Economics

Ten problems, or just one?

“Sir, The next financial apocalypse is imminent. I know this to be true because the House & Home section in FT Weekend is now assuming the epic proportions last seen before the great crash. Twenty-four pages chock full of adverts for mansions and wicker tea-trays for $1,000. You’re all mad.

 

Sell everything and run for your lives.”

 

  • Letter to the FT from Matt Long, Seilh, France, 3rd October 2014.

 

“Investors unfortunately face enormous pressure—both real pressure from their anxious clients and their consultants and imagined pressure emanating from their own adrenaline, ego and fear—to deliver strong near-term results. Even though this pressure greatly distracts investors from a long-term orientation and may, in fact, be anathema to good long-term performance, there is no easy way to reduce it. Human nature involves the extremes of investor emotion—both greed and fear—in the moment; it is hard for most people to overcome and act in opposition to their emotions. Also, most investors tend to project near-term trends—both favourable and adverse—indefinitely into the future. Ironically, it is this very short-term pressure to produce—this gun to the head of everyone—that encourages excessive risk taking which manifests itself in several ways: a fully invested posture at all times; for many, the use of significant and even extreme leverage; and a market-centric orientation that makes it difficult to stand apart from the crowd and take a long-term perspective.”

 

  • Seth Klarman, Presentation to MIT, October 2007.

 

 

“At first, the pendulum was swinging towards infinite interest, threatening the dollar with hyperinflation. Right now the pendulum is swinging to the other extreme, to zero interest, spelling hyper-deflation. This is just as damaging to producers as the swing towards infinite interest was in the early 1980’s. It is impossible to predict whether one or the other extreme in the swinging of the wrecking ball will bring about the world economy’s collapse. Hyperinflation and hyper-deflation are just two different forms of the same phenomenon: credit collapse. Arguing which of the two forms will dominate is futile: it blurs the focus of inquiry and frustrates efforts to avoid disaster.”

 

  • Professor Antal Fekete, ‘Monetary Economics 101: The real bills doctrine of Adam Smith. Lecture 10: The Revolt of Quality’.

 

“Low interest rate policy has the following grave consequences:

 

  • Normally conservative investors are increasingly under duress and due to the outlook for interest rates remaining low for a long time, are taking on excessive risk. This leads to capital misallocation and the formation of bubbles.
  • The sweet poison of low interest rates and easy money therefore leads to massive asset price inflation (stocks, art, real estate).
  • Through carry trades, interest rates that are structurally too low in the industrialized nations lead to asset bubbles and contagion effects in emerging markets.
  • A structural weakening of financial markets, as reckless behaviour of market participants is fostered (moral hazard).
  • A change in human behaviour patterns, due to continually declining purchasing power. While thrift is slowly but surely transmogrified into a relic of the past, taking on debt becomes rational.
  • The acquisition of personal wealth becomes gradually more difficult.
  • The importance of money as a medium of exchange and a unit of account increases in importance relative to its role as a store of value.
  • Incentives for fiscal probity decline. Central banks have bought time for governments. Large deficits appear less problematic, there is no incentive to implement reform, resp. consolidate public finances in a sustainable manner.
  • The emergence of zombie-banks and zombie-companies. Very low interest rates prevent the healthy process of creative destruction. Zero interest rate policy makes it possible for companies with low profitability to survive, similar to Japan in the 1990s. Banks are enabled to nigh endlessly roll over potentially delinquent loans and consequently lower their write-offs.
  • Unjust redistribution (Cantillon effect): the effect describes the fact that newly created money is neither uniformly nor simultaneously distributed in the population. Monetary expansion is therefore never neutral. There is a permanent transfer of wealth from later to earlier receivers of new money.”
  • Ronald-Peter Stöferle, from ‘In Gold We Trust 2014 – Extended Version’, Incrementum AG.

 

 

The commentary will have its next outing on Monday 27th October.

 

 

“When sorrows come,” wrote Shakespeare, “they come not single spies, but in battalions.” Jeremy Warner for the Daily Telegraph identifies ten of them. His ‘ten biggest threats to the global economy’ comprise:

  • Geopolitical risk;
  • The threat of oil and gas price spikes;
  • A hard landing in China;
  • Normalisation of monetary policy in the Anglo-Saxon economies;
  • Euro zone deflation;
  • ‘Secular stagnation’;
  • The size of the debt overhang;
  • Complacent markets;
  • House price bubbles;
  • Ageing populations.

Other than making the fair observation that stock markets (for example) are not entirely correlated to economic performance – an observation for which euro zone equity investors must surely be hugely grateful – we offer the following response.

  • Geopolitical risk, like the poor, will always be with us.
  • Yes, the prices for oil and natural gas could spike, but as things stand WTI crude futures have fallen by over 15% from their June highs, in spite of the clear geopolitical problems. And the US fracking revolution, in combination with fast-improving fundamentals for solar power, may turn out to be a secular (and disinflationary) game-changer for energy prices.
  • China, however, is tougher to dismiss. If we had any meaningful exposure to Chinese equity or debt we would be more concerned. But we don’t, so we aren’t.
  • Five of Jeremy Warner’s ‘threats’ are inextricably linked. The pending normalisation of monetary policy in the UK and US clearly threatens the integrity of the credit markets. It’s worth asking whether either central bank could possibly afford to let interest rates rise. This begets a follow-on question: could the markets afford to let the central banks off the hook ? Could we, in other words, finally see the return of the long absent and much desired bond market vigilantes ? That monetary policy rates are so low is a function of the growing prospect of euro zone deflation (less of a threat to solvent consumers, but deadly for heavily indebted governments). Absent a capitulation by the Bundesbank to Draghi’s hopes or intentions for full-blown QE, it’s difficult to see how the policy log-jam gets resolved. But since all German government paper out to three years now offers a negative yield, it’s difficult to see why any euro zone debt is worth buying today for risk-conscious investors. Cash is probably preferable and gives optionality into the bargain. ‘Secular stagnation’ is now a fair definition of the euro zone’s economic prospects. But all things lead back to Warner’s point 7: the size of the debt overhang. Since this was never addressed in the immediate aftermath of the Global Financial Crisis, it’s hardly a surprise to see its poison continue to drip onto all things financial. And since the policy response has been to slash rates and keep them at multi-century lows, it’s hardly a surprise to see property prices in the ascendant.
  • Complacent markets ? Check. But stocks have lost a lot of their nerve over the last week. Not before time.
  • Ageing populations ? Yes, but this problem has been widely discussed in the investment community over the past two decades – it simply isn’t new news.

We saw one particularly eye-catching chart last week, via Grant Williams, comparing the leverage ratios of major US financial institutions over recent years (shown below).

