Commentary: 2015 1st quarter musings
by Franco Seguso, April 2015

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1ST QUARTER 2015 MUSINGS

Sounding like a broken record

We all know that even broken watches can be right twice a day; writing my last musings, I appreciate how much my credit-bubble narrative of the past 15 years sounds like a broken record notwithstanding having proven accurate twice in 2002 and then again in
2008 when the tech and housing bubbles respectively popped.

In both meltdowns central banks doubled-down with new credit and money-engineered injections to save the day and postpone the deleveraging of the 200 trillion global debt mountain (excluding entitlements), corresponding to a stunning 286% of global GDP and the annual 4-5% of GDP in new credit needed to service it. The law of compounding tells us that there is a concept such as peak debt in our future, probably closer than we assume, once markets break through the manipulation of financial repression. Central bank policy since the 90s has been to deleverage accumulated debts by inflating the asset collateral (increasing the denominator), also known as the Greenspan ‘put’, rather than by paying down debt the old fashioned way (decreasing the numerator). The problem is that debts keep accruing a good deal faster than nominal growth, effectively at multiples of economic growth when entitlements are accounted for.

Never in the past were such levels of ‘promises to pay later’ accrued while the world keeps pushing the outer-limit of peak-debt and unfunded entitlements. Our current economic model assumes that debt don’t matter as long as future expected growth keep it sustainable, no matter how dismal real growth is eventually realized.

Only in the aftermath of post-bubble recessions, when even expected growth becomes impaired as in 2002 and then again in 2008, central banks set out increasing rounds of financial repression to preserve debtor sustainability as asset-deflation is simply no longer tolerable to a world awash in debt. This is the extend-and-pretend policy that is in force since the early 2000.

The age of financial repression

Financial repression acts as a direct subsidy to debt holders through very low or even negative real rates of interest and though asset inflation, as most debts are collateralized by underlying assets. Since 2000 the Fed has kept interest rates below inflation over 90% of the time, 13 years and counting!

If and when financial repression become inadequate to sustain the accumulated debt load and we face the threat of a generalized debt-deflation (risking a synchronized asset deflation as assets need to be liquidated to pay down margin calls), then money inflation will be required to pay for much of the debt, a stage famously described as helicopter money by Bernanke.

This is the stage when central banks start printing money to finance tax cuts (supply) and/or government expenditures (demand), both of which devalue outstanding money and credit purchasing power. So far Japan is the first developed country to have entered this last stage by subsidizing tax cuts with the printing press.

My guess is that we will see more helicopter-money in our future as the world becomes structurally growth-deficient (toxic mix of too much debt, declining demography and income deflation) to pay back its accumulated liabilities from current cash flows and savings.

Likewise helicopter-money, quantitative easing also qualifies as a money printing exercise, but is used by central banks to substitute an outstanding liability (mostly government bonds) with another (newly printed e-banknotes) to drive the entire yield curve lower.

By manipulating and flattening the yield curve, and removing from the market risk-free and low-risk assets, central banks force investors into a yield-seeking exercise towards riskier investments, inflating along the way their third asset bubble of the century; but this policy also promote malinvestment by over-indebted corporations and households, creating zombie economic agents that would have long gone through the creative destruction process if not for this monetary subsidy. For each zombie corporations that won’t fail there is a new one that won’t start, inhibiting the regenerative power of competition.

Quantitative easing has thus amplified deflationary strains in the real economy (debt overhang, malinvestment, oversupply, zombie agents, crowding out of labor) while systematically inflating financial assets.

Central banks are now trapped between their bloated balance sheets at the zero bound, from which the FED would like to escape, and the risk of losing control over bubbling financial markets. For the third time the Fed will attempt to exit from the monetary treadmill at the very moment most of its peers embark on new rounds of QE/NIRP. This policy divergence of the largest and most important central bank is going to be a very delicate exercise considering the outstanding $9 trillion global carry-trade funded in the appreciating US dollar.

The game for financial markets will remain one of front-running the FED, but this time to
avoid potential losses rather than to capture assured profits. Needless to say, we will soon
discover if markets are so damaged that permanent QE is required to avoid the dreaded
asset deflation.

If this is not a bubble …

We are now contemplating the third and by far the largest credit-induced bubble in just 15 years, a global phenomenon affecting all interest rate sensitive assets. The embedded leverage (credit bubble) is so large that developed economies are now not only dependent on incredibly low rates but highly vulnerable to any adverse interest rate shock.

To any observer paying attention, conditions in the global marketplace have been turned upside-down, becoming almost surreal.

