In 1985, Arnold Schwarzenegger played John Matrix in the action movie, Commando. One line stands out. While dangling a bad guy over the edge of a cliff Matrix said, “Remember, Sully, when I promised to kill you last?” The frantic man replied, and Matrix added, “I lied.” He let Sully go.
Thomas Jordan, Chairman of the Governing Board of the Swiss National Bank (SNB), must be channeling John Matrix. On December 18, 2014 Jordan said, “The SNB remains committed to purchasing unlimited quantities of foreign currency to enforce the minimum exchange rate with the utmost determination.” Last Thursday, not even a month later—he said, “The Swiss National Bank (SNB) has decided to discontinue the minimum exchange rate…”
Schwarzenegger said it better. Besides, Commando was just a work of fiction. Central bankers toy with people’s livelihoods. Several currency brokers have already failed, only one day after this reversal.
When a central bank attempts to peg its currency, it’s usually trying to stave off collapse. The bank must sell its foreign reserves—typically dollars—to buy its own currency. Recently, the Central Bank of Russia tried this with the ruble. It never lasts long. The market can see the dwindling dollar reserves, and pounces when the bank is vulnerable.
The SNB attempted the opposite, selling its own currency to buy euros. It faced no particular limit on how many francs it could sell. Despite that, the market kept testing its willpower. Here is a graph showing the price of the euro in Switzerland. The SNB’s former line in the sand, is drawn in red, a euro price of 1.2 francs.
The price of the euro was falling the whole year. Jordan’s promise caused but a blip. The pressure must have been intense. So he tried one last trick, familiar to any gambler.
Thomas Jordan bluffed.
He said the SNB is committed and tossed around words like unlimited. The market saw his bet, and raised. That forced him to fold.
I wrote about why the SNB pegged the franc. It wasn’t about exporters, but commercial banks. They borrow francs from their depositors, but lend many euros outside Switzerland. This means they have franc liabilities mismatched with euro assets. When the euro falls, they take losses.
The SNB inflicted this same problem on itself with its intervention. It borrowed in francs, creating a franc liability. This borrowing funded its purchase of euros, which are its asset.
As of November, its balance sheet showed 462 billion francs worth of foreign currencies, and it has disclosed that euros represent just under 50% of that. This puts their euro assets around 230B francs (which probably increased after that). The euro has fallen from 1.2 francs to just under 1.0, or 17%.
On Thursday, the SNB lost at least 38B francs, or 6 percent of Swiss GDP.
Why on earth did it choose to take this loss? It threw the commercial banks under the bus, and got tire tracks on its own back too. Without being privy to its internal discussions, we can make an educated guess.
The SNB hit its stop loss.
As traders kept buying francs, the SNB was obliged to keep increasing its bet. Its exposure to euro losses was growing. To continue meant more euro exposure on the same capital base—rising leverage. It chose to realize a big loss now, rather than continue marching towards insolvency.
The market is much bigger than the Swiss National Bank. If the citizens of insolvent states like Greece want to sell their euros for francs to deposit in Swiss banks, and if hedge funds and currency traders want to bet on the franc then the SNB can’t stop that freight train.
Everyone who holds francs is happy, because the franc went up. However, the fallout has just begun. Franc holders will discover that they are creditors. They can’t rejoice for long at their debtors’ pain. Pain will one day morph into defaults. Soon enough the franc will abruptly reverse. Who will bid on a defaulted bond, or a currency backed by it?
The game of floating paper currencies is not zero-sum, but negative-sum. Every move destroys someone’s capital. On Thursday, the SNB admitted it lost 38B francs. How much did commercial banks, pension funds, and other debtors in Switzerland lose in addition?
Greece is back in the spotlight amid renewed fears of a break-up of the Euro as the Syriza party show a 3.1% lead over the incumbent New Democracy in the latest Rass opinion poll – 4thJanuary. The average of the last 20 polls – dating back to 15th December shows Syriza with a lead of 4.74% capturing 31.9% of the vote.
These election concerns have become elevated since the publication of an article in Der Spiegel Grexit Grumblings: Germany Open to Possible Greek Euro Zone Exit -suggesting that German Chancellor Merkel is now of the opinion that the Eurozone (EZ) can survive without Greece. Whilst Steffen Seibert – Merkle’s press spokesman – has since stated that the “political leadership” isn’t working on blueprints for a Greek exit, the idea that Greece might be “let go” has captured the imagination of the markets.
A very different view, of the potential damage a Greek exit might cause to the EZ, is expressed by Market Watch – Greek euro exit would be ‘Lehman Brothers squared’: economistquoting Barry Eichengreen, speaking at the American Economic Association conference, who described a Greek exit from the Euro:-
In the short run, it would be Lehman Brothers squared.
Writing at the end of last month the Economist – The euro’s next crisis described the expectation of a Syriza win in the forthcoming elections:-
In its policies Syriza represents, at best, uncertainty and contradiction and at worst reckless populism. On the one hand Mr Tsipras has recanted from his one-time hostility to Greece’s euro membership and toned down his more extravagant promises. Yet, on the other, he still thinks he can tear up the conditions imposed by Greece’s creditors in exchange for two successive bail-outs. His reasoning is partly that the economy is at last recovering and Greece is now running a primary budget surplus (ie, before interest payments); and partly that the rest of the euro zone will simply give in as they have before. On both counts he is being reckless.
In theory a growing economy and a primary surplus may help a country repudiate its debts because it is no longer dependent on capital inflows.
The complexity of the political situation in Greece is such that the outcome of the election, scheduled for 25th January, will, almost certainly, be a coalition. Syriza might form an alliance with the ultra-right wing Golden Dawn who have polled an average of 6.49% in the last 20 opinion polls, who are also anti-Austerity, but they would be uncomfortable bedfellows in most other respects. Another option might be the Communist Party of Greece who have polled 5.8% during the same period. I believe the more important development for the financial markets during the last week has been the change of tone in Germany.
The European bond markets have taken heed, marking down Greek bonds whilst other peripheral countries have seen record low 10 year yields. 10 year Bunds have also marched inexorably upwards. European stock markets, by contrast, have been somewhat rattled by the Euro Break-up spectre’s return to the feast. It may be argued that they are also reacting to concerns about collapsing oil prices, the geo-political stand-off with Russia, the continued slow-down in China and other emerging markets and general expectations of lower global growth. In the last few sessions many stock markets have rallied strongly, mainly on hopes of aggressive ECB intervention.
Unlike the Economist, who are concerned about EZ contagion, Brookings – A Greek Crisis but not a Euro Crisis – sees a Euro break-up as a low probability:-
A couple of years ago the prospect of a Syriza-led government caused serious tremors in European markets because of the fear that an extremely bad outcome in Greece was possible, such as its exit from the Euro system, and that this would create contagion effects in Portugal and other weaker nations. Fortunately, Europe is in a much better situation now to withstand problems in Greece and to avoid serious ramifications for other struggling member states. The worst of the crisis is over in the weak nations and the system as a whole is better geared to support those countries if another wave of market fears arise.
It is quite unlikely that Greece will end up falling out of the Euro system and no other outcome would have much of a contagion effect within Europe. Even if Greece did exit the Euro, there is now a strong possibility that the damage could be confined largely to Greece, since no other nation now appears likely to exit, even in a crisis.
Neither Syriza nor the Greek public (according to every poll) wants to pull out of the Euro system and they have massive economic incentives to avoid such an outcome, since the transition would almost certainly plunge Greece back into severe recession, if not outright depression. So, a withdrawal would have to be the result of a series of major miscalculations by Syriza and its European partners. This is not out of the question, but the probability is very low, since there would be multiple decision points at which the two sides could walk back from an impending exit.
I think The Guardian – Angela Merkel issues New Year’s warning over rightwing Pegida group – provides an insight into the subtle change in Germany’s stance:-
German chancellor Angela Merkel in a New Year’s address deplored the rise of a rightwing populist movement, saying its leaders have “prejudice, coldness, even hatred in their hearts”.
In her strongest comments yet on the so-called Patriotic Europeans Against the Islamisation of the West (Pegida), she spoke of demonstrators shouting “we are the people”, co-opting a slogan from the rallies that led up to the fall of the Berlin Wall 25 years ago.
“But what they really mean is: you are not one of us, because of your skin colour or your religion,” Merkel said, according to a pre-released copy of a televised speech she was to due to deliver to the nation on Wednesday evening.
“So I say to all those who go to such demonstrations: do not follow those who have called the rallies. Because all too often they have prejudice, coldness, even hatred in their hearts.”
Concern about domestic politics in Germany and rising support for the ultra right-wing Pegida party makes the prospect of allowing Greece to leave the Euro look like the lesser of two evils. Yet a Greek exit and default on its Euro denominated obligations would destabilise the European banking system leading to a spate of deleveraging across the continent. In order to avert this outcome, German law makers have already begun to soften their “hard-line” approach, extending the olive branch of a potential renegotiation of the terms and maturity of outstanding Greek debt with whoever wins the forthcoming election. I envisage a combination of debt forgiveness, maturity extension and restructuring of interest payments – perish the thought that there be a sovereign default.
Last month the BIS – Financial stability risks: old and new caused alarm when it estimated non-domestic US$ denominated debt of non-banks to be in the region of $9trln:-
Total outstanding US dollar-denominated debt of non-banks located outside the United States now stands at more than $9 trillion, having grown from $6 trillion at the beginning of 2010. The largest increase has been in corporate bonds issued by emerging market firms responding to the surge in demand by yield-hungry fixed income investors.
Within the EZ the quest for yield has been no less rabid, added to which, risk models assume zero currency risk for EZ financial institutions that hold obligations issued in Euro’s. The preferred trade for many European banks has been to purchase their domestic sovereign bonds because of the low capital requirements under Basel II. Allowing banks to borrow short and lend long has been tacit government policy for alleviating bank balance sheet shortfalls, globally, in every crisis since the great moderation, if not before. The recent rise in Greek bond yields is therefore a concern.