Leverage Ratios

 

Source: Grant Williams, ‘Things that make you go Hmmm…’

 

The Fed’s leverage ratio (total assets to capital) now stands at just under 80x. That compares with Lehman Brothers’ leverage ratio, just before it went bankrupt, of just under 30x. Sometimes a picture really does paint a thousand words. And this, again, brings us back to the defining problem of our time, as we see it: too much debt in the system, and simply not enough ideas about how to bring it down – other than through inflationism, and even that doesn’t seem to be working quite yet.

 

In a recent interview with Jim Grant, Sprott Global questioned the famed interest rate observer about the likely outlook for bonds:

 

What would a bear market in bonds look like? Would it be accompanied by a bear market in the stocks?

“Well, we have a pretty good historical record of what a bear market in bonds would look like. We had one in modern history, from 1946 to 1981. We had 25 years’ worth of persistently – if not steadily – rising interest rates, and falling bond prices. It began with only around a quarter of a percent on long-dates US Treasuries, and ended with about 15% on long-dated US Treasuries. That’s one historical beacon. I think that the difference today might be that the movement up in yield, and down in price, might be more violent than it was during the first ten years of the bear market beginning in about 1946. Then, it took about ten years for yields to advance even 100 basis points, if I remember correctly. One difference today is the nature of the bond market. It is increasingly illiquid and it is a market in which investors – many investors – have the right to enter a sales ticket, and to expect their money within a day. So I’m not sure what a bear market would look like, but I think that it would be characterized at first by a lot of people rushing through a very narrow gate. I think problems with illiquidity would surface in the corporate debt markets. One of the unintended consequences of the financial reforms that followed the sorrows of 2007 to 2009 is that dealers who used to hold a lot of corporate debt in inventories no longer do so. If interest rates began to rise and people wanted out, I think that the corporate debt market would encounter a lot of ‘air pockets’ and a lot of very discontinuous action to the downside.”

We like that phrase “a lot of very discontinuous action to the downside”. Grant was also asked if it was possible for the Fed to lose control of the bond market:

 

“Absolutely, it could. The Fed does not control events for the most part. Events certainly will end up controlling the Fed. To answer your question – yeah. I think the Fed can and will lose control of the bond market.”

 

As we have written on innumerable prior occasions, we wholeheartedly agree. Geopolitics, energy prices, demographics – all interesting ‘what if’ parlour games. But what will drive pretty much all asset markets over the near, medium and longer term is almost entirely down to how credit markets behave. The fundamentals, clearly, are utterly shocking. The implications for investors are, in our view, clear. And as a wise investor once observed, if you’re going to panic, panic early.

 

Economics

Math Gone Mad: Regulatory Risk Modeling by the Federal Reserve

The U.S. financial system faces a major, growing, and much under-appreciated threat from the Federal Reserve’s risk modeling agenda—the “Fed stress tests.” These were intended to make the financial system safe but instead create the potential for a new systemic financial crisis.

The principal purpose of these models is to determine banks’ regulatory capital requirements—the capital “buffers” to be set aside so banks can withstand adverse events and remain solvent.

Risk models are subject to a number of major weaknesses. They are usually based on poor assumptions and inadequate data, are vulnerable to gaming and often blind to major risks. They have difficulty handling market instability and tend to generate risk forecasts that fall as true risks build up. Most of all, they are based on the naïve belief that markets are mathematizable. The Fed’s regulatory stress tests are subject to all these problems and more. They:

  • ignore well-established weaknesses in risk modeling and violate the core principles of good stress testing;
  • are overly prescriptive and suppress innovation and diversity in bank risk management; in so doing, they expose the whole financial system to the weaknesses in the Fed’s models and greatly increase systemic risk;
  • impose a huge and growing regulatory burden;
  • are undermined by political factors;
  • fail to address major risks identified by independent experts; and
  • fail to embody lessons to be learned from the failures of other regulatory stress tests.

The solution to these problems is legislation to prohibit risk modeling by financial regulators and establish a simple, conservative capital standard for banks based on reliable capital ratios instead of unreliable models. The idea that the Fed, with no credible track record at forecasting, can be entrusted with the task of telling banks how to forecast their own financial risks, displacing banks’ own risk systems in the process, is the ultimate in fatal conceits. Unless Congress intervenes, the United States is heading for a new systemic banking crisis.

[Editor's Note: the full document published by the Cato Institute can be found here]

Economics

A black mark for benchmarks

“Sir, So Ed Miliband “forgot” to mention the deficit. This from a man who was a key member of the team that ran up a massive structural debt pile when the UK should have been enjoying a cyclical surplus. He was part of a Labour administration that took the UK economy to the brink of effective bankruptcy. Yet less than five years on, as we still struggle to deal with the toxic mess that he and his colleagues left behind, he “forgot” to mention it. This surely ranks alongside “the dog ate my homework” for feeble and unbelievable excuses for non-performance of basic required tasks.”

  • Letter to the FT from Mr Max Irwin of Kew, Surrey, UK.

Politicians and diapers have one thing in common. They should both be changed regularly, and for the same reason.”

  • Anonymous.

It should be striking that government bonds, in nominal terms, have never been this expensive in history, even as there have never been so many of them. The laws of supply and demand would seem to have been repealed. How could this state of affairs have come about ? We think the answer is three-fold:

  1. The bond market is clearly not perfectly efficient.

  2. Bond yields are being manipulated by central banks through a deliberate policy of financial repression (and QE, of course).

  3. Many bond fund managers may be unaware, or unconcerned, that the benchmarks against which they choose to be assessed are illogical and irrational.

What might substantiate our third claim ? It would be the festering intellectual plague that bedevils the fund management world known as indexation. Bond indices allocate their largest weights to the most indebted issuers. This is the precise opposite of what any rational bond investor would do – namely, to overweight their portfolio according to those issuers with the highest credit quality (or perhaps, all things being equal, with the highest yields). But bond indices do exactly the opposite. They force any manager witless enough to have fallen victim to them to load up on the most heavily indebted issuers, which currently also happen to offer amongst the puniest nominal yields. As evidence for the prosecution we cite the US Treasury bond market, the world’s largest. The US national debt currently stands at $17.7 trillion. With a ‘T’. Benchmark 10 year Treasuries currently offer a yield to maturity of 2.5%. US consumer price inflation currently stands at 1.7%. (We offer no opinion as to whether US CPI is a fair reflection of US inflation.) On the basis that US “inflation” doesn’t change meaningfully over the next 10 years, US bond investors are going to earn an annualised return just a smidgen above zero percent.

How do US Treasury yields stack up against the longer term trend in interest rates ? The following data are from @Macro_Tourist:

10 year US Treasury yields since 1791

10 Year US Treasury Yields Since 1971

The chart shows the direction of travel for US market rates since independence, given that the Continental Congress defaulted on its debts.

