Two recent articles really highlighted the degree to which economists continue to treat the economy and markets as if they were true sciences as opposed to social sciences. The recent nobel laureate Eugene Fama was recently asked about the existence of bubbles to which he replied “I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.” The other article which also illustrated this ivory tower view of reality was the NY Times front page article on inflation. This article discusses the real dangers that lie in deflation, and goes to great lengths to articulate the positive aspects of inflation: pricing power, wage inflation, etc.. However, what both fail to deal with are the behavioral nature of the economy and markets. Professor Fama and Rogoff fail to adequately account for the fact that peoples behaviors are not driven necessarily by a rational examination of the facts, but rather by their expectations of their facts as they interpret them. The credit and housing bubbles were driven by behavior that was motivated by a set of facts that became self reinforcing (the pricing of both credit and housing would always remain advantageous). When the pricing of credit and housing became discontiguous and fractured, rationality was the ultimate victim. This type of self reinforcing behavior also becomes readily apparent in periods of rising inflation. Inflation, while it may be initially set in motion by external factors such as a drought or oil shock, ultimately becomes a lesson in behavioral expectations as price rises become ingrained across the board. While it is true that this is temporarily a positive for producer pricing, the end result is a decline in overall purchasing power, a decline in the value of ones currency, and a gross misallocation of resources. We continue to feel that Central Banks around the world put much credence in their own ability to micro-manage certain outcomes, many of which are not driven by fundamentals but rather by participant expectations. While we do not profess to know the future, we still strongly believe that the omniscient attitude that pervades the conference rooms of all global Central Banks will set the stage for the next secular shift towards hard assets.
Deflationistas and the danger of certainty
The recent trend over the past several months, particularly with the onset of tapering talk, has been a marked increase in the discussion of deflation. Gold, TIPS, as well as almost all commodities have been sold in anticipation of the coming deflationary environment. The question is: Have we really entered a disinflationary environment or have market participants simply lost patience with the potential for some type of resurgence in pricing pressure. To be sure, there has been scant evidence of a shift in the conditions necessary for a pickup in overall inflation. These would include an expansion, or at least flattening, of the money multiplier, some evidence of a pickup in overall loan demand, as well as an expansion of lending spreads at the bank level. However, a read of the financial press would suggest that the probabilities of such events occurring are essentially non-existent. However, if the events of the last several years has taught us anything, it is that building a portfolio anchored to the belief set that tomorrow will look like today only compounds the risk should some type of inevitable change occur. Those that are bracing themselves for deflation might also take notice that outright deflation (negative core rate) has never occurred in this country.
Bond Market: Handle with care
Back in November, we discussed the Nassim Talib concept of anti-fragile as it related to the U.S. Treasury Market. We described a Treasury Market which has been manipulated, shaped and coddled by the Federal Reserve and thus been rendered more unstable. Well, the action over the last several weeks provides us with fresh evidence of this instability. The comments that the Chairman made, post FOMC meeting, seemed to smack of micro-management as he described a situation whereby the Fed would either add to, or subtract from, its current asset purchase plan depending on whether its target variables are being met or exceeded. We all know that conventional monetary policy works with a definitive lag, we were however surprised to hear that this highly unconventional monetary policy has an almost immediate feedback loop. We don’t wish to belabor a point, but this latest round of bond market upheaval, in our opinion, is directly related to a diminished lack of credibility afforded by the Bond Market to the Central Bank. The process of micromanaging the Treasury curve to ensure stability has finally reached its apex, and the most recent instability in the market is the byproduct. In our opinion, this instability in rates should begin to translate into a severe dislocation in the dollar as well.
Back in the ridiculous days of the late 90’s there was a product called split alert. This pager device would receive a message when a stock was splitting, which would then cause a pavlovian buy response on the part of the user. The premise was, at the time, that stocks splits were bullish because as we all know a pizza sliced into 24 slices instead of 12 is inherently worth more. We look back on all of the ridiculous behaviors and attitudes that existed during this time and we shake our head as to how this mentality was allowed to take hold. For some reason, I was thinking about split alert as I listened to Chairman Bernanke’s comments post FOMC. I wondered if we will look back years from now in amazement as to the gullibility of a market so fixated on monetary stimulus that it failed to see the flaws in thinking that a $15 Trillion Economy could be micro-managed using untested, unconventional and, to date, unsuccessful monetary policies. A question was asked during the Q&A about the recent backup in rates and Chairman Bernanke went to great lengths to explain that the market simply was misinterpreting the Fed’s intent. They did not understand that, while at some time their pace of asset purchases may slow, the stocks of assets that the Fed holds will remain unchanged. This, he stated, should be sufficient to hold down rates. We would suggest to the Chairman that bond market participants are not hard of hearing. What they are hearing quite clearly is a Central Bank intent on pursuing a policy of reflation/inflation and they are voting with their feet. Buy stuff, sell paper.
The most recent backup in rates across the long end of the U.S. Treasury curve has prompted much speculation as to the exact cause. The general group -think credits the strength in the U.S. economy, particularly the housing market, as the most likely culprit. However, we would argue that the sharp rise in yields that we have experienced over the past several weeks have really been driven more by the Fed’s ambiguous comments as to the ultimate disposition of their burdensome balance sheet. Chairman Bernanke’s May 22nd testimony was particularly troublesome to the Treasury Market, as it introduced the possibility that the Fed reserves the right to resurrect QE at any time should conditions warrant, even in the event that near term tapering might be soon forthcoming. The subtle message to the market was ‘ we may take away the punch bowl, but at the slightest hint of market DT’s, that punch bowl will be right back’. While the stock market enjoyed such overt support for market “calm”, the Treasury Market seemed to convulse at the message sent by a Central Bank so seemingly obsessed with healthy ( a.k.a. rising) capital markets. We recently spoke to the burgeoning credibility gap that the Fed is creating with such comments, and we believe that the rise in rates substantiates the Treasury Markets increasing distrust. Some in the gold market have commented that the movements in gold reflect an increasing/decreasing trust in fiat currencies. We would maintain that, much like Gold, interest rates are now becoming a barometer for the Treasury Markets view on the soundness/saneness of Central Bank policy.
