Commentary: 2012 First Quarter Commentary
by Franco Seguso, April 2012

ECB jumps on the monetization bandwagon

Asset markets took an extensive vacation from economic reality in the first quarter, posting one of their best quarterly performances since the mighty 1998, although lacking in trading volumes. Never before has economic stagnation and festering credit problems felt so good with P/E expanding into an earning contraction.

The quarter modest and strangely solitary upswing in US economic activity was skewed by extremely favorable seasonal adjustments due to the warmest winter in recorded history (since 1895) as average temperatures have been running 20% above normal seasonal patterns. While official unemployment is back to 8.2%, people are falling off like flies from the labor participation pool (the denominator) to join the ranks of discourage workers or to collect disability benefits (at record high). This weather/seasonal adjustment anomaly seems to have caused several US data contradictions. Something clearly does not add up, or seems at least unsustainable, in this star and stripes recovery story.

Coordinated central bank liquidity injections are also no strangers to equity market exuberance, starting from the Fed ongoing operation twist to the BoE new monetization program, followed by the Bank of Japan inflation targeting, up to the massive LTRO (long term refinancing operation) injections by an about-faced ECB to avoid its own equivalent of a Lehman moment.

With LTRO, the Eurozone banking system has become a de-facto ward of the ECB and its cheap funding, removing insolvent banks re-financing risks from the equation. This has undoubtedly saved the day, but boxed the ECB into a corner as everyone recognize that at the next financial abyss they will hit the print button and further (re-) finance dodgy assets. We now have a Bernanke put in the US and a Draghi put in Europe.

Spain was the first to take advantage of this asymmetric relationship by unilaterally revising higher its budget deficit target. Now we have a situation of weak sovereigns financed by their weak banking systems that will be refinanced by a weakened ECB that is itself guaranteed by the same sovereigns. Circular logic in all its beauty!

Monetary morphine leads to creditor subordination

Asset markets have become increasingly addicted to easy money, and respond accordingly to the ebbs and flows of this monetary morphine. The developed world monetary base has trebled since 2008. However, at every ‘withdrawal symptoms’ asset prices crater, ‘forcing’ central bankers to restart the printing presses in a compounding leverage of their own balance sheets.

Exit strategies, constantly mentioned but never executed, are going to be challenging for asset prices and politically taxing to implement. With interest rates at rock bottom levels, fiscal policy and monetary policy are merged by the zero bound (a million in currency or a million in short term debt yield nothing), transforming central bankers in substitute fiscal agents. As politicians become even more addicted to monetary morphine than assets markets, any exit strategy will test the very notion of the independence of central banks.

The larger their balance sheets, the more subordinated central banks become to political (read fiscal) and market (read credit) imperatives to further monetize when facing a financial death-spiral; they print because they don’t have any other tool left and because they follow each other.

For us investors, understanding this issue of subordination is paramount to capital preservation. With central banks morphing into de facto ‘sovereign bad banks’ and increasingly subordinated to their own government fiscal imperatives, private holders of sovereign debts become ever more junior to official creditors (Governments, central banks, IMF). The more official creditors expand their balance sheet by providing loans to their national banking systems (ECB) or by buying sovereign debts (FED, BoJ and BoE), the more subordinated all the remaining private creditors become and the more potential dilution they face (private holders of Greek sovereign debts have been ‘voluntarily’ diluted 95% so far in order to repay the official creditors at par).

As a consequence, sovereign defaults (including too-big-to-fail banking systems) and subordination risks are being priced-in across the Eurozone to levels well in excess of potential nominal growth, further increasing structural deficits and austerity counter-measures (fiscal compact) in a self-defeating vicious loop. Europe economy remains highly unstable as there is simply too much debt (public and private) and not enough cash flow to sustain debt levels and growth, while adjustment programs are too little too late to make a dent into current debt dynamics.

No free lunch here

Every bailout, every fiscal extension and every central bank balance sheet expansion will eventually lead to plenty of unintended consequences later on, although they are barely on anyone radar screen right now. Fiscal austerity and/or monetary exit strategies will prove far more socially difficult, if not intractable, to implement while open-ended money creation (QE and ZIRP) and compounding public deficit policies are mathematically not feasible.

In the realm of unintended consequence, we can already identify the collapse in provident fund annuities as the yield curve is crushed across durations, further exacerbating pensions funds structural underfunding just as the demographic pyramid is inverting and life expectancy increasing; another consequence is the system-wide deleveraging induced by the zero bound on risk-free assets as intermediary costs are barely covered (banks, money market funds, insurances and your very modest manager as well): zero interest rates destroy as opposed to generate credit.

Finally, the crushing of the yield curve is artificially masking the true extent of the cost of debt should rate ever rise again from the zero bound: in the US every increase of 1% will add USD 150bn to the annual interest cost (6% of federal income).

As Hemingway said, there are two ways to go broke: slowly at first then all at once.

Forget peak oil, peak debt is the elephant in the room

Europe is facing hard times ahead as the debt crisis is getting deeper, broader and more lopsided. Greece is already in a depression, Spain and Italy in severe recessions. Debts have been under-reported and under-estimated across the Eurozone. The freshly minted fiscal compact has already joined the European Stability Pact (remember the 3% deficit and 60% total debt ratio of yesteryear) in the Euro-dustbin with Spain and the Netherlands expected to overshoot their previously agreed fiscal targets.

France election rhetoric could bring their target into discussion while recession in the Eurozone periphery will obliterate over-optimistic GDP growth targets. Altogether the Eurozone has a total debt load (public and private) of EUR 47 trillion versus a GDP of 10.5 for a ratio of 450%. Add the unfunded pension and social liabilities and the total debt raises to a stunning 950% of GDP.

