While the volatility in Equity and Credit markets over the past year has been quite benign, the volatility in currency markets has really heated up this year, most likely as a response to a perceived shift in Fed policy. What has really driven capital flows however has not been the relative rate adjustments by Central Banks, but the perceived economic strength of the U.S. vis-a vis almost all other G7 and non G7 countries. We have all heard the cute little analogies used to describe the relative strength of the dollar: ” The cleanest of the dirty shirts”, ” The smartest kid in summer school”, etc.. What is interesting to us is that such minuscule yield spreads are the impetus for such drastic movements in the relative value of currencies. Not only that, we are completely astonished that no one is really advocating the positioning into something which can hold its value relative to all currencies; namely hard assets. We know that our astonishment is too dogmatic however, as we are all aware that in reality Financial Markets are constructed to deliver product, most of which is designed to give people what they think they want and not what they really need. We still adhere to the precept of mean reversion (both in returns and relative currency values); a philosophy which is completely contra to todays current ideology. Kings don’t live forever, fade King Dollar and Buy Stuff
If you follow Howard Marks of Oaktree Capital, you know he is clearly one of the most astute investors around and his newsletters are among the best as well. In his latest missive, he references the above Albert Einstein quote when discussing the measurement of risk and reward. This quote got us thinking as to the state of the investment landscape today. The explosion of Algorithmic trading based on up- to- the second “information” as well as a fixation on monthly data which is itself suspect in its measurement and meaning leaves capital markets appearing to focus on only that which can be counted. The focus on what cannot be counted has never been more absent, as the prevailing thinking is that the risks associated with the unknown can be alleviated with the existing, or further iterations of, Central Bank policy. Nassim Taleb would refer to these uncountables as black swans, and it would seem as we move further and further away from the events of 2008/2009, the capital markets amnesia regarding the potential for such black swan moments becomes greater and greater. Those asset classes whose returns have been driven by leverage and momentum are most at risk when the amnesia wears off.
The recent decision by Credit Suisse to exit their commodities business, marks the latest in a long line of Commercial and Investment Banks that have made the conscious decision to exit their respective commodity businesses. This decision reminds us of previous exoduses in the past, such as in the late 90’s when Merrill Lynch left the business, only to re-enter in the early part of the 2000’s. As Chuck Prince astutely remarked in response to the frothiness of the credit markets in 2007,” as long as the music is playing you’ve got to get up and dance”. Well, faced with additional capital requirements and a myriad of Dodd-Frank related regulations, the decision by banks to not dance is probably the proper response. However, if one believes (as we do) that there is no better contra-indicator of value (outside of Central Bankers) than the behavior of Bankers, than this decision clearly indicates that the commodity area is ripe for outsized returns.
Recent comments by the Bank for International Settlements (BIS) that “Global Markets are under the spell of Central Banks and their unprecedented monetary policy settings” echoed what we and others have been saying for the past 3 years. Not only have they been under a spell, they have been put into a rate induced coma. However, as we have stated repeatedly, the aftershocks and consequences that will result once the spell is broken will be dramatic. It would appear however that neither the BOJ or the Federal Reserve are paying any attention to such talk, as both seem intent on achieving goals that are either ever-shifting or incongruous. Concurrent with these comments, was an article in the WSJ regarding the extensive security detail afforded The Fed Chairwoman. Not to be flippant, but we cannot understand why such security is directed at someone whose main activity these days is maintaing the status quo (doing nothing). Don’t be hypnotized, Buy Stuff.
The one singular characteristic of todays capital market environment that has been the most perplexing and frustrating has been the complete lack of concern for what “might” happen. As we have discussed, low rates and the absolute manic focus on additional yield at whatever cost, has produced an almost universal catatonic state. Nothing is more indicative of this than the markets complete lack of attention to the potential for reflation/inflation. We forgive the equity markets for their lack of focus as they have the attention span of a six year old, but it is curious that the Treasury Market continues to remain oblivious to what are emerging signs that pricing pressures are already upon us. Slack in the labor market, spare capacity, and seasonal one-off factors are only some of the reasons given as to why we should ignore what are clearly clouds on the inflationary horizon. Perception is reality however, and the reality of low long term rates will remain until the broadly held mis-perception on inflation/reflation changes. The argument is also made that inflation/pricing pressure will never come to bear primarily because we would have already seen it if it were going to take hold. Our feeling is that all of the liquidity sloshing around has flowed into the easiest parts of the capital markets (debt and equity markets), next up are the hard asset/commodities markets which will in turn lead to overall broad price increases, which will then ultimately flow through to wages. We have never seen the kind of uncharted, unfettered Central Bank action that we have most recently experienced, so rest assured that when this inflationary cycle unfolds it will most likely not look like anything we have seen before. Buy Stuff
Not content with its massive effort on the financial suppression front, the Federal Reserve has supposedly been discussing an imposition of fees on certain bond funds in an effort to avoid potential market dislocation. This causes us an unlimited amount of consternation for a number of reasons 1) They, and they alone, created the atmosphere whereby investors of all risk tolerances are forced to step out on the risk curve in an effort to earn anything 2) Charging exit fees in an effort to stem basic market forces is one more effort to cement their position as the ultimate arbiter of unforeseen events. We always have to pause in instances like this for fear of sounding like a conspiracy theorist, but one has to believe that this has the potential to open the fee floodgates with respect to any market that suddenly could become illiquid (note: this is every market).While some hard assets are criticized by many as non-yielding and thus unworthy of holding in ones portfolio, at least there is no fee imposed by the powers that be on this allocation decision. Sell Paper, Buy Stuff
I can’t help but feel like Bill Murray in the movie Groundhog Day, whereby it appears that every day in the Capital Markets is a repeat of the day prior. Forget the new normal, or the great moderation, we are now in the midst of the Groundhog Day Market. In this nirvana, Stocks rally, bonds rally or at least stay range bound, commodities sell off and volatility across the board stays stubbornly low. Investors in this new era, would appear, like Bill Murray, to be in some kind of twilight zone where it’s not “no news is good news”, its there is no new news. Every day the background noise is the same: “Stocks are the place to be given where rates are”,” The Fed will not raise rates until…”,” Inflation is dead”,” De-flation is the greatest risk”. This world would indeed be nirvana if not for the faulty premise that underlies all of this complacency; namely that Central Bankers have it (whatever it may ultimately be) under control. What concerns us is not the occurrence of some black swan event, but rather the high level of disjointedness which will occur given the significant mis-allocation of capital across all global Capital Markets.Major dislocations in markets usually do not stem from one single “event”, but rather from the collective group -think that believes that all events are simply one-off in nature and thus can be controlled. Market dislocations occur when the macro suddenly overwhelms the micro, thus rendering simple solutions (Central Bank action) relatively ineffective. Don’t mistake sameness for safety, Buy Stuff.