What should happen doesn’t , What could happen might
We read this quote recently from someone that covers the platinum industry in South Africa. This quote specifically referred to the cutbacks in production that producers were forced to rethink by the Government, in spite of economics which dictate that these, and other , cuts take place. Essentially, when looking at the platinum industry in South Africa, and elsewhere, any analysis is torn between the pragmatic and the dogmatic. Government represents the dogmatic side, arguing for full employment, and a maximization of indigenous mineral rents. Industry, on the other hand, represents the pragmatists which emphasize profit and shareholder value maximization. In a perfectly capitalistic world, pragmatism would far surpass dogma, however it would appear that the environment in South Africa dictates otherwise. As we have discussed in earlier blogs, the capital markets have weighed in on how they view this particular battle playing out in South Africa.
This battle of dogma versus pragmatism got us thinking about the Fed and the effectiveness of the various QE’s. The dogmatic Fed believes that low interest rates are the single greatest cure for what ails the global economy. In their mind, low rates: drive asset prices which in turn drive spending which in turn ultimately drives employment gains. The pragmatic Fed also understands that, above all else, their greatest influence must be manifest in general psychology (business and investor). However, the pragmatic Fed also probably understands that this influence is tenuous at best. Increasing amounts of the same medicine, somewhat counter-intuitively, undermines their ability to continue to affect this psychology. This diminished influence will prove critical, particularly in the event of another six sigma event ( you know, the ones we get every few years).
Risk On- More Risk On
We were waxing nostalgic recently for the bygone days of risk on-risk off. Our affinity for such periods does not stem from some kind of masochistic love for extreme volatility or a desire to feed our inner trader, but rather we miss the days when people actually gave some credence to the latent risks that still exist out there. While markets may ” climb a wall of worry”, todays’s markets prefer to leave the worrying to the Central Bankers and focus solely on the climbing part. It never ceases to amaze us how quickly perception changes in markets. It seemed like only yesterday we were dealing with a budgetary crisis which threatened to push us into another recession. However, today I read an analysis which argued that the Treasury Market, and the economy, should be able to withstand any Fed tapering given the shrinking budget deficits. While it is true that the sequestration has allowed both sides to make progress on the budget, it was only supposed to be a stop-gap measure designed to get both sides more actively engaged. In fact, Moodys just commented on the lack of real discussions, saying that the U.S. is risking another downgrade if no real progress is made on budgetary talks. While a downgrade may be irrelevant in a world where the Fed is the largest captive buyer, we assume that this will matter at some point to non- Central Bank buyers. It is curious that the more voluminous the talk on deflation becomes, the more amped up the capital markets become. We wonder whether these same markets truly grasp what the ramifications of a deflationary spiral would mean, particularly in the context of a still over-leveraged global economy.
Unconventional becomes Unbelievable
We read with astonishment a recent Bloomberg article which pointed out that in a recent survey of 60 Central Bankers, “23% said they own shares or plan to buy them”. Combine this with the recent comments by Mario Draghi in which he commented that policy makers had ” an open mind on negative deposit rates”. Is it just me, or are Central Bank actions starting to strain any level of credulity at all. In our minds, both are very targeted attempts on all forms of stranded liquidity. These actions are being taken against a backdrop of perceived dis-inflation, which is driving short term asset allocation decisions away from commodities/hard assets and towards fixed income and quasi fixed income. However, we re-emphasize that the seemingly contradictory behavior between global central bank actions and the price movements in various commodity sectors is laying the groundwork for the long term outperformance of said sectors. In short, actions speak louder than words, thus pay more attention to what Central Bankers are attempting to do, than what they are expressly stating they are attempting to do.
The recent proposal by the Obama administration to change the inflation index component from a simple CPI to a chain weighted CPI has caused some degree of consternation and concern. This concern comes not only from seniors but also from those involved in the TIPS markets. While the amount of the difference is relatively small, the point is that this move represents a significant step towards the active management of price data. TIPS buyers were initially drawn to this market as a hedge against core inflation. If TIPS owners begin to feel like the Government is haircutting them for their own budgetary needs, then that market will struggle to maintain its integrity and thus its liquidity. The more important takeaway from this latest sleight of hand, is that that we have a Central Bank desperately trying to create inflation, while at the same time we have its own Government trying to dampen its ultimate effects. While we have maintained that the timing of the unfolding inflation story is uncertain, the anecdotal evidence surrounding its emergence continues to build.
A recent study by Bain& Co. forecasts a “superabundance of capital” between now and 2020. Bain projects that there might be up to ten times the level of global financial assets relative to global GDP within the next several years. This divergence, driven by surpluses in Asia and the Middle East, should exacerbate bubble like behavior over the next 6-7 years the study reports. While we would normally ignore such drivel, it does make one think about all of the existing excess liquidity that exists today, and will most likely continue to exist going forward. The study assumes however, quite naively we might add, that this liquidity will flow mainly to public capital markets/financial assets. We maintain that smart capital seeking a home does not necessarily look only to traditional conduits of investment such as stocks and bonds but rather seeks out where it will be treated the best (return and safety). We highly doubt that the conditions which would warrant a sustained divergence between the real economy and the paper economy would be sustainable over any extended period of time. Very recent history would suggest that negative real rates of interest have oftentimes caused excess liquidity to bleed over into areas of the real economy, sometimes in highly unpredictable and highly disruptive manners.