Now it may well be that US Treasury yields have further to fall. As SocGen’s Albert Edwards puts it,

“Our ‘Ice Age’ thesis has long called for sub-1% bond yields and I see this extending to the US and UK in due course.”

As things stand, the trend is with the polar bears. The German bond market has already broken down through the 1% level (10 year Bunds at the time of writing currently trade at 0.98%).

Deutsche Bank Research – specifically Jim Reid, Nick Burns and Seb Barker – recently published an extensive examination of global debt markets (“Bonds: the final bubble frontier ?” – hat tip to Arnaud Gandon of Heptagon Capital). Deutsche’s strategists ask whether bonds constitute the culminating financial bubble after almost two decades of them:

“After the Asian / Russian / LTCM crises of the late 1990s we entered a supercycle of very aggressive policy responses to major global problems. In turn this helped encourage the 2000 equity bubble, the 2007 housing / financial / debt bubble, the 2010-2012 Euro Sovereign crisis and arguably some recent signs of a China credit bubble (a theme we discussed in our 2014 Default Study). At no point have the imbalances been allowed a full free market conclusion. Aggressive intervention has merely pushed the bubble elsewhere. With no obvious areas left to inflate in the private sector, these bubbles have now arguably moved into government and central bank balance sheets with unparalleled intervention and low growth allowing it to coincide with ultra-low bond yields.” [Emphasis ours.]

The French statesman George Clemenceau once commented that war is too important to be left to generals. At this stage in the game one might be tempted to add that monetary policy is far too important to be left to politicians and central bankers. We get by with free markets in all other walks of economic and financial life – why let the price of money itself be dictated by a handful of State-appointed bureaucrats ? We were once told by a fund manager (a Japanese equity manager, to be precise – rare breed that that is now), around the turn of the millennium, that Japan would be the dress rehearsal, and that the rest of the world would be the main event. Again, the volume of the mood music is rising in SocGen’s favour.

We nurse no particular view in relation to how the government bond bubble (for it surely is) plays out – whether yields grind relentlessly lower for some time yet, or whether they burst spectacularly on the back of the overdue return of bond market vigilantes or some other mystical manifestation of long-delayed economic common sense. But Warren Buffett himself once said that,

“If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”

The central bank bond market poker game has been in train for a good deal longer than half an hour, and the stakes have never been higher. Sometimes, if you simply can’t fathom the new rules of the game, it’s surely better not to play. So we’re not in the business of chasing US Treasury yields, or Gilt yields, or Bund yields, ever lower – we’ll keep our bond exposure limited to only the highest quality credits yielding the highest possible return. Even then, if Fed tapering does finally dissipate in favour of Fed hiking – stranger things have happened, though we can’t think of any off the top of our head – it will make sense at the appropriate time to eliminate conventional debt instruments from client portfolios almost entirely.

But indexation madness is not limited to the world of bonds. Its malign, unthinking mental slavery has fixed itself upon the equity markets, too. Equity indices, as is widely acknowledged, allocate their largest weights to the largest and most expensive stocks. What’s extraordinary is that even as stock markets have powered ahead, index trackers have enjoyed their highest ever inflows. The latest IMA data show that more UK retail money was put into tracker funds in July than in any other month since records began. We accept the ‘low cost’ aspect of tracker funds and ETFs; we take serious issue with the idea of buying stock markets close to or at their all-time high and being in for any downside ride on a 1:1 basis.

But there is a middle way between the Scylla of bonds at all-time low yields and the Charybdis of stocks at all-time high prices. Value. Seth Klarman of the Baupost Group once wrote as follows:

“Stock market efficiency is an elegant hypothesis that bears quite limited resemblance to the real world. For over half a century, disciples of Benjamin Graham, the intellectual father of value investing, have prospered buying bargains that efficient market theory says should not exist. They take advantage of the short-term, relative performance orientation of other investors. They employ an absolute (not relative) valuation compass, patiently exploiting mispricings while avoiding overpaying for what is popular and trendy. Many are willing to concentrate their exposures, knowing that their few best ideas are better than their hundredth best, and confident in their ability to tell which is which.

“Value investors thrive not by incurring high risk (as financial theory would suggest), but by deliberately avoiding or hedging the risks they identify. While efficient market theorists tell you to calculate the beta of a stock to determine its riskiness, most value investors have never calculated a beta. Efficient market theory advocates moving a portfolio of holdings closer to the efficient frontier. Most value investors have no idea what this is or how they might accomplish such a move. This is because financial market theory may be elegant, but it is not particularly useful in formulating a successful investment strategy.

“If academics espousing the efficient market theory had no influence, their flawed views would make little difference. But, in fact, their thinking is mainstream and millions of investors make their decisions based on the supposition that owning stocks, regardless of valuation and analysis, is safe and reasonable. Academics train hundreds of thousands of students each year, many of whom go to Wall Street and corporate suites espousing these beliefs. Because so many have been taught that outperforming the market is impossible and that stocks are always fairly and efficiently priced, investors have increasingly adopted strategies that eventually will prove both riskier and far less rewarding than they are currently able to comprehend.”

That sounds about right to us. Conventional investing, both in stocks and bonds on an indexed or benchmarked basis, “will prove both riskier and far less rewarding” than many investors are currently able to comprehend.

Law

Understanding Deposit Insurance (I): Deposit Insurance is a Creature of the State

Deposit insurance is one of the most misunderstood – and also most dangerous – forms of government intervention into the financial system.

 

Let’s start with the common misconception that deposit insurance is an industry-operated affair independent of the government.

 

In the UK, deposit insurance is provided by the Financial Services Compensation Scheme (FSCS). To quote from its website:

 

“The FSCS is the UK’s statutory fund of last resort for customers of financial services firms. This means that FSCS can pay compensation to consumers if a financial services firm is unable, or likely to be unable, to pay claims against it. The FSCS is an independent body, set up under the Financial Services & Markets Act 2000 (FSMA).”

 

It also explains that the FSCS is funded by levies on firms authorised to operate by either of the Prudential Regulation Authority or the Financial Conduct Authority.

 

So the FSCS is notionally independent and the guarantees are financed by levies on participating firms.

 

However, this does not mean that deposit insurance is in any way a free-market phenomenon: it is explicitly the creature of legislation and participating firms are compelled not just to join, but to join on dictated terms. This is rather like having a system of compulsory car insurance and, moreover, a compulsory system that mandates the exact terms (including the pricing) of the car insurance itself – compulsory one-size-fits-all.

 

This should set off alarm bells that there might be something wrong with it.

 

And how do we know that its designers designed it properly? We don’t.