An additional concern is that the Greek government bond yield curve has inverted dramatically in the past month. The three year yields have risen most precipitously. This is a problem for banks which borrowed in the medium maturity range in order to lend longer. Fortunately most banks borrow at very much shorter maturity, nonetheless the curve inversion represents a red flag : –
Over the same period Portuguese government bonds have, so far, experienced little contagion:-
Greece received Euro 245bln in bail-outs from the Troika; if they should default, the remaining EZ 17 governments will have to pick up the cost. Here is the breakdown of state guarantees under the European Financial Stability Facility:-
||Guarantee Commitments Eur Mlns
Assuming the worst case scenario of a complete default – which seems unlikely even given the par less state of Greek finances – this would put Italy on the hook for Eur 43bln, Spain for Eur 28.5bln, Portugal for Eur 6bln and Ireland for Eur 3.8bln.
The major European Financial Institutions may have learned their lesson, about over-investing in the highest yielding sovereign bonds, during the 2010/2011 crisis – according to an FTinterview with JP Morgan Cazenove, exposure is “limited” – but domestic Greek banks are exposed. The interconnectedness of European bank exposures are still difficult to gauge due to the lack of a full “Banking Union”. Added to which, where will these cash-strapped governments find the money needed to meet this magnitude of shortfall?
The ECBs response
In an interview with Handelsblatt last week, ECB president Mario Draghi reiterated the bank’s commitment to expand their balance sheet from Eur2 trln to Eur3 trln if conditions require it. Given that Eurostat published a flash estimate of Euro area inflation for December this week at -0.2% vs +0.3% in November, I expect the ECB to find conditions requiring a balance sheet expansion sooner rather than later. Reuters – ECB considering three approaches to QE – quotes the Dutch newspaper Het Financieele Dagbad expecting one of three actions:-
…one option officials are considering is to pump liquidity into the financial system by having the ECB itself buy government bonds in a quantity proportionate to the given member state’s shareholding in the central bank.
A second option is for the ECB to buy only triple-A rated government bonds, driving their yields down to zero or into negative territory. The hope is that this would push investors into buying riskier sovereign and corporate debt.
The third option is similar to the first, but national central banks would do the buying, meaning that the risk would “in principle” remain with the country in question, the paper said.
The issue of “monetary financing” – forbidden under Article 123 of the Lisbon Treaty – has still to be resolved, so Outright Monetary Transactions (OMT) in respect of EZ government bonds are still not a viable policy option. That leaves Covered bonds – a market of Eur 2.6trln of which only around Eur 600bln are eligible for the ECB to purchase – and Asset Backed Securities (ABS) with around Eur 400bln of eligible securities. These markets are simply not sufficiently liquid for the ECB to expand its balance sheet by Eur 1trln. In 2009 they managed to purchase Eur 60bln of Covered bonds but only succeeded in purchasing Eur 16.9bln of the second tranche – the bank had committed to purchase up to Eur 40bln.
Since its inception in July 2009 the ECB have purchased just shy of Eur 108bln of Covered bonds and ABS: –
||Total Eur Mlns
|Covered Bonds 1
|Covered Bonds 2
|Covered Bonds 3
|* Original purchase Eur 60bln
These amounts are a drop in the ocean. If the ECB is not permitted to purchase government bonds what other options does it have? I believe the alternative is to follow the lead set by the Bank of Japan (BoJ) in purchasing corporate bonds and common stocks. To date the BoJ has only indulged in relatively minor “qualitative” easing; the ECB has an opportunity to by-pass the fragmented European banking system and provide finance and permanent capital directly to the European corporate sector.
Over the past year German stocks has been relatively stable whilst Greek equities, since the end of Q2, have declined. Assuming Greece does not vote to leave the Euro, Greek and other peripheral European stocks will benefit if the ECB should embark on its own brand of Qualitative and Quantitative Easing (QQE):-
Source: Bloomberg Note: Blue = Athens SE Composite Purple = DAX
It is important to make a caveat at this juncture. The qualitative component of the BoJ QQE programme has been derisory in comparison to their buying of JGBs; added to which, whilst the socialisation of the European corporate sector is hardly political anathema to many European politicians it is a long way from “lending at a penal rate in exchange for good collateral” – the traditional function of a central bank in times of crisis.
Conclusion and investment opportunities
European Government Bonds
Whilst the most likely political outcome is a relaxation of Article 123 of the Lisbon Treaty, allowing the ECB, or the national Central Bank’s to purchase EZ sovereign bonds, much of the favourable impact on government bond yields is already reflected in the price. 10 year JGBs – after decades of BoJ buying – yield 30bp, German Bunds – without the support of the ECB – yield 46bp. Aside from Greek bonds, peripheral members of the EZ have seen their bond yields decline over the past month. If the ECB announce OMT I believe the bond rally will be short-lived.
Given the high correlation between stocks markets in general and developed country stock markets in particular, it is dangerous to view Europe in isolation. The US market is struggling with a rising US$ and collapsing oil price. These factors have undermined confidence in the short-term. The US market is also looking to the Europe, since a further slowdown in Europe, combined with weakness in emerging markets act as a drag on US growth prospects. On a relative value basis European stocks are moderately expensive. The driver of performance, as it has been since 2008, will be central bank policy. A 50% increase in the size of the ECB balance sheet will be supportive for European stocks, as I have mentioned in previous posts, Ireland is my preferred investment, with a bias towards the real-estate sector.
Whilst the EUR/USD rate continues to decline the Nominal Effective Exchange Rate as calculated by the ECB, currently at 98, is around the middle of its range (81 – 114) since the inception of the currency and still some way above the recent lows seen in July 2012 when it reached 94. The October 2000 low of 81 is far away.
If a currency war is about to break-out between the major trading nations, the Euro doesn’t look like the principal culprit. I expect the Euro to continue to decline, except, perhaps against the JPY. Against the GBP a short EUR exposure will be less volatile but it will exhibit a more political dimension since the UK is a natural safe haven when an EZ crisis is brewing.
2014 ended with two ominous developments: the strength of the US dollar and a collapse in key commodity prices.
It is tempting to view both events as one, but the continuing fall in oil prices through December reveals they are sequential: first there was a greater preference for dollars compared with other currencies and this still persists, followed by a developing preference for all but the weakest currencies at the expense of raw materials and energy. These are two steps on a path that should logically lead to a global slump.
Dollar strength was the first warning that things were amiss, leading to higher interest rates in many of the emerging economies as their central banks sought to control investment outflows. Since this followed a prolonged period of credit expansion these countries appear to be entering the bust phase of the credit-driven boom-and-bust cycle; so for them, 2015 at a minimum will see a slump in economic activity as the accumulated malinvestments from the past are unwound. According to the IMF database, emerging market and developing economies at current prices account for total GDP of over $30 trillion, compared with advanced economies’ GDP totalling $47 trillion. It is clear that a slump in the former will have serious repercussions for the latter.
As the reserve currency the dollar is central to the exchange value of all other currencies. This is despite attempts by China and Russia to trade without it. Furthermore and because of this dependency, the global economy has become more geared to the dollar over the years because it has expanded relative to the US. In 2000, the US was one-third of global GDP; today it is about one-fifth.
The second development, falling energy and commodity prices, while initially driven by the same factors as dollar strength, confirms the growing likelihood of a global slump. If falling prices were entirely due to increased supply of the commodities involved, we could rejoice. However, while there has been some increase in energy and commodity supply the message is clear, and that is demand at current prices has unexpectedly declined, and prices are now trying to find a new equilibrium. And because we are considering world demand, this development is being missed or misread by economists who lack a global perspective.
The price of oil has approximately halved in the last six months. The fall has been attributed variously to the west trying to bankrupt Russia, or to Saudi Arabia driving American shale production out of business. This misses the bigger picture: according to BP’s Statistical Review 2014, at the beginning of last year world oil consumption comfortably exceeded supply, 91.3million barrels per day compared with 86.8. This indicates that something fundamental changed in 2014 to collapse the price, and that something can only be a sudden fall in demand in the second half.
Iron ore prices have also halved over the last six months, but other key commodities, such as copper which fell by only 11% over the period, appear to have not yet adjusted to the emerging markets slump. This complies with business cycle theory, because in the early stages of a slump businesses remain committed to their capital investment plans in the vain hope that conditions will improve. This being the case, the collapse in demand for energy can be expected to deepen and spread to other industrial raw materials as manufacturers throw in the towel and their investment plans are finally abandoned.
Therefore the economic background to the financial outlook for the global economy is not encouraging. Nor was it at the beginning of 2014, when it was obviously going to be a difficult year. The difference a year on is that the concerns about the future are more crystallised. This time last year I wrote that we were heading towards a second (to Lehman) and unexpected financial and currency crisis that could happen at any time. I only modify that to say the crisis has indeed begun and it has much further to go this year. This is the background against which we must briefly consider some of the other major currencies, and precious metals.
Japan and the yen
The complacency about Japan in the economic and investment communities is astonishing. Japan is committed to a scale of monetary inflation that if continued can only end up destroying the yen. The Bank of Japan is now financing the equivalent of twice the government deficit (¥41 trillion) by issuing new currency, some of which is being used to buy Japanese equity ETFs and property REITs. By these means pricing in bond, equity and commercial property markets has become irrelevant. “Abenomics” is about financing the government and managing the markets under the Keynesian cover of stimulating both the economy and animal spirits. In fact, with over ¥1.2 quadrillion of public sector debt the government is caught in a debt trap from which it sees no escape other than bluff. And since Abenomics was first embarked upon two years ago, the yen has fallen from 75 to the US dollar to 120, or 37%.