The monetary toolbox has now been complemented with a new instrument, negative interest rates (NIRP). Already over a third of European public debt is trading at negative rates, meaning that governments are getting paid to borrow money. In Copenhagen people are getting paid to take out mortgages while Nestlé was the first ever corporation to have outstanding debt trading at negative rates. Spain just issued its first ever short term debt at negative rates …

More startling are Italy and Spain long term debt, with respectively non-performing loans of 11% and 17% of GDP, trading at half the yield of default-free USA. France is selling its 50-year bond at the conspicuous yield of 1.5% while Japan sells its own 10 year debt at a yield of 0.4% after the BOJ has all but nationalized the JGB market by becoming the only buyer. In a reversal of Economics 101, the more indebted, the cheaper and the better!

Bond vigilantes have been truly euthanatized alongside the rentier, leaving their successors no choice but to chase the last remaining holdouts of yield left, mostly in dividend paying equities.

In the US public debt has almost doubled in the past 7 years to over 100% of GDP (18 trillion), not including State and local government debt (another 30% of GDP), and compounding at 9% per year, yet they keep calling this barely 2% annual GDP growth a recovery …

This yield-seeking migration from bonds to equities is feeding into equity valuations that have all the hallmarks of past bubble tops: on reliable historic metrics, the US stock market is as expensive today as in 1929, 2000 or 2007.  Total market capitalization-to GDP of 1.3x is twice its historic mean; price/sales are past record highs while the Shiller CAPE and Tobin-Q are second highest in recorded history.

Median price-earnings multiple of 22x for all NYSE stocks with positive earnings (GAAP)  are now exceeding the year 2000 bubble levels, helped by a staggering $450 billion of margin debt and 1 trillion in buy-back and dividend payouts.

The back-to-back 30 year return for the S&P is at an all-time high of 400% coming from almost zero in 1994 (zero total returns from 1964 to 1994).

But the Speculative Nobel price goes to the Russell 2000 that sports a yawning gap between Wall Street projected 2015 price-earnings of 19x versus its own 2014 GAAP trailing price-earnings of 91x (this is not a typo).

Investment

But the Speculative Nobel price goes to the Russell 2000 that sports a yawning gap between Wall Street projected 2015 price-earnings of 19x versus its own 2014 GAAP trailing price-earnings of 91x (this is not a typo).

Although no one knows when the credit bubble will pop or confidence will stop, another financial crisis is highly likely. By now volatility is surfacing in commodity and currency markets, with the dollar strength signaling that dwindling liquidity and resulting deflationary pressures are building across the global economy.

We will need to further hedge portfolio risks with long dated US Treasuries. Our bond portfolio is progressively maturing and we are not adding to it as the yield curve flattens out and offer no safety; also, liquidity in the corporate bond market has never been so low with some exit risk to consider.

As long as the QE policy divergence between the Fed and the remaining central banks is in place, we should expect the dollar to remain a major beneficiary of the unwinding dollar carry-trade. The structural flaws of the Euro and Japan fiscal mess should continue to keep pressure on the value of these currencies.

Physical gold remains the cornerstone of portfolio insurance as a debt and governmentfree store of value. For the more speculative portfolios, a short JPY long physical gold should be considered.

Cash should account for a sizeable portion of the portfolio, and should avoid large bank deposits as the next crisis will witness systemic bank bail-ins rather than bail-outs by the public purse.

Public equity investments remain in a ‘damn if you do, damn if you don’t’ dilemma. On one hand we know that there is a huge and growing gap between valuations and fundamentals; on the other hand we also know that central banks will go to lengths that no one could ever imagine propping up ‘their’ latest bubble, including through the outright buying of equities if they fear deflation (Bank of Japan is today the largest single owner of publicly listed Japanese equities). However, extremely elevated valuations imply mechanically extremely poor long-term returns, so we will err on the side of caution and keep our publicly listed equity exposure lower than we would like.

We will opt instead for illiquid and thus more risky private equity and real estate assets where valuation metrics remain sensible and where we have confidence in the value proposition of the managers. To mitigate the overall portfolio riskiness we would rather keep sizable cash balances (as stated above).

I would like to conclude this musing with the graph of the last 15 year relationship between the much maligned gold price (dark blue line) and the much vaunted S&P 500 price (dotted line).

As can be seen gold, the quintessence of a real unencumbered store of value, remains by far one of the best performing asset in an age of financial repression, and one that is overly justified in this world awash in doubtful debts and colonized by central bankers contemplating helicopter money drops.

Thank you for your patience and enjoy the spring

Franco

April 8th, 2015