It has been some time since this author has posted and can only put that down to the rather pesky explanation of being caught up in having to earn a living, but just when I thought I was out it has pulled me back in.
My self -imposed mandate for this blog is to inform and try to simply explain what is going on in the world whether it be geo-political or economic issues. The type of issues that too often get removed from front pages of mainstream media and replaced by rather more trivial issues.
There has been much to talk about over the last few months and rather than rehash it all verbatim perhaps it would be best to start with a snapshot of where we are today both economically and politically.
Since my last post a few things have changed but stayed exactly the same, what I mean by that is that we still live in a world where central banks are dominating the landscape and controlling markets around the world. The saying ” the FED is the only game in town” can be extended to “the FED, the ECB, the BOJ and the BOE are the only games in town”, and probably to be fair in that order as-well. Ben Bernanke has left the FED to be replaced by Janet Yellen, who by all accounts is a very capable economist. Despite a few gaffes here and there due to inexperience conversing with the savage hungry international finance journalists, she has done a half decent job of controlling an exit strategy from the infamous Quantitative Easing ( QE ) programme in the US which has been going on for circa 5 years now and been probably the biggest economic experiment of our lifetime.
What does an exit from QE by the US actually mean though? To simplify matters think of how you learned to ride a bike for the first time, first you learned with stabilizers then gradually as your balance improved you removed the stabilizers and put your faith in your parents holding on to your saddle while you got to grips with propelling yourself along, then one day your sneaky parents let you ride off away from them without you knowing they were not holding your saddle, the result was you either crashed instantly or you realized you were doing just fine without them and pedaled on. This is what the FED are attempting, to let go of the saddle and hope that the economy rides off into the sunset.
If I knew what the outcome of the FED exiting the stimulus programme would be I would be a very rich man indeed, but the truth is no-one knows. we can all pontificate (and I can ensure you many do….all the time) But the truth is no-one knows as this experiment has little in terms of precedence, I.E. we have no play book . Throughout the whole QE campaign most commentators have said what a huge mistake it is and it will lead to hyperinflation and the FED is manipulating markets etc etc. In truth we have not seen hyperinflation but we have seen a dramatic rise in the valuations of both equity and bond investments around the world. This is because as I have argued before the idea or theory behind QE is probably a good idea but like many good ideas the transmission is the most important step of the process and this I believe is flawed.
The one common theme often associated with growth in an economy is credit creation. If there is no demand for credit then an economy will struggle for growth. What the FED have done is step in and replaced the drop in demand for credit, until such a time as it picks up again. By lowering rates (i.e interest rates on savings) to near zero they are trying to redirect that capital (savings) into investment capital to spur growth. Also by “printing money” and buying treasuries ( Government bonds) they are again encouraging the capital normally invested in these instruments to find a new home and again stimulate investment and eventually growth.
Here’s the catch, the very people that need credit to grow are small businesses or individuals, the process of getting the money from the FED (the transmission) is flawed as the money or credit created by the FED is residing with the banks or large corporations or those with easy access to credit (think high net worth individuals). Now these people see that they are being lent money at historically very low interest rates so the rational thing for them to do is put that money into another productive asset that will earn them more on interest or growth of capital than the rate being charged for the “loan.” The average guy on the street does not see the benefit of this credit creation for a few reasons. Average Joe is still hungover from the last credit binge and struggling under the weight of trying to pay down debt or just keep his head above water, Joe’s wages have either been stagnant or lowered over the last 5 years and not kept pace with inflation, Joe does not have the credit score to get a loan owing to tighter lending standards imposed by regulators on banks as a smack on the wrist for their wreckless behavior in the past.
Also if I were a small to medium enterprise I would be very confused by the push-pull situation I fund myself in, the political heads are at pains to say how they support the working class and making every effort to support SME’s as they are so vital to the growth of a country. But at every opportunity fail to back that up and preferred treatment is given to large corporations through bailouts, tax breaks and bowing to political lobbyists. If I were trying to set up a new business now the risk of failure to me as an individual is a lot higher than the risk of failure of a large corporation, and yet the government is practically blaming me for the lack of growth and doing nothing to ensure that large corporations are pulling their weight by increasing employment rather than cutting it. Anyway that is more rant than informative so I will stop there.
The FED actions are in some way or another being replicated all around the worlds economies, which is to say that central banks or government vehicles have drastically expanded their balance sheets (i.e bought or appropriated some form of assets be it bonds, banks, loan books or properties) in order to prop up the drop in demand for those assets. Think of two weightlifters one who weighs twenty stone and one who weighs ten stone, it is more likely the twenty stone lifter wont buckle under the pressure of a heavy weight for longer than the ten stone lifter and therefore one of the most precious commodities of all has been bought …..time.
What has confused most and especially this year is that bond yields in these countries while not at all time historic lows are trending lower again (bond yields move inversely to price i.e. demand). Many are confused on this topic as they assume that because the FED is unwinding QE it inevitably means that official interest rates are going to go higher and therefore bond yields have to actually rise (i.e investors sell bonds) to compensate for this. As is so often the case in financial markets conventional “wisdom” rarely correlates to what actually happens and leaves many to scratch their head.