 

In fact, we know that they couldn’t possibly have designed it properly, as any rational insurance system would tailor the charges to the riskiness of clients, include co-insurance features and other incentives to moderate risk-taking, have charges that would evolve over time in response to changing market conditions, and so forth. This is insurance 101.

 

This is not how deposit insurance works, however.

 

Most of all, any rational system would have the product delivered by the market, not by some jerry-built contraption dreamt up by committees of legislators and regulators who have neither the knowledge nor the incentive to get it right. One also might add few if any of these people have any experience in or understanding of the industry they are meddling with, but let’s move on.

 

It then occurred to me that perhaps my kids are right and I am too cynical – maybe Father Christmas and the fairies do exist: one should keep an open mind – so I checked out the FSCS website to have a closer look at their system. What I found was a masterpiece of gobbledegook that I highly recommend to other connoisseurs of regulatory gibberish:

 

http://www.fscs.org.uk/industry/funding/levy-information/

 

Backward ran sentences until reeled the mind. My favourite bit is the explanation of the levy calculation that does not explain how the levy is actually calculated.

 

All this said, the banks rather like deposit insurance because it gives them a great marketing tool: bank with us and your money is safe because we are members of the deposit guarantee scheme, and you will get your money back even if we happen to fail.

 

They also like it because they can game the system – taking extra risks and offering higher deposit rates than they would otherwise be able to get away with – in effect, exploiting the risk-taking subsidy created by deposit insurance and passing the extra risks to the fund itself.

 

But surely, if the banks like the system, they would create one themselves if the government didn’t create it for them? No. Were this true, the banks would have done exactly that many years ago, and there would have been no ‘need’ for the state to have intervened to do it for them. The fact is that they didn’t.

 

The reason they didn’t is because the service that deposit insurance provides to the retail customer – reassurance or confidence – is better provided in other ways, most notably, by pursuing conservative lending policies and maintaining high levels of capital. And the reason for this is simply that deposit insurance introduces an additional layer of moral hazard and governance headaches that can be avoided if the banks self-insure via moderate risk-taking and high levels of capital.

 

This should come as no surprise. True confidence does not come from “you can trust us if we screw up because someone else will bail you out” but from “you can trust us because it is demonstrably in our interest to make sure we don’t screw up”. Deposit insurance is an inferior confidence product – one might even say, a confidence trick.

 

We can also look at this another way. Suppose that a group of banks attempted to set up a scheme similar to the current one, of their own free will and with no government intervention. They would soon realise that the scheme was not viable – no bank would want to be liable for the risks the others were taking, with no means of controlling those risks. So it would never get off the ground – and the current system only got off the ground because the state imposed it.

 

In short, deposit insurance is not a creature of the market but a creature of the state, and a decidedly inferior one at that. It is, indeed, a classic instance of that regulatory Gresham’s Law by which state intervention causes the bad to drive out the good. Where have we seen that before?

Economics

Yield curve and the US economy

So far in August the differential between the yield on the 10-year Treasury note and the yield on the 3-month Treasury bill stood at 2.38% against 2.95% in December 2013.

Historically the yield differential on average has led the yearly rate of growth of industrial production by fourteen months. This raises the likelihood that the growth momentum of industrial production will ease in the months ahead, all other things being equal.

 

Yield Spread

It is generally held that the shape of the yield curve is set by investors’ expectations. According to this way of thinking – also labeled as the expectation theory (ET) – the key to the shape of the yield curve is the notion that long-term interest rates are the average of expected future short-term rates.

If today’s one-year rate is 4% and next year’s one-year rate is expected to be 5%, the two-year rate today should be (4%+5%)/2 = 4.5%.

It follows that expectations for increases in short-term rates will make the yield curve upward sloping, since long-term rates will be higher than short-term rates.

Conversely, expectations for a decline in short-term rates will result in a downward sloping yield curve. If today’s one-year rate is 5% and next year’s one – year rate is expected to be 4%, the two-year rate today (4%+5%)/2 = 4.5% is lower than today’s one year rate of 5% – i.e. downward sloping yield curve.

But is it possible to have a sustained downward sloping yield curve on account of expectations? One can show that in a risk-free environment, neither an upward nor a downward sloping yield curve can be sustainable.

An upward sloping curve would provoke an arbitrage movement from short maturities to long maturities. This will lift short-term interest rates and lower long-term interest rates, i.e., leading towards a uniform interest rate throughout the term structure.

Arbitrage will also prevent the sustainability of an inverted yield curve by shifting funds from long maturities to short maturities thereby flattening the curve.

It must be appreciated that in a free unhampered market economy the tendency towards the uniformity of rates will only take place on a risk-adjusted basis. Consequently, a yield curve that includes the risk factor is likely to have a gentle positive slope.

It is difficult to envisage a downward sloping curve in a free unhampered market economy – since this would imply that investors are assigning a higher risk to short-term maturities than long-term maturities, which doesn’t make sense.

 

The Fed and the shape of the yield curve

Even if one were to accept the rationale of the ET for the changes in the shape of the yield curve, these changes are likely to be of a very short duration on account of arbitrage. Individuals will always try to make money regardless of the state of the economy.

Yet historically either an upward sloping or a downward sloping yield curve has held for quite prolonged periods of time.

We suggest an upward or a downward sloping yield curve develops on account of the Fed’s interest rate policies (there is an inverse correlation between the yield curve and the fed funds rate).

While the Fed can exercise a certain level of control over short-term interest rates via the federal funds rate, it has less control over long-term interest rates.

FedFundsVsYield

For instance, the artificial lowering of short-term interest rates gives rise to an upward sloping yield curve. To prevent the flattening of the curve the Fed must persist with the easy interest rate stance. Should the Fed slow down on its monetary pumping the shape of the yield curve will tend to flatten. Whenever the Fed tightens its interest rate stance this leads to the flattening or an inversion of the yield curve. In order to sustain the new shape of the curve the Fed must maintain its tighter stance. Should the Fed abandon the tighter stance the tendency for rates equalisation will arrest the narrowing or the inversion in the yield curve.

The shape of the yield curve reflects the monetary stance of the Fed. Investors’ expectations can only reinforce the shape of the curve. For instance, relentless monetary expansion that keeps the upward slope of the curve intact ultimately fuels inflationary expectations, which tend to push long-term rates higher thereby reinforcing the positive slope of the yield curve.

Conversely, an emerging recession on account of a tighter stance lowers inflationary expectations and reinforces the inverted yield curve.

A loose Fed monetary policy i.e. a positive sloping curve, sets in motion a false economic boom – it gives rise to various false activities. A tighter monetary policy, which manifests through an inversion of the yield curve, sets in motion the process of the liquidation of false activities i.e. an economic bust is ensued.

