Commentary: 2013 Annual Commentary
by Franco Seguso, April 2013

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Performance lost in translation

After spending 3 years to this day in defensive posture following the 2009 rebound, and having failed to achieve any meaningful performance in our portfolios, it is time for a strategic re-assessment of our defensiveness.

Five full years into this crisis, and without an end in sight, the first conclusion is that our quite pessimistic economic assessments of year pasts have been somewhat off the mark; with the benefit of hindsight, reality has been significantly worse than our most pessimistic expectations for the economy, with nearly all metrics failing to regain pre-crisis levels notwithstanding truly astonishing reflationary policies worldwide.

Continuing and open-ended interventions at both the monetary and fiscal levels are testament to the secular as well as structural nature of this crisis as opposed to the customary cyclical recession of the past. This is a once-in-a-century crisis, a generational occurrence, a major tipping point for our business-as-usual models. The last structural crisis on such scale was the Great Depression of 1929.

Yet, asset markets have so far taken a dim view of this aborted economic recovery, the worst ever since the 1930s, and have rallied in V shape fashion. Why such disconnect for so long? Why plain to see depressed economic fundamentals are failing to translate into lower and more reasonably priced asset valuations?

The immediate answer so far has been to point the finger to our central banker easy money policies that have lifted all boats at once, and continue to do so. There are little doubts that the monetary wizards are targeting asset prices with their fabled wealth effect theory. No doubt also that ZIRP and QE have succeeded in crowding out safe heaven investments, forcing anyone in need of some sort of yield to move along the risk spectrum, bidding up ever riskier asset prices in the process.

Massive fiscal deficits together with dwindling saving rates in the developed world, and unprecedented credit expansion in China, have also played a crucial role in sustaining the private sector incomes, mainly corporate profits as household incomes have been contracting in real terms.

Yet, economics 101 teaches us that markets are supposedly rational and discount the temporary nature of these policy actions with lower multiples, as opposed to higher ones.
My self-serving answer would be to contemplate the fact that there are no more free markets, traditionally defined as a place where buyers and sellers interact to establish the price of a good or service. Policy makers have systematically distorted or covertly manipulated price signals that the very definition of a price discovery is now questionable.

In doing so they not only have distorted and manipulated all the discount mechanisms that a price signal generates (chief among them the price of money that defines the cost of capital), but they also have rewarded failure on a scale that is unprecedented by removing from the market one of its most powerful feature: creative destruction. Today policies are allowing zombie companies and economies that would simply not be sustainable at a somewhat higher interest rate.

Imagine going to a casino and having no risk of losses associated with your betting: tail you win, face someone else loses. If your back is systematically covered and risk is removed from the equation, then you are left with a menu of only winners.

That is precisely what our policy wizards have been doing since 2008 with layer after layer of monetary and fiscal acronyms (TARP, QE, ZIRP, OMP…): suppressing asset risk premiums by removing failure from the equation. No more tail risks, no more failure, no more reflexivity. Only winners, at least until the risk anesthetic lasts.

Meanwhile, failure of fiscal consolidation has been rewarded with the lowest cost of debt in recorded history through ZIRP and QE while banking failures have been rewarded with a massive transfer from depositors (no more interest income) and taxpayers in favor of stakeholders. In our post-Lehman world, financial failure has become anathema and has been transferred to ordinary people through taxes, austerity, financial repression and income compression.

Bubble mania

With the substantial benefit of hindsight we can evaluate the most recent bubbles with amazement to the lack of market foresight; how could we have bought Japanese real estate and shares at 100x price-earnings in 87-89? Or those Asian shares based on 40% annual compound growth expectations in 95-97? And Nasdaq shares based on mouse-click at over 100x P/E in 1998-2000 and the S&P500 at over 40x in the 1999-2001 new millennium economy? Then came the infamous US housing bubble-turned-ATM machine just a short few years after the bursting of the 2003 stock bubble, followed at close range by its cousins in Ireland, Spain and Hungary.

Maybe a few years from now we will be looking back at this era with incredulity to our own gullible belief than debt and money can be costless, abundant and freely available. Or that Central Bankers have finally discovered the formula to convert debt into wealth like rating agencies converted junk into AAA in the most recent bubble. That we can spend our way to prosperity with debt and paper money in a ZIRP world. Or that consumer price inflation is unquestionably contained within the 2% lower bound all the while we can enjoy our annual dose of double-digit asset inflation guaranteed by our Central Bankers-turned-Santa Claus.

Maybe we will look at all these trillions of debt issued at negative real interest rate as we look at those Dutch people trading a single tulip bulb for the equivalent of 15kg of gold or those more recent investment managers accumulating Cisco at 100x distorted earnings: what were we thinking?

Money flows drive disconnect between markets and economies

Today financial markets are way past the inflection point in relation to their income generation capacity to sustain the existing financial leverage within a demographically challenging horizon. There is simply too much debt, unlikely to generate sufficient cash-flows to repay interest and principal. Ireland, Greece, Spain, Portugal, Egypt, Cyprus and now Japan are all recent examples of this contagious dynamic at play. And in each case massive wealth and savings are being destroyed and/or expropriated as debts are written off.