While I am far from an expert in bond markets two things smack me in the face for the case for lower bond yields. the first most obvious one is that despite winding down their purchases the FED is still a huge owner of government securities and therefore the supply of treasuries has been greatly reduced, the author acknowledges he does not know the actual amount but it is safe to say that they have an awful lot, the current pace of purchases is still $45 BLN a month so if I knew that the market I traded had a guaranteed buyer of $45 bln a month despite knowing their intentions to reduce purchase I would still do what Paul Tudor Jones (a very famous and successful trader) recently said and wait to see the “whites of their eyes” before I gave up my long in that asset.
Secondly so much of bond investing is done by pension fund managers that are more often than not driven not by out-performance but by liability driven investing. Again not being a bond expert but basically this means matching your assets with your liabilities. So if I am a pension fund manager and able to estimate very accurately what my future liabilities are in respects to paying out income to my participants I can then make an investment today that will match my income to my liabilities. Pension funds biggest drag on performance is often inflation, inflation is not as predicted running away with itself, on the contrary is some parts of the world (Europe) central bankers are more concerned about deflation. Current CPI (index that tracks inflation) in US is approx 2%, current 10 year treasury yields are at the time of writing approx 2.476% so I can still purchase these instrument and match my future needs. In reality it is not as simple as that I appreciate but the basic premise holds.
Enough talk of the US what is happening elsewhere. Well if you are a resident in Europe then its all very exciting (in a very boring European way). Mr. Draghi who if wasn’t a highly respected economist would make an excellent poker player has been battling an exchange rate that just wont die and the mortal enemy of of any central banker deflation. Europe is suffering from malaise caused by an over burdened banking sector, a European union that is slowly rejecting the concept of unity and leaders who are caught between their own country’s needs and a framework that stops them from acting in their countries best interest.
Next week Draghi will unveil from his magic hat either a rabbit that will stop deflation or a set of stimulus measures that will give Europe the kick in backside it needs. My money is on. The most likely event or outcome is that Draghi will re-iterate his commitment to using ” unconventional tools ” of monetary policy (with little clarity on what they are) and move the overnight deposit rate (refinancing rate) to near zero and official deposit rates probably to 15bps. Again this is similar to what the US did, moving the interest rate gained on savings to near zero ” should” provide an incentive for capital or savings to find a new home where it can earn a return better than zero and at least in line with or above inflation. there has been speculation that he will roll out European QE which I just feel is not the case, unless this author has missed something the structure and legal framework needed to conduct a massive government bond buying scheme is still not in place in Europe and therefore his hands are tied on that one. Average Joe should think himself lucky on this one as taking cue from the US experiment all that would happen would be inflation in stock market valuations and profit margins at large corporates which has not necessarily translated into full employment or an increase in the participation rate. What it does mean however is that with negative interest rates that capital that normally earned interest on savings will have to find a home somewhere or runs the risk of losing its purchasing power (which is like death by a thousand cuts).
To an extent this has already been happening. Moving the interest on savings from its most recent 25 bps to 15 bps is not exactly earth shattering and this excess capital has to some extent already found a home. Those of you living in Ireland will have witnessed the recent mini rebound taking place in prices for property in Dublin. While you can say it is a mini bubble etc and the rest of country may not be going through it you would be correct but this is where it starts and this author feels it is as a direct result of investors looking for a yield (rent) that will surpasses their expectations of inflation over the medium to long term. It just helps that those house prices were hit to valuations not seen in the country for some time. This author does not feel it is sustainable unless Ireland achieves anything close to its growth rates in the past which as we all know now was built on nothing but quicksand.
Europe still has very high levels of unemployment especially among the youth but also levels of underemployment which can often mask the government statistics. These levels of unemployment and low morale amongst Europe are leading to a slowly gathering but definable movement against European Union. All countries which have gone through local and MEP elections for Europe recently including UK has seen significant gains for right wing parties that either did not exist or were totally irrelevant ten years ago. Most of these parties are often labelled in the press as racist or crackpots, and the majority of them have a similar agenda in that they want to stem the flow of immigrants into their country from weaker EU states or they are riding the populist wave of anti EU propaganda. No matter what they stand for or how much or little they actually know about running an entire country (which I suspect is little) it is hard to deny their current achievements and possibly the best contribution they are making is they are highlighting just how out of touch current parties are with their electorate. This author is largely ignorant of politics but finds it amazing that times of strife and difficulty seems to be the most fertile grounds for extreme right wing parties to make gains, so more established parties should concentrate their efforts understanding that votes for these parties usually demonstrate a protest vote against the current regime and that there are issues needing to be addressed sooner rather than later.