A situation could emerge however where the federal funds rate is around zero, as it is now, and then the shape of the yield curve will vary in response to the fluctuations in the long-term rate. (The fed funds rate has been around zero since December 2008).

Once the Fed keeps the fed funds rate at close to zero level over a prolonged period of time it sets in motion a severe misallocation of resources – a severe consumption of capital.

An emergence of subdued economic activity puts downward pressure on long-term rates. On the basis of a near zero fed funds rate this starts to invert the shape of the yield curve.

At present, we hold the downward slopping yield curve has emerged on account of a decline in long term rates whilst short-term interest rate policy remains intact.

We suggest this may be indicative of a severe weakening in the wealth generation process and points to stagnant economic growth ahead.

Note again the downward sloping curve is on account of the Fed’s near zero interest rate policy that has weakened the process of wealth formation.

Economics

Storm warning

“When Nobel Prize-winner Joseph Stiglitz was asked in Germany this week if the country and its neighbours would suffer a lost decade, his response was unequivocal. “Is Europe going the same way as Japan ? Yes,” Mr Stiglitz said in Lindau at a meeting for Nobel laureates and economics students. “The only way to describe what is going on in some European countries is depression.”

‘Spectre of Japan-style lost decade looms over eurozone’, Claire Jones, The Financial Times, August 22, 2014.

Few films have managed to convey the feeling of approaching menace more effectively than Jeff Nichols’ 2011 drama, ‘Take Shelter’. Its blue collar protagonist, Curtis LaForche, played by the lantern-jawed Michael Shannon – whose sepulchral bass tones make his every utterance sound like someone slowly dragging a coffin over a cello – begins to suffer terrifying dreams and visions; he responds by building a storm shelter in his back yard. It transpires that his mother was diagnosed with schizophrenia at a similar stage in her own life. Are these simply hallucinations ? Or are they portents of darker things to come ?

Nichols, the film’s writer and director, has gone on record as stating that at least part of the film owes something to the financial crisis:

“I think I was a bit ahead of the curve, since I wrote it in 2008, which was also an anxious time, for sure, but, yeah, now it feels even more so. This film deals with two kinds of anxiety. There’s this free-floating anxiety that we generally experience: you wake in bed and maybe worry about what’s happening to the planet, to the state of the economy, to things you have no control over. In 2008, I was particularly struck with this during the beginning of the financial meltdown. Then there’s a personal anxiety. You need to keep your life on track—your health, your finances, your family..”

There’s a degree of pretention in claiming to have a reliable read on the psychology of the marketplace – too many participants, too much intangibility, too much subjectivity. But taking market price index levels at face value, especially in stock markets, there seems to be a general sense that since the near-collapse of the financial system six years ago, the worst has passed. The S&P 500 stock index, for example, has just reached a new all-time high, leaving plenty of financial media commentators to breathlessly anticipate its goal of 2,000 index points. But look at it from an objective perspective, rather than one of simple-minded cheerleading: the market is more expensive than ever – the only people who should be celebrating are those considering selling.

There are at least two other storm clouds massing on the horizon (we ignore the worsening geopolitical outlook altogether). One is the ‘health’ of the bond markets. Bloomberg’s Mark Gilbert points out that Germany has just issued €4 billion of two year notes that pay no interest whatsoever until they mature in 2016. The second is the explicitly declining health of the euro zone economy, which is threatening to slide into recession (again), and to which zero interest rates in Germany broadly allude. The reality, which is not a hallucination, is that years of Zero Interest Rate Policy everywhere and trillions of dollars, pounds, euros and yen pumped into a moribund banking system have created a ‘Potemkin village’ market offering the illusion of stability. In their June 2014 letter, Elliott Management wrote as follows:

“..Stock markets around the world are at or near all-time nominal highs, while global interest rates hover near record lows. A flood of newly-printed money has combined with zero percent interest rates to keep all the balls suspended in the air. Nonetheless, growth in the developed world (US, Europe and Japan) has been significantly subpar for the 5 ½ years following the financial crisis. Businesses have been reluctant to invest and hire. The consumer is still “tapped out,” and there are significant suppressive forces from poor policy, including taxes and increased regulation. Governments (which are actually responsible for the feeble growth) are blaming the shortfall on “secular stagnation,” purportedly a long-term trend, which enables them to deny responsibility..

“The orchestra conductors for this remarkable epoch are the central bankers in the US, UK, Europe and Japan. The cost of debt of all maturities issued by every country, corporation and individual in the world (except outliers like Argentina) is in the process of converging at remarkably low rates. In Greece (for goodness sake), long-term government debt is trading with a yield just north of 5%. In France, 10 year bonds are trading at a yield of 1.67%.

“..Sadly, financial market conditions are not the result of the advancement of human knowledge in these matters. Rather, they are the result of policymaker groupthink and a mass delusion. By reducing interest rates to zero and having central banks purchase most of the debt issued by their governments, they think that inflation can be encouraged (but without any risk that it will spin out of control) and that economic activity consequently can be supported and enhanced. We are 5 ½ years into this global experiment, which has never been tried in its current breadth and scope at any other time in history.. the bald fact is that the entire developed world is growing at a sluggish pace, if at all. But governments, media, politicians, central bankers and academics are unwilling to state the obvious conclusion that their policies have failed and need to be revised. Instead, they uniformly state, with the kind of confidence only present among the truly clueless, that in the absence of their current policies, things would be much worse.”

Regardless of the context, stock markets at or near all-time highs are things to be sceptical of, rather than to be embraced with both hands. Value investors prefer to buy at the low than at the high. The same holds for bonds, especially when they offer the certainty of a loss in real terms if held to maturity. But as Elliott point out, the job of asset managers is to manage money, and not to “hold up our arms and order the tide to roll back”. (We have written previously about those who seem to believe they can control the tides.) So by a process of logic, selectivity and elimination, we believe the only things remotely worth buying today are high quality stocks trading at levels well below their intrinsic value.

We recently wrote about the sort of metrics to assess stocks that can be reliably used over the long run to generate superior returns. Among them, low price / book is a stand-out characteristic of value stocks that has generated impressive, market-beating returns over any medium term time frame. So which markets currently enjoy some of the most attractive price / book ratios ?

The four tables below, courtesy of Greg Fisher and Samarang Capital, show the relative attractiveness of the Japanese, US, Vietnamese and UK markets, as expressed by the distributions of their price / book ratios. Over 40% of the Japanese market, for example, trades on a price / book of between 0.5 and 1. We would humbly submit that this makes the Japanese market objectively cheap. The comparative percentage for the US market is around 15%.

