Do Backwashes Always Follow Surges?
Could the "great surge" soon succumb to a sizable "backwash"? Anyone familiar with the hydraulics of a tsunami will know that the backwash can be just as dangerous as the original wave ... depending on where you stand. In this allegory, the wave would represent the massive, unprecedented government interventions that have surged into credit markets, bank balance sheets and direct government spending this past year. The "backwash" will happen when the force behind this extraordinary impulse begins to dissipate, collapse upon itself, or, perhaps be withdrawn. But, must this happen?
There now are a lot of portfolio surfers belatedly still trying to catch the wave. As numerous recent investment polls confirm, there has been quite a scramble to get to the front of the surf over the past two months.
Yet, for the time being, a maelstrom of different and opposing forces is battling it out. This is the main reason why we have dubbed the current financial/economic complex as "M&M" — meaning "Murky and Mushy." Frankly, there are so many distortions and influences at work, it's difficult to discern confirmation of a classic, selfsustaining economic recovery. How to separate the effects of one-off interventions from a self-reinforcing investment-led or income led economic recovery?
To better explain our thoughts here, I again resort to some concepts of previous commentaries — the Bungee Chord, the Rocketship and the Tractor Pull Effects. To recall:
#1. The Bungee Cord Effect: This is the elastic "whip effect" that occurs as the supply and production chains begin to back up. As this happens, inventories pile up and manufacturers shut down production and capacity. For a period of time, inventories rise as sales are declining faster than production is being drawn down. All of this sets up a demand shock once orders snap back into line with underlying demand. Then, idled industry capacity and insufficient inventories cause bottlenecks. Normally, it is only after the inventory/sales ratio has declined that the inventory cycle snaps back. Then prices and orders surge. This is now evident only in some sectors.
#2. The Rocketship Effect. Here we refer to government and central bank interventions in two separate orbits: financial circulation and industrial circulation. The effect upon "industrial circulation" is intuitive. Increased government spending (i.e. direct spending) boosts demand and incomes. For a time, this sustains expenditure growth (GDP). However, as in rocketry, once the fuel is spent, the space craft again succumbs to gravity and falls back to earth. The higher the trajectory without settling into a self-sustaining orbit, the steeper the subsequent fall. Here, any demand stimulus can only trigger a long-term fillip if self-sustaining spending is driven by real income growth.
A similar effect is observable in financial markets. There have been a myriad of stimulus and bail-out programs initiated in the U.S. and elsewhere over the past 18 months intended to impact financial circulation (meaning the banking system, the GSA's and insurance companies). Trillions in triage have been marshaled to date in either direct purchases of financial assets or guarantees. Research suggests that much of the improvements in various interest rate spreads are largely instigated by governmentinduced resuscitations. Once these artificial flows are either removed or lessened (and market expectations follow suit), natural demand and risk assessment will need to sustain these yields.
Left to their own, it is doubtful that yield spreads will be sustained given the continuing deterioration in asset quality. In the current environment of deleveraging and consumer balance-sheet restructuring, odds of this occurring anytime soon are slim. In time, more rocket fuel will be needed.
All the Secular Trends (STs, of which we can count at least 10) that blew wind into the sails of the "Greatest Financial Stories Ever Told by Wall Street" during the last five decades have either changed course or have been exhausted. This doesn't seem to have sunk in.
For example, the ST of "financialization" for the Occidental World (the collective for what we call the Schlerotics, representing approximately 50% of world GDP ... see graph on front page) is on the wane ... their financial and economic "trick bags" near empty, save government debt expansion. It is not possible for a secular trend that built to an enormous epochal excess over a period of 5 decades — to many standard deviations above trend — to collapse, and wash-out back to ruddy health in 18 months.
The GFC was a world-changing event, also holding significant geopolitical implications as was long obvious far in advance. After all, it would have been nothing less than dereliction to not have noticed that the massive imbalanced global reserve growth of the past decade, the strange phenomenon of "capital running up-hill" and near-total denial of the non-sustainability of financial and credit market trends.