To ring fence these debts Europe has set up its own financial firewall, the EUR 800bn ESM (European Stability Mechanism). The good news stops here as the ESM is nothing but an accounting gimmick. Funds have been pledged, not disbursed; they have been double counted as 220bn have already been committed; and finally the contributions due by Greece (20bn), Spain (176bn) and the others troubled nations are doubtful at best. And to cap this bookkeeping gimmick, none of these pledges and guarantees is accounted for in Government books, giving the ESM the dubious status of an off-balance sheet vehicle.

The UK is also flirting with recession, total outstanding public and private debts of 500% of GDP, a deficit of over 8% of GDP, yet with revenues expected to grow by a eye-catching 33% over the next 5 years to close their fiscal gaping hole (good luck with that).

Japan remains a fiscal bug in search of a windshield, with its nominal GDP down 8% in the last 3 years, of which 6% are due to deflating prices. Tax revenues have been declining 2% per year for a decade, yet the country would need an instant fiscal adjustment equivalent to 10% of GDP (JPY 50 trillion) just to stabilize its public debt-to-GDP ratio at the current 215%. There are parliamentary discussions to double the VAT from 5 to 10% over several years, yet the impact would amount to no more than JPY 10 trillion new income, corresponding to a single year of fiscal drain (2% of GDP). Japan, with total outstanding public and private debts of 500% of GDP, mired in deflation and facing demographic decline is the poster-child of an intractable debt equation.

In the US total outstanding debt (public and private) stands at 350% of GDP equivalent to USD 52 trillion and unfunded social liabilities are equivalent to 400% of GDP (60 trillion) for a grand total of 750% of GDP. This is our debt ugly contest winner!

A lot of this accumulated debt is unproductive, from unfunded defined benefits pension scheme to housing stocks. And once an economy become extremely over-indebted, debt controls most if not all other economic variables (Fisher) until debt deleveraging is achieved through austerity, inflation, default, growth or any combination of these.

The reason I put so much emphasis on debt ratios is that they compound exponentially. In a simplified example, an economy leveraged 5 times (average G7) and growing at 3% a year will need a real effective interest rate of only 0.6% just to stabilize its debt-to-GDP ratio. If the economy instead grows a more realistic 2% a year and effective interest rates are at 3% that ratio will increase by over 13% of GDP. Over-indebted western economies are becoming hostage of this compounding law, and their central bankers’ hostage of the zero bound. This will not end well.

God created economists to make weathermen look credible

Despite correctly anticipating the debt crisis, I underestimated the eagerness of policy makers to monetize and socialize private losses rather than to purge the excesses from the credit system, as well as their capacity to add substantial layers of new public debts to solve a private debt crisis and massive layers of liquidity to tackle solvency issues. Debt deflation has scared policy makers into extremes that were just unthinkable few quarters ago, delaying the debt deleveraging process (extend and pretend) but also the necessary economic adjustments that are the causes of the crisis (balance of payments in the first place).
And it comes at a cost as we are now in unchartered territory, both on the fiscal front (with consolidated public debt of 5x GDP on average in the developed world) and on the monetary front (with their central bank balance sheets at 30% of GDP). Unchartered territory implies also unintended consequences, liquidity leakages (bubbles), regressive inflation distribution (food and energy) and regressive fiscal transfers (as average savers are systematically penalized).

Most likely we have already planted the seeds for the next financial crisis by further leveraging an already over-levered financial system at a time of significant demographic decline in the West. Excessive indebtedness acts as a dead weight on future growth whatever its positive short term impact.

Central banks manipulation of yield curves, money quantities and asset prices has also obliterated fundamental investment analysis as ‘investment’ success is now predicated on anticipating money spigot operations: the closer you are to the knob, the easier you can trade for profits. For real investors, remaining balanced when facing such liquidity induced burst of irrational exuberance is a frustrating experience.

The impressive liquidity-driven performance of the S&P (see chart at the end) since the crisis has been a constant drag and source of frustration on our defensive strategy. Yet, notwithstanding all these quantitative manipulations and short term performance, the S&P index has barely budged in over 10 years, living dividends as the only source of compensation against inflation (in inflation-adjusted terms the S&P is down 30%). It is telling that an unproductive asset like gold has returned 600% during this same timeframe and has outperformed the S&P every single year.


No major change here as we remain pessimistic, defensive and oriented to capital preservation and income generation.

The global economy is facing the two opposite fat tail risks of financial implosion (uncontrolled deleveraging) and monetary inflation (QE, LTRO). Policy makers will try to control these outcomes through financial repression and ‘nationalization’ of domestic savings, with its corollary of tightening global liquidity. Slow growth will also reduce the accumulation of foreign exchange reserves by Asia, another source of tightening global liquidity.

Deflation should therefore remain the dominant trend as deleveraging is engulfing more and more financial systems and their sovereigns’ sponsors. We will keep our bond ladder duration around 5-6 years and favor senior debt instruments from high quality corporate issuers. Avoid sovereigns and their banking system debt markets as they have become at best a desert of value, at worst a confiscation mechanism.

Accelerating monetary accommodation from the all five major central banks worldwide as well as increasing aggregate debt levels will continue to underpin gold as the ultimate safe asset and our best hedge against easy money induced chaos (both tail risks).

We will start rebalancing our S&P short position into the next correction to a level that is half or a third of our gold exposure. We remain committed to our long gold/short S&P strategy but have to acknowledge the persistent and aggressive monetary policies by the major central banks to underpin nominal asset values (don’t fight the Fed as they say) and adjust our weightings accordingly and opportunistically.


All the best

Bangkok, April 10th, 2012


Don’t fight the FED …

…. although the million dollar question is when fundamentals will prevail over liquidity and where liquidity side-effects will strike next?