund to sell its gold holdings (13% of the fund) on the premise that it was too risky.

In an NBER paper last year, Carmen Reinhart and M. Belen Sbrancia pointed the way. As their abstract states,

Historically, periods of high indebtedness have been associated with a rising incidence of default or restructuring of public and private debts. A subtle type of debt restructuring takes the form of financial repression.

Financial repression includes directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between governments and banks.. Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt. Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation

The UK government has already achieved partial control of directed lending given that it owns half of our banking system. (Not that it seems to know how to control its remuneration. But then it is practically a binding characteristic of governments to be half-assed about virtually everything.) Both of the Anglo-Saxon economies have also achieved saver theft status by the manipulation of interest rates. Next on the list will be a creeping abuse of those captive domestic audiences and, perhaps, regulation on capital controls.

Very few of these will actually be novelties. The US previously had Regulation Q, for example, which put a government-sanctioned limit on the interest rates available for savings deposits. Indeed Reinhart and Sbrancia point out that the widespread use of such policies between 1945 and 1980 has been‚ ‘collectively forgotten’. We have had half a century of increasingly free markets. In the official governmental version of reality, those markets became too free, and now require the firm hand of the state. Governments are unlikely to acknowledge the extent to which their own untenable borrowings laid the groundwork for the financial crisis.

Highly paid shills for the status quo on Wall Street have recently been wheeled out to observe the fundamental ugliness of western government bonds. They are correct. This is an asset class that has managed to defy the laws of economics in becoming ever more expensive even as its supply swells. Their response has been to recommend piling into stocks instead. The logic here is not so pristine. If Napier’s thesis is correct, the West faces a period of outright deflation, which will be deeply traumatic for exactly the sort of speculative stocks that have lately done so well. Admittedly, the picture is confused, and prone to all sorts of political horseplay, as observers of the long-running euro zone farce can attest. Nevertheless, when faced with a) huge underlying uncertainties; b) structurally unsound banking and government finances; and c) central banks determinedly priming the monetary pumps, we conclude that the last free lunch in investment markets remains diversification. G7 government bond markets are a waste of time (though you may end up being cattle-prodded into them regardless). But there are still investment grade sovereign markets offering positive real yields. Stock markets are partying like 1999. Which, in many cases, it probably is. We would normally advise to enjoy the party but dance near the door. This time round, we weren’t invited to the party — and we don’t mind in the slightest.