The reasonableness and straightforwardness of comments by Fed Governor Richard Fisher makes one wonder: Who Invited this guy to the Party? Mr. Fisher, in a speech much similar to one given several weeks ago, continued to question the sanity of providing additional liquidity to a market that clearly does not need it. One has to wonder whether Mr. Fisher is even on the same team as other Fed officials when he states ” Of greatest concern to me is that the risk of scrutiny and criticism might hinder policymakers from acting quickly enough to remove or dampen the dry inflationary tinder that is inherent in the massive, but currently fallow, monetary base”. Compare this with other Fed Governors who have made numerous calls to tie further Treasury purchases to some minimum level of inflation. We have to believe that mentality of the group advocating higher inflation has been driven to such conclusions by their perception that each new iteration of QE deals with the micro rather than the macro. These Fed officials know we are not dealing with bazookas anymore like we were in 2008/2009, but instead most at the Fed believe we are simply working around the edges of a precise, targeted balance sheet management program, which can be reversed at any time. This would all be wonderful if this thinking even came close to resembling the reality of Fed policy transmission. As we have stated before, Fed policy even under the most normal of circumstances, works with a most undefined lag. Governor Fisher understands this, the others understand this as well but have chosen to ignore it(For Now). There is no new Central Bank Paradigm: Buy Stuff.
Once again, another year has passed and we are now inundated with the end of year projections as to what will happen in 2014. We generally find these projections without merit, but we have a particular distaste for such guesstimates given the self-reinforcing behavior that currently overwhelms todays capital markets. Early on in these various monetary science experiments market participants looked at the potential mismatch between objectives and the measures taken. Today, however, it would appear that this analysis has fallen by the wayside along with any concern over the possible unintended consequences. There is no longer talk of whether we should be going down this path, but rather what will be the harm if we shift to another path. Forget the fact that the current path may take us in directions or places we never imagined. Many scoff at comparisons between today’s Central Bank actions and those of the Central Bank of Japan during the 90s and beyond. However, recent comments by the BOJ Governor should validate those comparisons. In a recent FT interview, the BOJ Governor remarked that they were the first to enact quantitative easing back in 2001, and even though it has essentially accomplished nothing, they continue to push forward with a program to double (at least) its holdings of JGBs. The recent actions by the BOJ are driven by a desire to break the deflationary spiral that has existed in Japan for over a decade, the question however becomes at what price. If Inflation comes purely as a result of a rapidly depreciating currency, and does not necessarily translate into wage growth then the “benefits” of inflation for the population in general is moot. More importantly, the BOJ Governor also does not rule out using other more radical tools should the current ones prove, yet again, unsuccessful. What also stands out from this interview is the disconnect between what is happening on the monetary side and what is occurring on the fiscal side. The Governor acknowledges the potential for a sharp rise in rates as a result of their current strategy, however he soft peddles the effect such a rise would have on Government finances. The BOJ has travelled down this QE path for years, but rather than shifting to another possibly more advantageous side road, they have instead chosen to simply proceed at a higher rate of speed. If the definition of insanity is doing the same thing over and over and expecting different results, choose rational thought: Buy Stuff.
Fed Governor Richard Fisher’s recent remarks at an Ag Summit in Chicago appeared to have gone almost completely unnoticed by Mr. Market. While we understand that Mr. Fisher is one of the more reasonable Fed Governors, we were taken aback by the veracity of his arguments against further Fed purchases. His exact words were as follows ” …we have a surfeit of excess liquidity sloshing about in the system, the idea of ramping up inflation expectations from their current levels strikes me as short-sighted and even reckless. We already have enough kindling for potential long-term inflation, which will sorely test our capacity to manage policy going forward. I do not wish to add further to that wood pile”. The markets inattention to this comment was as expected, given the fact that markets prefer to respond to a fire only once it has completely engulfed the residence. This indifference should also not surprise as all forms of fire insurance (inflation protection) have steadily fallen out of favor:gold, precious metals, TIPs, etc.. As with most insurance, it is cheapest to purchase in an environment not seemingly conducive to any potential payout by the insurer. Get your fire insurance, buy stuff.