Commentary: 2014 3rd quarter musings
by Franco Seguso, November 2014

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3RD QUARTER 2014 MUSINGS

Geopolitics in the driving seat

We truly live in captivating, albeit unnerving times.

The third quarter is ending very much where it started, with drifting markets, the worshipping of central banking well and alive, spreading geopolitical instability, and more questions than answers.

The US remains on its universal mission to expand Pax Americana by fermenting or instigating regime changes from Iraq, Libya and Syria to Cuba and Ukraine. As an aside, recent unrest in Hong Kong is coincidentally similar in form and process to the color revolutions of Eastern Europe where the same US NGOs appearing in Hong Kong
(National Endowment for Democracy and the National Democratic Institute) were spearheading ‘democratic’ uprisings through student associations and the social media.
 
Financial warfare is now aggressively deployed against Iran, Syria, Russia and Argentina with a declared goal to bring their unreceptive leaders to their senses, or on their knees.
The Arab Spring was nothing but an optical illusion in the desert as the Middle East spins out of control, with chaos and civil war unleashed and abetted by consecutive failed coups and wars. More alarming, NATO propaganda artwork on the Ukraine imbroglio is reminiscent of the psychological groundwork that preceded the post-9/11 wars against
Iraq, Libya and Syria, except that Russia is a nuclear power.
 

Macro-economy on central-bank pilot

Central banks have done an inconceivable job at anesthetizing risks and flattening volatility while keeping the economic patient on life support fully six year into this crisis; over the last two years of this quite odd ‘recovery’, the world’s major central banks have injected far more liquidity in the global financial system than the already staggering amounts injected in the 2008/9 crisis response, a time when financial markets were imploding. On the metric scale trillion have now replaced yesterday billion and reflationary injections have replaced yesterday emergency injections.

The central banks scheme is to deleverage the financial superstructure not by reducing debts, but by re-flating capital (equity, bonds and housing stock) in order to normalize debt-to-equity ratios and thus the whole debt edifice; this scheme, however, is clearly not working its way into the real economy (trickle-down economics). Unproductive debt (think an excessive mortgage value) is thus scaled down in relative terms by inflating non-productive capital (think inflated house prices); this is central bank’s magic wand of painless deleveraging through asset inflation, rather than the old-fashioned, andundoubtedly more painful, working-out of debt. This is truly our 21st century alchemy, better known as a free lunch!

So far our money wizards have avoided, if not deferred, the dreaded debt-deflation spiral but at the cost of a relentless bubble in asset valuations and an ever-increasing disconnect between the real productive economy and its financial engineered superstructure. While they can artificially inflate nominal capital, this does not amount to an increase in productive capital and leaves the overall system far more fragile and exposed to a bubble burst than generally perceived (non productive capital does not generate cash flows, and can deflate on a whim).

Inequality is another direct consequence of this over financialized super-structure, with half of all income accruing to a top 10% privileged that control the leverage, leaving the remaining 9 deciles of the population to live on just half the national income; deprived of genuine sources of income generation (median household income has been stagnating since the 80s and is in outright decline this century), credit and more recently government transfers have been the only available tools to maintain consumption.

The housing bubble allowed households to extract credit for consumption, until it busted in 2007. Since then, households have been left with a debt hangover and have become increasingly dependent on government handouts and other subsidized credit channels (outstanding student loans and auto loans are now 2.4 trillion dollars, equivalents to $7,500 per US citizen). Public or private debts to finance consumption are clearly not a very productive use of credit, yet the Fed is steadfast in inflating this new massive bubble to avoid the debt deleveraging trap. That is, until the next bust.
 
The deleveraging or austerity myths

The great deleveraging has always been a myth: debts and unfunded liabilities have been piling up everywhere, from public deficits to corporate debt and consumer credit, and have increased globally by a whopping 40% since the 2007 crisis.

In the US, households have indeed deleveraged somehow, although by defaulting rather than by paying down their debts. Financial institutions also have deleveraged to a certain extent, but by socializing losses, transferring toxic liabilities onto the public balance sheet and receiving boatloads of free money from their central banks.

For the corporate sector, notwithstanding the relentlessly advertised cash hoarding at record levels, reality is at a much more nimble 15 year low when netted of debts. Lost in translation is the total corporate outstanding debt of 13.8 trillion, fully 25% above its
2007 peak of 11 trillion. This almost 3 trillion debt binge did not find its way into real investment (still 5% below its 2007 level) or employment (just 0.7% above its 2007 level), but into financial engineering: share buy-backs, dividends payout, LBO and M&A.

China is navigating its own gargantuan credit bubble, one of a kind, having added the equivalent of 15 trillion dollar of new credit to its banking balance sheet in a mere 6 years. To put this number in perspective, it amounts to today entire US banking balance sheet!