If you are still with me on this article first of all congrats! but second of all perhaps you are wondering what is happening out in Asia ? China the country that most fear because of its size and scale is like nothing we have known before is rapidly advancing still, growth rates are well off the highs of above 10% a year but still a very respectable and equally jaw dropping +7%. These are of course the official figures from the politburo in China which many authors are always at pains to tell us are totally unreliable. Whether they are unreliable or not this author will choose to take them at face value as he has no way of disproving the numbers. Earlier this year China threw a scare into investors when the overnight lending rate SHIBOR spiked suddenly. Many of you will remember that back in the early days of the credit crunch one of the big warning signs of impending doom was the LIBOR spiking. This is the rate at which banks are willing to lend money to each other overnight or for certain other duration as in an indication of overall liquidity and confidence levels etc. Well SHIBOR is just the Chinese equivalent of this and the spike in it is significant because it shone a light on an area where most peoples concern in China lies. the rather murky sounding ” CHINESE SHADOW BANKING SYSTEM”. Much has been written about this and this author can only come to the conclusion that the reason we most fear it is because we cant see it or understand it.
Traditionally the Chinese banking sector has been state controlled so the government can turn on and off lending at the flick of a switch and thereby control the rate at which growth takes place. However despite doing this China is becoming to an extent less state controlled, so another tier of financing is taking place, and sadly its off balance sheet lending. My understanding is that non-traditional lending companies are loaning money for development projects which are increasingly falling victim to the laws of gravity whereby growth can not go in one straight line all the time. As an example think of a steel mill in china lending money to a developer of real estate, the developer buys the steel and produces the apartment block and pays back the loan to the steel mill who in turn pays back the money to the bank. The reason this is scary is because its off balance sheet of the traditional banks and the money lent to the steel mill in the first place has now been leveraged more times than the original loan. One step wrong is this chain will have a larger domino effect than traditional lending and hence it is a problem.
While this is a concern to me I will stop short of prophetic warnings about the imminent collapse of China and therefore Armageddon and take some confidence in the fact that If I know there is an existence of a shadow banking system in China and roughly how it happens then you can be sure the Chinese Government know who the players are and how it is occurring, as long as corruption doesn’t get in the way (which it does) then the state can step in and wield a mighty axe when it wants despite their movement to be less centralized state.
Geo-politics has also played a role in shaping the headlines of late an none more so than the annexation of Crimea by Russia. Plenty has been written about the topic and most of it is a guessing game as to Russia’s intentions, certainly if you look at Crimea on its own it offers very little strategic value in owning. However a few things stand out. Crimea juts out into the Black sea a potential goldmine of natural gas resources of which Russia would like to stake claim to, in a handy twist of events for Putin he was able to dominate it by “standing up for Russians”, as the majority of population is of Russian descent. Despite Russia currently feeling the pinch for these actions owing to sanctions imposed on their major industries and key players by both US and Europe there will come a time when this will work counter productive for Europe as we rely heavily on gas imports from Russia. Whether EU has stockpiled enough to get through the next winter is doubtfull and whether Putin is stubborn enough and strong enough to undergo these pressures is still up for debate but it does lead to my next point that it seems like he is the kind of guy who just like to poke sticks at people in an assertion of Russian dominance and power. One of my favorite quotes from recent Batman film from Alfred below sums it up. While it might be a stretch to say Putin wants to see the world burn I do think he is a complex character that enjoys power just a little too much, (although I would not say that to his face!)
- “Some men aren’t looking for anything logical, like money. They can’t be bought, bullied, reasoned or negotiated with. Some men just want to watch the world burn.”
Through my line of work I have learnt that projections about the future are completely futile and fruitless however it does not stop us trying so in that vein what I suspect will happen going forward is summarised in a few simple bullet points:
- The FED will continue to stimulate its economy either through asset purchases for the next few months and continuing in a zero rate environment for at least another year. Despite all the talking heads this will probably lead to equities continuing higher. How high is a mystery but will be filled with periods of intermittent panic and pullbacks. Once we are on a relevant course for higher interest rates then things will start to get very tricky but for now the music is still playing and no chairs have been removed.
- The ECB will move to zero or even negative rates in an effort to stimulate inflation which is their main agenda, they will probably increase schemes like LTRO which provides discount lending to banks for refinancing but until they have the political will and framework in place will stop short of actually buying bonds but continue to threaten to do so. Equity Property prices and general productive assets (income producing assets) will have a tick up across the EU especially in the PIGS countries (as everyone like a perceived bargain ). Politically I have no idea what will happen in EU but I know it will take a VERY LONG TIME to do anything as it normally does.
- China will continue to grow but less so each year until it becomes a more mature economy and diversified, I feel the glory days of producing cheap products to sell to western markets are behind it due to a more empowered Chinese worker and less confident consumer in the west. History also has a habit of repeating itself and manufacturing will always move to the lowest cost provider. So as China grows it will have to find new ways to diversify that growth. But a country that has the entrepreneurial spirit, a massive workforce, improving standards of education and slowly but surely improving standards of governance will always be a force to be reckoned with.
With that, I hope I have painted a simple picture of where we are and hopefully where we might be headed, congrats if you stuck with me till the end and I hope to get back to more regular postings in the future albeit shorter! Comments, questions etc are as always welcome and I will endeavor to respond however trolling will be ignored and filed away in the trash can!