Instead of learning the lessons of previous hyperinflations, mainstream economists fall for the official line and ignore the facts. The facts are simple: Japan is a welfare state with an increasing and unsustainable ratio of retirees to tax-paying workers. She is the leading advanced nation on a debt path the other welfare nations are closely following. Consensus forecasts that the Japanese economy will be stimulated into recovery in 2015 are wide of the mark: instead she is destroying her currency and private sector wealth with it.
Eurozone and the euro
In the short-term the Eurozone is being revisited by its Greek problem. Whether or not the next Greek government backs off from confronting the other Eurozone members and the ECB remains to be seen. The problems for the Eurozone lie considerably deeper than Greece, made worse by politicians who have been reluctant to use the time bought by the ECB to address the structural difficulties of the 19 Eurozone members. The result is the stronger northern bloc (Germany, Netherlands, Finland and Luxembourg) is being crippled by the burden of the Mediterranean states plus Portugal plus France. And Germany and Finland have suffered the further blow of losing valuable export business from Russia.
In the coming months the Eurozone will likely face gas shortages from Russia through the trans-Ukrainian pipeline, and price deflation driven by energy and other commodity prices. Price deflation spurs two further points to consider, one false and the other true: lower prices are deemed to be recessionary (false), and falling prices increase the burden of real debt (true). The consequence is that the ECB will seek ways to expand money supply aggressively to stop the Eurozone from drifting into an economic crisis. In short, the Eurozone will likely develop its own version of Abenomics, the principal difference being the Eurozone’s timeline is behind Japan’s.
US and UK
Japan and the Eurozone account for total GDP of $18.3 trillion, slightly more than the US and added to the emerging and developing economies, gives a total of $48 trillion, or 62% of global GDP for nations leading the world into a slump. So when we consider the prospects for the US and the UK, together producing $20.4 trillion or 26% of the world’s GDP, their prospects are not good either. The UK as a trading nation exposed to the Eurozone has immediate risk, while the US which is not so dependent on international trade, less so.
The foregoing analysis is of the primary economic drivers for 2015 upon which all else will ultimately depend. The risk of a global slump can be called a first order event, while the possibility of a banking crisis, derivatives default or other market dislocation brought on by a slump could be termed a second order event. There is no point in speculating about the possibility and timing of second order events occurring in 2015, because they ultimately depend on the performance of the global economy.
However, when it becomes clear to investors that the global economy is indeed entering a slump, financial and systemic risks are certain to escalate. Judging this escalation by monitoring markets will be difficult because central banks, exchange stability funds and sovereign wealth funds routinely intervene in markets, rendering them misleading as price signals.
Precious metals are the only assets beyond the long-term control of governments. They can distort precious metal markets in the short term by expanding the quantity of derivatives, and there is a body of evidence that these methods have been employed in recent years. But most price distortion today appears to have come from bullion and investment banks who are fully committed to partying in bonds, equities and derivatives, and for which gold is a spoiler. This complacency is bound to be undermined at some point, and a global economic slump is the likely catalyst.
The dangers of ever-inflating currencies are clearly illustrated by the Fiat Money Quantity, which has continued to expand at an alarming rate as shown in the chart below.
FMQ measures the amount of fiat currency issued as a replacement for gold as money, so is a measure of unbacked monetary expansion. At $13.52 trillion last November it is $5.68 trillion above the long-established pre-Lehman crisis growth path, stark evidence of a depreciating currency in monetary terms. Adjusting the price of gold for this depreciation gives a price today the equivalent of $490 in dollars at that time and quantity, so gold has roughly halved in real currency terms since the Lehman crisis.
There is compelling evidence that 2015 will see a global slump in economic activity. This being the case, financial and systemic risks will increase as evidence of the slump accumulates. It can be expected to undermine global equities, property and finally bond markets, which are currently all priced for economic stability. Even though these markets are increasingly controlled by central bank intervention, it is dangerous to assume this will continue to be the case as financial and systemic risks accumulate.
Precious metals are ultimately free from price management by the state. Furthermore, they are the only asset class notably under-priced today, given the enormous increase in the quantity of fiat money since the Lehman crisis.
In short, 2015 is shaping up to be very bad for fiat currencies and very good for gold and silver.
Recent dollar strength has been a surprise to many but a strong dollar was also a key component of the Asian currency crises of 1997-98. These contributed to sharply lower oil prices, which in turn helped to trigger the 1998 Russian debt default, European bond spread de-convergence and spectacular blowup of hedge-fund Long Term Capital Management (LTCM). It is worth recalling that, when LTCM failed, the dollar abruptly gave up a full year of gains. While history rhymes rather than repeats, I suspect something comparable is likely in 2015, although with US total economy debt much higher, the potential for a sharp decline in the dollar is that much greater.
Back when I managed macro strategy teams at investment banks, I had a simple set of guidelines that I required junior strategists to follow when making investment recommendations, that is, in addition to those required by the firm or the regulators. These included:
- Recommendations must be supported by a broad range of fact-checked evidence, rather than one or two ‘cherry-picked’ pieces;
- Recommendations must be ‘actionable’ in a practical way by the target clients and one or more of these must be specified;
- Recommendations must not only provide a specific price (or return) target, but also an estimate of risk (or volatility) and reference to a specific time horizon;
- Recommendations must include one or more conditions under which the particular investment would no longer be as attractive, if at all.
In practice, most analysts managed in their initial draft recommendations to follow the first two but struggled when it came to the third and fourth. The reason for this is most probably the inclination that many if not all quantitative-analytical types have for expecting that financial assets be priced ‘correctly’, according to whatever analytical framework is applied. If something is out of line, so the thinking goes, it should start correcting as soon as the analysis in question is complete and should completely correct over the short-to-medium term time horizon of primary importance to the bulk of those active in the investment management industry.
While that might seem reasonable, the problem is that, notwithstanding claims to the contrary, investors are not rational. Indeed, I would hold that no economic actors are rational in any meaningful, measurable way. This is due in part to my view of human nature and modern psychology seems to uncover new ways in which our minds are biased and irrational with each passing day. But if all investment opinions are biased and irrational to some degree, the sum of all such opinions—the financial markets—is most probably also biased and irrational.
So-called ‘behavioural investing’ tries to address these biases in a systematic way in order generate excess investment returns over time with acceptably low risk. However, the problem with any such ‘fight the irrational herd’ approach is, to paraphrase Keynes, “The herd can remain irrational longer than the rational investor can remain solvent.” On top of this there is the added complexity of the so-called ‘beauty contest’, also mentioned by Keynes, in which investors constantly try to out-guess each others’ intentions, irrational, behavioural or otherwise, so what in fact is ultimately decisive in price determination at any point in time arguably has little if anything to do with any underlying, fundamental, rational investment process.
Having been an active investor for many years, I have experienced a number of profit and loss events across a broad range of assets and strategies. In the end, while idea generation, however rudimentary, is necessary to active trading or investing, it is ultimately some aspect of risk management, of knowing when NOT to trade or invest, that often tips the balance between success and failure. Sure, anyone can be ‘smart’ or ‘lucky’ for a time but the irrational herd is far more dangerous to the unusually smart than to the lucky, even though many in the latter category no doubt consider themselves also (or perhaps exclusively) in the former camp.
The fight against irrationality, if one wishes to call it that, is thus one that is overwhelming more likely to be won in the longer-term, over which most investors have only little or no interest. In the economic jargon, investors have high ‘time preference’ to front-load investment returns, by implication taking irrationally large longer-term risks. For institutional investors managing other peoples’ money, it is often a losing business proposition to fight the herd so aggressively as to risk losing clients, even if the investment views implemented ultimately work out longer-term. Holding on to client money month after month, quarter after quarter, year after year, when an apparently irrational market chooses to become ever more irrational is a potentially career-limiting move in the extreme. Thus herd-following, rather than fighting, becomes the industry norm, and those who rise to the top of large asset management organisations do so not because they are great investors but because they are skilled at retaining client assets regardless of the direction in which the irrational herd is travelling.
This natural (if irrational) herding tendency is further exaggerated when economic or monetary officials intervene in order to ‘stabilise’ asset markets, which at least since 1987 has meant to prevent them from correcting violently to the downside. 1. When the herd believes that officials have their backs, they tend to ignore the risks closing in on their backsides for far longer than they ought to. And so the inevitable bubbles that form can continue to grow and grow, yet concern about them fades and fades, as normalcy bias and policy goals converge in a world of ever-rising or at least not falling asset prices.
In this world, biased by policy towards steadily rising asset prices, returns beget leverage, and leveraged returns beget greater leverage. Regulators pretend as if they can manage this and its probable future effects on the financial system and economy, but 2008 and many other manias, panics and crashes that have come and gone before inform us otherwise. Sure, a new regulatory effort is rolled out now and again, to much fanfare: Note the central bankers’ ‘macroprudential’ PR campaign over the past two years. The ivory-tower academic folk who originally propose such measures—or so they claim—applaud on the sidelines while taking implied, self-serving credit. (These academics are equally quick to blame the ‘private sector’ whenever anything goes wrong, as their ideas can’t possibly be at fault.)
I’ve been around long enough to see this dynamic play out on multiple occasions. I also witnessed first-hand the spectacular events of 1997-98, a period with strong parallels to today. Back then, the dollar rose on the false view that the US could decouple from crises abroad. When events abruptly proved otherwise, the dollar gave up a full year’s gains in just two weeks. The same could happen in 2015.
POOR-QUALITY GROWTH, RISING IMBALANCES
Following six years of zero interest rates and QE, the US economy has still failed to resume healthy, sustainable growth. Yes, the economy is growing at present and there have been some pockets of deleveraging. But this amounts to ‘cherry picking’ the range of available evidence and thus fails to adhere to even the first of my guidelines for investment recommendations. Looking behind the numbers in more detail, as I prefer to do, one sees an unbalanced economy that is re-leveraging amid the growth of yet another asset bubble.
