Macro
The Capitulation of Complacency
Good morning! The last week before the whole of Asia takes a siesta for Chinese New Year next week.
Let’s pick up where we left off on Friday. Last week I spent a lot of time talking about inflation and the looming sovereign debt crises facing the globe. The two are, of course, related – given than there is much debt coming due which needs to be refinanced. Run-away inflation would result in significantly higher interest payments, something even economies like the US simply cannot afford. We are on a trajectory where projected interest payments on US Governement liabilities will soon become the single largest expenditure of the Federal Budget. When you repair a road or build a hospital or increase the salaries of teachers this is a “cost”, but on the other side of the ledger there are benefits to this which usually result in long term benefits to the economy. In fact, this type of Federal expenditure should not be considered as costs, they are investments. What do you get when you pay interest to foreign counterparts? Nothing, Zilch, Zip, Didly-squat.
You will recall I also made a throw-away comment on Friday about the “surprise” of downturns and how sell-offs like the one we have just seen rarely come at times we expect.
In my opinion, this is a typical sell-off in the markets. They never happen when you expect them to, do they? That’s because they are sparked by a sudden change in sentiment and sentiment is notoriously hard to predict. But because this is a psychological issue I can deduce two things:
- There is not much substance to this sell-off
- There is a lot of substance to this sell-off
If you see what I mean… or in other words: I have no idea why the markets have chosen the last 3 weeks to stage their sell-off. It seems to be 3 weeks like any other in my opinion. If anything Earnings looked to come in line with expectations and the GDP print was much higher than we thought it would be. It’s a funny old World.
While I was being a little facetious here, the truth is, there rarely seems to be logic behind the timing of market corrections. This is because, while underlying fundamental conditions could be argued, bears and economic pessimists are best known for how long they are “wrong” before they are “right”. The “trigger point” for a sell-off is largely psychological, which makes them incredibly difficult to predict and, as we know from the adage; the market can remain irrational much longer than you can remain liquid. This is often where the opinions of market participants diverge from economists (no surprises there). We must be humble enough to realize that there are things we do not always understand even in the market place – it is dangerous to follow economic theory right to the bitter end in a market dominated by a psychology which is continuously moving and evolving.
A physicist, a chemist, and an economist are shipwrecked on a desert island. Starving, they find a case of canned pork and beans on the beach, but they have no can opener. So, they hold a symposium on how to open the cans. The physicist goes first: “I’ve devised a physical solution. We find a pointed rock and propel it at the lid of the can at, say, 25 meters per second –”
The chemist breaks in: “No, I have a chemical solution: we heat the molecules of the contents to over 100 degrees Centigrade until the pressure builds to –”
The economist, condescension dripping from his voice, interrupts: “Gentlemen, gentlemen, I have a much more elegant solution. Assume we have a can opener…”
Macro Data to Watch:
- Swiss Jobs
Markets
On the psychology of the markets still; Mauldin quotes Rogoff and Reinhart’s book “This Time It’s Different” where they try to make sense of market psychology – the crucial link between underlying economic fundamentals and market activity. This concept is important as it connects everything I’ve been saying about debt, federal deficits, sovereign creditworthiness, fiscal and monetary policy and how this relates to the psychology of the market place.
A Crisis of Confidence
Let’s lead off with a few quotes from This Time is Different, and then I’ll add some comments. Today I’ll focus on the theme of confidence, which runs throughout the entire book.
“But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.”
“If there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom. Infusions of cash can make a government look like it is providing greater growth to its economy than it really is. Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels, and make banks seem more stable and profitable than they really are. Such large-scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short term and needs to be constantly refinanced. Debt-fueled booms all too often provide false affirmation of a government’s policies, a financial institution’s ability to make outsized profits, or a country’s standard of living. Most of these booms end badly. Of course, debt instruments are crucial to all economies, ancient and modern, but balancing the risk and opportunities of debt is always a challenge, a challenge policy makers, investors, and ordinary citizens must never forget.”
And this is key. Read it twice (at least!):
“Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence-especially in cases in which large short-term debts need to be rolled over continuously-is the key factor that gives rise to the this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang!-confidence collapses, lenders disappear, and a crisis hits.
“Economic theory tells us that it is precisely the fickle nature of confidence, including its dependence on the public’s expectation of future events, that makes it so difficult to predict the timing of debt crises. High debt levels lead, in many mathematical economics models, to “multiple equilibria” in which the debt level might be sustained – or might not be. Economists do not have a terribly good idea of what kinds of events shift confidence and of how to concretely assess confidence vulnerability. What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fueled asset price explosions seem too good to be true, they probably are. But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite.”
Mauldin then goes on to summarize:
The point is that complacency almost always ends suddenly. You just don’t slide gradually into a crisis, over years. It happens! All of a sudden there is a trigger event, and it is August of 2008. And the evidence in the book is that things go along fine until there is that crisis of confidence. There is no way to know when it will happen. There is no magic debt level, no magic drop in currencies, no percentage level of fiscal deficits, no single point where we can say “This is it.” It is different in different crises.
While it is difficult to predict the timing of such macro volatility, this type of environment never-the-less suits those who seek to opportunistically trade upon this market volatility when it occurs, in particular those portfolios which seek to maintain a “long volatility bias” for the next few years. This degree of indebtedness, inflation uncertainty and macro economic fundamentals inevitably leads to market which are hypersensitive to psychological flippancy. This is fodder for active and deliberately-focused long term volatility products.
The Dollar Rally continues as I expected, there is still some juice left in this I think. The Euro and GBP are getting smashed.
As investors sought safety the not only piled into Dollars, they fled from risk assets and ploughed into Euro Bonds. Graph of the day is a 2 year picture of the 5 year swap rate for European Bonds dropped to a 52 week low… actually that’s a 3 year low… errmm, actually 10 year low…sorry… I mean, the lowest level ever recorded. You’ll just get a measly 2.5% return on your investment in Euro Bonds and this is supposed to be an inflationary environment?
Source: Bloomberg
Global Stocks to Watch:
- I think as the Dollar continues to rebound it’s worth revisiting those company revenues which will be affected by the Dollar rally. Obviously unhedged US exporters but also those who stand to gain such as unhedged exporters to the US in Europe.
- The biggest movers on Friday were the banks and resource stocks in Europe and Japan. I’d expect a bit of a rebound given the late rally in the US, but I’ve been wrong before!
- Earnings:
- Resources: Xstrata, Anglo Platinum
- Finance: Sumitomo Mitsui Financial Group (SMFG),
- Consumer/diversified: Asahi Beer, Loews, CVS
- Tech: Hon Hai Precision
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