Since 2009 leverage has been actively transferred from bank balance sheets towards those of the sovereigns (deficits) and their central banks (QE). Public balance sheets’ deleveraging are now being set in motion through a mix of financial repression, entitlement reneging, currency debasement and inflationary default. A sizable part of these debts and entitlements will not be paid back in an orderly way as central banks monetize impaired assets and government debts: higher inflation is clearly the monetary tool of choice for the cleanup of sovereign balance sheets.

Why are we so short on memory that we are once again piling our hope of artificial wealth onto this double-headed monetary-fiscal leviathan? Why are we so confident that this time we will be able to leave the party before the liquidity stops flowing? Why are we even listening to those same monetary wizards that drove us into each one of the previous disasters, unable to foresee what was so obvious to many and the destructive legacies of their policies? Why are we infatuated by such monetary wonders and entrust our future to God-like central bankers: Geld Marshall Von Havenstein last century, maestro Greenspan yesteryear, chairman Bernanke today and governor Kuroda (or Carney or Yellen) tomorrow? Von Havenstein and Greenspan have already entered history books as the most ruinous central bankers ever; they will not be the last.

We are told not to fight the FED and its fellow central banker’s reflationary policies but if memory serves me properly, it did not end well for those overstaying the free money party as they were literally crushed by the eventual bursting of each bubble. The problem I have, and the very cause of our lack of performance, is timing. I have no idea if, or when, the music stops but I am quite confident that the end will not be pretty.

Today world is sitting on a credit bubble of epic proportion, from Europe to the US, from Japan to China, a bubble inflated and maintained through central bank manipulation of interest rates and balance sheet expansion. Bubbles have this frustrating characteristic to inflate in slow motion but to collapse suddenly, without warning. And each bubble so far collapsed more dramatically than its forerunner.

Dead end for financial assets?

So, where do we stand now? Five years into this crisis we find ourselves into a monetary and fiscal complex landscape we have never been before, unlike any other we have known in modern history. Generating portfolio performance is about front running policy makers and understanding when (rather than if) they will lose control of such complexity. It’s about being tactical rather than strategic. However, the ability to simplify such complexity is beyond most of us, reason why we have chosen to mainly preserve wealth rather than chase tactical performance, to favor the return of capital rather than the return on capital. We deem that the embedded risks of collapse of this capital misallocation dwarf all other factors, including performance, although we are cognizant that bubbles can grow much larger than we ever thought.

From our lenses the economy remains in the intensive care unit of policy makers; repeated doses of monetary morphine have managed to keep the symptoms at bay (volatility and debt deflation) but have hardly made a dent in the cause of the disease (excessive debt accumulation, demographic decline and secular loss of productivity). Meanwhile these ever-increasing doses of monetary morphine are provoking collateral damages to already underfunded pension systems (as compounding returns are crushed by ZIRP), to capital spending and to asset allocation (companies are using cash to retire equities rather than to invest in new capacity) as money flows toward the most speculative and levered part of the financial edifice rather than towards the economic edifice itself.

Meanwhile central bankers have become hostages to their swelling balance sheets as any exit strategy is now too painful even to contemplate, let alone implement within a democratic society. Their independence is being curtailed by fiscal dominance of monetary policy. This central bank loss of independence as fiscal deficit enablers of last resort will ultimately unleash rounds of competitive devaluations, better known as currency wars.

Portfolio

So here we are, not yet renouncing our defensive positioning notwithstanding the uncomfortable and frustrating market movements of the last few years. Imbalances and implied fragility have been increasing beneath a veneer of low volatility engineered by central bankers. Risk remains underestimated and underpriced, while value is elusive since the depth of 2009 (equity markets were never ‘cheap’ throughout this whole crisis).

Asset continuing ramp up in prices into bubble territory has been a recurrent precondition to lose money in each previous financial burst, and we believe this one will be no different although we do not know its timing.

There is no single way to answer the investment conundrum we are facing. We continue to progressively tilt the portfolio towards inflation protection by shortening the median maturity of the bond ladder towards 4 years, increasing real assets that cannot be printed (real estate, resources, mining, oil) and moving money out of harm way from the ring of confiscation/sequestration/taxation and preferably into direct productive assets.

Currencies offer a relative value play (short JPY, GBP and EUR vs long gold, Scandinavian currencies, SGD, BRL, MXP and CAD).

Most publicly traded investable assets, sitting at the top of a massive run-up in prices, offer too little prospective returns adjusted for risk or duration. Most debt is in an outright bubble as investors over-pay for depressed yields. Equities are also in bubble territory as inflated profit margins (70% above their historical relationship to GDP due to non-recurring factors) distort the perception of reasonable valuations. It has become very difficult to maintain value discipline as the whole investable world around us is bid up well over fair value.

It is also quite startling that with so much ongoing asset reflation from all the major central bankers, monetization of government debts and overt efforts to generate inflation that precious metals haven’t responded in a more powerful way. Part of the reason could be the rotation of the monetary wheel debasement, as gold is hitting record levels in Yen and Pounds notwithstanding its lackluster Dollar performance. It remains the only real and liquid store of value that remains independent from policy makers’ financial gimmicks as large Cypriot depositors can testify. And its value as doubled since the last equity peak in 2007. Gold is the ultimate insurance against central bankers’ monetary gimmicks.

Thank you for your loyalty and patience with our strategy

Bangkok, April 9th, 2013