I suppose this is my annual warning to long-term investors to tread carefully in the investment markets. 2016 has been a year of rotations with the net composite of a balanced portfolio not moving a whole lot (i.e. things that did well in the first half of the year have done poorly during the second half, since the election stocks are up but bonds are down, etc.). I only see the investment markets becoming more volatile in the years ahead with what looks like some pretty big short-term swings and further rotations. Timely repositioning will be required to manage volatility and capture opportunities that are created.
A speech that William White gave earlier this year titled Ultra-Easy Money: Digging the Hole Deeper? was recently released and it is a must read if you’re looking for a big picture overview of the current global environment. William White currently works for the Economic and Development Review Committee at the OECD in Paris but is best known for his work while the head of the Monetary and Economic Department at the Bank of International Settlements (BIS) from 1994-2008. The BIS is basically the central bank for the world’s central banks, meaning it’s a very important in-the-know organization. Mr White was one of the few people warning about the issues that were building in 2006 and 2007 so people listen when he speaks.
This speech highlights every risk I’ve commented on over the years and sums it all up so eloquently. I highly recommend reading the whole thing (which you can find here) but if you’re short on time, here are some key excerpts:
Commenting on the current global economic climate:
The global situation we face today is arguably more fraught with danger than was the case when the crisis first began. By encouraging still more credit and debt expansion, monetary policy has ‘‘dug the hole deeper.’’ The fundamental analytical mistake has been to model the economy as an understandable and controllable machine rather than as a complex, adaptive system.
On the fragility of the system:
The collapse of the subprime mortgage market in the United States, and the complex financial instruments based on such mortgages, was simply the trigger that revealed a prevailing systemic fragility. The problems have been building over the decades… How did we get into this mess? I want to suggest that monetary policy, guided by flawed theory, has played a big role even if other agents also contributed materially. The flawed theory is, essentially, that growth and job creation deemed to be inadequate are solely due to inadequate demand and that this can always be remedied with expansionary monetary policy…. In the successive cycles noted above, monetary easing generated ‘‘rational exuberance’’ which then slowly and inconspicuously transformed itself into ‘‘irrational exuberance’’; a boom and bust process. This set the scene for the next downturn, the perceived need for still more monetary easing, and the generation of still more imbalances… I would contend that all the relevant policy makers were seduced into inaction by a set of comforting beliefs, all of which we now see were false. Central bankers believed that, if inflation was under control, all was well. As a corollary, in the unlikely case that problems were to emerge, monetary policy could quickly clean up afterwards.
On policy focused on increasing debt:
This suggests that, by following polices that have actively discouraged deleveraging, we may instead have set ourselves up for an even more serious crisis in the future.
On easy-money policies by central banks that due more harm than good in the long run:
It seems possible, even likely, that all of these undesired effects of ultra-easy money have been building up under the surface. There are clearly grounds for believing that monetary policy, both before and since the crisis, has contributed to a reduction in the level of potential or even its growth rate. In fact, both seem to have declined sharply in AMEs in recent years. As Schumpeter might have put it, without destruction there can be no creation. It is a fact that in many countries, the entry of new firms and the exit of old ones has been on a declining trend. Worse, if easy money actually lowers potential growth, and this induces still more easy money, the possibility of a vicious downward spiral is clear… Very easy monetary conditions have encouraged banks to evergreen loans to ‘‘zombie companies,’’ which in turn prey on the otherwise healthy and lower their productivity…
On easy-money policies affecting the investment markets:
Another financial side effect is that the functioning of financial markets seems to have changed for the worse since the crisis began. With monetary policy (especially that of the Fed) seen to be the crucial factor driving all markets, there has been a marked increase in the correlation of returns within and across asset classes. Moreover, as perceptions changed as to whether monetary policy would be effective or not, market reactions have bifurcated. When the mood is positive, financing flows (Risk On) to more risky assets, and when the mood is negative the opposite occurs (Risk Off). This focus of RORO investors, essentially on tail risks, seriously reduces the longer run benefits of diversification and of value investing. A similar set of outcomes will be produced by the recent, massive shift of investors into Exchange Traded Funds (ETF). These financial market trends cannot be good for economic growth over time. As well, the likelihood of sharp swings in the prices of financial assets would also seem enhanced. Against the background of these swings in sentiment, the easy stance of monetary policy might also have contributed to financial market prices getting well ahead of ‘’fundamentals.’’
On market pricing anomalies:
The BIS Annual Report for 2016 also highlights a number of persistent market anomalies. Not only do they indicate price distortions and potential misallocations but could also indicate underlying structural developments whose full implications for market liquidity are not yet obvious. Recall the plight of European banks in 2008 who had borrowed dollars from money market mutual funds in the U.S. When this source of funding dried up, the Federal Reserve was forced to reopen U.S. dollar swap lines that it had closed only a few years earlier. All that can be said with certainty, is that we are in uncharted territory when it comes to market functioning. And for the record, it should be noted that central bank policies might have had other downsides as well. First, with income distribution already a source of great concern (due mainly to changing technology and globalization) the recent stance of monetary policy has likely made it worse. The rich own most of the risky financial assets whose prices have increased the most. Conversely, the middle classes mainly hold the less risky interest-bearing assets whose yields are at record lows.