Various stock markets as expressed in price / book ratios

PriceBookRatios

Source: Bloomberg LLP

Even more strikingly, nearly 60% of the Vietnamese stock market trades on a price / book of between 0.5 and 1. The comparative figure for the UK market is approximately 20%.

Conversely, nearly 60% of the US market trades on a price / book of above 2 times. We would humbly submit that this makes the US market look expensive. There is clearly a world of difference between a frontier market like Vietnam which is limited by way of capital controls, and a developed market like that of the US which isn’t. But the price / book ratio is a comparison of apples with apples, and US stock market apples simply cost more than those in Japan or Vietnam. We’d rather buy cheap apples.

As clients and longstanding readers will appreciate, we split the investible universe into four asset classes: high quality credit; value equity; uncorrelated funds; and real assets, notably precious metals. As a result of the extraordinary monetary accommodation of the past six years or so, both credit markets and stocks have been boosted to probably unsustainable levels, at least in the West. Uncorrelated funds (specifically, trend-following funds) and gold and silver have recently lagged more traditional assets, though we contend that they still offer potential for portfolio insurance when the long-awaited storm of reality (financial gravity) finally strikes. But on any objective analysis, we think the merits of genuine value stocks are now compelling when set against any other type of investment, both on a relative and absolute basis. Increasingly desperate central banks have destroyed the concept of safe havens. There is now only relative safety by way of financial assets. The mood music of the markets is becoming increasingly discordant as investors (outside the euro zone at least) start to prepare for a turn in the interest rate cycle. There is a stark choice when it comes to investment aesthetics. Those favouring value and deep value investments are, we believe, more likely to end up wearing diamonds. Those favouring growth and momentum investments are, we believe, more likely to end up wearing the Emperor’s new clothes. We do not intend to end up as fashion victims as and when the storm finally hits.

Economics

Stocks and the Stockdale Paradox

 “Anything can happen in stock markets and you ought to conduct your affairs so that if the most extraordinary events happen, you’re still around to play the next day.”

  • Warren Buffett.

Vice Admiral James Stockdale has a good claim to have been one of the most extraordinary Americans ever to have lived. On September 9th, 1965 he was shot down over North Vietnam and seized by a mob. Having broken a bone in his back ejecting from his plane he had his leg broken and his arm badly injured. He would spend the next seven years in Hoa Lo Prison, the infamous “Hanoi Hilton”. The physical brutality was unspeakable, and the mental torture never stopped. He would be kept in solitary confinement, in total darkness, for four years. He would be kept in heavy leg-irons for two years, on a starvation diet, deprived even of letters from home. Throughout it all, Stockdale was stoic. When told he would be paraded in front of foreign journalists, he slashed his own scalp with a razor and beat himself in the face with a wooden stool so that he would be unrecognisable and useless to the enemy’s press. When he discovered that his fellow prisoners were being tortured to death, he slashed his wrists to show his torturers that he would not submit to them. When his guards finally realised that he would die before cooperating, they relented. The torture of American prisoners ended, and the treatment of all American prisoners of war improved. After being released in 1973, Stockdale was awarded the Medal of Honour. He was one of the most decorated officers in US naval history, with 26 personal combat decorations, including four Silver Stars. Jim Collins, author of the influential study of US businesses, ‘Good to Great’, interviewed Stockdale during his research for the book. How had he found the courage to survive those long, dark years ?

“I never lost faith in the end of the story,” replied Stockdale.

“I never doubted not only that I would get out, but also that I would prevail in the end and turn the experience into the defining moment of my life, which in retrospect, I would not trade.”

Collins was silent for a few minutes. The two men walked along, Stockdale with a heavy limp, swinging a stiff leg that had never properly recovered from repeated torture. Finally, Collins went on to ask another question. Who didn’t make it out ?

“Oh, that’s easy,” replied Stockdale. “The optimists.”

Collins was confused.

“The optimists. Oh, they were the ones who said, ‘We’re going to be out by Christmas.’ And Christmas would come, and Christmas would go. Then they’d say, ‘We’re going to be out by Easter.’ And Easter would come, and Easter would go. And then Thanksgiving. And then it would be Christmas again. And they died of a broken heart.”

As the two men walked slowly onward, Stockdale turned to Collins.

“This is a very important lesson. You must never confuse faith that you will prevail in the end – which you can never afford to lose – with the discipline to confront the most brutal facts of your current reality, whatever they might be.”

As Collins’ book came to be published, this observation came to be known as the Stockdale Paradox. For Collins, it was exactly the same sort of behaviour displayed by those company founders who had led their businesses through thick and thin. The alternative was the average managers at also-ran companies that enjoyed average returns at best, or that failed completely.

At the risk of stating the blindingly obvious, this is hardly a ‘good news’ market. Ebola. Ukraine. Iraq. Gaza. In a more narrowly financial sphere, the euro zone economy looks to be slowing, with Italy flirting with a triple dip recession, Portugal suffering a renewed banking crisis, and the ECB on the brink of rolling out QE. If government bond yields are a reflection of investor confidence, the fact that two-year German rates have gone below zero is hardly inspiring.

And we have had interest rates held at emergency levels for five years now – gently igniting who knows what form of as yet unseen problems to come. In Europe interest rates seem set to stay low or go even lower. But in the UK and the US, the markets nervously await the first rate hike of a new cycle while central bankers bluster and dither.

What are the implications for global asset allocation and stock selection ?

Both in absolute terms and relative to equities, most bond markets (notably the Anglo-Saxon) are ridiculously overvalued. Since the risk-free rate has now become the return-free risk, cash now looks like the superior asset class diversifier.

As regards stock markets, price is what you pay, and value (or lack thereof) is what you get. On any fair analysis, the US market in particular is a fly in search of a windscreen. Using Professor Robert Shiller’s cyclically adjusted price / earnings ratio for the broad US stock market, shown below, US stocks have only been more expensive than they are today on two occasions in the past 130 years: in 1929, and in 2000. The peak-to-trough fall for the Dow Jones Industrial Average from 1929 equated to 89%. The peak-to-trough fall for the Dow from 2000 equated to “just” 38%. Time will tell just how disappointing (both by scale and by duration) the coming years will be for US equity market bulls.

But we’re not interested in markets per se – we’re interested in value opportunities incorporating a margin of safety. If the geographic allocations within Greg Fisher’s Asian Prosperity Fund are any guide, those value opportunities are currently most numerous in Japan and Vietnam. In the fund’s latest report he writes:

“Interestingly, and despite China’s continued underperformance, the Asian markets in aggregate have done better at this stage in 2014 than last year, while other global markets have fared less well. In our view the reason is simple – a combination of more attractive valuations than western markets, especially the US, but also, compared with 12-18 months ago, recognisably poor investor sentiment and consequently under-positioning in Asia, leading to the chance of positive surprises.”