Now my mainstream economic critics will scoff at this, pointing to the recently-released Q3 GDP report, for example, as demonstrating that healthy US growth has resumed. But when you look behind the numbers at the composition, the quality of the growth, it remains poor. One way to do this is to strip out the volatile inventory cycle and see what remains of ‘core’ GDP growth, referred to as ‘real final sales’. US real final sales growth has been positive over the past few years but, notwithstanding massive policy stimulus, has barely managed to rise above 2% year-over-year. Past recoveries have seen rates two to three times higher.
‘CORE’ GDP GROWTH STUCK AROUND 2% Y/Y
If you go one step further and strip out population growth, what remains is a per-capita core growth rate of little more than zero. And what has it taken to achieve this near zero rate of per-capita growth? Why, huge government deficits which have not been spent on long-term infrastructure investment but rather programmes designed to promote current consumption. Moreover, households have been re-leveraging following a period of sharp retrenchment in 2008-9. The savings rate, averaging about 4.5% over the past few years, is only marginally higher than it was in the bubble years of 2004-7.
HOUSEHOLD LEVERAGE HAS SOARED AGAIN…
…AS THE SAVINGS RATE HAS DECLINED ANEW
There was some material deleveraging of corporate balance sheets in 2009-12 but that has now given way to re-leveraging. Much of this is occurring via share buy-backs, which were all the rage in 2014, perhaps because without them, earnings per share would not have risen by much, if at all, given now-negative US corporate profit growth.
Now this may be the first you have heard about ‘negative’ US corporate profit growth. But if you look at profits not in the ‘pro-forma’ way that corporations present them to shareholders but in how they actually report them for official pourposes according to the methodology used in the national accounts, this is precisely what you see.
CORPORATE PROFIT GROWTH NOW NEGATIVE
This is not to say that the huge monetary and fiscal stimulus in the wake of the GFC had no effect. No, it had a huge effect. But that effect was primarily to bring future consumption artificially forward and thereby to reduce the savings available to provide for investment and future consumption. Eminent Austrian Economist Ludwig von Mises famously claimed that this was akin to “burning the furniture to heat the home.” (The pernicious effects of capital consumption are discussed in greater detail here.)
The fact is that the US is not saving enough to provide for current much less future consumption and thus must continue to borrow from the rest of the world. While the US trade deficit is not as large today as it was back in the bubble years of 2004-7—in large part due to increased domestic energy production—it remains sizeable in a historical comparison and, of course, adds to the enormous cumulative deficit that already exists.
US STILL DEPENDENT ON FOREIGN CAPITAL
So not only is US growth not on a sustainable path; to the extent there is growth, much of it is being financed with US-issued IOUs (ie dollars). The dollar may be strong at present due to flows out of various underperforming emerging markets. But this should not disguise the fact that the US economy cannot possibly decouple from the rest of the world when it is in fact highly dependent on the rest of the world as a source of financing.
DECLINING OIL PRICES ARE A KEY MECHANISM OF AN INEVITABLE RECOUPLING
Much us external financing is in the form of recycled ‘petrodollars’ from the larger oil-exporting countries such as Saudi Arabia, who take oil revenues and invest them in US assets such as Treasury bonds. This has two inter-related effects, supporting demand for the US dollar and helping to hold down US interest rates. As oil prices decline, however, so do oil revenues, in particular if global demand is declining, as it appears to be doing. This implies less recycling of petrodollars.
While in theory declining oil prices are supportive of growth, this is true only to the point that the financial system is not leveraged to oil revenues. Russia’s 1998 default on its external debt is a classic case in point. All of a sudden what appeared a benign development for the US economy was anything but, as through various financial linkages, the US financial system was in fact exposed to a sharp decline in global oil revenues.
Global liquidity, sloshing as it does from place to place, is much like the tides of the oceans. Local observers in different locations might not notice or care that a high tide in one place implies a low tide in another. But the global observer knows better: An extreme high tide in one part of the world will correspond to an extreme low tide elsewhere. But these need not occur simultaneously, as the flow from high to low between locations can take time.
Collapsing oil revenues were the proximate trigger for Russia’s 1998 decision to default on its external debt. European banks were among Russia’s primary creditors and thus they had to liquidate holdings of peripheral EU debt in order to raise capital. This pushed peripheral bond spreads sharply wider, reversing the trend in leveraged euro ‘convergence trades’ in the run-up to European monetary union. LTCM was one of the largest, most highly-leveraged followers of this strategy and found it suddenly faced huge losses potentially exceeding its capital. LTCMs creditors—primarily bulge-bracket Wall Street banks—demanded additional collateral be posted immediately. But there wasn’t enough high-quality collateral to go around and so the price of the highest-quality collateral—US Treasury bonds—soared to records in the scramble.
The Fed soon realised the scale of the potential danger: A default cascading through the heart of Wall Street. It thus placed pressure on all LTCM’s creditors to agree to a plan to ease off on collateral calls, allowing for an orderly unwind of positions. In return, the Fed would lower interest rates, to the benefit of all participants.
While these actions succeeded in containing the damage, they signalled to the world that the US financial system was in fact highly leveraged to the international financial markets and thus exposed indirectly to the serial crises elsewhere. Moreover, the Fed was willing to lower interest rates as required to bail out the US financial system. Hence the dollar was not the safe-haven it was previously thought to be and suddenly plunged in value, wiping out an entire year’s gains in a violent, two-week selloff.
A YEAR’S DOLLAR GAINS ERASED IN WEEKS
The US stock market also took notice, falling sharply as the re-coupling of the US to global reality set in. It was not until the Fed announced the LTCM bail out and rate cuts that the stock market began to recover.
Over the next two years, it did more than merely recover. With Fed policy actions having stimulated aggressive herd buying of equities, the NASDAQ crack-up boom took place, followed by the inevitable bust of 2001-03.
…AND A MAJOR STOCK MARKET CORRECTION
DE-CONVERGENCE HAS RUN A LONG WAY; RE-CONVERGENCE COULD OCCUR AT ANY TIME
The parallels with 1997-98 are increasingly clear. Currencies, asset markets and growth have slumped across Asia and Europe, yet US financial markets have been largely unaffected, happily continuing to climb. The dollar has strengthened steadily. Yet in the sharp decline in oil and other commodity prices we see a mechanism in motion that, in some way yet unseen, will eventually choke off the flow of liquidity into US financial markets. While I don’t anticipate that Russia will default this time round—Russia’s external government debt is tiny—there are a number of other countries out there highly dependent on commodity exports for external debt service.
Indonesia and Malaysia are two cases in point, the former being a relatively large emerging market economy. Sharp weakness in these countries’ currencies of late is an indication of growing stress eerily similar to 1997. Either or both of these countries could soon find they are unable to prevent large withdrawals of foreign capital. But devaluing a currency to deal with a balance-of-payments crisis doesn’t work as the problem is external debt denominated in a foreign currency, in this case dollars. The International Monetary Fund might try to come to the rescue, as it did in 1997-98, but the scale of the problem is far larger this time round.
Also worth mentioning here is something rather closer to home. The US shale industry is hugely dependent on leveraged financing from the US banking and shadow banking systems. (The latter uses structured financing vehicles of various kinds. By some estimates as much as a quarter of the entire US high yield debt market is related to the shale industry in some way.) With crude oil prices now plunging below $50/bbl, a huge portion of shale oil production has become unprofitable. Yet with debt to service, producers have no choice but to continue producing as much oil as they can. This will help to keep a lid on prices but will also bleed the most poorly financed producers to the point of insolvency and default, with potentially grave implications for the US financial system. (Some readers may recall the Texas oil, property and savings and loan collapse of the late 1980s, a key contributor to the eventual federal bail out of the entire US savings and loan industry.)
There are thus several ways in which today’s commodity price bust could turn into a more general financial crisis, as in 1997-98. It is impossible to know. But in my opinion, unless commodity prices soon recover, it is only a matter of time before a wave of balance-of-payment crises and/or corporate insolvences begin to dissolve the pillars of sand on which the strong dollar currently stands.
STRATEGIES FOR A DOLLAR REVERSAL
Those investors who agree that dollar strength is likely to reverse, perhaps abruptly, in 2015, should consider now those strategies that will perform well in that sort of environment.
There are various ways to speculate on a weaker dollar, the most straightforward of which is to short the dollar against other currencies in the foreign exchange markets. The difficultly with this, however, is that investors then need to take a view regarding which currencies are most likely to re-strengthen versus the dollar. Given that many countries would oppose currency strength at present, investors should take care. A diversified approach is probably best, and there are various vehicles that exist for this purpose, including the Merk currency funds. (Disclosure: Axel Merk is a personal friend I have known for many years. However I have no financial interest in his funds, nor do I receive commissions or compensation of any sort for recommending them.)
However, given that many countries might resist currency strength, the case can be made that gold has more upside potential in a dollar reversal. Moreover, if the environment turns decidedly risk-averse, as it did in 1998 for example, gold can benefit two-fold. Last year, Axel Merk launched the Merk Gold Trust (NYSE: OUNZ), a vehicle that allows for investors to take physical delivery of their gold, if desired, without this qualifying as a taxable event.
Gold’s poor sister silver is arguably better value at present, although in a risk-off environment it would be normal for gold to outperform silver. A simple diversification compromise would be to allocate 2/3 to gold and 1/3 to silver. This is because silver is normally about twice as volatile as gold. From a risk perspective, this implies an equal risk weighting in each of these two monetary metals. There are ETFs available that can be rebalanced periodically to keep holdings from drifting too far from the target 2/3 and 1/3 allocations.
Finally, a quick word on oil. While I have written above about the potentially negative financial market consequences of the recent, sharp decline in oil prices, there is of course much underlying demand for oil that is not particularly cyclical in nature but will occur even in a weak or zero-growth environment. Here I note that, even in the depths of the 2008 crisis, the oil price (WTI) found support around $40/bbl before recovering. At just under $50/bbl at time of writing, that is still a 20% decline from here, but the eventual upside recovery potential is probably far greater than 20%. For investors willing to take a risk amid what admittedly appears to be a ‘blood on the streets’ environment for oil at present, I’d recommend building a position here, either through an ETF or just by buying shares of upstream oil producers.