In Europe, debts-to-GDP are also hitting all time highs in almost every country (Germany and Finland are the exceptions) while the cost of servicing these record debts are at multi-century lows! This debt bubble is unmistakable when six countries in Europe are being ‘paid’ (through negative interest rates) for going deeper into debt, when
Ireland can issue short term debt at negative rates, when France long term rates are equivalent to Germany, when Italy 10 year yield is below the US, when Spain can issue a 50 year bond at 4% and when all together they ‘boost growth’ by including drug and prostitution in their GDP.

Manifestly such metrics do not reflect underlying trends in growth, investment, inflation, debt dynamics, productivity or unemployment, but are testament to the monetary shenanigan driving this frenzied and leveraged reach for yield. Because so much debt and leverage is pegged to government bonds, should prices ever start falling, watch out for the mother of all margin call to drive the entire debt edifice into a deflationary trap.

The consequences of these credit extremes are being deferred by the central banks, but not indefinitely as the debt edifice will eventually collapse under its own weight, bringing the great deleveraging as a shock rather than a choice. That day we will find out how much of the wealth created in these 3 bubbles was due to value creation and how much was due to this unconscionable debt splurge.

We may discover too late that central banks were not the solution, but the root of the whole problem: they have become de-facto fiscal agents that by-pass voters and democratic accountability, they are under regulatory capture by the very industry that drove the world on the brink, they are also too-big-to-fail or prosecute of their own, and they are unwilling to purview the credit/money bubbles that they have been inflating at each passing crisis. Events will eventually end up controlling central bankers rather than the other way around.

Major central banks at a crossroad: is the Fed exit for good? 

In the US, the Fed attempts its 3rd exit plan in as many years while the ECB is tinkering with negative rates and the BoJ with the expansion of a quadrillion balance sheet.

The timing of this 3rd tentative exit is doubtful as the US economy has neither achieved escape velocity (growth level firmly above 2%) nor sustainable growth (a combination of
1 trillion public deficit, 1 trillion monetary expansion and over 3 trillion in deferred liabilities are generating a measly 330 billion GDP growth).

Markets cognitive dissonance

US equity market valuations continue to defy fundamentals with a market capitalization to GDP of 1.3 x, a Tobin-Q of 1.2 x and a CAPE ratio at 26x. While average equity price/earnings are below their 2000 extremes, price-to-sales and median valuations have already surpassed those extremes. Adjusted for the level of profit margins vs. GDP, today
CAPE would be above 30 xs.
 
Accounting gimmicks are also back as reported EPS growth of 6.5% in the first semester of 2014 shrinks to a rounding error of 0.2% when based on GAAP income tax reports (generally accepted accounting principles), and turn outright negative when excluding share buybacks.

Elevated multiples on cyclically elevated earnings produce an arithmetic certitude of dismal future returns. Add the probability of higher interest rates (and thus lower discounted future earnings), higher taxes, and the justification for current valuations rests on the twin assumption that interest rates will remain at current artificial low levels and that earnings will remain at their elevated levels on a secular horizon.

We are navigating our 3rd asset bubble in 15 years, and it feels like an eternity since markets last traded on fundamentals. Investment decisions based on fundamentals are no longer a viable strategy as liquidity flows trump all other valuation processes. There are no more unambiguously cheap assets, too few safe places to hide, just relatively cheaper bubbles. With central banks pursuing reflationary policies, the market most coherent course is to invest in equities until it last: the only rule is to exit the bubble before everyone else.
 
Conclusions and portfolio

When unsustainable debt dynamics collide and merge with geo-political dislocations and demographic obsolescence, losses are socialized through debt jubilees, defaults, wars and inflations or hyperinflations. Never in history have we accrued such an astonishing global web of debts, interconnected and interdependent. The very sustainability of these debts, leverage, liabilities and promises to pay later is entirely based on the assumption that growth dynamics almost never sustained in time past will finally materialized in a lasting future notwithstanding demographic, productivity and debts constrains. Stagnation has become unaffordable, recession unthinkable.

Today global monetary policy start diverging, with the US (China peg) and UK attempting again an exit strategy while the Euro zone (Swiss peg) and Japan are digging themselves deeper into the monetary pit. While I remain highly skeptical of the Fed/BoE capacity to normalize their monetary policies without triggering severe market dislocations and breakdown of the pegs, the expectations embedded into the markets of such normalization will dominate macro-economic dynamics, and by extension create exchange rate opportunities in coming months.

There is no single way to answer the investment conundrum we are facing. Needless to say we maintain a highly defensive and diversified stance in our portfolios, with lesser exposure to publicly traded markets where we measure the worst bubble metrics, and an emphasis on real assets through a well diversified mix of real estate, private equity and physical gold. We also aim at moving money out of harm way from the risk of confiscation, sequestration, and taxation into more direct and productive assets.

Traditional yield strategies (bonds and credit) have reached values that do not offer an adequate margin of safety, and should be scaled down progressively.

All the best
Franco

Bangkok, October 10th, 2014