Cylically adjusted price / earnings ratio for the S&P 500 Index

Cyclically Adjusted PE Ratios

Source: www.econ.yale.edu/~shiller/data/ie_data.xls

The Asian Prosperity Fund is practically a poster child for the opportunity inherent in global, unconstrained, Ben Graham-style value investing. Its average price / earnings ratio stands at 9x (versus 18x for the FTSE 100 and 17x for the S&P 500); its price / book ratio stands at just one; historic return on equity is an attractive 15%; average dividend yield stands at 4.2%. And this from a region where long-term economic growth seems entirely plausible rather than a delusional fantasy.

Vice Admiral Stockdale was unequivocal: while we need to confront the “brutal facts” of the marketplace, we also need to keep faith that we will prevail. To us, that boils down to avoiding conspicuous overvaluation (in most bond markets, for example, and a significant portion of the developed equity markets) and embracing equally conspicuous value – where poor sentiment is likely to intensify subsequent returns. In this uniquely oppressive financial environment, with the skies darkening with the prospect of a turn in the interest rate cycle, we think optimism could be fatal. Or as Warren Buffett once observed,

“You pay a very high price in the stock market for a cheery consensus.”

Economics

Keep calm and carry on

At the end of July global equity bull markets had a moment of doubt, falling three or four per cent. In the seven trading days up to 1st August the S&P500 fell 3.8%, and we are not out of the woods yet. At the same time the Russell 2000, an index of small-cap US companies fell an exceptional 9%, and more worryingly it looks like it has lost bullish momentum as shown in the chart below. This indicates a possible double-top formation in the making.

Russell 2000 08082014

 

Meanwhile yield-spreads on junk bonds widened significantly, sending a signal that markets were reconsidering appropriate yields on risky bonds.

This is conventional analysis and the common backbone of most brokers’ reports. Put simply, investment is now all about the trend and little else. You never have to value anything properly any more: just measure confidence. This approach to investing resonates with post-Keynesian economics and government planning. The expectations of the crowd, or its animal spirits, are now there to be managed. No longer is there the seemingly irrational behaviour of unfettered markets dominated by independent thinkers. Forward guidance is just the latest manifestation of this policy. It represents the triumph of economic management over the markets.

Central banks have for a long time subscribed to management of expectations. Initially it was setting interest rates to accelerate the growth of money and credit. Investors and market traders soon learned that interest rate policy is the most important factor in pricing everything. Out of credit cycles technical analysis evolved, which sought to identify trends and turning points for investment purposes.

Today this control goes much further because of two precedents: in 2001-02 the Fed under Alan Greenspan’s chairmanship cut interest rates specifically to rescue the stock market out of its slump, and secondly the Fed’s rescue of the banking system in the wake of the Lehman crisis extended direct intervention into all financial markets.

Both of these actions succeeded in their objectives. Ubiquitous intervention continues to this day, and is copied elsewhere. It is no accident that Spanish bond yields for example are priced as if Spain’s sovereign debt is amongst the safest on the planet; and as if France’s bond yields reflect a credible plan to repay its debt.

We have known for years that through intervention central banks have managed to control the prices of currencies, precious metals and government bonds; but there is increasing evidence of direct buying of other financial assets, including equities. The means for continual price management are there: there are central banks, exchange stabilisation funds, sovereign wealth funds and government-controlled pension funds, which between them have limitless buying-power.

Doubtless there is a growing band of central bankers who believe that with this control they have finally discovered Keynes’s Holy Grail: the euthanasia of the rentier and his replacement by the state as the primary source of business capital. This being the case, last month’s dip in the markets will turn out to be just that, because intervention will simply continue and if necessary be ramped up.

But in the process, all market risk is being transferred from bonds, equities and all other financial assets into currencies themselves; and it is the outcome of their purchasing power that will prove to be the final judgement in the debate of markets versus economic planning.

Economics

Lessons in investment warfare

“Let us learn our lessons. Never, never, never believe any war will be smooth and easy, or that anyone who embarks on that strange voyage can measure the tides and hurricanes he will encounter. The statesman who yields to war fever must realise that once the signal is given, he is no longer the master of policy but the slave of unforeseeable and uncontrollable events.

“Antiquated War Offices, weak, incompetent or arrogant commanders, untrustworthy allies, hostile neutrals, malignant fortune, ugly surprises, awful miscalculations – all take their seats at the Council Board on the morrow of a declaration of war. Always remember, however sure you are that you can easily win, that there would not be a war if the other man did not think he also had a chance.”

Winston Churchill, ‘My Early Life’, quoted by Charles Lucas in a letter to the FT, 23rd July 2014.

And there is a war being conducted out there in the financial markets, too, a war between debtors and creditors, between governments and taxpayers, between banks and depositors, between the errors of the past and the hopes of the future. How can investors end up on the winning side ? History would seem to have the answers.

For history, read in particular James O’Shaughnessy’s magisterial study of market data, ‘What Works on Wall Street’ (hat-tip to Abbington Investment Group’s Peter Van Dessel). O’Shaughnessy offers rigorous analysis of innumerable equity market strategies, but we are instinctively and philosophically drawn most strongly towards the value factors highlighted hereafter.

The chart below shows the results accruing to various strategies across the All Stocks universe – all companies in the Standard & Poor’s Compustat database with market capitalisations above $150 million, a dataset which comprises between 4,000 and 5,000 individual companies. The analysis takes in over half a century’s worth of data.

Making the (fairly reasonable) assumption that the data in this study is sufficiently broad to mitigate the effects of shorter term market “noise”, the results are unequivocal. Buying stocks with high price-to-sales (PSR) ratios; buying stocks with high price / cashflow ratios; buying stocks with high price / book ratios; buying stocks with high price / earnings (PE) ratios; all of these are disastrous strategies relative to the performance of the broad index itself. Caution: these all happen to be ‘growth’ strategies.

Value of $10,000 invested in various strategies using the All Stocks universe, from January 1951 to December 2003

RatesOfReturn1

(Source: What Works on Wall Street by James P. O’Shaughnessy, Third Edition, McGraw-Hill 2005)

But the converse is also true – in spades. Buying stocks with low price-to-sales ratios; buying stocks with low price / book ratios; these are both outstandingly successful strategies over the longer term, converting that initial $10,000 into over $22 million in each case. Buying stocks on low price / cashflow ratios is also a winning strategy. The relatively simple ‘high yield’ and ‘low p/e’ strategies also comfortably outperform the broad market. Note that these are all ‘value’ strategies.