In relative terms, oil looks even better value, for example relative to industrial metals such as copper or aluminium. Yes, the latter have also seen prices come off but not to anywhere near the same extent. Platinum group metals may be precious but they are used overwhelmingly in industrial applications, in particular autocatalysts, and in the event that automobile demand should slow, there is much potential for these to decline relative to the price of oil. Palladium is considerably more exposed than platinum to this scenario and is thus the better short.
The really brave might even take a look at the debt of distressed shale producers, although I have no particular expertise in that area. A distressed industry is one that will likely be restructured in some way, such as by private equity firms swooping in, taking viable companies private, and restructuring them for the longer-term, out of the public spotlight.
1. There is in fact a far longer history of such interventions. In the US these include the devaluation of the US dollar by executive fiat in 1934 and abrogation of Bretton-Woods treaty obligations in 1971.
“Sir, John Authers, in Loser’s Game (The Big Read, December 22), could have delved deeply into the flaws in the asset management business as it has evolved in recent decades, rather than accepting the industry’s own terms or focusing on tweaks to “active” management that might improve results..
“Mr Authers could also have challenged the bureaucratic thinking and methods asset management has adopted in the course of chasing its “bogeys”, starting with the Big Ideas.. Then there are the model portfolios, relative-weightings, “style drift”, investment committees, the requirement to be fully invested and so on — all bog down decision-making and most have nothing to do with genuine investing. In adopting these practices the fund management business has created a recipe for mediocrity.
“In investing, it is never a good idea to do what everyone else is doing. Piling into passive index funds during a year of decidedly poor relative results for active managers, and especially after a long period of rising security prices is likely to lead to future disappointment, just as it did in 1999. This leads us to another line of inquiry for Mr Authers: even assuming “beating” an index is worthwhile, why must we do it all of the time? It is a paradox of investment that in order to do well in the long run, you sometimes have to do “poorly” in the short run. You have to accept the fact that often you will not “beat” an index; sometimes you don’t even want to — think of the Nasdaq in 1999, for example..”
– Letter to the FT from Mr. Dennis Butler, December 30, 2014.
A happy new year to all readers.
For historians, there are primary sources and secondary sources. Primary sources are the original documents that point to the raw history, like the original Magna Carta, for example. Secondary sources are effectively historical derivatives – they incorporate interpretation and analysis. In financial markets, the equivalent of primary sources are prices – the only raw data that speak unequivocally of what occurred by way of financial exchange between buyer and seller. Everything else amounts to interpretation and analysis, and must by definition be regarded as subjective. So-called fundamentals, therefore, are subjective. There is the price – and everything else is essentially chatter.
It says much for the quality and depth of our mainstream media that one of the most insightful and thought-provoking pieces of social and cultural analysis of the last year came in the form of a 5 minute essay within a satirical news review of 2014. The piece in question was by the cult documentary maker Adam Curtis and you can watch it here. The following extracts are taken directly from the film:
“So much of the news this year has been hopeless, depressing, and above all, confusing. To which the only response is to say, “oh dear.”
“What this film is going to suggest is that that defeatist response has become a central part of a new system of political control. And to understand how this is happening, you have to look to Russia, to a man called Vladislav Surkov, who is a hero of our time.
“Surkov is one of President Putin’s advisers, and has helped him maintain his power for 15 years, but he has done it in a very new way.
“He came originally from the avant-garde art world, and those who have studied his career, say that what Surkov has done, is to import ideas from conceptual art into the very heart of politics.
“His aim is to undermine people’s perceptions of the world, so they never know what is really happening.
“Surkov turned Russian politics into a bewildering, constantly changing piece of theatre. He sponsored all kinds of groups, from neo-Nazi skinheads to liberal human rights groups. He even backed parties that were opposed to President Putin.
“But the key thing was, that Surkov then let it be known that this was what he was doing, which meant that no-one was sure what was real or fake. As one journalist put it: “It is a strategy of power that keeps any opposition constantly confused.”
“A ceaseless shape-shifting that is unstoppable because it is undefinable..
“But maybe, we have something similar emerging here in Britain. Everything we’re told by journalists and politicians is confusing and contradictory. Of course, there is no Mr. Surkov in charge, but it is an odd, non-linear world that plays into the hands of those in power.
“British troops have come home from Afghanistan, but nobody seems to know whether it was a victory or whether it was a defeat.
“Ageing disk jockeys are prosecuted for crimes they committed decades ago, while practically no one in the City of London is prosecuted for the endless financial crimes that have been revealed there..
“..the real epicentre of this non-linear world is the economy, and the closest we have to our own shape-shifting post-modern politician is [U.K. Chancellor of the Exchequer] George Osborne.
“He tells us proudly that the economy is growing, but at the same time, wages are going down.
“He says he is reducing the deficit, but then it is revealed that the deficit is going up.
“But the dark heart of this shape-shifting world is Quantitative Easing. The government is insisting on taking billions of Pounds out of the economy through its austerity programme, yet at the very same time it is pumping billions of Pounds into the economy through Quantitative Easing, the equivalent of 24,000 Pounds for every family in Britain.
“But it gets even more confusing, because the Bank of England has admitted that those billions of Pounds are not going where they are supposed to. A vast majority of that money has actually found its way into the hands of the wealthiest five percent in Britain. It has been described as the biggest transfer of wealth to the rich in recent documented history.
“It could be a huge scandal, comparable to the greedy oligarchs in Russia. A ruthless elite, siphoning off billions in public money. But nobody seems to know.
“It sums up the strange mood of our time, where nothing really makes any coherent sense. We live with a constant vaudeville of contradictory stories that makes it impossible for any real opposition to emerge, because they can’t counter it with any coherent narrative of their own.
“And it means that we as individuals become ever more powerless, unable to challenge anything, because we live in a state of confusion and uncertainty. To which the response is: Oh dear. But that is what they want you to say.”
The start of the New Year is traditionally a time for issuing financial forecasts. But there seems little point in doing so given the impact of widespread financial repression on the price mechanism itself. Are prices real, or fake ? The cornerstone of the market structure is the price of money itself – the interest rate. But interest rates aren’t being set by a free market. Policy rates are being kept artificially low by central banks, while the term structure of interest rates has been hopelessly distorted by monetary policy conducted by those same central banks. Inasmuch as ‘real’ investors are participating in the bond market at all, those institutional investors have no personal skin in the game – they are economic agents with no real accountability for their actions. Other institutional players can be confidently assumed simply to be chasing price momentum – they likely have no ‘view’ on valuation, per se. The world’s bond markets have become a giant Potemkin village – nobody actually lives there.
So of the four asset classes to which we allocate, three of them offer at least some protection against the material depradations and endless price distortions of the State. ‘Value’ listed equities give us exposure to the source of all fundamental wealth – the actions of the honest entrepreneur. Systematic trend-following funds are the closest thing we can find to truly uncorrelated investments – and we note how 2014 saw a welcome return to form. The monetary metals, gold and silver, give us Stateless money that cannot be printed on demand by the debt-addicted. We are slowly coming to appreciate the counsel of a friend who suggested that the merit of gold lies not in its price so much as in its ownership. What matters is that you own it. (It also matters why.) Which leaves debt. Objectively high quality debt – a small market and getting smaller by the day.
The practice of sensible investment becomes difficult when our secondary information sources (“fundamentals”) are inherently subjective. It becomes almost impossible when our primary information sources (prices) can’t be trusted because they have politicians’ paw-prints all over them. “Nothing really makes any coherent sense.. We live with a constant vaudeville of contradictory stories.. We live in a state of confusion and uncertainty.” If the pursuit of certainty is absurd, the only rational conclusion is to acknowledge the doubt, and invest accordingly.
At a time of the year when gift giving and charitable good spirit fills the air, please allow me to be the one who rains on the parade: “Yes, Virginia, there is no Santa Claus!”
I don’t mean the Santa who comes down the chimney with toys for every girl and boy. This is the Santa who really is Mom or Dad, Grandparent or other family members or close friends who out of their own earned income choose to purchase, wrap and give gifts to those little ones on Christmas morning.
The small child may have been told the fairy story about an jolly, fat man in a red suit who lives in the far north, working with his elves all year long so the toys and other presents are ready to be miraculously delivered to every “good boy and girl” around the world in one night.
But we “adults” all know that is all just a story for the children at an early and gullible age when the fantasy of it all seems possibly real. And many of us cherish those early years of wonder and make-believe, before the reality breaks through that it just does not and cannot happen that way.
The Redistributing and Regulating Political Santa
I mean the Uncle Sam “Santa” that, not just at Christmas time, but year-round, is believed by many people to have the ability to bring them many of the good things they want from a mythical North Pole called Washington, D.C., or any governmental capital around the world.
This is the political Santa who delivers subsidies of various sorts to farmers or “alternative energy” manufacturers. The Santa who redistributes vast sums of money for educational expenditures, or public housing, welfare and food stamps, or government defense contracts, and even “bridges to nowhere.”
This is also the political Santa who can magically fill the global skies with unmanned drones for surveillance and death, or fund decade-long trillion-dollar wars in far-off lands, or bankroll “friendly” governments in other places around the world while punishing “bad” countries for what Uncle Sam defines as “misbehavior.”
This is the Santa who claims the power and ability remake human nature, control human thought, and redesign some or even all of human society into various preferred shapes and forms.
This political Santa works hard to create the illusion that prosperity and improvement in the human condition cannot happen if not for the guiding, regulating, and manipulating hand of “benevolent” government.
The Political Myth of Something for Nothing
But while almost all children grow out of their belief in a Santa Claus with his home at the North Pole who “somehow” succeeds in manufacturing all those “goodies” that he carries on his sleigh on Christmas Eve, many people go through their entire life convinced of the Santa-like abilities of a paternalistic government that can “somehow” assure many, if not all, of the desired good things of life.