That some high-income economies again seem to have surfaced above-water recently (the GDP of both Germany and France logged in a growth rate of 0.3% in the second quarter) doesn't really merit much celebration in our view, other than to confirm what should have been expected six months prior. Surely, $5 trillion plus in new government borrowing around the world will buy some improved GDP numbers ... at least for a time ... and better numbers yet.
We do not disagree with the view that the North American economy is planing out. But, that is not the same as expecting a typical post-World War II deep "V" rebound nor denying the odds of a second slowdown. Far from it.
Since late last year, our most probable scenario was the Stop/Go/Stop. It didn't play out exactly as we thought. Yes, there has been a "Go" phase as far as financial markets seem to have discounted. However, the real thing in economic terms has been muted to date. So far, the Bungee and Rocket Ship Effects and have been countered by the Tractor Pull Effect, a concept next explained.
#3. The Tractor Pull Effect. The cumulative weight of debt, economic malinvestment and other hindrances (including regulation, wealth skews and perhaps protectionism) progressively weighs down the sled to the point where no amount of power will propel the sled forward. As in the popular "farmland" sport of tractor pulls, even super-charged tractors come to a stop ... blowing pistons and breaking axles.
There is a lot of cumulative dead weight, debt and leaden financial balance sheets on the trailer that will likely overcome the momentum of one-off "rocket fuel "and sodden "bungee chord" effects. We expect this will become evident by early 2010.
Final conclusions? All in all, the water is again a little too warm and frothy for our risk appetites. We jumped in when the water was still frigid, and risk could be bought cheaply. But now, the beachfront is a little too crowded ... the mood too celebratory on behalf of governments and central bankers. Belatedly, there has been a lot of desperate capital that is trying to catch up to the surf at the front of the wave. They risk being carried out back to sea ... at least in part.
Risk managers will want to readjust their tolerances ... before the water again turns yellowish. In a greater sense, consider that a giant gambit is being wagered worldwide. The greatest interventions ever attempted on a global scale have been conceived to outrun the geometric forces of credit collapse. Will it work? The odds of disappointment are sufficiently high to argue returning to a cautious stance.
Major Current Investment Themes & Key Issues
• Our "Stop/Go/Stop" scenario is unfolding ... but "Go" stage is anemic. Still worried that another "stop" still has significant probabilities.
• The "bungee cord" & "rocket ship launch" effects are now in play ... although mutedly. Attention now to following scenarios required. We consider 5 as odds are shifting.
• Four big questions frame our considerations:
#1. Every crisis has had one or more false dawns. Should one be expected now?
#2. The trend of real estate values remains core issue: Whether bottom near or not is not the germane question.
#3. Will central banks remove the punch bowl? Ultimately, they must. But recovery dependent on more "rocket fuel."
#4. Global reflation is underway. A rising tide is needed to levitate all ships, including real estate. However, the circuit-breakers of currencies, energy prices and bond markets now come to the fore.
• As such, not yet possible to forecast zero probability to a second phase a the GFC.
• At best, post-GFC world will be different ... a view not reflected in current market valuations. Deleveraging on the private balance sheet expected to continue.
• A good crisis wasted? No globally-coordinated policy changes as of yet.
• Signs of financial unfreezing/loosening: Manipulated or real? A mix of both.
• Risk again increasing: Equity markets no longer offer compelling value.
• U.S. dollar decline behind...now to trade in wide range?
Long-term Investment Themes
• Appropriate to view global investment policy through bipolar lenses: The Sclerotic vs. the Growth countries ... moving to multipolarism globally.
• A global "velocity inflation" being attempted.
• Inflation watch: Where will monetary inflation go?
Investment Stance - Key Distinctions
Raising bonds & cash, lowering extreme equity overweight.
Risk Assessment: (Overall Financial Markets) Medium to High.