This leads O’Shaughnessy to question the legitimacy of the so-called Capital Asset Pricing Model, in which investors are compensated for taking more risk:

“..the higher risk of the high P/Es, price-to-book, price-to-cashflow, and PSRs went uncompensated. Indeed, each of the strategies significantly underperformed the All Stocks Universe.”

Perhaps the market is indeed less efficient than certain academics would have us believe. The world’s most successful investor, Warren Buffett, would seem to think so. As he was quoted in a 1995 issue of Fortune magazine,

“I’d be a bum on the street with a tin cup if the markets were always efficient.”

And note that careful addition of the word “always”. Buffett wasn’t even going so far as to suggest that the markets are never efficient, but rather that the patient investor can take advantage of Mr. Market’s occasional lapses into the realms of absurdity, whether in the form of bullishness or outright despair.

O’Shaughnessy frames the returns from these various ‘growth’ and ‘value’ strategies more explicitly in the chart below.

Compound average annual rates of return across various strategies for the 52 years ending in December 2003

RatesOfReturn

(Source: What Works on Wall Street by James P. O’Shaughnessy, Third Edition, McGraw-Hill 2005)

Special pleaders on the part of ‘growth at any cost’ might argue that the time series is insufficient. But if 52 recent years – easily an investor’s lifetime – taking in at least two grinding bear markets are not enough, how much would be ?

Again, the conclusions are clear. Buying stocks on low price-to-sales ratios is a winner, tying with stocks on a low price-to-book ratio with an annualised return over the longer term of 15.95%. Low price-to-cashflow is also a stellar performer. Buying stocks with a high yield also beats the broad market, as does buying stocks with low price / earnings ratios. Again, these are all explicit ‘value’ strategies.

Since we appear to be living through something of a speculative bubble (a bubble inflated quite deliberately by explicit central bank action), it is worth recalling one prior instance of ‘growth’ outperforming. As O’Shaughnessy points out,

“Between January 1, 1997 and March 31, 2000, the 50 stocks from the All Stocks universe with the highest P/E ratios compounded at 46.69 percent per year, turning $10,000 into $34,735 in three years and three months. Other speculative names did equally as well, with the 50 stocks from All Stocks with the highest price-to-book ratios growing a $10,000 investment into $33,248, a compound return of 44.72 percent. All the highest valuation stocks trounced All Stocks over that brief period, leaving those focusing on the shorter term to think that maybe it really was different this time. But anyone familiar with past market bubbles knows that ultimately, the laws of economics reassert their grip on market activity. Investors back in 2000 would have done well to remember Horace’s Ars Poetica, in which he states: “Many shall be restored that are now fallen, and many shall fall that are now in honour.”

“For fall they did, and they fell hard. A near-sighted investor entering the market at its peak in March of 2000 would face true devastation. A $10,000 investment in the 50 stocks with the highest price-to-sales ratios from the All Stocks universe would have been worth a mere $526 at the end of March 2003..

“You must always consider risk before investing in strategies that buy stocks significantly different from the market. Remember that high risk does not always mean high reward. All the higher-risk strategies are eventually dashed on the rocks..”

This might seem to imply that there is safety simply in the avoidance of explicitly high-risk strategies, but we would go further. We would argue today that central bank bubble-blowing has made the entire market high-risk, with a broad consensus that with interest rates at 300-year lows and bonds hysterically overpriced and facing the prospect of interest rate rises to boot, stocks are now “the only game in town”. We concede that by a process of logic and elimination, selective stocks look way more attractive than most other traditional assets, but the emphasis has to be on that word “selective”. We see almost no attraction in stock markets per se, and we are interested solely in what might be called ‘special situations’ (notably, in ‘value’ and ‘deep value’ strategies) wherever they can be identified throughout the world. We note, in passing, that markets such as those of the US appear to be virtually bereft of such ‘value’ opportunities, whereas those in Asia and Japan seem to offer them in relative abundance. In this financial war, we would prefer to be on the side of the victors. If history is any guide, the identity of the losers seems to be self-evident.

Economics

A tale of two certainties

It is common knowledge that Japan is in extreme financial difficulties, and that the currency is most likely to sink and sink. After all, Government debt to GDP is over 250%, and the rate of increase of retirees has exceeded the birth rate for some time. A combination of population demographics, escalating welfare costs, high government debt and the government’s inability in finding a solution to Japan’s ongoing crisis ensures for international speculators that going short of the yen is a no-brainer.

 
Almost without being noticed, the Japanese yen has already lost about 30% against the US dollar and nearly 40% against the euro over the last two years. The beneficiaries of this trend unsurprisingly are speculators borrowing yen at negligible interest rates to speculate in other markets, expecting to add the yen’s depreciation to their profits. Thank you Mr Abe for allowing us to borrow yen at 1.06 euro-cents two years ago to invest in Spanish 10-year government bonds at 7.5%. Today the bonds yield 2.65% and we can buy back yen at 0.72 euro-cents. Gearing up ten times on an original stake of $10,000,000 has made a clear profit of some $300,000,000 in just two years.

 
Shorting the yen has not been profitable this year so far, with the US dollar falling against the Japanese yen from 105.3 on December 31st to 101.5 at the half-year, an annualised loss of 7.2%. This gave a negative financing return on all bond carry trades, which in the case of Spanish government debt deal cited above resulted in annualised losses of over 5%, or 50% on a ten times geared position. The trader can either take the view it’s time the yen had another fall, or it’s time to cut the position.

 
These returns, though dependant on market timing, are by no means unique. Consequently nearly everyone in the hedge fund and investment banking communities has been playing this lucrative carry game at one time or another.

 
Not only has a weak yen been instrumental in lowering bond yields around the world, it has also been a vehicle for other purchases. On the sale or short side, another commonly agreed certainty has been the imminent collapse of the credit-driven Chinese economy, which will ensure metal prices continue to fall. In this case, gearing is normally obtained through derivatives.

 
However, things don’t seem to be going according to plan for many investment banks and hedge funds, which might presage a change of strategy. Copper, which started off as a profitable short by falling 12.5% to a low of $2.93 per pound, has recovered sharply this week to $3.26 in a sudden short-squeeze. Zinc is up 6.4% over the last six months, and aluminium up 6%. Gold is up 11%, and silver 8.5%. So anyone shorting a portfolio of metal futures is making significant losses, particularly when the position is highly geared.

 
It may be just coincidence, but stories about multiple rehypothecations of physical metal in China’s warehouses have emanated from sources involved with trading in these metals. These traders have had to take significant losses on the chin on a failed strategy, and may now be moving towards a more bullish stance, because China’s warehouse scandal has not played out as they expected.

 
So two certainties, the collapse of both the yen and of Chinese economic demand don’t seem to be happening, or at least not happening quickly enough. The pressure is building for a change of investment strategies which is likely to drive markets in new directions in the coming months.