However, just as “Santa” is really Mom and Dad who buy the presents, and wrap them to put under the Christmas tree, governmental “Santa” are those in political office who have no ability to bestow desired benefits on “all” without, in fact, first taking from some to give to others.
Mom and Dad work. They assist in producing goods or in performing services for others in the marketplace, which earns them a salary or nets them a profit. They have had to first produce to, then, through the income they earned, have the ability to consume, including on the goods that their children find on Christmas morning.
The governmental Santa must, first, tax away the income and wealth of some to, then, redistribute it in one form or another to others in the country over which those in political power assert fiscal and regulatory authority.
For the mythical Santa at the North Pole there are no costs for anything he does. The resources, raw materials and tools with which his Christmas goodies are made just appear. The elves work, apparently, for nothing and their food and clothes do not need to be produced, either.
For our political Santa Claus to rain redistributive “gifts” on those he considers deserving and “nice,” he must take from those found to be “naughty” and not nice.
Political Santa’s “Gifts” Carry High Costs
Our political Santa Claus imposes real and meaningful costs on many in society to do his magical “social work.” First, he must appropriate part of the material wealth produced by those productive members of society. People who, in a free market, only earn what they have by peacefully offering to others things those others desire and value enough to pay an agreed-upon price to acquire.
A portion of the intellectual and material effort of real men and women are seized from them through compulsory taxation. The government classifies these net taxpayers in society as having more than they “really” need, and usually don’t ethically “deserve.”
They get “sack of coal” for being “bad” in the form of being left with less than the full value of their creative and hardworking effort. They are denied the opportunity and the right to enjoy the complete fruits of their mental and physical labors. Their choices to spend what they have honestly earned are narrowed to what the political Santa decides they should have available to spend.
The “good” little political citizens who are given the redistributive benefits, therefore, are the net recipients of what others have produced, and which they have received due the ideological and pressure group power they can bring to bear in collaboration with the political Santa in the municipal, state, and national halls of governmental control.
But the costs of political Santa’s generosity do not come just in the form of direct redistributions. They also come in the form of regulations, restrictions, and licensing requirements that determine who may allowed to compete, work, and earn a living in a particular line of enterprise, production, and trade.
This “sack of coal” for the “bad” citizens also comes in the form in the inability to start a business or expand and successfully run an enterprise as the result of the regulatory hand of political Santa. The costs also take the form of closed opportunities for those with little or no skills to find work or be hired at a starting wage that would give them a chance at improving their own lives through honest employment in the free marketplace.
It also costs the consumers who find their choices and options are more limited or nonexistent than the free market would have provided, if only the government had not imposed these barriers, walls, and hurtles in the way of those who merely wish to be left alone to go about their private and personal affairs of life by offering new, better, and less expense goods and services to their fellow men through honest, peaceful, and mutually agreed terms of trade.
The “good little citizens” in this case are those on the supply-side of the market who are sheltered from the competition of real or potentially more efficient and productive rivals. Their larger market shares, greater profit margins, and costly inefficiencies are protected by the political Santa’s regulatory power; he, in turn, receives the campaign contributions and implicitly bought votes on election days that keep him in office.
The Myth of Needing a Political Santa for Life
For political Santa to pursue his mythical game in governmental plunderland, he must do all in his power to persuade and convince his citizen “children” that they do not have a right to their own life and to live it in their own chosen way. They must be indoctrinated to either passively accept the role of life-long dependent upon the political Santa, or to serve as the self-sacrificing elves who must do the work to produce all the goods and services in the world that will be redistributed out of the political Santa’s sack of taxed and regulated benefits.
Santa will educate you; he will see that you have a job and that you receive a “fair” wage. He will make sure that you are safe and satisfied by controlling what is produced, how it produced, and the terms under which the “bad” business children under his regulatory supervision market and sell many of those “goodies” to you.
When sick or disabled, political Santa will give you medical care; and he will guarantee you a retirement free from the need for planning for these things yourself.
All you need to do is accept your status as a lifetime adolescent needing supervision, care, and oversight in everything and in all things that you do. The spirit and psychology of being political Santa’s dependent was captured in that government website cartoon during the first Obama Administration called “The Life of Julia.”
“Julia” needed government to supply the hospital in which she was born; to provide the pre-school education with which her political indoctrination began; too see that Julia was given not only a government high school diploma, but got taxpayer subsidies and special quotas to make it into a preferred college or university; to see that gender affirmative action laws guaranteed a “fair chance” to a good paying job and career that she otherwise could never get on her own; and to see that in later years Julia has the safety-net of government Social Security, without having to bear the responsibility of carrying for this herself.
Self-Sacrificing “Elves” to Serve Political Santa
The other side of political Santa’s plunderland is the indoctrination of the productive and producer “elves” who are needed to do the work that supplies all that government can give away. This requires convincing everyone that “society” comes before the individual; that anything that the individual has is not due to his own effort and his peaceful and voluntary associations with others, or as President Obama asserted, “You did not built it.”
Instead, what you have is due to the collective efforts of all, so that you cannot claim a right to anything or any more than what the collective deems you to deserve. And it is political Santa who represents and acts for the social collective in determining what shall be expected from you and in what form, and what you shall be allowed to have from “society” (or that you are allowed to keep) as bestowed by the government’s redistributive and regulatory activities.
But just as there is no Santa at the North Pole, there is no political Santa in society. Political Santa is really those who run for political office to gain and retain governmental control and power over other people’s lives. Political Santa is really all the special interest groups who wish to use the halls of governmental power to obtain through regulation and taxation what they cannot honestly earn in the open competition of the free marketplace.
Ethical Benevolence vs. Political Immorality
Benevolence and voluntary charity, and a properly understood spirit of “giving” to those you value and love at Christmas time are right and virtuous sentiments of free people in the open society.
But belief in and actions based upon the idea of a “political Santa” only succeeds in weakening and finally destroying the spirit and ethical health of a free and prosperous society.
So, yes, Virginia, there is no Santa Claus. Neither a North Pole Santa who comes down the chimney in a red suit, nor a political Santa who can give people “something for nothing” in a world in which all that people want and desire must be creatively produced by someone before it may used to satisfy those wants and desires.
What makes the mythical belief in a political Santa far worse than the short-lived childhood belief in the North Pole Santa, is that the idea of a political Santa challenges and destroys the spirit of individualism upon which the good, free and prosperous society ultimately rests.
“Except for US Treasuries, what can you hold ? US Treasuries are the safe haven. For everyone, including China, it is the only option.. Once you [Americans] start issuing $1 trillion – $2 trillion.. we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.”
– Luo Ping, official at the China Banking Regulatory Commission, addressing an audience in New York in early 2009.
“This is a big change and it cannot happen too quickly, but we want to use our reserves more constructively by investing in development projects around the world rather than just reflexively buying US Treasuries. In any case, we usually lose money on Treasuries, so we need to find ways to improve our return on investment.”
– Unnamed senior Chinese official, cited in an FT article, ‘Turning away from the dollar’, 10th December 2014.
The Commentary will shortly be off for its winter break. We wish all clients and readers a merry Christmas and a peaceful and prosperous New Year. See you in 2015.
“Mutually assured destruction” was a doctrine that rose to prominence during the Cold War, when the US and the USSR faced each other with nuclear arsenals so populous that they ensured that any nuclear exchange between the two great military powers would quickly lead to mutual overkill in the most literal sense. Notwithstanding the newly dismal relations between the US and Russia, “mutually assured destruction” now best describes the uneasy stand-off between an increasingly indebted US government and an increasingly monetarily frustrated China, with several trillion dollars’ worth of foreign exchange reserves looking, it would now appear, for a more productive home than US Treasury bonds of questionable inherent value. Until now, the Chinese have had little choice where to park their trillions, because only markets like the US Treasury market (and to a certain extent, gold) have been deep and liquid enough to accommodate their reserves.
The FT article, by James Kynge and Josh Noble, points to three related policy developments on the part of the Chinese authorities:
1) China’s appetite for US Treasury bonds is on the wane;
2) China is ramping up its overseas development programme for both financial and geopolitical reasons;
3) The promotion of the renminbi as a global currency “is gradually liberating Beijing from the dollar zone”.
The US has long enjoyed what Giscard d’Estaing called the “exorbitant privilege” of issuing a currency that happens to be the global reserve currency. The FT article would seem to suggest that the days of exorbitant privilege may be coming to an end – to be replaced, in time, with a bi-polar reserve currency world incorporating both the US dollar and the renminbi. (The euro might be involved, if that demonstrably dysfunctional currency bloc lasts long enough.) Here’s a quiz we often wheel out for prospective clients:
1) Which country is the world’s largest sovereign miner of gold ?
2) Which country doesn’t allow an ounce of that gold to be exported ?
3) Which country has advised its citizenry to purchase gold ?
Three questions. One answer. In each case: China. Is it plausible that, at some point yet to be determined, a (largely gold-backed) renminbi will either dethrone the US dollar or co-exist alongside it in a new global currency regime ? We think the answer is yes, on both counts.
Meanwhile the US appears to be doing everything in its power to hasten the relative decline of its own currency. There is a new ‘big figure’ to account for the size of the US national debt, which now stands at some $18 trillion. That only accounts for the on-balance sheet stuff. Factor in the off-balance sheet liabilities of the US administration and pretty soon you get to a figure (un)comfortably north of $100 trillion. It will never be paid back, of course. It never can be. The only question is which poison extinguishes it: formal repudiation, or informal inflation. Perhaps we, or future generations, get both.
So the direction of travel of two colossal ‘macro’ themes is clear (the insolvency of the US administration, and its replacement on the geopolitical / currency stage by that of the Chinese). The one question neither we, nor anybody else, can answer precisely is: when ?
