Treading Lightly: No Tired Track for 2014
By Wilfred Hahn, Chairman & co-CIO
After a rather cathartic start to the year (equity markets tumbling at the fastest pace in years) markets are again romping to the tune of the now familiar, well-told story. While we celebrate new equity market highs, we think the old story is tired; looking more like a re-tread here in early 2014. Why? Crucially, because the global financial story is changing. We therefore now need to be looking ahead … not warming our old convictions on the hopes of a passing story.
But first, let’s review the soothing story that still seems to be warming everyone’s cockles.
Here are its major tenants and beliefs:
• Economic growth is stable around the world. 2% GDP growth is low, but not to worry, this is constructively positive.
• Central banks have the upper hand and can artificially set prices indefinitely. Interest rates will stay low and QE will continue to drive up asset prices … even if not economic growth.
• Various countries are cheapening their currencies and this is stimulative, if anything. There is no risk of a deflationary shock.
• Central bankers are on standby to apply the cardio-electrode thumpers should economies, financial markets, or monetary systems again fall to arrhythmia. Not to worry … it has worked before. There is little risk out there.
• More government debt and more deficit spending is the solution to low demand. There is no limit to the amount of debt that can be carried. After all, the IMF just released an important Working Paper (WP/14/24) , concluding that “we find no evidence of any particular debt threshold above which medium-term growth prospects are dramatically compromised.”
• Corporations can continue to extract an ever greater proportion of national income and convert it into profits and high dividend payouts. It is a gravy train for equities. Is there any other choice?
• Inflation is low … and lower. This is good.
• Europe can continue to be the global chump while Japan hugely raises its export competitiveness. Germany can indefinitely continue to draw in a huge export surplus from the rest of Europe without killing its host.
• Emerging markets, though they may have some instabilities from time to time, can be relied upon to continue growing faster than the developed world. China can continue to paper over any problems with more credit and bail-outs.
• Gold is an anachronism (and for that matter, other commodities, too); it has no intrinsic value; especially so in a low interest rate world.
• That Shinto Abe (the Prime Minister of Japan) can continue to play the confidence game of pulling the collective Japanese economy up by its own petards. More QE, more recklessness, more prestidigitations, can continue to bamboozle and foster more carry trade.
It has been a great script. Not because it holds much causal or theoretical credibility, but because it has been joyously believed. Somewhat dangerously, there’s no one left to convert to this perspective. Mostly everyone is confident.
Never before have financial markets been as complicit with the bidding of the central banks. Its players are in collusion with the narrative that the central banks want to create, each signaling to the other that they must play together to create a rising wealth effect — the biggest unhinged financial bubble of some time.
It’s a colossal experiment that at some point will end up unfortunately, in one way or another. We identify current conditions as a renewed financial bubble that carries uncompensated risks. That’s why we have been maintaining a cautious stance in our portfolios. Timing and judging the possible extent of over-exuberance is always problematic. Nevertheless, we think there will be rewards for the prudent and patient. It has always worked out that way before.
Just what is the new story? It holds some very significant shifts. These, in part, we think, will recognize the unsustainability of the past tenants as well as patent theoretical falsehoods.
Here is the new story that we perceive is coming on the scene:
• The most serious misreading is the inflation regime. Overindebtedness, secular shifts , and the impact of technology betray an underlying disinflation (even deflationary) influence despite what central banks may wish to do. There is no way that profit growth can continue indefinitely in such an environment. The cash economy, in nominal terms, is being gradually squeezed.
• Crucially, emerging markets are now (have been) the world’s locomotive. Once upon a time, the world relied up the U.S. as its economic engine. When it pulled out of the station, so did the rest of the world’s economies … eventually. Right now, the U.S. is adding a slowing influence upon rest-of-world GDP growth. Post the Global Financial Crisis, China and other less-advanced nations contributed two-thirds of world GDP growth. That period (for now) is over. This is a critical difference.
• Economic growth still does not show any sign of acceleration. This has been the major hope for 2014. It is not happening. It is becoming ever more difficult to believe in the tooth fairy.
• It is now more than five years post-GFC and central banks are still seeking to stimulate economic growth. The record has been catastrophic. In the meantime, economies have become inured to near-zero interest rates and continual QE. That means that the next economic recession (and surely one will arrive eventually) will occur with policy interest rates still near zero. That will be a first. That such an outlook would be celebrated with inflated asset values (including the stock market) begs incredulity.
• Financial systems are again vulnerable to instability. Speculative financial positions are again high and unsustainable. Financial excesses are again evident virtually everywhere. What this means (usually) is that policy reversals or accidents are likely to meet ill-prepared markets.
• The gold price is the reciprocal of the collective faith put in central banks. Yes, right now central bankers are received as the Masters of the Universe. But money has a metaphysical power born of collective humanity’s will to pursue and preserve wealth. All manipulated, fiat money systems have failed throughout history. For now, at the very least, gold-related holdings are still merited for insurance purposes and also as an insulation to malingering deflationary forces. And, if 2014 finally does cast aspersions on the immortality and foresight of central bankers, gold will prove to be a resilient investment this year.
• The denouement of the central banking confidence game may likely already be in sight. That we see in Japan. The Abe “confidence” boost is playing out. Massive QE has still not boosted GDP growth … and that is the case, even without the slowing impacts of Abe’s “third arrow” of reforms.
• In Europe this year the European Central Bank (ECB) will be stress testing 130 major banks as it prepares to assume the role of a common European regulator. We expect that this will show that the quality of assets on the banks’ books are much poorer than commonly believed. (The same is also true in the U.S.).
• All in all, we remain in a new, uncharted monetary environment. Just as economic and monetary policies have been unprecedented to this point (i.e. … QE, OPMF … etc.) so will be the next monetary tightening phase. In fact, it is already here. It will likely not take the form of rising interest rates (as everyone expects) but in terms of lower QE (that’s what the “taper” is all about); or simply, even lower monetary velocity; and/or further waning impact of QE. The message? The next tightening phase is underway. Caution is in order.
Yes, we too want to believe that the old story will continue indefinitely. But, more than that, we want to make sure that our clients aren’t vulnerable to yet another reckless, feckless financial bubble … remarkably, the third one in 15 years.
We may risk missing the last “high risk” returns that are being extracted from libidinous investor enthusiasm (misplaced as we believe that it is). However, as our track record well proves, it’s how much one keeps during the inclement financial times that is a major determinant of long-term returns.
The third financial bubble in 15 years is underway at present. No one can really know how far it may yet expand. The extremities of human emotions and possible policy responses really cannot be forecast in 2014. What we do know for certain is that overall investment risks have again risen. Our current investment policies have been adjusted accordingly. We remain broadly and globally diversified, holding some insurance as well as relying on higher yields.