Dr. Kurt Richebächer Getting His Due: It is nice to see that Kurt Richebächer is getting some recognition these days... but unfortunately, posthumously. He was one of the few voices that cogently and precisely diagnosed the financial lunacy that finally culminated in the full-blown Global Financial Crisis. Thanks to his work, we were well aware that financial systems were on a deadly road.
Just this past week, I was contacted for information by an individual who was editing a piece about Richebächer on Wikipedia.
Also, in a recent paper by Dirk Bezemer of Groningen University, "No One Saw This Coming," Kurt's advance warnings are recognized and documented briefly.
Kurt was a friend. He passed away 2 years ago this month. He was 88. A tragic thing was that he did not live to see his long-running warnings come to be vindicated. Just as he fell ill, events began to cascade into the vicious credit crash that erupted in August of 2007.
That month, we dedicated an issue of the Global Spin to his tribute. It can be found at this link:
This issue's front-page quote was one of Kurt's favorites.
Here is an excerpt from Bezemer's paper.
"Kurt Richebächer (1918-2007) wrote one of the longeststanding investment newsletters, "The Richebächer Letter," which at various times also circulated as "Currencies & Credit Markets." Richebächer was chief economist for Dresdner Bank from 1964 and moved into private consultancy in 1977. He warned against the bubble in technology stocks in the late '90s. After its collapse, he warned against the bubble in housing, writing in September 2001: "the new housing boom is another rapidly inflating asset bubble financed by the same loose money practices that fuelled the stock market bubble." He went on to predict "that the housing bubble - together with the bond and stock bubbles - will invariably implode in the foreseeable future, plunging the U.S. economy into a protracted, deep recession." (Bonner 2007). Writing in 2006, Richebächer held that "the recovery of the U.S. economy since November 2001 has been dominated by an unprecedented consumer borrowing-and-spending- binge. ..."wealth creation" though soaring asset prices has been driven by ultra-cheap and loose money and credit, and not by saving and investment..." Richebächer (2006a:4). Just before the turning of the U.S. housing market in summer 2006, Richebächer (2006a:4) in July 2006 commented that "[t]he one thing that still separates the U.S. economy from economic and financial disaster is rising house prices that apparently justify ever more credit and debt"... "Given this precarious income situation on the one hand and the debt explosion on the other, it will be clear that in the foreseeable future there will be heavy selling of houses, with prices crashing for lack of buyers" (Richebächer, 2006a:11). As this prospect began to materialize in the next month, Richebächer wrote in his August 2006 newsletter that "a recession and bear market in asset prices are inevitable for the U.S. economy. ... This will not be a garden-variety recession, in which monetary easing unleashes pent-up demand, as it used to do in past business cycles". He again emphasized its cause: "the great trouble for the future is that the credit bubble has its other side in exponential debt growth" ... "The U.S. liquidity deluge of the last few years has had one single source: borrowing against rising assets backed by the Fed's monetary looseness... all hinging on further rises in asset prices. But they are going to plunge" (Richebächer, 2006b:1,5,9,11-12). And in September 2006 he wrote hat "housing bubbles, when bursting, generally do considerable damage to the economy. Today, they are bound to do far more damage...." (Richebächer, 2006c:4). The question was not if, but "how fast the U.S. economy and its asset markets will turn down. ... "There is no question that the U.S. housing bubble is finished. All remaining questions pertain solely to speed, depth and duration of the economy's downturn" (Richebächer, 2006c:9).
Paul Volker, former Chairman of the U.S. Federal Reserve and a long-time friend of Richebächer, once remarked that the challenge for modern central bankers "is to prove Kurt Richebächer wrong." Richebächer regarded the expansion of credit under Greenspan as laying the foundation of the worst post-World War II economic contraction. He died on August 24, 2007, two weeks after the events leading up to that contraction began (Bonner, 2007)." (Source: No One Saw This Coming": Understanding Financial Crisis Through Accounting Models. Bezemer, Dirk J, Groningen University.