There are other statements that beg the response: when Government bond yields have already entered a ‘twilight zone’ of practical irrelevance to rational and unconstrained investors. But when do they go into reverse ? When will the world’s most frustrating trade (‘the widow-maker’, i.e. shorting the Japanese government bond market) start finally to work ? When will investors be able to enter or re-enter stock markets without having to worry about the malign impact of central bank price support mechanisms (a polite way of describing asset price boosterism and state-sanctioned inflationism) ?
Here’s another statement that begs the response: when ? The US stock market is already heavily overvalued by any objective historical measure. When is Jack Bogle, the founder of the world’s largest index-tracking business, Vanguard, going to acknowledge that advocating 100% market exposure to one of the world’s most expensive markets, at its all-time high, might amount to something akin to “overly concentrated investment risk” ? Barron’s Magazine asks broadly the same question.
Lots of questions, and not many definitive answers. Some suggestions, though:
- At the asset class level, diversification – by geography, and underlying asset type – makes more sense than ever, unless you strongly believe you can anticipate the actions and intentions of central banking bureaucrats throughout the world. Warren Buffett once said that wide diversification was only required when investors do not understand what they are doing. We would revise that statement to take into account the unusual risks at play in the global macro-economic arena today: wide diversification is precisely required when central bankers do not understand what they are doing.
- Expanding on the diversification theme, explicit value (“cheapness”) today only exists meaningfully in the analytically less charted territories of the world. @RobustCap highlights the discrepancy between valuations in the US stock market versus those of Russia, China and emerging Europe. There are clearly ‘fundamental’ and corporate governance reasons that account for some of this discrepancy, but in our view certainly not the entirety of it. Some examples:
Country C.A.P.E. P/E P/B
North America 23.8 20.2 2.7x
Russia 5.2 6.8 0.7x
China 17.2 6.9 1.1x
Austria 6.8 43.4 0.9x
In emerging and ‘challenged’ markets, there are always reasons not to invest. Nevertheless, price is what you pay and value is what you get.
- Some form of renminbi exposure makes total sense as part of a diversified currency portfolio.
- US equities should be selected, if at all, with extreme care; ditto the shares of global mega-cap consumer brands, where valuations point strongly to the triumph of the herd.
- And whatever their direction of travel in the short to medium term, US Treasuries at current levels make no sense whatsoever to the discerning investor. The same holds for Gilts, Bunds, JGBs, OATs.. Arguments about Treasury yields reverting to a much lower longer term mean completely ignore a) the overwhelming current and future oversupply, and b) the utter lack of endorsement from one of their largest foreign holders. Foreign holders of US Treasuries, you have been warned. The irony is that many of you are completely price-insensitive so you will not care.
- There are other reasons to be fearful of stock market valuations, notably in pricey western markets, over and above concerns over the debt burden. As Russell Napier points out in his latest ‘The Solid Ground’ piece,
“In 1919-1921, 1929-1932, 2000-2003, 2007-2009 it was not a resurgence in wages, Fed-controlled interest rates or corporate taxes which produced a collapse in corporate profits and a bear market in equities. On those four occasions equity investors suffered losses of 32%, 85%, 41% and 51% respectively despite the continued dormancy of labour, creditors and the state. It was deflation, or the fear of deflation, which cost equity investors so much. There is a simple reason why deflation has always been so damaging to corporate profits and equity valuations: it brings a credit crisis..
“Investors forget at their peril what can happen to the credit system in a highly leveraged world when cash-flows, whether of the corporate, the household or the state variety, decline. In a deflationary world credit is much more difficult to access, economic activity slows and often one very large institution or country fails and creates a systemic risk to the whole system. The collapse in commodity prices and Emerging Market currencies in conjunction with the general rise of the US$ suggests another credit crisis cannot be far away. With nominal interest rates already so low, monetary remedies to a credit seizure today would be much less effective. Such a shock, after five and a half years of QE, might suggest that the patient does not respond to this type of medicine.”
- And since Christmas fast approaches, we can’t speak to the merits of frankincense and myrrh, but gold, that famous “6,000 year old bubble”, has always been popular, but rarely more relevant to the investor seeking a true safe haven from forced currency depreciation and an ever vaster mountain of unrepayable debt.
There has been no greater threat to life, liberty, and property throughout the ages than government. Even the most violent and brutal private individuals have been able to inflict only a mere fraction of the harm and destruction that have been caused by the use of power by political authorities.
The pursuit of legal plunder, to use Frédéric Bastiat’s well-chosen phrase, has been behind all the major economic and political disasters that have befallen mankind throughout history.
Government Spending Equals Plundering People
We often forget the fundamental
truth that governments have nothing
to spend or redistribute that they do not first take from society’s producers. The fiscal history of mankind is nothing but a long, uninterrupted account
of the methods governments have devised for seizing the income and wealth of their citizens and subjects.
Parallel to that same sad history must be an account of all the attempts by the victims of government’s legal plunder to devise counter-methods to prevent or at least limit the looting of their income and wealth by those in political power.
Every student who takes an economics course learns that governments have basically three methods for obtaining control over a portion of the people’s wealth: taxation, borrowing, and inflation––the printing of money.
It was John Maynard Keynes who pointed out in his 1919 book, The Economic Consequences of the Peace:
“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they also confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some . . .
“There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
Limiting Government with the Gold Standard
To prevent the use of inflation by governments to attain their fiscal ends, various attempts have been made over the last 200 years to limit the power of the State to print money to cover its expenditures. In the nineteenth and early twentieth centuries the method used was the gold standard. The idea was to place the creation of money outside the control of government.
As a commodity, the amount of gold available for both monetary and non-monetary uses is determined and limited by the same market forces that determine the supply of any other freely traded good or service: the demand and price for gold for various uses relative to the cost and profitability of mining and minting it into coins or bullion, or into some other commercial form.
Any paper money in circulation under the gold standard was meant to be money substitutes––that is, notes or claims to quantities of gold that had been deposited in banks and that were used as a convenient alternative to the constant withdrawing and depositing of gold coins or bullion to facilitate everyday market exchanges.
Under the gold standard, the supply of money substitutes in circulation was meant to increase and decrease to reflect any changes in the quantity of gold in a nation’s banking system. The gold standard that existed in the late nineteenth and early twentieth centuries never worked as precisely or as rigidly as it is portrayed in some economics textbooks. But, nonetheless, the power of government to resort to the money printing press to cover its expenditures was significantly limited.
Governments, therefore, had to use one of the two other methods for acquiring their citizens’ and subjects’ income and wealth. Governments had to either tax the population or borrow money from financial institutions.
But as a number of economists have pointed out, before World
War I many of the countries of North
America and western and central Europe operated under an “unwritten
fiscal constitution.” Governments, except during times of national emergency, were expected to more or less
balance their budgets on an annual
If a national emergency
(such as a war) compelled a government to borrow money to cover its
unexpected expenditures, it was expected to run budget surpluses to
pay off any accumulated debt when the emergency had passed.
This unwritten balanced-budget rule was never rigidly practiced either, of course. But the idea that needless government debt was a waste and a drag on the economic welfare of a nation served as an important check on the growth of government spending.
When governments planned to do things, the people were more or less explicitly presented with the bill. It was more difficult for governments to promise a wide variety of benefits without also showing what the taxpayer’s burden would be.
World War I Destroyed the Gold Standard
This all changed during and after World War I. The gold standard was set aside to fund the war expenditures for all the belligerents in the conflict. And John Maynard Keynes, who in 1919 had warned about the dangers of inflation, soon was arguing that gold was a “barbarous relic” that needed to be replaced with government-managed paper money to facilitate monetary and fiscal fine-tuning.
In addition, that unwritten fiscal constitution which required annual balanced budgets was replaced with the Keynesian conception of a balanced budget over the phases of the business cycle.
In practice, of course, this set loose the fiscal demons. Restrained by neither gold nor the limits of taxation, governments around the world went into an orgy of deficit spending and money creation that led some to refer to a good part of the twentieth century as the “age of inflation.”
Politicians and bureaucrats could now far more easily offer short-run benefits to special-interest groups through growth in government power and spending, while avoiding any mention of the longer-run costs to society as a whole, in their roles as taxpayers and consumers.
The Counter-Revolution Against Keynesianism
Beginning in the late 1960s and 1970s a counter-revolution against Keynesian economics emerged, especially in the United States, which came to be identified with Milton Friedman and monetarism.
To restrain government’s ability to create inflation, Friedman proposed a “monetary rule”: the annual increase in the money supply should be limited to the average annual increase in real output in the economy. Put the creation of paper money on “automatic pilot,” and governments would once more be prevented from using the printing press to capriciously cover their expenditures.
But in the years after receiving the Nobel Prize in economics in 1984, Friedman had second thoughts about the effectiveness of his monetary rule. He stated that Public Choice theory – the use of economic theory to analyze the logic and incentives in political decision-making – persuaded him that trying to get central banks to pursue a monetary policy that would serve the long-run interest of society was a waste of time.
Just like the rest of us, politicians, bureaucrats, and central bankers have their own self-interested goals, and they will use the political power placed at their disposal to advance their interests.
Said Friedman: “We must try to set up institutions under which individuals who intend only their own gain are led by an invisible hand to serve the public interest,” He also concluded that after looking over the monetary history of the twentieth century, “Leaving monetary and banking arrangements to the market would have produced a more satisfactory outcome than was actually achieved through government involvement.”
Separating Money from Government Control
Though Milton Friedman was unwilling to take his own argument that far, the logical conclusion of his admission that the control of money can never be trusted in the hands of the government is the need to separate money creation from the State. What is required is the denationalization of money, or in other words, the establishment of monetary freedom in society.
Under a regime of monetary freedom the government would no longer have any role in monetary and banking affairs. The people would have, to use a phrase popularized by the Austrian economist F. A. Hayek, a “choice in currency.” The law would respect and enforce all market-based, consensual contracts regardless of the currency or commodity chosen by the market participants as money. And the government would not give a special status to any particular currency through legal-tender laws as the only “lawful money.”