On the lack of action by governments:
Finally, and perhaps most importantly, what the central banks have done has encouraged governments to believe that the central banks have the economic situation under control. Governments desperately want to believe this since it absolves them from having to pursue other, politically difficult, policies that might in fact lead to stronger and more sustainable growth over time. (emphasis added)
On the coming short-squeeze in the US dollar against Emerging Markets:
Adding to concerns about prospective capital outflows from EMEs must be the nature of the previous inflows. Whereas in earlier years they were adding to concerns about prospective capital outflows from EMEs must be the nature of the previous inflows. Whereas in earlier years they were mostly driven by cross border bank loans, the flows in recent years have been dominated (especially in South East Asia and Latin America) by off-shore issues of EME corporate bonds purchased largely by asset management companies. Since most of these bonds have been denominated in dollars and euros, in response to low interest rates, this raises the specter of currency mismatch problems of the sort seen in the South Eastern Asia crisis of 1997. Recent years have been dominated (especially in South East Asia and Latin America) by off-shore issues of EME corporate bonds purchased largely by asset management companies. Since most of these bonds have been denominated in dollars and euros, in response to low interest rates, this raises the specter of currency mismatch problems of the sort seen in the South Eastern Asia crisis of 1997.
On the growing issues being created by the Fed’s policies affecting the rest of the world and the self-interested responses by other central banks:
…to the degree the Fed still sets global monetary policy, there is a deficiency. The Fed’s policies must, by law, be set with only American interests in mind. Others must then protect themselves as best they can, perhaps by rolling back open markets through intrusive capital controls and macroprudential policies. We clearly need to revisit the issue of the international monetary system and the rules that might govern it. We have no global anchor. Today, absent any rules but domestic self-interest, virtually all central banks (and certainly all the major ones) have the monetary and credit spigots wide open in pursuit of their domestic interests. What this collective monetary experiment might eventually imply at the global level still remains to be seen.
On the need to exit today’s radical monetary policies:
What has been done is totally unprecedented and totally experimental. But there is another no less powerful argument for eventual exit. If the effects on aggregate demand decline with time, while the undesired side effects cumulate with time, at some point these two functions must intersect. At that point, monetary policy would have to be judged to be doing more harm than good. At this due date, ‘‘exit’’ would then be warranted. Finally, and more in keeping with the conventional wisdom, exit would be warranted if there signs of emerging inflationary pressures. This danger seems greater today in the U.S. than elsewhere.
On why exiting these radical monetary policies will likely be delayed:
Exit will also be delayed due to pressure from those benefiting from the status quo. As noted above, debtors are gaining at the expense of creditors, and governments are essentially the biggest debtors of all…. This predicament is increasingly referred to as ‘‘the debt trap.’’ Raising rates is thought not to be an option, but leaving rates low only makes the underlying problem worse.
On potential end-game outcomes (this has been happening since the election, so far):
Were inflation and inflationary expectations to rise in this faster growth scenario, a belated monetary response might lead to recession, as has been common in the post-war period. The risk of such a policy mistake (exiting ‘‘too late’’) is not insignificant…. In this case, sharply higher bond rates and associated financial disruption could also abort the recovery in AMEs, even in the face of further central bank easing to avoid this outcome. Capital outflows from EMEs might lead to the same outcome in their case. Even assuming that inflation and inflationary expectations were not shocked upwards by ever more aggressive monetary easing, we could again face the possibility of a global slowdown given these negative feedback effects…. If there are risks to the optimistic scenario, there are even darker possibilities. The current, relatively slow pattern of global growth could continue or even weaken further. The secular factors suggested by Gordon [2016] could contribute to this, as could the accumulating headwinds of debt. In this case, both policy rates and longer-term risk-free rates would be expected to stay very low. However, in this environment, current equity prices and narrow risk spreads will be increasingly seen as unrealistic. Resulting sharp declines in the prices of such financial assets are likely to catch out many speculators and could, potentially, do further harm to banking systems in countries already affected by the crisis.
On the need to stop “digging the hole deeper” by relying solely on central banks:
…they indicate some of the profound risks we face in relying totally on central banks to restore strong growth. If it succeeds, which is doubtful, it seems unlikely to be either ‘‘balanced or sustainable.’’ If it fails, the vaunted ‘‘credibility’’ of central banks will be destroyed. Indeed there are worrisome signs that this process has already begun. We should be under no illusions as to how hard it will be politically for governments to carry out the policies suggested here, even if the G20 provides an organizing framework for coordinated action. That is why they have come to rely so heavily on central bank stimulus in the first place. As suggested above, absent these government policies that could work, central banks are destined to ‘‘just keep digging.’’ Moreover, as the hole deepens, still broader risks arise. Future economic setbacks tied to ultra-easy money could threaten social and political stability, particularly given the many signs of strain already evident worldwide. In short, the policy stakes are now very high.
Hopefully you can see why I spend so much time focusing on managing risks, have had my clients invested in a very conservative manner for the past year and a half, and I’m now transitioning much more toward short-term, nimble, systematic management strategies. Below is a chart showing how out of whack the net worth of US households has become relative to actual economic growth via asset price inflation. This highlights the amazing, not harmful in any way work of Greenspan and Bernanke, which they then passed off to Janet Yellen to deal with.
I wrote this post because I think we’re at the start of a regime change in markets. That’s not to say that I think markets are going to crash, just that I think investors are going to have to change the way they approach investing and how they structure their portfolios in the years ahead. More on this to come. Be careful out there.
-Nick