Monetary freedom encompasses what is known as “free banking.” That is, private banks are at liberty to accept deposits in any commodity money or currency left in their trust by depositors and to issue their own private banknotes or claims against these deposits.
To the extent these banknotes and claims are recognized and trusted by a growing number of people in the wider economic community, they may circulate as convenient money substitutes. Such private banks would settle their mutual claims against each other on behalf of their respective depositors through private clearinghouses that would have international connections as well.
Few advocates of the free market have included the privatization of the monetary system among their proposed economic policy reforms. The most notable advocate of monetary freedom and free banking in the twentieth century was the Austrian economist Ludwig von Mises, who demonstrated that as long as governments and their central banks have monopoly control over the monetary system inflations and the business cycle are virtually inevitable, with all of their distorting and devastating effects.
But the last 30 years have seen the emergence of a body of serious and detailed literature on the desirability and workability of a fully private and competitive free-banking system as an alternative to government central banking.
Self-Interest and Monetary Freedom
Its political advantage is that it completely removes all monetary matters from the hands of government. However effective the old gold standard may have been before the First World War, it nonetheless remained a government-managed monetary system that opened the door to eventual abuse.
Furthermore, a free-banking system fulfills Milton Friedman’s recommendation that the monetary order should be one that harnesses private interest for the advancement of the public interest through the “invisible hand” of the market process.
The interests of depositors in a reliable banking system would coincide with the self-interest of profit-seeking financial intermediaries. A likely unintended consequence would be a more stable and adaptable monetary system than the systems of monetary central planning the world labors under now.
Of course, a system of monetary freedom does not do away with the continuing motives for government to grow and spend. Even limits on the government’s ability to create money to finance its expenditures does not preclude fiscal irresponsibility, with damaging economic consequences for a large segment of the population through deficit spending and growing national debt.
Monetary Freedom and a Philosophy of Liberty
In the long run, the only way to limit the growth of government spending and power over society is to change political and ideological thinking. As long as many people want government to use its power to tax and regulate to benefit them at the expense of others, it will retain its power and continue to grow.
Monetary and fiscal reform is ultimately inseparable from the rebirth and implementation of a philosophy of freedom that sees government limited to the protection of each individual’s right to his life, liberty, and honestly acquired property.
As Ludwig von Mises expressed it ninety years ago in the aftermath of the First World War and during the Great German Inflation of the early 1920s:
“What is needed first and foremost is to renounce all inflationist fallacies. This renunciation cannot last, however, if it is not firmly grounded on a full and complete divorce of ideology from all imperialist, militarist, protectionist, statist, and socialist ideas.”
If the belief in and desire for personal and economic liberty can gain hold and grow once more in people’s hearts and minds, monetary freedom and fiscal restraint will eventually come by logical necessity.
[Editor’s note: this piece first appeared here http://www.epictimes.com/richardebeling/2014/12/the-case-for-monetary-freedom-and-free-banking/]
Last week I wrote that contrary to the prevailing mood US dollar strength could reverse at any time. This week I look at another aspect of the dollar, which almost certainly will become a significant source of supply: a global shift out of it by foreign holders.
As well as multinational corporations that account in dollars, there are non-US entities that use dollars purely for trade. And so long as governments intervene in currency markets, governments end up with those trade dollars in their foreign reserves. Some of these governments are now pushing hard to replace the dollar, having seen its debasement, which is beyond their control. This has upset nations like China, and that is before we speculate about any geopolitical angle.
The consequence of China’s currency management has been a massive accumulation of dollars which China cannot easily sell. All she can do is stop accumulating them and not reinvest the proceeds from maturing Treasuries, and this has broadly been her policy for at least the last year. So this problem has been in the works for some time and doubtless contributed to China’s determination to reduce her dependency on the dollar. Furthermore, it is why thirteen months ago George Osborne was summoned (that is the only word for it) to Beijing to discuss a move to urgently develop offshore renminbi capital markets, utilising the historic links between Hong Kong and London. Since then, it is reported that last month over 22% of China’s external trade was settled in its own currency.
Given the short time involved, it is clear that there is a major change happening in cross-border trade hardly noticed by financial commentators. But this is not all: sanctions against Russia have turned her urgently against the dollar as well, and together with China these two nations dominate and carry with them the bulk of Asia, representing nearly four billion rapidly industrialising souls. To this we should add the Middle East, most of whose oil is now exported to China, India and South-East Asia, making the petro-dollar potentially redundant as well.
In a dollar-centric currency system, China is restricted in what she can do, because with nearly $4 trillion in total foreign exchange reserves she cannot sell enough dollars to make a difference without driving the renminbi substantially higher. In the past she has reduced her dollar balances by selling them for other currencies, such as the euro, but she cannot rely on the other major central banks to neutralise the market effect of her dollar sales on her behalf. Partly for this reason China now intends to redeploy her reserves into international investment to develop her export markets for capital goods, as well as into major infrastructure projects, such as the $40bn Silk Road scheme.
This simply amounts to dispersing China’s dollars into diverse hands to conceal their disposal. Meanwhile currency markets have charged off in the opposite direction, with the dollar’s strength undermining commodity prices, most noticeably oil, very much to China’s benefit. And while the talking-heads are debating the effect on Russia and America’s shale, they are oblivious to the potential tsunami of dollars just waiting for the opportunity to return to the good old US of A.
“What will futurity make of the Ph.D. standard ? Likely, it will be even more baffled than we are. Imagine trying to explain the present-day arrangements to your 20-something grandchild a couple of decades hence – after the Crash of, say, 2016, that wiped out the youngster’s inheritance and provoked a central bank response so heavy-handed as to shatter the confidence even of Wall Street in the Federal Reserve’s methods.
“I expect you’ll wind up saying something like this: “My generation gave former tenured economics professors discretionary authority to fabricate money and to fix interest rates. We put the cart of asset prices before the horse of enterprise. We entertained the fantasy that high asset prices made for prosperity, rather than the other way around. We actually worked to foster inflation, which we called ‘price stability’ (this was on the eve of the hyperinflation of 2017). We seem to have miscalculated.”
– Excerpt from James Grant’s November 2014 Cato speech. Hat-tip to Alex Stanczyk.
You can be for gold, or you can be for paper, but you cannot possibly be for both. It may soon be time to take a stand. The arguments in favour of gold are well known, and just as widely ignored by the paperbugs, who have a belief system at least as curious because its end product is destined to fail – we just do not know precisely when. The price of gold is weakly correlated to other prices in financial markets, as the last three years have clearly demonstrated. Indeed gold may be the only asset whose price is being suppressed by the monetary authorities, as opposed to those sundry instruments whose prices are being just as artificially inflated to offer the illusion of health in the financial system (stocks and bonds being the primary financial victims). Beware appearances in an unhinged financial system, because they can be dangerously deceptive. It is quite easy to manipulate the paper price of gold on a financial futures exchange if you never have to make delivery of the physical asset and are content to play games with paper. At some point that will change. Contrary to popular belief, gold is supremely liquid, though its supply is not inexhaustible. It is no-one’s liability – this aspect may be one of the most crucial in the months to come, as and when investors learn to start fearing counterparty risk all over again. Gold offers a degree of protection against uncertainty. And unlike paper money, there are fundamental and finite limits to its creation and supply.
What protection ? There is, of course, one argument against gold that seems to trump all others and blares loudly to sceptical ears. Its price in US dollars has recently fallen. Not in rubles, and not perhaps in yen, of course, but certainly in US dollars. Perhaps gold is really a currency, then, as opposed to a tiresome commodity ? But the belief system of the paperbug dies hard.
The curious might ask why so many central banks are busily repatriating their gold ? Or why so many Asian central banks are busily accumulating it ? It is surely not just, in Ben Bernanke’s weasel words, tradition ?
If you plot the assets of central banks against the gold price, you see a more or less perfect fit going back at least to 2002. It is almost as if gold were linked in some way to money. That correlative trend for some reason broke down in 2012 and has yet to re-emerge. We think it will return, because 6,000 years of human history weigh heavily in its favour.
Or you can put your faith in paper. History, however, would not recommend it. Fiat money has a 100% failure rate.
Please note that we are not advocating gold to the exclusion of all else within the context of a balanced investment portfolio. There is a role for objectively creditworthy debt, especially if deflation really does take hold – it’s just that the provision of objectively creditworthy bonds in a global debt bubble is now vanishingly small. There is a role for listed businesses run by principled, decent management, where the market’s assessment of value for those businesses sits comfortably below those businesses’ intrinsic worth. But you need to look far and wide for such opportunities, because six years of central and commercial banks playing games with paper have made many stock markets thoroughly unattractive to the discerning value investor. We suggest looking in Asia. There is a role for price momentum strategies which, having disappointed for several years, though not catastrophically so, now appear to be getting a second wind, from the likes of deflating oil prices, periphery currencies, and so on.
As investors we are all trapped within a horrifying bubble. We must play the hand we’ve been dealt, however bad it is. But there are now growing signs of end-of-bubble instability. The system does not appear remotely sound. Since political vision in Europe, in particular, is clearly absent, the field has been left to central bankers to run amok. The only question we cannot answer is: precisely when does the centre fail ? The correct response is to recall the words of the famed value investor Peter Cundill, when he confided in his diary:
“The most important attribute for success in value investing is patience, patience, and more patience. THE MAJORITY OF INVESTORS DO NOT POSSESS THIS CHARACTERISTIC.”
But the absence of patience by the majority of investors is fine, because it leaves more money on the table for the rest of us. The only question remaining is: in what exact form should we hold that money ?
Be patient, and do please set aside thirty minutes to listen to James Grant’s quietly passionate and wonderfully articulate Cato Institute speech. It will be time well spent.